Mortgage Defaults Headed Higher as Rates Rise

Sticker shock is setting in for homeowners with adjustable mortgages. Just how bad will it get for them—and for the banks they owe money to?

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

Matthew Mogul, Associate Editor, The Kiplinger Letter

February 23, 2007

Banks with lots of subprime mortgages face a bumpy ride in the months ahead. With variable loan rates likely to skyrocket for the very borrowers least able to pay more, delinquency rates on subprime loans will rise to as much as 20% by year end, from the current rate of 14%. Delinquencies in the overall market will go up much more modestly, from 4.7% now to 5% by midyear.

Among the banks that could be hurt is HSBC, the world's third-biggest bank by market value, which was forced to set aside an additional $1.76 billion—20% more than what analysts expected—to cover problem subprime loan losses. Other lenders with big subprime exposure are IndyMac Bancorp, Fieldstone Investment Corp., National City Corp., New Century Financial Corp., NovaStar Financial, Washington Mutual and Wells Fargo.

Subprime loans carry higher interest rates than conventional loans to compensate for the greater risk lenders take when they give mortgages to applicants with weak credit ratings. A combination of low interest rates and looser lending standards in recent years has helped subprime loans swell to $1 trillion, accounting for about 10% of all mortgages.

A wave of class-action lawsuits will complicate the picture. A growing number of homeowners holding exotic mortgages, such as interest-only adjustable rate mortgages, will claim they were misled into buying unsuitable mortgages, not fully understanding how high and fast interest rates could jump. Most suits will focus on subprime lenders. Two lenders, Chevy Chase Bank of Maryland and First Horizon Home Loan Corp. of Tennessee, already face suits filed by borrowers.

None of this will trigger a banking crisis, though increasing delinquencies may temper economic growth as they prompt lenders to tighten requirements. Fewer potential buyers could mean a longer convalescence for the slumping housing market, keeping it largely flat well into 2008.

Most banks will easily weather the storm. For one thing, lenders are more diversified than they were in the last major real estate slump, which was 1988-1991. They earn more from fees, from trading stocks and bonds and from selling insurance, so they rely a lot less on mortgages to turn a profit. Several years of record profits have also allowed a good number of banks to build up a cushion of reserves to sustain them during down years.

Another plus: a vibrant secondary mortgage market allows more banks to sell off the riskiest of their home loans to Wall Street firms that slice up and repackage the mortgages into tradable securities. That spreads out loan risk to investors and cuts down the odds that a single lender's failure would be contagious.

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