Subprime Bubble?

In its latest quarterly analysis of mortgage credit and the housing market, the Federal Deposit Insurance Corporation (FDIC) said there is a perception home prices will plunge nationwide because brisk appreciation in home prices over the past several years has outpaced income growth.

But, since most of the factors affecting home prices are local in nature, the FDIC said a nationwide housing bubble is highly unlikely — even if mortgage rates rise from current lows.

A pair of economists at Fannie Mae recently predicted the 30-year fixed rate will rise to 6.10% by the end of the year.

“However, risks remain in mortgage portfolios dominated by highly-leveraged borrowers with volatile incomes or limited financial reserves,” said the FDIC, an independent agency of the federal government. “Subprime borrowers and homebuyers in high-priced home markets tend to rely heavily on adjustable-rate mortgages, leaving them vulnerable to rising debt service costs once short-term interest rates begin to rise.”

The FDIC pointed out that subprime variable rate borrowers in high priced homes were among the homeowners who recently pushed the nation’s ownership rate to record levels during a time of historically low interest rates — and many were able to obtain a home only through low-down-payment and adjustable-rate mortgages (ARMs).The low rate environment facilitated more than three-quarters of currently outstanding mortgage debt — $6.6 trillion by the third quarter 2003 — to be originated over the past three years, the FDIC said. While mortgage credit quality indicators have shown slight improvement since the 2001 recession — delinquencies on all residential mortgage loans have declined to 4.28% since peaking at 4.83% in the third quarter that year — subprime loans historically have shown default rates ten times greater than prime loans extended to borrowers with solid credit records. High loan-to-value mortgages also show higher default rates, said the agency. Subprime borrowers have recently performed well in the low rate environment. According to the fourth quarter delinquency survey released last week by the Mortgage Bankers Association of America, the delinquency rate on subprime borrowers actually fell 110 basis points to 11.59% — even below the FHA delinquency level, which reportedly rose.

Meanwhile, the popularity of adjustable-rate mortgages in high-priced markets also raises concern. According to the study, ARMs comprised one-fifth of total conventional mortgage originations in 2003, and their share more than doubled from January to December, going from 14% to 32%.

ARMs made up about 28% of all mortgage applications taken last week, according the Mortgage Banker Association’s weekly survey.

The trend, said FDIC, “suggests that at least some homebuyers were stretching to keep their monthly payments manageable in the face of rising home prices.” This is especially true for borrowers in high-priced housing markets such as San Francisco, San Diego, Los Angeles, New York, Boston, Seattle and Denver, where for affordability purposes, borrowers use ARMs more frequently than borrowers elsewhere. Since these places have historically posted some of the widest home price swings, homeowners in these markets are potentially exposed to both rising monthly mortgage payments and falling house prices if interest rates rise.

Although overall mortgage quality has improved somewhat since the 2001 recession, consumer debt has grown rather than deleveraged, said the agency. In just one year ending September 2003, U.S. households acquired nearly $925 billion in debt, an increase of more than 11% — “households have not assumed debt so quickly since the late 1980s.” While the amount of household credit debt is not worrisome in itself, it is the high concentration among high-credit-risk households that poses additional risk to residential lenders. Credit losses may in turn affect nonmortgage consumer lenders if households prioritize paying their mortgage over paying unsecured consumer credit, such as credit cards, said the FDIC.