Increased delinquencies on monthly mortgage payments are spreading from the sub-prime market, where home loans were made to borrowers with poor credit ratings, to the prime market, where home loans were made to borrowers with good incomes and sterling credit histories. That’s a bad sign.

COMMENTARY:

The latest bad news on housing reveals that a surprising increase in late loan payments and defaults among home owners with good credit is coming from traditional woes, like divorces, job losses and unexpected medical bills.

But analysts are also saying that the next and biggest wave of problem loans could come as monthly payments soar for both prime and sub-prime borrowers who took out adjustable-rate loans with little or no documentation proving that they had good credit ratings. These non-traditional loans were the only way many borrowers could afford to get into the housing market, as home prices soared over the last decade.

Countrywide Financial Corp., the top U.S. mortgage lender, reported last Tuesday that its second-quarter profit shrank by nearly a third, as falling home prices led to rising delinquencies and mortgage defaults. Countrywide laid part of the blame for the rise in delinquencies on borrowers with good credit who had taken out home equity loans.

And analysts are saying that the trend could continue, particularly in areas of the country that have been hardest hit by job losses or seen a decline in construction that had been driven by real estate speculation, such as South Florida, parts of California, and Las Vegas.

More signs of the housing slowdown surfaced Wednesday, as the National Association of Realtors reported that sales of existing homes fell by 3.8 percent in June to the slowest pace in more than four years.

The mortgage industry anticipates that it could face a rash of defaults in coming months, as many adjustable-rate mortgage loans made in 2005 and 2006, during the height of the housing market frenzy, begin to reset to higher interest rates.

Adjustable-rate mortgage loans were attractive to borrowers, because of their cheaper “teaser” interest rates, but such loans can adjust higher after as little as two years. Even a small percentage increase can translate into a significant monthly payment increase.

The mortgage industry has already started to tighten lending standards, in response to the jump in defaults by sub-prime borrowers. As a result, fewer buyers are entering the market. People who need to sell their homes are now facing falling house prices.

Those aforementioned home equity loans have been helping to fuel much of the consumer spending over the past several years. Falling house prices translate into less equity, which will drive down home equity loan volume. With consumer spending driving 70 percent of economic activity, any falloff in home equity loan volume could push the American economy into recession.

As I write this, the stock market is getting hammered. Why am I not surprised?

Brian Farmer
Brian is a Research Associate of the John Birch Society.