Subprime loans in default well before resetting

Financial planners would generally tell you to avoid the "cross your fingers and hope for the best" variety of financial planning. Now it seems that there are plenty of people who were not able to afford subprime mortgages even from the beginning, as they're defaulting well before the infamous toxic resets we've been hearing about for months.

For months, we've fretted about the Armageddon that will hit when subprime adjustable rate mortgages start resetting to much higher interest rates.

What's happening is even worse: Many of these loans are defaulting well before their rates increase.

Defaults for subprime loans issued in 2007 - none of which have reset yet - hit 11.2 percent in November. That represents perhaps 300,000 households, and is twice the default rate that 2006 loans had 10 months after being issued, according to Friedman, Billings Ramsey analyst Michael Youngblood.

Defaults are spiking well before resets come into play thanks to the lax lending environment of the past few years. Many borrowers were approved for mortgages that they had little chance of affording, even at the low-interest teaser rates ...

Originally, concerns about these loans focused on the fact that that most homeowners wouldn't survive such pricey resets. In late 2006, the Center for Responsible Lending (CRL), predicted that 2.2 million subprime ARM borrowers would lose their homes in the following two years due to reset shock.

But these mortgages were doomed from the start.

For instance, in both 2006 and 2007, well over 40 percent of subprime borrowers were awarded mortgages with either little or no documentation of their ability to pay. With these so-called "liar loans," borrowers did not have to show proof of either earnings or assets.

And even when borrowers did go on the record about their earning power, it didn't bode well. Both 2006 and 2007 saw a large proportion of loans with high debt-to-income ratios (DTI), which indicates the percentage of gross income required to pay debt. In 2007 subprime originations, the DTI hit 42.1 percent, up from 41.1 percent in 2006. Borrowers were simply taking on more debt that they could afford.

What's more, many borrowers started out with low- or no-down payment loans, which left them with almost no equity in their home...

During the boom, rapid price appreciation meant borrowers built up home equity quickly. That minimized defaults, since owners could draw from that equity to pay their bills - including their mortgages - through home equity loans.

But prices fell starting in 2006,leaving borrowers with less home equity to draw upon when they run into financial problems...

Owners with mortgages worth more than their homes simply began walking away from their homes when costs become unmanageable.

By late 2006, lenders knew that the housing market was heading south. Foreclosure filings took off during the third quarter that year, up 43 percent from 12 months earlier, according to RealtyTrac, the online marketer of foreclosure properties. And home prices began to drop.

But instead of cutting back on risky loans, lenders kept lending. Why?

"Because investors continued to buy the loans," said Doug Duncan, chief economist of the Mortgage Bankers Association.

Despite their quality, subprime mortgages were as profitable as any other for lenders like Countrywide (CFC, Fortune 500) and Wells Fargo (WFC, Fortune 500), who were able to quickly securitize the loans and sell them in the secondary market. The loans sold easily because they carried the promise of high yields...

Of course that's a bet that went bad. And it's likely to get worse as resets for ARMs issued in 2006 and 2007 kick in this year.

So what does this all mean in such an important election year? A much stronger likelihood of some type of homeowner bail-out. After all, the unwilling homeless make very cranky voters!