Our take on the arc of eventual subprime mortgage losses is simple: most estimates, particularly of losses on loans originated in 2006 and 2007, are significantly too high. The reason why they’re too high is simple, too. They assume that last year’s credit performance will persist far into the future. Only it won’t.

Three events in particular sharply skewed subprime credit performance last year. First, the decline in home prices, particularly in the hottest markets, flushed out both the overt and covert speculators. One servicer reports almost 50% of its foreclosures last year were investor-owned properties, though only 16% were listed as investor-owned on the original mortgage application. Once leveraged investors are underwater on their properties, they’re very likely to default quickly. It’s uneconomic to do anything else.

Second, the supply of mortgage credit dramatically tightened. That reduced the refinancing options for borrowers facing sharply higher monthly payments once their teasers reset, and reduced the demand for homes generally.

Finally, the borrowers in 2006 and 2007 who never should have gotten a mortgage of the sizes they did, but could anyway because of lax underwriting, couldn’t refinance their loans, and defaulted.

As a result of these factors, subprime credit quality got bad in a hurry last year, as the rate at which current loans became delinquent ballooned, and the rate at which delinquent loans moved from early-delinquency buckets moved into later-delinquency ones rose sharply.

One-two punch

This one-two punch of a higher inflows and deteriorating roll rates led industry observers, most notably the rating agencies, to dramatically increase their estimates for cumulative losses for loans originated in 2006 and 2007.  I think the agencies significantly overreacted to what happened last year. The monthly reports filed by the companies that service the loans provide support for my view.

 Here’s a quick (and pretty intuitive) summary of how delinquency rates affect eventual losses: when new-delinquency inflows and delinquency roll rates rise, estimates of cumulative losses, particularly for recently originated loans, must rise, as well. They have too. More iffy loans at the front of the pipeline means higher chargeoffs several months down the road.  Similarly, if new delinquency inflows and roll rates are stable, so should estimates of cumulative losses.  But here’s the important part.