Analysts at Standard & Poor’s RatingsDirect say that even if home prices stabilize and the U.S. economy remains strong, the performance of subprime loans originated and resold on the secondary market in 2006 will be the worst in 10 years.

Losses on the 2006 “vintage” of subprime loans securitized on Wall Street are expected to be between 5.25 percent and 7.75 percent, but could be higher if home prices fall dramatically or the country experiences a recession, Standard & Poor’s analysts Michael Stock and Scott Mason said in a March 22 report.

The report concludes that concerns about default rates among recently originated subprime loans is justified, given slowing home-price appreciation and potential fallout from “imprudent underwriting standards” of late 2005 and 2006.

Stock and Mason compared subprime loans securitized last year to the same types of loans made in another challenging year: 2000. With the economy struggling through the aftermath of the dot-com stock market bust and higher unemployment rates, subprime loans originated in 2000 experienced record-setting early payment defaults. But the most recent crop of subprime loans appear to have a 50 percent higher loss probability than those made six years earlier, Stock and Mason conclude.

Although subprime borrowers had better credit scores in 2006 — the average FICO score was 625, compared with 593 in 2000 — that has proved to be less important than higher loan-to-value ratios, reduced documentation, and the increased use of adjustable-rate mortgages.

The average combined loan-to-value ratio climbed from 80 percent to 85 percent between 2000 and 2006, and the percentage of loans relying on limited income documentation nearly tripled, from 28 percent to 77 percent. The percentage of ARM loans in the loan pools analyzed also grew, from 60 percent in 2000 to 83 percent six years later.

The higher concentration of ARM loans in 2006 made borrowers more vulnerable to interest-rate changes. Because interest rates were falling at the beginning of the decade, it was easier for those facing a payment reset to refinance into a new loan.

“The 2006 vintage does not enjoy a similar falling interest and mortgage rate environment, and these loans may remain outstanding longer, therefore exposing (them) to higher losses,” the Standard & Poor’s report concluded.

A March 19 report by First American CoreLogic Inc. predicted 1.1 million foreclosures in the next six to seven years among ARM loans originated between 2004 and 2006. The study estimated that each 1 percent change in home prices could increase or decrease the number of foreclosures by 70,000 homes.

Another dramatic change between 2000 and 2006 uncovered in the Standard & Poor’s report was the number of loans with a simultaneous second lien: 29 percent in 2006, compared with 6.2 percent in 2000. But Stock and Mason concluded that second liens were not tracked as well in 2000, so the historical numbers are probably unrealistically low.

The average loan balance more than doubled between 2000 and 2006, growing from $96,000 to $200,000. That’s partly because home prices shot up, but also because lenders discovered they can actually lose more money on small-balance loans when they default.

Legal fees, eviction costs, insurance and preservation are largely fixed costs regardless of property value, Stock and Mason noted. If a loan servicer loses $10,000 liquidating a property, a $40,000 loan with an 80 percent loan-to-value ratio will cost more in default than a $200,000 loan with a 90 percent LTV ratio, they said. When subprime lenders realized this, they cut back on small-balance loans, including those collateralized by manufactured homes.

Stock and Mason think subprime loans originated in 2006 have several advantages over those issued in 2000. Many of the defaults in the most recent crop of loans have been “partially attributed to fraud, which traditionally has little to no impact on pool performance after the first year,” they note. “Defaults in the 2000 vintage have been largely attributed to borrowers who lacked the sophistication to make mortgage payments on a regular basis, which caused further losses well beyond the first year.”

Unemployment is below 5 percent and economic growth is better than six years ago. Although the jobless rate is higher in the Midwest, loan pools that don’t have high concentrations of loans from that area “should not suffer defaults due to an increase in unemployment,” the report said.

Show Comments Hide Comments
Sign up for Inman’s Morning Headlines
What you need to know to start your day with all the latest industry developments
By submitting your email address, you agree to receive marketing emails from Inman.
Thank you for subscribing to Morning Headlines.
Back to top
Only 3 days left to register for Inman Connect Las Vegas before prices go up! Don't miss the premier event for real estate pros.Register Now ×
Limited Time Offer: Get 1 year of Inman Select for $199SUBSCRIBE×
Log in
If you created your account with Google or Facebook
Don't have an account?
Forgot your password?
No Problem

Simply enter the email address you used to create your account and click "Reset Password". You will receive additional instructions via email.

Forgot your username? If so please contact customer support at (510) 658-9252

Password Reset Confirmation

Password Reset Instructions have been sent to

Subscribe to The Weekender
Get the week's leading headlines delivered straight to your inbox.
Top headlines from around the real estate industry. Breaking news as it happens.
15 stories covering tech, special reports, video and opinion.
Unique features from hacker profiles to portal watch and video interviews.
Unique features from hacker profiles to portal watch and video interviews.
It looks like you’re already a Select Member!
To subscribe to exclusive newsletters, visit your email preferences in the account settings.
Up-to-the-minute news and interviews in your inbox, ticket discounts for Inman events and more
1-Step CheckoutPay with a credit card
By continuing, you agree to Inman’s Terms of Use and Privacy Policy.

You will be charged . Your subscription will automatically renew for on . For more details on our payment terms and how to cancel, click here.

Interested in a group subscription?
Finish setting up your subscription