In examining the link between the rate of home price inflation and residential mortgage default rates for subprime loans, Fitch Ratings demonstrates the strong negative correlation between the two. In short, high rates of home price inflation (HPI) helps keep subprime default rates low. Conversely, slow home price growth and home price deflation drives defaults higher as is the case with the 2006 subprime vintage. In California, home prices based on the weighted average of the loans' geographic concentration are relatively flat, growing by a meager 0.2% between 4Q05 and 4Q06.

With stalling home price inflation, borrowers experiencing difficulty making payments are less able to resolve their problems through a profitable sale or refinancing, leading to rising defaults. 2006 vintage mortgage pools were composed of loans that were mostly originated in late 2005 or 2006, when the trend of home price appreciation started to slow down or even reverse. Default rates for the 2006 vintage are significantly higher than those of other vintages with similar age.

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