Introduction and summary
We have all heard a lot in recent months about the soaring number of defaults among subprime mortgage borrowers; and while concern over this segment of the mortgage market is certainly justified, subprime mortgages account for only about one-quarter of the total outstanding home mortgage debt in the United States. The remaining 75 percent is in prime loans. Unlike subprime loans, prime loans are made to borrowers with good credit, who fully document their income and make traditional down payments. Default rates on prime loans are increasing rapidly, although they remain significantly lower than those on subprime loans. For example, among prime loans made in 2005, 2.2 percent were 60 days or more overdue 12 months after the loan was made (our definition of default). For loans made in 2006, this percentage nearly doubled to 4.2 percent, and for loans made in 2007, it rose by another 20 percent, reaching 4.8 percent. By comparison, the percentage of subprime loans that had defaulted after 12 months was 14.6 percent for loans made in 2005, 20.5 percent for loans made in 2006, and 21.9 percent for loans made in 2007. To put these figures in perspective, among loans originated in 2002 and 2003, the share of prime mortgages that defaulted within 12 months ranged from 1.4 percent to 2.2 percent and the share of defaulting subprime mortgages was less than 7 percent. (1) How do we account for these historically high default rates? How have recent trends in home prices affected mortgage markets? Could contemporary observers have forecasted these high default rates?
Figure 1, panel A summarizes default patterns for prime mortgages; panel B reports similar trends for subprime mortgages. Both use loan-level data from Lender Processing Services (LPS) Applied Analytics. Each line in this figure shows the cumulative default experience for loans originated in a given year as a function of how many months it has been since the loan was made. Several patterns are worth noting. First, the performance of both prime and subprime mortgages has gotten substantially worse, with loans made in 2006 and 2007 defaulting at much higher rates. The default experience among prime loans made in 2004 and 2005 is very similar, but for subprime loans, default rates are higher for loans made in 2005 than in 2004. Default rates among subprime loans are, of course, much higher than default rates among prime loans. However, the deterioration in the performance of prime loans happened more rapidly than it did for subprime loans. For example, the percentage of prime loans that were 60 days or more overdue grew by 95 percent for loans made in 2006 compared with loans made in 2005. Among subprime loans it grew by a relatively modest 53 percent.
Home prices are likely to play an important role in households' ability and desire to honor mortgage commitments. Figure 2 describes trends in home prices from 1987 through 2008 for the ten largest metropolitan statistical areas (MSAs). This figure illustrates the historically high rates of home price growth from 2002 through 2005, as well as the sharp reversal in home prices beginning in 2006. One of the things we consider in this article is whether prime and subprime loans responded similarly to these home price dynamics.
Although the delinquency rate among prime mortgages is high and rising fast, it is only about one-fifth the delinquency rate for subprime mortgages. Unfortunately, however, this does not mean that total losses on prime mortgages will be just one-fifth the losses on subprime mortgages. The prime mortgage market is much larger than the subprime mortgage market, representing about 75 percent of all outstanding mortgages (International Monetary Fund, 2008), or a total of $8.3 trillion. (2) Taking the third quarter of 2008 as the starting point, we estimate that total losses from prime loan defaults will be in the neighborhood of $133 billion and that total losses from subprime loan defaults will be about $364 billion. …