by Calculated Risk on 11/24/2007 01:44:00 PM

The WSJ features a front page story this morning from Ruth Simon: Rising Rates to Worsen Subprime Mess

The subprime mortgage crisis is poised to get much worse.

Next year, interest rates are set to rise -- or "reset" -- on $362 billion worth of adjustable-rate subprime mortgages, according to data calculated by Bank of America Corp.

It is accurate to say the "subprime crisis is poised to get much worse". As is the mortgage crisis in general, including prime loans. As is the housing market crisis. As is the overall credit crisis.

But the WSJ sticks to subprime, as David Einhorn noted:

"Subprime is not about us, for we are not subprime."

This morning I drove through Laguna Beach, a very nice area of southern California. I saw house after house with "For Sale" signs, many with added teasers like "price reduced" or "seller motivated". I guarantee these desperate sellers didn't buy these multi-million dollar homes with subprime loans!

But the WSJ sticks to subprime reporting. Oh well ...

Ms. Simon does catch a glimpse of the real problem when she notes that resets weren't the primary driver for defaults this year:

Many of the subprime mortgages that have driven up the default rate went bad in their first year or so, well before their interest rate had a chance to go higher. Some of these mortgages went to speculators who planned to flip their houses, others to borrowers who had stretched too far to make their payments, and still others had some element of fraud.

Forget flippers and fraud, the real driver for defaults over the next couple of years will be a combination of borrowers who "stretched too far" and falling home prices. Yes, subprime matters, and the coming resets will make the problem worse. But, the problem will be much more widespread than subprime.

Also, the WSJ article mentions a recent Bear Stearns research report:

The projected supply of foreclosed homes is equal to about 45% of existing home sales and could add four months to the supply of existing homes, says Dale Westhoff, a senior managing director at Bear Stearns. This is a "fundamental shift" in the housing supply, says Mr. Westhoff, who believes that home prices will drop further as lenders "mark to market" repossessed homes.

As I noted on Oct 1st, in some neighborhoods of San Diego, a large percentage of homes on the market are already distressed (REOs, or offered as short sales):

I spoke with one of the top agents in San Diego this weekend, and she was analyzing one neighborhood for a client in the $375K to $450K price range. There were 70 listings (very high for that neighborhood and price range), but she was shocked to find that approximately 75% of the listings were short sales, and a similar percentage were vacant.

So I'm not surprised that Bear expects a fairly large percentage of the existing home inventory to be distressed next year, but I'm not sure this will add four months to the overall inventory (as Bear Stearns suggests). As the number of REOs surge, I'd expect some of the less desperate homeowners to take their homes off the market.

Currently the months of supply for existing home inventory is at 10 months. As sales continue to fall, I wouldn't be surprised to see 12 months of inventory next year. Right now I don't expect to see another 4 months of inventory on top of that - but it is possible.