Crisis in Prime Mortgages on Horizon

This post first appeared on Minyanville and Cirios Real Estate.

The private sector is actively engaging the mortgage crisis with the first broad-based, systemic attempt to prevent foreclosure. Both Bank of America (BAC) and JPMorgan (JPM) are attempting to help hundreds of thousands of troubled homeowners with massive loan modification efforts.

Regulators and bank executives are operating under the assumption that reducing foreclosures will slow record drops in home prices. In turn, this will help stabilize the financial system - and, by extension, the economy as a whole.

This logic isn't necessarily flawed - but it's reactive, rather than proactive, which is what's most needed now.

Most foreclosures are concentrated in regions where homebuilders like Centex (CTX), KB Homes (KBH) and Lennar (LEN) built huge developments, using cheap financing to help fuel speculation and massive over-valuation. These areas, especially those where homes were purchased by lower income buyers, are being decimated by delinquencies and repossessions.

This, however, is widely known. What's less well-understood is the storm that’s brewing on the horizon: Trouble in the prime mortgage market -- where borrowers with good credit are starting to miss payments with alarming frequency -- is looming on the horizon.

Recent delinquency data indicates that while defaults on subprime loans are occurring at a less frenetic pace than in recent months, prime borrowers are starting to feel the pinch. In early September -- before the financial crisis accelerated in October -- the Mortgage Bankers Association released its quarterly delinquency data, concluding,

"The increase in prime ARMs foreclosure starts was greater than the combined increase in fixed-rate and ARM subprime loans. Thus the foreclosure start numbers will likely be increasingly dominated by prime ARM loans."

There is still a vast misconception that only “subprime” people maxed out credit cards, took out loans they couldn’t afford, and were generally reckless with their personal finances.

This couldn’t be further from the truth.

As the economic slowdown swirls outward into the broader economy, cracks are starting to form in established neighborhoods that have thus far experienced minimal home price depreciation. Many of these areas experienced stratospheric appreciation -- just as their subprime neighbors did -- but the strong job and stock markets insulated middle- and upper-middle income homeowners from rising interest payments and the slowing economy.

As mortgage underwriting requirements have tightened in recent months, home buying has slowed in these more well-to-do areas. This trend is being masked by spikes in the distressed sales driving broad housing market indicators.

As layoffs continue, homeowners in these areas will be forced to sell for the first time in years. The illiquidity in these markets means it will take just a few such sales to readjust prices dramatically downward. Homeowners that don’t sell by choice, particularly if they’ve accumulated equity in their homes, are apt to be less picky about their price.

Furthermore, it’s likely the recent onslaught of modification programs, tomorrow’s election, and pundits’ continued obsession to call a bottom in housing will encourage buyers to step back into the market. Increased sales transactions -- even if they continue to be concentrated in distressed areas -- will fuel the perception that the housing market is stabilizing.

This is likely to encourage a fresh round of selling, as anxious homeowners leap to take advantage of “improving” market conditions. This new supply won’t necessarily offset inventory that’s kept off the market by preventing foreclosures on a unit-to-unit basis; instead, the supply will simply crop up in different neighborhoods.

The subprime mortgage crisis may indeed be waning; its final battles are now being aggressively fought in Washington and bank boardrooms across the country. The prime wave, however, is just beginning to crest.