News Analysis: Foreclosures Rise, and Trend May Persist

An increasing body of data show that the foreclosure rate is rising, especially among nonconforming loan products, and at least one analysis suggests the upward momentum is far from over.

A study by First American CoreLogic predicts that 13% of adjustable-rate mortgages originated between 2004 and 2006 will end up in foreclosure as payments reset at higher interest rates.

The study analyzed 8.37 million ARMs valued at $2.2 trillion, predicting that 1.1 million of them will go into foreclosure over a six- to seven-year period. That would mean 13% of the loans, representing $326 billion of debt, would end up in foreclosure. Furthermore, the CoreLogic study predicts that owners, lenders and investors will lose approximately $112 billion after the resale of homes.

Christopher Cagan, author of the study and director of research and analytics at First American, told MSN that the numbers aren't as intimidating in the context of the broader economy as they might seem at first. In fact, he said the housing markets are basically transitioning to more normal conditions. The lenders and borrowers most at risk are the ones who bought property at the peak of the market with little equity and unusual loan terms, he said.

"This is the business cycle. This is not the end of the world," he said. "Basically, we are going back to a normal market, and in normal market conditions riskier investments are riskier than conventional investments, and we are finding that out right now. The people who did stuff at the very top and did the most adventurous or risky loans are the most exposed."

Mr. Cagan anticipates that the effect of payment resets on loans originated during the study period will play out over six to seven years because the loans don't all reset at the same time, and even after a reset occurs, financially stretched borrowers will not automatically default right away. He said that after 2008 the worst of the reset problems should begin to taper off, because lenders have already started to tighten underwriting.

But he does not believe that the anticipated rise in foreclosures will swamp the housing market, noting that annual home sales volume has exceeded six million in recent years. Nationally, a couple hundred thousand more foreclosures "doesn't take over and dominate the market," Mr. Cagan said.

He said the impact of reset-based foreclosures will be greatest on subprime mortgages as well as "teaser-rate" loans with low initial rates, interest-only features or negative-amortization features.

The study predicts that 32% of teaser-rate loans where the homeowner does not have any equity in the property will default.

The actual performance will be affected by future interest rate and home price movements, naturally. FirstAmerican CoreLogic estimates that each 1% fall in home prices would lead to an additional 70,000 ARM reset driven foreclosures. Each 1% gain in home prices would diminish the foreclosure level by 70,000.

And a quarterly delinquency survey conducted by the Mortgage Bankers Association found that late last year the rate of new foreclosure starts reached a record level.

The rate of home loans entering foreclosure rose to 0.54% in the fourth quarter of 2006, a record for the MBA's 35-year-old National Delinquency Survey. It was eight basis points higher than the previous quarter. For subprime credit quality loans, foreclosure starts rose to a rate of 2% in the fourth quarter, meaning one in 50 loans were entering the foreclosure process.

With more than one in every 200 loans overall entering the foreclosure process, it's little wonder that the foreclosure inventory also rose. The percentage of loans at some point in the foreclosure process rose 14 basis points from the third quarter to 1.19% in the fourth quarter. For subprime loans, the foreclosure inventory was 4.53%.

And the wider weakening of credit - overall, 4.95% of home loans were at least 30 days late, up from 4.67% in the third quarter - also was most pronounced among subprime loans and government backed loans.

In a conference call with reporters, MBA chief economist Doug Duncan said the increase in delinquencies was expected. He added that although the economy remains fundamentally sound, slowing home sales and appreciation took a toll on credit quality. And he doesn't see much evidence that the market will turn around until late this year or early next.

He also noted that the seasoning of loans originated in the previous three years, a higher share of adjustable-rate loans outstanding, and a higher share of subprime credits all are primary causes of the increase in delinquencies.

While the rise in foreclosures and losses was significantly higher for subprime loans than for prime loans, he said the market has responded to these problems.

"Credit spreads on lower-rate tranches of subprime securities widened appreciably over the quarter as investors demanded a higher return for exposure to this credit risk," he said.

In both foreclosures and delinquencies, subprime and FHA loans fared the worst, according to the MBA's survey. The FHA delinquency rate rose 66 basis points to end 2006 at a record high of 13.46%, according to the MBA.

The overall delinquency rate on subprime loans rose 77 basis points to 13.33%. For adjustable-rate subprime mortgages, a category that includes pay-option, interest-only and other innovative but risky products, the delinquency rate rose 122 basis points from the third quarter to 14.44% in the fourth.

During this industry downturn, it seems unlikely that rising home prices will bail the industry out of potentially higher defaults. Mr. Duncan said he expects home prices to remain flat over the next couple of years.

The credit deterioration has spread to the jumbo-sized home loan market as well, according to Moody's Investors Service. In January, the rate of serious delinquency on prime securitized jumbo loan pools reached 0.349%, 18% higher than the serious delinquency rate one year earlier, Moody's said.

Snapshot: Predicted ARM Foreclosure Rate

Loan Product Projected Default Rate

Teaser Loans 32%

Subprime ARMs 12%

Market-Rate ARMs 7%

Source: First American CoreLogic. Study projects defaults on ARMs originated from 2004 through 2006 over the next six to seven years.

Credit Deterioration Broadens

Foreclosure Starts

Loan Type 3rd Qtr '06 4th Qtr '06

All Loans 0.46% 0.54%

Subprime 1.82% 2.00%

FHA 0.79% 0.93%

VA 0.32% 0.34%

Prime 0.19% 0.24%

Source: MBA National Delinquency Survey.

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