by Calculated Risk on 4/03/2008 09:52:00 PM

San Francisco Fed President Janet Yellen spoke today: The Financial Markets, Housing, and the Economy. Yellen points out that delinquency are more closely correlated to falling house prices as opposed to interest rate resets:

Much has been made in the news about the role of interest rate resets in causing delinquencies and foreclosures. After all, delinquency rates on variable-rate subprime loans are far higher and are rising much faster than those on fixed-rate subprime mortgages. However, research suggests that this has not been a major factor, at least so far. The vast majority of subprime loans are recent vintages, so only a fraction had hit reset dates as of late 2007. Moreover, in many cases, the initial—or “teaser”—rates were not set that far below the formula, and some of the short-term rates that enter into these formulas have come down since last summer. Moreover, it turns out that variable-rate subprime loans are more likely to become delinquent because the pool of borrowers that took out these loans had higher risk characteristics than those who took out fixed rate loans.

To the extent that the subprime meltdown is tied to declining house prices rather than interest rate resets, other borrowers, including prime borrowers, also could be affected. Indeed, while default rates for the latter loans are lower than for subprime loans, delinquency rates among all categories are highly correlated with house price declines across regions of the country. More formal statistical analysis confirms that differences in house-price change account for most of the regional differences in delinquency rates, whether borrowers are prime or nonprime, or whether loans have fixed or variable rates.

This analysis underscores the importance of house-price movements both to future developments in the housing sector and also to the ultimate magnitude of credit losses that are likely to be realized by leveraged financial institutions on their holdings of mortgage-backed securities and other housing-related loans. Looking ahead, it seems likely that the period of house price declines will not be over very soon, since some models of the fundamental value of houses suggest that prices are still too high, and futures markets for house prices indicate further declines this year. This trajectory of house prices plays a critical role in the economic outlook ...
all emphasis added

Perhaps we could state this simply: "It's the house prices, stupid!"

And a few excerpts on the economic outlook:

It seems likely that residential construction will be a major drag on the overall economy through the end of this year and into 2009.

Until recently, the deflating housing bubble had not spilled over to the rest of the economy. But now it has. Based on monthly data that cover most of the first quarter, it appears that growth in consumption and business investment spending has slowed markedly after years of robust performance, and, as a result, the economy has all but stalled and could contract over the first half of the year.

Containment is lost. Recession!

Note: Yellen is not a voting member of the FOMC this year.