A Primer for the Subprime Problem

(page 3 of 3)

From Standard & Poor's RatingsDirect

Consolidation will continue, as the housing markets continue to slow and these lenders sell out to larger companies or close their doors altogether, voluntarily or through bankruptcy (see BusinessWeek.com, 2/19/07, "Out of the Basement for Housing").

What will be the overall effects on big banks?

The financial impact should be minimal. The rated banks' exposure to subprime mortgages is in the range of 9% to 12% of loans held for investment, and typically 10% to 15% of overall loan production. Large financial institutions have the advantages of diversified product portfolios, overall business diversification, and adequate long-term funding, including the access to deposits. Also, several of the larger banks never aggressively pursued the subprime market or aren't in the business, such as Bank of America (BAC).

What are the credit implications of a continuing drop in the growth rate for residential real estate values?

During the next year, mortgage-bank profitability will be under pressure and will undoubtedly see limited growth, given the current negative trends in the mortgage and housing markets. Although these markets are inherently cyclical, the degree of cyclicality is critical to the potential credit exposures embedded in residential mortgage loans. Housing values and market trends are regional and localized, so a lender's geographic diversification clearly benefits credit performance. To date, the region of the country experiencing the most acute housing value decline is the upper Midwest, with Michigan and Ohio among the weaker housing states.

The housing markets are currently experiencing a "correction" of the rapid price appreciation levels experienced during the past three years of record mortgage volumes, which were fueled by historic low mortgage rates. According to the recent Office of Federal Housing Enterprise Oversight House Price Index, home price appreciation slowed to an annualized rate of 1.1% in fourth-quarter 2006, the slowest level since first-quarter 1999. We expect the mortgage-origination market to shrink in 2007, with current estimates indicating mortgage originations for the year will be 5% lower than in 2006.

Wagner is a credit analyst for Standard & Poor's Ratings Services.