Housing.

• Author: Fisher, Jeffrey D.

The housing slump that started in 2006 continued to worsen in 2007 as the term "subprime mortgage" entered many people's vocabulary for the first time. A subprime loan is a loan made to someone who does not qualify for a more favorable rate because of low credit scores. These loans have higher interest rates and fees than prime loans and are often issued by mortgage brokers who are not regulated. During the boom in home prices in 2004 and 2005, lenders became increasingly aggressive in making subprime loans and often required little if any documentation of the borrower's income. Of all the mortgage loans made in 2005, 29 percent were subprime loans, up 88 percent from 2004. The loans were often given, at close to 100 percent of the home's value, to borrowers who were stretched to make the monthly payments. As long as home prices were rising, borrowers could refinance the home and take out cash to help cover their mortgage payments. An increasing proportion of the subprime loans issued in recent years were adjustable rate mortgages (ARMs). These loans had an initial "teaser" rate (also called "exploding ARMs")--meaning the rate was artificially low during the initial term of the mortgage but would reset to a higher interest rate even if mortgage interest rates stayed the same.

During 2007, when the rate on these ARMs was due to reset, interest rates had risen. So the interest rate on the loans increased due to both rising mortgage rates and because the initial interest rate was a teaser rate. This resulted in borrowers facing payment shock when their mortgage payments were increased substantially and they could no longer afford the payments. Furthermore, because home prices were no longer appreciating, borrowers could not refinance to help cover their costs. What took credit markets by surprise was the number of borrowers who were caught in this situation and defaulted on their loans. Clouding the outlook is the fact that approximately 2.5 million loans are still set to adjust upward in 2008; thus, the number of foreclosures in 2008 is likely to be very high.

According to RealtyTrac, a company that tracks foreclosures, the number of foreclosures in 2007 will double those in 2006. This pace of foreclosures could continue into 2008 unless lower interest rates help to mitigate the problem (see Figure 1). The foreclosure rate is expected to be 21 percent for loans originated during 2006--when lending standards tended to be the most lax.

As loans...