See below article by Benjamin Tal (CIBC econominst) regarding the US Sub Prime market
It’s far from over. The news from the US subprime space will get much worse in the coming year, with default rates surging to
unprecedented levels. But what really counts for the market is how much of this bad news is already reflected in current prices. It turns
out that not only did the barrage of negative headlines of recent months raise the level of market immunity to adverse subprime
news, but in fact, even after its recent improvement, the mortgage-backed market is currently pricing in a darker picture than
the one likely to emerge when the smokeclears.
Subprime Defaults—You Ain’t SeenNothing Yet
While the credit squeeze extended well beyond subprime, the reality is that, at its core, this is a subprime crisis. And the news
coming from that space will continue to dominate markets. So let’s see what’s in the pipeline. The process of mortgage rate resets—the catalyst of the subprime meltdown—is far from over. Interest rates on roughly $700 billion worth of mortgages are due to be adjusted upward by the end of 2008. The number of reset ortgages will reach its peak late this year and will start easing slowly during the course of 2008. More than three-quarters of those mortgages are securitized, and more than 70% of them are subprime (Chart 1).
That picture is well understood. But what matters is not just the direction of the default rate, but its ultimate magnitude. There is
enough information in the pipeline to allow us to form an educated guess regarding the likely trajectory of subprime defaults in the
coming years.
Bad Loans Getting Worse
Since the vast majority of the subprime mortgages taken since 2004 were originated with a teaser rate that is fixed for two years,
the mortgages now being reset and those that will be reset in 2008 are the ones that were originated in 2005 and 2006. And as
illustrated in Chart 2, the quality of those mortgages has deteriorated with every passing vintage year. The risk distribution of
adjustable rate mortgages taken in 2006 (to be reset in 2008) is much less favorable than the 2005 vintage which, in turn, is
worse
than the 2004 vintage.
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