Fluctuations in delinquency rates are an innate part of subprime lending, and the current numbers do not point to the disaster that some fear, several industry sources said.
Fueled by a red-hot economy and increased competition, subprime lending surged in the late 1990s. Lenders became more aggressive in the lucrative yet competitive market, some observers said, leading to creative underwriting and perhaps looser lending criteria.
Now as the economy cools, these observers say, this lending looks increasingly vulnerable to delinquency, default, and loss.
But other analysts and industry experts are playing down the risk, saying that many factors are causing increased delinquencies. More important, these experts say, though subprime loans do have higher loss rates than prime loans, most active subprime lenders understand how to underwrite and price their products to avoid any problems.
Jonathan E. Gray, an analyst with Sandford C. Bernstein, said that because much of the subprime lending is relatively new, increased defaults could simply reflect a "seasoning" of the portfolios. Mortgage loans - prime or subprime - generally see their highest delinquency rates in the years three to five, the age that many subprime loans are now entering.
Further, Mr. Gray said, just because a mortgage is delinquent does not mean it will result in a loss.
"A lot of the subprime borrowers go in and out of delinquency all the time," he said. "If you miss a payment once every year and a half, on average you've got 6% delinquency. But as long as you're current the next month, it doesn't necessarily produce higher losses."
And though many big players are dipping further into the subprime market - Chase Manhattan Mortgage Corp.'s new chief executive recently gushed over the business' potential - their strength as financial services giants means the risk is not great, sources said.
In addition to Chase, Bank of America, Washington Mutual, Countrywide Credit Industries Inc., and Citigroup Inc., are big players in the subprime market.
"Most of the larger companies have very good asset diversification and should avoid any problems," said Thomas J. Abruzzo, a senior director with Fitch Inc. "They have intentionally been moving down the credit spectrum, but for the big names out there it's not a big percentage of their overall book of business. It's managed to a prudent degree."
Critics have also nervously pointed to rising unemployment claims, which they fear will hit many of the subprime borrowers - and thus the holders of the loans - the hardest.
Those who lose their jobs and have nothing saved are by definition in default, Mr. Gray conceded, but he said as long as the home does not fall in price, the risk of loss remains small. The borrower simply puts the home on the market, sells it, and extracts the equity.
"A precondition for losses on subprime home mortgages is a decline in home prices - and to date, the behavior of prices in most major regional markets has been very healthy," he said. "When you throw people out of work, a rise in delinquencies in pools of mortgages is not at all surprising. But unless it's followed by meaningful declines in home prices, it is by no means clear that we are going to see a rise in actual loss."
On Monday the National Association of Realtors reported its second-quarter metro area home price report, showing increases in most metropolitan areas. On average, median existing-home prices rose 6.4% in the three months, to $146,900, compared with last year. Thirty-four of the 125 areas covered in the report had double-digit increases in median existing-home prices; only five areas posted declines, and those were small.
Moreover, though subprime loans have higher losses, they also fetch higher yields and higher premiums, several sources said.
Luke Hayden, an executive vice president of J.P. Morgan Chase & Co. in New York, said subprime lending "is profitable on a risk-adjusted basis," and that higher revenues come with the higher risk.
"The fact is, the risk comes in clumps," he said. "You have to price risk into your business model, and have to expect that to arise at the most inopportune times."
If a subprime loan produces 30 basis points of loss but provides 50 or 60 basis points of premium, this is not bad news. Most observers agreed that the risk lurking in subprime mortgage portfolios all comes down to the pricing of the loan.
"The bigger focus is whether companies are properly pricing the risk they're taking," Mr. Abruzzo said. "The loans are far more profitable than a traditional prime mortgage loan, and the reason is that there's clearly a lot more risk in these than a prime mortgage."
Charles Coudriet, the chairman of Saxon Mortgage in Glen Allen, Va., said that if the lender underwrites and prices properly, subprime mortgage lending is as safe as consumer lending can get. The key to secure execution of the subprime product is being very careful, spending more time and money, and using high-touch underwriting, he said.
Mr. Gray said, "The issue isn't whether subprime loans produce higher losses, or even substantially higher losses, than prime loans. They do. Everyone knows that or the loans wouldn't be subprime. The question is whether you've priced adequately."
Erick Bergquist contributed to this article.
