From CNN/Money:

Subprime loans defaulting even before resets

For months, we’ve fretted about the Armageddon that will hit when subprime adjustable rate mortgages start resetting to much higher interest rates.

What’s happening is even worse: Many of these loans are defaulting well before their rates increase.

Defaults for subprime loans issued in 2007 - none of which have reset yet - hit 11.2 percent in November. That represents perhaps 300,000 households, and is twice the default rate that 2006 loans had 10 months after being issued, according to Friedman, Billings Ramsey analyst Michael Youngblood.

Defaults are spiking well before resets come into play thanks to the lax lending environment of the past few years. Many borrowers were approved for mortgages that they had little chance of affording, even at the low-interest teaser rates .

“I was rather shocked by the characteristics of the 2007 loans,” said Youngblood.
…
Originally, concerns about these loans focused on the fact that that most homeowners wouldn’t survive such pricey resets. In late 2006, the Center for Responsible Lending (CRL), predicted that 2.2 million subprime ARM borrowers would lose their homes in the following two years due to reset shock.
…
For instance, in both 2006 and 2007, well over 40 percent of subprime borrowers were awarded mortgages with either little or no documentation of their ability to pay. With these so-called “liar loans,” borrowers did not have to show proof of either earnings or assets.

And even when borrowers did go on the record about their earning power, it didn’t bode well. Both 2006 and 2007 ushered in a large proportion of loans with high debt-to-income ratios (DTI), which indicates the percentage of gross income required to pay debt. In 2007 subprime originations, the DTI hit 42.1 percent, up from 41.1 percent in 2006. Borrowers were simply taking on more debt that they could afford.

What’s more, many borrowers started out with low- or no-down payment loans, which left them with almost no equity in their home.

During the boom, rapid price appreciation meant borrowers built up home equity quickly. That minimized defaults, since owners could draw from that equity to pay their bills - including their mortgages - through home equity loans, lines of credit or cash-out refinancings.

But prices fell starting in 2006,leaving borrowers with less home equity to draw upon when they run into financial problems.
…
Owners with mortgages worth more than their homes simply began walking away from their homes when costs become unmanageable.
…
“Lenders felt they had to take the loans to preserve their access [to the rest of the loan pool],” he said. They were willing to accept some risky subprime loans so that the mortgage brokers would also send them safer prime and Alt-A loans.

Of course that’s a bet that went bad. And it’s likely to get worse as resets for ARMs issued in 2006 and 2007 kick in this year.