Prime Loans Holding Up

Aggregate mortgage defaults are expected to rise to $100 billion in 2007 and $130 billion in 2008 if home prices are flat, according to analysts at Lehman Brothers. Defaults could rise even more if there is a sharp pullback in leveraged lending as mortgage resets reach $900 billion in the two-year period — with $650 billion of this in subprime loans.

In 2005 and 2006, defaults averaged about $40 billion. The $60 billion increase in defaults this year would result in incremental losses of around $25 billion, which would create a “real pain to the system,” the Lehman fixed-income research team lead by Srinivas Modukuri reported.

Although delinquencies have been increasing on prime as well as subprime mortgages, the magnitude of the surge in prime is “benign relative to subprime and previous credit cycles, they noted.

“The credit woes in the subprime market have been fairly contained and prime mortgage credit performance is holding up fine for now,” they stated.

“Actual credit performance of Alt-A, option-ARMs, and jumbo loans has been well behaved,” they pointed out. “Hence we see little evidence that the underwriting-related credit issues of subprime are showing up in prime loans as well.”

Further, these projected defaults are unlikely in themselves to have a significant effect on the economy as a whole, they said.

“For mortgage defaults to become a drag on the overall economy,” they explained, “the projected $100 billion defaults need to be a catalyst for a bigger event. The number in itself is unlikely to do it.”

Still, the risks the defaults pose to the housing industry are high, they warned, explaining that “the repricing of mortgage credit risk could result in the selling of distressed assets, thereby affecting the capital markets through some liquidity mechanisms.”

Another bright spot, according to the team, is that, despite a modest tightening of lending standards, mortgage applications have not declined, rather have remained flat, suggesting that healthier borrowers are returning to the market.

Prepayment speeds, after rising in December and January, are expected to continue slow as they did in February, the Lehman team also maintained.

The team, in a report on MBS, which was issued Monday, said that while there has been a resurgence of volatility mostly from the “subprime shake-up … high quality MBS has benefited so far from a flight to quality.”

The Lehman fixed-income research team, last September, was ranked first in a survey of analysts and portfolio managers conducted by Institutional Investor magazine.

Jerry DeMuth is an award winning journalist who has been reporting for four decades.

e-mail Jerry at demuth933@earthlink.net