|A white paper published by an investment banker refutes the concept that weak underwriting and rising rates are contributing to the higher default rates of recent adjustable-rate subprime originations. Instead, the author suggests local economic conditions and natural disasters are the culprit.
The paper by Michael Youngblood, a research managing director for Friedman, Billings, Ramsey Group Inc. examined the potential reasons why subprime loans originated in 2005 are experiencing higher default rates than loans of the same age originating in the two previous years.
While research showed that the default rate of subprime adjustable-rate mortgage securities originated in 2005 at 20 months of age is lower than average — as it is lower than for loans of the same age originated in 2000 through 2002 and below the average of those originated in 2000 through 2005 — it is 15 percent and 6 percent higher than the default rates of subprime loans of the same age originated in 2003 and 2004, respectively, according to the study.
“Market participants are concerned about the credit performance of adjustable-rate subprime residential mortgage-backed securities originated in 2005,” Youngblood reported. “We cannot accept the popular explanation that the higher default rate reflects the influence of rising short-term interest rates, to which adjustable-rate subprime loans generally are indexed. Nor can we explain the relatively higher default rates of adjustable-rate subprime loans originated in 2005 by reference to the erosion of underwriting criteria.”
About 4 out of 5 subprime loans last year were ARMs, with a great majority being hybrid ARMs. However, only 6 percent of 2005 hybrids adjust at one-year or shorter intervals, compared to 75 percent with a 2/28 term. Hence, most of the ARM subprime loans originated in January 2005 will not reset at the earliest until January 2007, he noted.
Furthermore, the weighted-average mortgage rates in the year ending July 2006 of all subprime ARMs in each of the nation’s 361 metropolitan statistical areas reportedly fell by 35 basis points over the year to 7.12%.
“Therefore, rising short-term interest rates — and the related payment shock of the borrowers — cannot explain the relatively higher default rates of adjustable-rate subprime loans originated in 2005,” Youngblood explained.
The researcher dismissed eroded underwriting as the reason for higher defaults because the salient characteristics of subprime loans — combined loan-to-value ratio, debt-to-income ratio, and credit score — did not diverge last year from long-run averages and because the layering of credit risk occurred in only 2 percent of all subprime loans.
Rather, Youngblood concluded that weak economic conditions in 95 of the 361 metro areas and the ongoing aftermath of Hurricanes Katrina and Rita in Louisiana and Mississippi are to blame for the increase in default rates in the more-recently originated subprime loans.
For example, at least 48 of the 76 metro areas experiencing persistently high subprime default rates depend on employment by automobile manufacturers and related companies, and, in those markets, unemployment rose by 3.7 percent during the year ending in July, compared to a decrease of 3.2 percent nationally, the study said.
In the 13 markets struck hardest by the two hurricanes payroll employment fell by 4.2 percent and unemployment rose by 23.8 percent year over year in July, and subprime default rates soared to 19.11 percent from 9.45 percent, according to the report.
“If we remove these 95 MSAs from the aggregate of all subprime loans, default rates would have increased by 40.4% from 4.16% in July 2005 to 5.84% in July 2006,” Youngblood said. “Therefore, we may attribute the sharp increase year over year in the default rates of subprime loans generally to the outsized increases in the default rates of loans in a minority of MSAs, which are experiencing weak local economic conditions.
“The default rates of adjustable-rate subprime loans originated in 2005 inevitably reflect these conditions.”
So, you’re interested in refinancing your mortgage. Maybe you want some extra capital to do that home project you’ve always dreamed of, interest rates are nearing record lows, or you want to start consolidating debt. Regardless of the motivation behind the refinance,...