Home Prices and Credit Risk

There is no shortage of news articles stating what seems obvious. For example, the AP reported today that "stagnant home prices are leading more borrowers with patchy credit histories to miss payments on their mortgages." That doesn't come as a big surprise, does it? And guess what loan types are to blame. You guessed it..."subprime"!

The article has some interesting statistics. In 2005, for example, home prices rose an average of 17% and default rates were at only 1.7%. In 2006, however, home prices went flat and defaults exploded...to 8.3%.

So here's the real problem. Many borrowers tapped out their home equity as their home's "value" shot up like a rocket. For borrowers who might have inadvertently (or ignorantly?) wandered into a less-than-desirable subprime loan (or even a plain vanilla ARM or option-ARM), the time to refinance may be right around the corner...but with no equity and no cash to pay the closing fees, what is a borrower to do?

Once again, the domino effect is hitting other areas of the economy. As more buyers default, there will be more foreclosures, which adds to the already-high inventory, which inventory won't sell as quickly because fewer buyers will qualify for the loans to purchase the excess inventory. Builders have been slashing prices (April new home sales supports this) to move inventory, which means someone gets a good deal, but Joe and Sally Buyer who purchased a neighboring property in 2006 are now upside down with their loan! Builders and lenders are laying off folks, which means less income, fewer potential buyers...or...more defaults due to lack of ability to service the loan. Much of this is my own speculation, but does it seem far from reality?

Here's the link to the AP article I referenced: http://www.forbes.com/feeds/ap/2007/05/24/ap3756033.html