Weak home prices, not rate resets, drive defaults

By Julie Haviv - Analysis

NEW YORK (Reuters) - Stumbling home prices and already heavy monthly payments are a bigger problem for borrowers with adjustable-rate mortgages than the looming rise in the cost of their loans, and it could blunt attempts to ease the strain on homeowners.

With hundreds of billions of dollars of adjustable-rate mortgages, or ARMs, having reset so far in 2007 and almost a trillion dollars expected to adjust to a higher interest rate by the end of 2008, many analysts have pointed to this as the main driver of surging defaults.

But the worst-performing mortgages were made in 2006 and have not yet reset and will not until at least mid-2008.

The larger problem stems from the lax lending standards in 2006, which allowed many borrowers, particularly subprime and "Alt-A" mortgage candidates, to take on too much debt. Many now hold loans with monthly payments they cannot afford.

"While subprime ARM resets get a lot of headlines, that is really not what is causing the huge rise in delinquencies and defaults," said Nicholas Strand, manager within the mortgage strategy group at Barclays Capital in New York.

"People have missed the boat on what is the underlying factor driving delinquencies in the present environment because ARM resets cannot explain the delinquencies that we have seen thus far," he said. "If you look at loan level data, it is really the very highly leveraged borrowers whose default rates have increased over the past year."

Many Washington policy initiatives have been aimed at helping subprime and Alt-A borrowers tackle the "payment shock" when their ARM resets to a higher rate.

Legislative efforts to soften the increase of resets may prove fruitless as many borrowers cannot even meet the payments on below-market teaser rates, let alone higher rates that reflect the risk posed by their credit history.