A second, far larger wave of U.S. mortgage defaults is building
The first wave of Americans to default on their home mortgages appears to be cresting, but a second, far larger one is building with alarming speed.
After two years of upward spiraling defaults, the problems with mortgages made to people with weak, or subprime, credit are showing the first, tentative signs of leveling off.
But with the U.S. economy struggling, homeowners with better credit are now falling behind on their payments in growing numbers. The percentage of mortgages in arrears in the category of loans one rung above subprime, so-called alternative-A, or alt-A, mortgages, quadrupled to 12 percent in April from a year earlier. Delinquencies among prime loans, which account for most of the $12 trillion market, doubled to 2.7 percent in that time.
While it is difficult to draw precise parallels among various segments of the mortgage market, the arc of the crisis in subprime loans suggests that the problems in the broader market may not peak for another year or two, analysts said.
Defaults are likely to accelerate because many homeowners' monthly payments are rising rapidly. The higher bills come as home prices continue to decline and banks are tightening their lending standards, making it harder for people to refinance loans or sell their homes. Of particular concern are alt-A loans, many of which were made to people with good credit scores without proof of their income or assets.
Much will depend on the course of the economy, particularly unemployment. A weaker job market would push more homeowners toward the financial brink. The U.S. Labor Department reported Friday that the unemployment rate climbed to a four-year high in July. Other downbeat reports last week documented another drop in home prices, slower economic growth than expected and a huge loss at General Motors.
"Subprime was the tip of the iceberg," said Thomas Atteberry, president of First Pacific Advisors, a investment firm in Los Angeles that trades mortgage securities. "Prime will be far bigger in its impact."
During a conference call with analysts last month, James Dimon, the chairman and chief executive of JPMorgan Chase, said he expected losses on prime loans at his bank to triple and described the outlook for them as "terrible."
Delinquencies on mortgages tend to peak three to five years after loans are made, said Mark Fleming, the chief economist at First American CoreLogic, a research firm. Not surprisingly, subprime loans from 2005 appear closer to the end than those made in 2007, for which default rates continue to rise steeply.
"We will hit those points in a few years and that will help in many ways," Fleming said, referring to the loans made later in the housing boom. "We just have to survive through this part of the cycle."
Data on securities backed by subprime mortgages show that 8.41 percent of loans from 2005 were delinquent by 90 days or more or in foreclosure in June, up from 8.35 percent in May, according to CreditSights, a research firm with offices in New York and London. By contrast, 16.6 percent of 2007 loans were troubled in June, up from 15.8 percent.
Some of that reflects basic math. Over the years, some loans will be paid off as homeowners sell or refinance, and some will be foreclosed and sold. That reduces the number of loans from those earlier years that could possibly default. Also, since the credit market seized up last year, lenders have become much more conservative and have stopped making most subprime loans and cut back on many other popular mortgages.
The resetting of rates on adjustable mortgages, which was a big fear of many analysts in 2006 and 2007, has become less problematic because the short-term interest rates that many of those loans are tied to have fallen significantly as the Federal Reserve has lowered U.S. rates. The recent U.S. tax rebates and efforts to modify more loans have also helped somewhat, analysts say.
What will sting borrowers more than rising interest rates, analysts say, is having to pay interest and principal every month after spending several years paying only interest or sometimes even less than that. Such loan terms were popular during the boom with alt-A and prime borrowers and made sense while home prices were rising and interest rates were low.
But now, payments could jump 50 percent or more for some borrowers, and they may not be able to sell their properties for as much as they owe.
Prime and alt-A borrowers typically had a five- or seven-year grace period before having to start making payments toward their principal. By contrast, subprime loans had a two- to three-year introductory period. That difference partly explains the lag in delinquencies between the two types of loans, said David Watts, an analyst with CreditSights.
"More delinquencies look like they are on the horizon because so few of them have reset," Watts said about alt-A mortgages.
The wave of foreclosures is still rising in states like California, where more homeowners turned to creative mortgages during the boom. From April to June, mortgage companies filed 121,000 notices of default in California, up nearly 7 percent from the first quarter and more than twice as many as in the second quarter of 2007, according to DataQuick, a real estate data firm. The firm said that the median age of the loans increased to 26 months from 16 months a year earlier.
The mortgage-financing giants Freddie Mac and Fannie Mae, which own or guarantee nearly half of all mortgages, are trying to stem that tide. Last week, the companies said that they would pay more to mortgage-servicing companies that they hire to modify delinquent loans and avoid foreclosures.
Delinquencies in prime and alt-A loans are particularly challenging for banks because they hold more such loans on their books than they do subprime mortgages. Downey Financial, which owns a savings bank that operates in California and Arizona, recently reported that 11.2 percent of its loans were delinquent at the end of June, a big increase from the 6.1 percent that were past due at the end of last year.
The bank's troubles stem from its $6.2 billion portfolio of so-called option adjustable rate mortgages, which allow borrowers to pay less than the interest owed on their mortgage in the early years.
The unpaid interest is added to the principal due on the loan, so over time borrowers can owe more than when they first got the loan. Eventually, when loans grow by 10 percent or 15 percent, the borrowers are required to start paying both the interest and principal due.
Many borrowers who got these loans during the boom had good credit scores, but many of them owe more than their homes are worth. Analysts said they believed that many would not be able to or want to make higher payments.
"The wave on the prime side has lagged the wave on subprime side," said Rod Dubitsky, head of asset-backed research at Credit Suisse. Resetting the option adjustable rate mortgage loans "is a big event that will drive the timing of delinquencies."