2008 Housing: Increased Defaults, Decreased Prices

by: Barry Ritholtz

Front page of the WSJ Saturday morning discussing what readers here will recognize as pretty old news: A boatload of 2/28 APR mortgages are about to reset next year, and it's not going to pretty:

"The subprime mortgage crisis is poised to get much worse.

Next year, interest rates are set to rise -- or "reset" -- on $362 billion worth of adjustable-rate subprime mortgages, according to data calculated by Bank of America Corp.

While many accounts portray resetting rates as the big factor behind the surge in home-loan defaults and foreclosures this year, that isn't quite the case. Many of the subprime mortgages that have driven up the default rate went bad in their first year or so, well before their interest rate had a chance to go higher. Some of these mortgages went to speculators who planned to flip their houses, others to borrowers who had stretched too far to make their payments, and still others had some element of fraud.

Now the real crest of the reset wave is coming, and that promises more pain for borrowers, lenders and Wall Street. Already, many subprime lenders, who focused on people with poor credit, have gone bust. Big banks and investors who made subprime loans or bought securities backed by them are reporting billions of dollars in losses." (emphasis added)

The most interesting issue raised is in the emphasis added above: The entire credit crisis has been precipitated not due to the resetting mortgages, but rather due to the lack of risk management and the poor quality of the loans themselves.

A quote from the article captures this: "The initial wave was largely driven by a higher frequency of fraudulent loans...and loose underwriting."

Here's the really bad news: The projected supply of foreclosed homes is about ~45% of existing home sales -- adding four months to the supply of existing homes. According to Dale Westhoff of Bear Stearns, this is a "fundamental shift" in the housing supply -- and as such, home prices are likely to drop further as lenders dump many repossessed homes.

Foreclosed homes typically sell at a discount of 20% to 25% compared to the sale of an owner-occupied home, analysts say. Lenders are eager to unload the properties, and the homes tend to be in poorer condition.

The question we will find out in 2008 is whether the credit crunch, precipitated by the initial wave of defaults, is going to get that much worse..

Rising Rates to Worsen Subprime Mess
Interest Payments Set To Grow on $362 Billion In Mortgages in 2008
WSJ, November 24, 2007