Key elements of recent policy initiatives, such as the revised HARP program and the Fed's "Twist," have focused on either pushing down fixed mortgage rates or taking advantage of their current low levels. In addition to the Fed's actions, many observers have placed a devotional faith in the Fed's ability, as Lawrence Summers wrote in a recent op-ed piece in the Washington Post, to "...support demand and the housing market by again expanding purchases of mortgage-backed securities." However, an underappreciated threat to the mortgage and housing markets is the reliance of many American borrowers on low Libor rates. This means that the Fed and other policymakers must be aware of the vulnerability of the U.S. housing markets to rate spikes resulting from upheavals in the European financial system.

This dependence results from the fact that many borrowers still have adjustable-rate loans linked to either six- or 12-month Libor. While data on the exact composition of the outstanding mortgage market is limited, it's reasonable to believe that somewhere between one-fifth and one-quarter of outstanding loans have adjustable rates, most of which are indexed off Libor. Moreover, many outstanding ARMs are subprime loans with potentially onerous features. While most prime hybrid ARMs were issued with gross margins of 225 basis points over 12-month Libor, subprime loans typically have reset margins of 500-700 basis points. Depending on how "subprime" is defined, I'd estimate that roughly $400 billion in subprime ABS remains outstanding, which equates to more than 2 million loans.

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