Subprime. The word itself now breeds thoughts of failure, greed, and stupidity. We all know the story: Mortgage bankers lent money to anyone with a central nervous system; homeowners knowingly lied on their mortgage applications; Wall Street gladly bought it all without asking questions. The result was a trifecta of insanity like never before.
But subprime was 2007 and 2008's crisis. In fact, newly initiated subprime foreclosures actually decreased 16.7% over the past year.
Unfortunately, subprime's decelerating assault has given way to a bigger, badder offender: prime mortgages.
Prime mortgages are just what they seem -- loans made to people with good credit scores, documented income, and down payments. They're held in bulk by banks like Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC), and in crazy amounts by Freddie Mac (NYSE:FRE) and Fannie Mae (NYSE:FNM).
But over the past year, prime mortgage foreclosures have been growing faster than any other mortgage segment. Have a look:
|
Mortgage Type |
Y-O-Y Change
|
Newly Initiated Foreclosures
|
|---|---|---|
|
Prime |
25.6% |
132,730 |
|
Alt-A |
(6.9%) |
56,948 |
|
Subprime |
(16.7%) |
64,628 |
|
Other |
2.5% |
36,614 |
|
Total |
3.8% |
290,920 |
Source: Comptroller of the Currency, Office of Thrift Supervision, June 2009.
Even though the default rate is significantly higher with subprime, the total amount of prime mortgages makes it one of -- if not the -- biggest areas of trouble. One year ago, there were around one-third more seriously delinquent subprime mortgages than prime mortgages. Today, that number has flipped, with seriously delinquent prime mortgages running roughly 38% higher than subprime.
Prime has, in a sense, become the new subprime.
It was bound to happen
What's causing the surge in prime foreclosures? Many things, to be sure, but one of the big ones is what I discussed last week: Homeowners that are underwater, or owe more than their home is worth.
A recent op-ed in the Wall Street Journal elaborates on this. Regression analysis compiled by a University of Texas economics professor shows that being underwater is by far the dominant cause of foreclosure. Factors that assign prime borrower status -- such as credit scores, monthly payments, and income -- aren't nearly as conducive to foreclosure as whether a homeowner owes more than their home is worth. As the article states:
[M]erely because an individual has a home with negative equity does not imply that he or she cannot make mortgage payments so much as it implies that the borrower is more willing to walk away from the loan.
In other words, being "prime" really doesn't matter. If you're underwater, you have an incentive to walk away, regardless of whether you can afford your mortgage payment. Subprime borrowers were jettisoned early from the market because they couldn't afford their monthly payments. Prime borrowers are now defaulting because steadily falling home prices steadily increase their incentive to skip town.
Illusions of a bubble
The crazy giddiness of the real estate boom may also have helped to distort the designation of "prime borrower" status. CNBC's David Faber recently wrote a fantastic book on the housing meltdown that includes a passage from a hedge fund manager who describes exactly that:
Imagine you're a subprime borrower in 2004 and you refinanced your loan in 2005 into a bigger loan so you could cash out some money. So if you cash out and refinance, your credit score goes up because you just paid off a huge loan. So your first loan might have been subprime, but on your next loan you're a prime borrower.
In short, many "prime" borrowers might just be subprimers with inflated credit scores. This is also true for people who used the proceeds from home equity loans on one property as a down payment for another. The big down payment made the borrowers look financially fit, but it was all an illusion that didn't reflect their true creditworthiness. They were simply moving debt from one inflated house to another.
In addition, the housing bubble's income distortion also made millions appear more creditworthy than they really were. According to noted economist Mark Zandi, 23% of all new jobs created during the 2003-2006 recovery were housing-related. This includes everyone from mortgage bankers at Citigroup (NYSE:C) to construction workers at KB Home (NYSE:KBH) to (ostensibly) checkers at Home Depot (NYSE:HD). To some degree, the prosperity of all of these jobs was artificially magnified. In a wildly extreme example, Faber's book describes people who went from delivering pizza to working as mortgage brokers making $20,000 a month. (I'd assume they ultimately wound up in the unemployment line). All of this created a stunning short-term illusion of prosperity that allowed armies of borrowers to qualify as "prime" when they were far, far from it.
All bubbles burst. As the financial blog Calculated Risk regularly puts it, "We're all subprime now."
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