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The Problem With Falling Home Prices

One of the more grievous missteps in the construction of subprime mortgages was their sensitivity to home prices. In a world where values are always flat or rising -- as was thought to be the case in the U.S. -- this relationship could safely be ignored.

That’s because with the help of an adjustable rate loan, a borrower could buy a home with little or no-money down, and when it came time for the interest rate to reset updward, he could instead refinance into another adjustable rate mortgage and get started on a new set of affordable monthly payments. Rinse and repeat every to two-to-three years.

 From a recent working paper by St. Louis Federal Reserve economist Radeep Sengupta and Vanguard Group economist Geetesh Bhardwaj:

Subprime mortgages were meant to be rolled over and each time the horizon deliberately kept short to limit the lender's exposure to high-risk borrowers.

And surprisingly, a large number of these prepayments (that is, refinancing for the most part) occurred during a rising interest-rate environment:

As much as 83 percent of ... surviving hybrid-ARMs originated in 2003 were prepaid by the end of 2007 [a period in which interest rates rose]. The corresponding percentage for FRMs [fixed rate mortgages] is 63 percent. Significantly, these numbers not only suggest high prepayment rates on all product types but also that the low-interest-rate environment around 2003-2004 did not play a large role in the prepayment behavior of subprime mortgages. Nevertheless, such high prepayment rates raise doubts about the sustainability of this market over a longer period.

Bhardwaj and Sengupta also find some suggestive evidence that the average subprime borrower refinanced because of financial hardship. Tellingly, once home prices started to fall in 2006, mortgage prepayments fell dramatically as well -- which makes sense, since it's tough to pay off an old mortgage with a new one when your house is worth less than the old mortgage. This also meant, and continues to mean, that foreclosures rose.

And while much of the worrying has been over subprime loans, the hemorrhaging in the prime sector from falling home prices has proven to be quite sizable too. Gene Amromin and Anna L. Paulson of the Chicago Fed estimate that the total loss from prime loans will be about $133 billion, compared with the $364 billion in expected losses from subprime defaults.

--Zubin Jelveh