- The Washington Times - Saturday, August 11, 2007

NEW YORK (Dow Jones/AP) — If you think defaults and delinquencies are high for subprime loans now, wait until the next wave of these loans shifts to higher rates.

Investors in mortgage bonds backed by subprime loans — indeed, investors across all fixed-income asset classes — are already feeling the pain as acute subprime credit troubles have caused a sharp repricing of risk, pushing down prices for all types of bonds except supersafe government securities.

But as high as defaults and delinquencies already are for the subprime loans that cater to borrowers with poor credit histories, they are poised to go much higher still. That’s because subprime adjustable-rate loans taken out in the second half of 2005 are starting to reach the end of their low fixed-rate period — which typically lasts two years — and shift to much higher floating rates.

That shift will cause monthly mortgage payments to rise for already stretched borrowers. And unlike those subprime borrowers who have already seen their mortgage payments rise, this next wave of borrowers will see monthly payments increase at a time when home prices are likely to be lower than they were when these loans were taken out.

With lending standards tightening drastically in recent months, these borrowers will face problems finding a lender to refinance their loans.

In short, going into the second half and especially the fourth quarter of this year — and on into 2008 — the borrowers who face higher payments for subprime adjustable-rate mortgages with two-year fixed-rate periods are going to be people who took those loans out at “exactly the wrong time,” said Karen Weaver, global head of securitization research for Deutsche Bank in New York. And they are “just going to get hammered” between the decline in home prices and the clampdown on credit, she said.

From July until the end of 2007, according to Deutsche Bank research, about $150 billion in subprime ARM loans are due to shift to higher, floating-rate payments. And another $250 billion in loans are due to reset to higher rates in 2008.

For typical adjustable-rate subprime loans, the monthly payment will increase about 35 percent, said Jay Guo, director of asset-backed securities research for Credit Suisse in New York. For example, a borrower whose monthly payment is $1,000 will see that payment increase to $1,350.

That increase is substantial for subprime borrowers, who tend to have lower incomes than prime borrowers and are usually more financially stretched. Typically, 45 percent of a subprime borrower’s pretax income goes toward paying their debts, said Miss Weaver of Deutsche Bank. And that’s at the lower, initially fixed rate of interest.

When the loans adjust, something more like 55 percent of pretax income is going to pay their debts, and “that’s pretty hard to deal with,” she said.

Already, about 14 percent of borrowers who are up-to-date on their mortgage payments just before the rates shift, slip two months (60 days) or more behind on their mortgages over a period of 12 months following the rate adjustment, Credit Suisse’s Mr. Guo said.

“The pain of payment shock is indeed there,” he said, and “will be even more severe” in the future.

So far, subprime borrowers whose rates have adjusted higher this year have, for the most part, at least had the benefit of home price appreciation. That gave them some built-in equity in their homes, so that even if the new payment was too high most could still refinance their loans.

However, those options will diminish for borrowers who took out loans in 2005 or into 2006, when home prices started to fall in many cities, Mr. Guo said. As a result, “the delinquency rate will be much higher.”

In the past, Miss Weaver of Deutsche Bank said, borrowers with these types of adjustable-rate subprime loans with low initial fixed rates used to keep refinancing when the initial fixed-rate period was over. And as long as home prices kept going up, this was not a problem.

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