Last week, former baseball player and steroid expose author Jose Canseco walked away from his home.  On Inside Edition, he said “It didn't make financial sense for me to keep paying a mortgage on a home that was basically owned by someone else."

Like thousands of others, Canseco realized there was no point in paying a mortgage on a property that was underwater.  He might have consulted www.youwalkaway.com, one of many web sites devoted to those caught in the sub-prime crisis.

Phenomena such as this, previously unheard of in American history, are keeping the sub-prime crisis in the headlines.  One of the most frequently discussed topics concerns the stage of the crisis or, given Canseco’s former profession, “what inning are we in?”

We believe we are in the first or second inning.

A Look at the Data

To identify stage of the sub-prime crisis, we begin by looking at the volume of sub-prime loans that have passed their original reset date, and the volume with upcoming resets.  According to First American CoreLogic, who provides mortgage data through their LoanPerformance service, approximately $400 billion of sub-prime mortgages reset in 2007, and another $125 billion reset in the first quarter of 2008. 

There is a 12-15 month lag between the reset date and what the mortgage industry call an “E.O.D.” – event of default.  Thus, defaults for the bulk of the $525 billion of sub-prime loans that have already reset will surface over the remainder of this year.

In addition, See our related articles:
The Size, Scope and Future of the Sub-prime Crisis
Two Forecasts for the Sub-prime Crisis
Will the US Sub-prime Crisis be as Bad as History Suggests? First American confirmed that $264 billion of sub-prime loans will reset in Q2, Q3, and Q4 of 2008.  Another $137 billion will reset in 2009 and beyond.  In total, $925 billion of sub-prime mortgages have or will reset and are potential candidates for default.

A few caveats apply to this data.  First, the 12-15 month lag is a national average, and varies significantly by state and, within state, by metropolitan area.  Second, as Mark Fleming, Chief Economist for First American notes, the reset date is not necessarily the trigger for when a property will default.   Fleming notes that some properties are re-financed before their reset date.  Conversely, once a property goes underwater, the homeowner may not wait for the reset date to walk away.  Lastly, going forward, homeowners will be increasingly exposed to economic risk through job losses and inflation, and this may play a greater role in triggering defaults than the interest rate shock stemming from mortgage resets.

Fleming said the first determinant of whether a house will go into foreclosure is whether there is equity.  “Where there is equity, there is a sale or refinance option,” he said. 

Since the majority of sub-prime mortgages were made with very little equity, and with the continued decline in housing prices (the most recent Case Shiller data showed a 12.7% year-to-year decline through February), we expect very few sub-prime mortgages have equity, and an even smaller number of those that will reset over the remainder of this year and beyond will have equity.

The default rate on sub-prime mortgages stands at 26.6%, up from 11.6% a year ago.  It is reasonable to expect this rate to rise dramatically.  A very conservative estimate would be that a third of the $925 billion problematic sub-prime loans will default.  We believe real estate prices will continue to decline.  For 100 years, until the beginning of this century, home prices tracked inflation.  The housing bubble led to peak values 30% above the trend line of inflation.  An additional 20% correction will be necessary to bring home values in line with historical data.  A 20% decline would put virtually all sub-prime mortgages underwater, and rates of default would be double or triple their current value.

Alt-A and Other Prime Mortgages

Sub-prime mortgages are the most problematic aspect of the mortgage crisis, but they are not the only mortgages subject to default.  We were provided the following data by Credit Suisse, showing the volume of all mortgages scheduled to reset going forward:

The Credit Suisse data shows over $2 trillion in adjustable rate mortgages scheduled to reset, starting in April of 2008, including sub-prime mortgages.  As the volume of sub-prime resets wind down in 2009, a wave of Alt-A mortgage resets emerges, peaking in late 2011.

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