The Subprime Meltdown Will Be Nothing Compared To The Prime Meltdown

James Dimon, the chairman and chief executive of JPMorgan Chase, is not optimistic about the mortgage market. He told investors that he expects the losses mortgages given to people with good or excellent credit to be “terrible.” According to the New York Times, “The first wave of Americans to default on their home mortgages appears to be cresting, but a second, far larger one is quickly building.” How can this be?

The trouble stems from the “Alt-A” borrowers and Option-ARM loans. These loans were often issued to borrowers with good credit who were speculating on the housing market or who lacked the proper documentation of income to qualify for a traditional mortgage. Households with prime credit make up the bulk of the mortgage market, and delinquencies are rising fast, particularly in the Alt-A sector. The Times says Alt-A delinquencies quadrupled to 12 percent in April from a year earlier. The credit crunch is, of course, exacerbating the issue, as borrowers are finding it much more difficult to refinance or sell their homes as their monthly payments become unaffordable.

“Subprime was the tip of the iceberg,” said Thomas H. Atteberry, president of First Pacific Advisors, a investment firm in Los Angeles that trades mortgage securities. “Prime will be far bigger in its impact.

What will sting borrowers more than rising interest rates, analysts say, is having to pay interest and principal every month after spending several years paying only interest or sometimes even less than that. Such loan terms were popular during the boom with alt-A and prime borrowers and appeared appealing while home prices were rising and interest rates were low.

But now, some borrowers could see their payments jump 50 percent or more, and they may not be able to sell their properties for as much as they owe.

Although this mortgages sound exotic, the Times says that banks carry many more of them on their books than subprime mortgages. Option-ARM mortgages will prove particularly troublesome to deal with, because its so much more likely that the borrower will owe significantly more than the property is worth. Option-ARM mortgages allow the borrower to pay little or nothing at first — and any unpaid interest is added to the principal due on the loan. This results in a mortgage that grows over time. Eventually, when the borrower owes 10-15% more than the original loan, the payments increase rapidly.

“The wave on the prime side has lagged the wave on the subprime side,” said Rod Dubitsky, head of asset-backed research at Credit Suisse. “The reset of option ARM loans is a big event that will drive the timing of delinquencies.”

Housing Lenders Fear Bigger Wave of Loan Defaults [NYT]
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