In the midst of the upheavals surrounding the subprime market a new study has emerged that appears to quantify the problem and, at the same time, offer hope that it isn't as bad as it seems.

Christopher L. Cagan, Ph.D., Director of Research and Analysis of First American CoreLogic recently released Mortgage Payment Reset: The Issue and the Impact. Dr. Cagan utilized two large databases to conduct his study: information on over 32 million single-family homes and condominiums and townhouses in 694 counties and 41 states plus Washington, D.C and including over two thirds of the nation's population; and a database consisting of 25.9 million active first mortgages from all fifty states and the District. Each of these loans was originated between 2004 and 2006 and totaled $5.38 trillion. Both data sets are proprietary to First American and its subsidiaries.

First American claims to be the nation's largest collector and provider of real estate focused public record information, serving more than 600,000 users nationwide. It collects data for its customers on more than 138 million properties annually and on 4.5 million property and mortgage transactions each month; more than 99 percent of all transactions in the U.S.

The study looks at the possible results as adjustable rate loans adjust and payments on those loans reset to long-term levels from several different perspectives.

  • How much will mortgage payments change on a national basis?
  • How will these reset payments impact on homeowner default and foreclosure?
  • When will the impact actually...impact?
  • How will changes in the real estate market mitigate or magnify the impact of mortgage rate resets?
The study analyzed the data using techniques to classify market segments on both a payment and an equity axis. On the payment side loans were quantified as relatively safe or vulnerable under the pressure of mortgage payment reset and according to its initial and fully reset rates to find the proportional increase in monthly payments. Loans were put into a laddered arrangement with adjustments for time and the type of loans. On the equity side a laddered arrangement was established for time and loan type to classify each loan into one of five levels of equity; assigning to each an associated probability of equity risk and level of influence upon possible default. By examining both the risk of reset and the risk of equity Cagan was able to build projections of overall default that arise when borrowers cannot make payments after reset and there is insufficient equity to allow them to sell or refinance the property.

The highest reset impact is among those loans with the lowest initial rates; generally the teaser loans with artificially low initial rates often under 4 percent; even as low as 1 percent. The second greatest impact is with market rate adjustable mortgages. Payment increases in this group can be sizeable, but these borrowers more often have the financial capabilities to survive the impact. Sub-prime loans may have resets that are actually proportionally lower than market rate loans but these borrowers are likely to have fewer financial resources or they would not be in the subprime category in the first place.

Mortgage payments are expected to change by $42 million per year. This amount, however, represents only 0.36 percent of the $12-trillion dollar economy. Thus, reset will not break the national economy but it will affect the subset of loans subject to adjustment.

The study found that the risk of default due to rate reset will result in some 1.1 million foreclosures, but they will be spread out over a total period of six to seven years. This number represents 13 percent of all adjustable-rate mortgages originated for purchase or for refinancing from 2004 to 2006 and will total $326 billion in debt It is further projected that an additional $112 billion will be lost post foreclosure and resale to remaining equity, lenders, and investors, again spread over several years. "These losses represent less than one percent of the total mortgage lending projected for that period. Thus, mortgage payment reset will not break the national economy or the mortgage lending industry."

This impact, however, will not be spread evenly. It will be the teaser-rate and sub-prime mortgages originated in the last three years that will bear the brunt of the reset. These loans will begin the reset processes earlier than market-rate adjustable loans and are more likely to default.

The study projects that 32 percent of teaser loans will default due to reset as will 12 percent of sub-prime loans while only 7 percent of market rate adjustable rate loans will do so.

But these projections of foreclosure are sensitive to changes in home prices. Because the default risk is a combined effect of higher payments and lower equity even a small increase in house prices will lift homes into a positive or near positive equity position and allow potentially defaulting buyers to escape difficulty through refinance or sale. Conversely, a small decrease in housing prices will have the opposite effect, increasing the risk of default. In fact, each one-percent rise in national prices will result in 70,000 fewer homes lost to reset-driven foreclosure while a one-percent fall in prices will cause an additional 70,000 homes to enter foreclosure.

The study also looks at remediation. External remediation such as might come from government or another type of outside intervention is likely to happen only after problems begin to occur. Therefore, regulators, lenders, and investors should be aware that teaser-rate and subprime loans will be the "canary in the coalmine."

Marketplace remediation has, according to the study, already begun. Borrowers are, on their own refinancing out of risky loans and lenders are working with clients to modify or refinance loans to avoid default.

One can assume from the results of the study that rate resets may cause a lot of individual pain and some market discombobulation but that the overall economy is strong enough to withstand the fallout which will represent only a small percentage of the mortgage market.