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Fed: Subprime Problems Contained

Fed: Subprime Problems ContainedChicago Federal Reserve releases report

July 2, 2007


A recent report from the Federal Reserve indicates that subprime mortgage problems are limited to less than 8 percent of the total mortgage market — reducing the likelihood that problems will spill over into the rest of the mortgage market.

The problems appear to be limited to adjustable-rate subprime borrowers, according to a letter from the Federal Reserve Bank of Chicago for August 2007. The report was authored by economists Sumit Agarwal and Calvin T. Ho.

“We show that the subprime mortgage market is facing substantial problems, as measured by delinquency rates, while the prime mortgage market is experiencing more typical delinquency rates,” the authors wrote. “Within the subprime mortgage market, we observe a substantial increase in delinquency rates, mostly for adjustable-rate mortgages.”

Prime loans accounted for 80 percent of the $10 trillion mortgage market at the end of last year and Alt-A mortgages represented 5 percent, the report indicated.

Subprime mortgages represent about represented $1.5 trillion of the market, with most subprime mortgages performing well, Agarwal and Ho wrote. ARMs accounted for about half of subprime loans outstanding. Subprime borrowers generally pay 200 to 300 basis points higher than prime rates. In addition, these higher risk borrowers are also subject to more origination fees and prepayment penalties.

ARMs have gone from 11 percent of the prime market in 2001 to 18 percent last December, while the subprime share of ARMs has gone from 28 percent in 1998 to 50 percent in December 2006, the Fed said. While no subprime contagion is apparent, some Midwest states that have shown substantial subprime ARM growth have recently suffered economic slowdowns — with Michigan and Indiana exceeding national delinquency averages.

But weaker economic conditions have emerged along with declining real estate appreciation and rising rates — placing upward pressure on subprime ARM borrowers, the report indicated. As a result, even as prime delinquency has remained near its historical average of around 3 percent, subprime ARM delinquency jumped to 14 percent by the end of last year.

“However, over the same period, the delinquencies for the fixed-rate prime and subprime markets were below their historical highs of 2.5% and 16.6%, respectively, and stayed relatively flat,” the Fed reported. “This suggests that about 7.5% of the overall mortgage market has experienced a significant increase in delinquencies, reducing the likelihood of any spillover effects on the rest of the mortgage market.”

Michigan, which had a subprime share of near 16 percent, ended 2006 with a subprime delinquency rate 21.1 percent, according to the data. Indiana, with an 18 percent subprime share, saw yearend subprime delinquency around 16 percent.

The Fed noted Fannie Mae and Freddie Mac have offered to step in and acquire subprime loans facing resets while Citibank and Bank of American have established a $1 billion fund for borrowers facing foreclosure. States including New York, Ohio and Pennsylvania have or are pursuing similar funds.

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