Light at the End of the Subprime Tunnel

The Mortgage Bankers Assn.'s new numbers are grim, but the group's chief economist says a recovery, though delayed, is in sight

by Peter Coy

The percentage of U.S. mortgages entering the foreclosure process set a record in the second quarter of 2007, even before the late-summer subprime meltdown, the Mortgage Bankers Assn. announced on Sept. 6. The group's chief economist, Douglas Duncan, says the ongoing turmoil in the financial markets will delay the market's eventual recovery by at least a few months.

On the bright side, the mortgage group said, the increase in foreclosures was concentrated in just four states: California, Florida, Nevada, and Arizona. Those states had big shares of adjustable-rate mortgages, high prices, and lots of home purchases by speculators. Excluding them, "we would have seen a drop in the rate of foreclosure filings," Duncan said in a statement accompanying the report. Problems are also severe in the Upper Midwest industrial states of Michigan, Ohio, and Indiana, where manufacturing job losses have damaged the housing market.

Seeing Past the Pain

Nationally, the core of the problem is subprime adjustable-rate mortgages that were originated in 2005 and 2006, when lending standards became extremely lax. But default rates also ticked up for ARM loans issued to prime borrowers—that is, those borrowers considered most likely to repay.

Troubles in subprime grew significantly worse in the months after the April-to-June period that the report covers. Dozens of subprime lenders went out of business and others tightened their lending standards significantly. Making matters worse, home prices have fallen in many areas, wiping out the equity of recent buyers. As a result, many borrowers who ordinarily would have been able to refinance into a lower-interest-rate loan are stuck paying high rates that they may not be able to afford. For people with ARM loans, those rates are resetting upward.

Despite those problems, Duncan took a more positive view of the market than some other economists have taken. He said the recent turmoil (BusinessWeek.com, 8/28/07) is likely to postpone the eventual turnaround of the market by about one quarter. He now thinks the delinquency rate will peak some time between the end of 2007 and the middle of 2008, with the foreclosure rate peaking one to two quarters after that. In an interview, Duncan said, "The longer you see the freeze-up [in the credit markets]… the more likely there will be a delay in the peak."

Richard DeKaser, chief economist of Cleveland-based bank National City (NCC), said in an interview that he roughly agreed with Duncan, predicting that foreclosures will probably peak sometime around the middle of next year. He predicts that prices will hit bottom then as well, dropping by roughly 4% from their peak in the 2007 second quarter as measured by the Office of Federal Housing Enterprise Oversight. That prediction is mild compared to some other forecasts that prices could drop 10% or more, but it is pessimistic by historical standards. Home prices have rarely fallen on a national basis since the Depression of the 1930s.

The Numbers

The Mortgage Bankers quarterly report is chock-full of numbers for types of loans and parts of the country. For example:

• The share of mortgages entering the foreclosure process was 0.65% on a seasonally adjusted basis in the second quarter, surpassing the previous record of 0.58% that was set in the first quarter of 2007.

• In contrast, the total share of homes currently in the foreclosure process did not set a record, although it rose to 1.4% from 1.28% in the first quarter.

• The delinquency rate—meaning the share of mortgages that are at least 30 days past due but not in the foreclosure process—was 5.12%, which was up from 4.84% in the first quarter but did not set a record.

• Among subprime ARM loans, the worst-performing sector, the share of mortgages entering the foreclosure process was 3.84%; the share currently in the foreclosure process was 8.02%; and the delinquency rate was 16.95%.

• At the other extreme, the prime fixed-rate mortgage market has seen almost no deterioration. The share of mortgages entering foreclosure in the second quarter was 0.18%; the share currently in the foreclosure process was 0.41%; and the delinquency rate was 2.25%.

Coy is BusinessWeek's Economics Editor.