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Defaults On Prime Mortgages Spike

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Economic malaise spreading upward.

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Economic data in the past two days supports the view that the American consumer may finally be rolling over.

This morning's non-farm payroll data showed the biggest jump in unemployment since 1986, from 5.1% to 5.5%. While job losses were in line with analysts' expectations, the increase in joblessness caught investors off guard. Yesterday on The Buzz & Banter, Mr. Practical hinted the data would be worse than expected.

As for mounting evidence the economic malaise is spreading up the socio-economic ladder, data released yesterday from the Mortgage Bankers Association shows prime mortgages are following their subprime brethren into the abyss.

According to The Wall Street Journal, 39% of subprime borrowers with adjustable rate mortgages are at least one month past due, while 10% of prime adjustable rate mortgages, or prime ARMs, are late on their payments. Prime defaults, however, are rising more rapidly. Earlier this year I discussed how this trend would lead to the next subprime.

The prime market dwarfs that of subprime loans. While many are looking at Alt-A -- the market between prime and subprime -- as the next shoe, prime is far and away the bigger risk.

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Prime mortgage-backed securities, especially those backed by Fannie Mae (FNM) and Freddie Mac (FRE), are structured to handle very few losses. Even though prime default rates are still much lower than subprime on an abslute basis, deviations from historical trends blow up securities, no just high delinquency rates.

Mathematical models used to create mortgage-backed securities analyze historical data to predict default rates and movements in the prices of homes. Property values have already fallen more than expected, reducing the worth of mortgage-backed bonds. As delinquencies rise relative to historic norms, prime securities will face the same cash shortfalls that have destroyed the value of subprime bonds.

Money center banks like JPMorgan Chase (JPM) and Bank of America (BAC) have thus far skirted many of the same subprime-related losses that ensnared Citigroup (C) and Merrill Lynch (MER). Their focus on borrowers with better credit has helped keep them out of the mire.

As economic conditions worsen and home prices continue to fall, prime securities will become increasingly toxic. The fallout is likely to materialze in 2008 or early 2009, but its a very long train, running down a very steep hill. Investors would be wise to step aside and let it pass.

No positions in stocks mentioned.

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