With subprime mortgage problems continuing to grab headlines, analysts are starting to look at whether subprime woes will spill over and pose systemic risk.
At this point, there is little evidence that the poor performance in subprime has spilled into the prime sector, Lehman Brothers analysts said in a report. While delinquencies have increased, the magnitude of the increase is benign relative to subprime volume and if previous credit cycles are considered, they noted.
The analysts stated that 2006 vintages shouldn't be compared to 2003 and 2004 vintages, for example, as this group has benefited from strong home price appreciation. Lehman analysts believe a better benchmark would be 2000 originations. Under this comparison, Lehman estimated that the 2006 vintage subprime loans to be about 10% worse. They warned, however, that the magnitude of underperformance might actually be higher given the sharp increase in the share of subprime originations.
Analysts projected mortgage defaults of $225 billion in 2007 and 2008. To arrive at this figure, analysts assumed that home prices would remain flat for the next two years, and then gradually converge to a long-term average of 4% annual appreciation by the end of four years. They also assumed a 20% to 25% worse default rate on 2005 and 2006 originations due to lower underwriting standards. Specifically, they projected defaults in 2007 to total $26 billion in prime mortgages and $70 billion in subprime. In 2008, prime defaults are predicted at $32 billion, with subprime increasing to $97 billion.
Although nominally the number is not overwhelming, analysts said that it's the increase in defaults that should be the focus. They estimated actual defaults in 2005 and 2006 averaged about $40 billion. They warned that the, "real pain to the system is incremental defaults of $60 billion resulting in incremental losses of around $25 billion." At the same time, however, in a mortgage market that totals $8.5 trillion and a housing stock valued at $17 trillion, Lehman believes "the incremental defaults seem manageable."
Home price appreciation and ARM resets, analysts said, could make problems in the mortgage sector worse. Regarding ARM resets, analysts are concerned that the magnitude of subprime ARM resets in this year and next could make their default projections too optimistic. They estimated that just over $900 billion in currently outstanding mortgages are subject to resets over the next two years, with subprime's share at $650 billion. This is why it is critical that these borrowers are able to roll into a new mortgage prior to reset.
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