Loan defaults on rise despite uptick

Despite recent signs of economic improvement, defaults are soaring on all kinds of loans to businesses and consumers, including commercial real estate, prime mortgages and credit cards.

These rising defaults are causing deep losses at banks further imperiling the credit system, and have become a major reason - along with high unemployment - why the Federal Reserve is expected to keep interest rates near zero when it meets on Wednesday.

Fed officials have sounded alarms recently about the deepening crisis in commercial real estate: Property prices have fallen by 35 percent and are causing a tidal wave of defaults among businesses, many of which are no longer able to find financing for buildings and projects in credit markets that remain shut to all but top-rated borrowers.

“As the recession’s gotten worse in the last six months or so, we’re seeing increased vacancy, declining rents, falling prices, and so more pressure on commercial real estate,” Federal Reserve Chairman Ben S. Bernanke recently told the Senate Banking Committee, adding that the development merits “very close attention.”

Meanwhile, the mortgage default crisis has spread from subprime loans to prime mortgages in a major way, while defaults on credit cards - a major source of business for banks - have soared to double-digit levels. Nearly one in 10 U.S. homeowners was no longer making mortgage payments in the last quarter, according to the Mortgage Bankers Association. Prime borrowers accounted for the biggest increase in delinquencies.

Fannie Mae and Freddie Mac both reported rising losses last week from sharply increasing defaults and foreclosures on conventional, 30-year loans, which they attributed to rising job losses and falling home prices.

For the first time since the mortgage crisis broke out two years ago, “prime fixed-rate loans now represent the largest share of new foreclosures,” said Jay Brinkmann, chief economist at the mortgage bankers’ group. “This points to the impact of the recession and drops in employment” on the ability of homeowners to keep making payments.

Bank of America, the largest bank in the country, reported its default rate on credit cards jumped to 13.8 percent in June from 12.5 percent in May, while default rates at Citigroup, American Express, Capital One and other major credit card companies were close to 10 percent.

“The biggest bank in America does not expect to collect on almost 14 percent of its credit card loans,” said Bill Hardekopf, author of “The Credit Card Guidebook.” “That is a tremendous loss, and it helps explain why Bank of America is raising rates, increasing balance transfer fees, and switching from fixed to variable rates on a number of their credit cards. They can’t continue to lose money on loans without increasing revenue in a number of ways.”

Credit-card deliquencies usually track the unemployment rate, but this year for many banks they have surpassed the sharp rise in the unemployment rate to 9.4 percent. The surge in unemployment also has become a key reason why otherwise creditworthy homeowners are increasingly defaulting on their mortgages, economists say.

“It does not appear the level of mortgage defaults will begin to fall until after the employment situation begins to improve,” said Mr. Brinkmann. But like the Fed, the mortgage group does not expect unemployment to peak and start heading lower until the middle of next year.

The toxic synergy between rising unemployment and loan delinquencies is a major reason why many economists think the Fed will refrain from raising interest rates any time soon. David Wyss, chief economist at Standard & Poor’s Corp., does not expect the Fed to take any action on rates for more than a year.

“Continued financial turmoil and the weak jobs market likely will keep the Fed on hold through most of 2010,” he said.

Frederick Cannon, equity strategist at Keefe, Bruyette & Woods, said Wall Street investors have gotten a false sense of euphoria out of recent signs of stabilization in home sales and prices, which has prompted them to anticipate an improvement in delinquencies and foreclosures at banks. In the recent strong rally on Wall Street, investors have bid up the prices of bank and financial stocks in a way that may not be entirely justified, he said.

While recent economic reports provide cause for hope that the housing market will slowly mend, “partial truths are hiding some of the challenging issues facing an economy in the aftermath of the financial crisis,” Mr. Cannon said.

Most of the improvement in housing has been at the low-priced end of the market, where a flood of foreclosed properties is making bargains available for first-time homeowners and investors and accounts for half or more of housing sales in many parts of the country, he said. But higher-priced homes remain hard to sell, and their prices are still coming down rapidly.

The reason that all but the low-end housing market remains depressed is that foreclosure sales by banks do not result in trade-up moves up to higher-priced homes by owners of low-priced homes, as normally occurs in a healthy housing market, he said. That reality will continue to put a lid on sales in most of the housing market for some time, he said.

Mr. Cannon expects the reality of rising foreclosures and unemployment - and their effects on the housing market and banks - to eventually sober up the stock market, as well.

“The current rally is likely to fade as the economic rebound turns out to be modest and credit issues linger well into 2010 and beyond,” he said.