There are signs that the sub-prime collapse is, finally, beginning to stabilize: The rate at which delinquencies are rising has started to flatten, especially on pre-2007 vintages (in part because mortgages that are paid or or houses that are foreclosed on don't count). But now, says Vikas Bajaj at the NYT, a larger wave of prime and Alt-A defaults is likely to take over. If so, this will likely finish blowing many bank balance sheets to smithereens.

Key points

The percentage of mortgages in arrears in the category of loans one rung above subprime, so-called alternative-A mortgages, quadrupled to 12 percent in April from a year earlier. Delinquencies among prime loans, which account for most of the $12 trillion market, doubled to 2.7 percent in that time...

While it is difficult to draw precise parallels among various segments of the mortgage market, the arc of the crisis in subprime loans suggests that the problems in the broader market may not peak for another year or two, analysts said.

Defaults are likely to accelerate because many homeowners’ monthly payments are rising rapidly. The higher bills come as home prices continue to decline and banks tighten their lending standards, making it harder for people to refinance loans or sell their homes. Of particular concern are “alt-A” loans, many of which were made to people with good credit scores without proof of their income or assets.

The cause of the latter, interestingly, is not just the resetting of "teaser" rates. It's the shift from paying interest-only to interest plus principal:

The resetting of rates on adjustable mortgages, which was a big fear of many analysts in 2006 and 2007, has become less problematic because the short-term interest rates to which many of those loans are tied have fallen significantly as the Federal Reserve has lowered rates. The recent federal tax rebates and efforts to modify more loans have also helped somewhat, analysts say.

What will sting borrowers more than rising interest rates, analysts say, is having to pay interest and principal every month after spending several years paying only interest or sometimes even less than that...

But now, some borrowers could see their payments jump 50 percent or more, and they may not be able to sell their properties for as much as they owe.

Prime and alt-A borrowers typically had a five- or seven-year grace period before payments toward principal were required. By contrast, subprime loans had a two-to-three-year introductory period.

All of which is just fabulous news for banks:

Delinquencies in prime and alt-A loans are particularly challenging for banks because they hold more such loans on their books than they do subprime mortgages. Downey Financial, which owns a savings bank that operates in California and Arizona, recently reported that 11.2 percent of its loans were delinquent at the end of June, a big increase from the 6.1 percent that were past due at the end of last year.

The bank’s troubles stem from its $6.2 billion portfolio of so-called option adjustable-rate mortgages, which allow borrowers to pay less than the interest owed on their mortgage in the early years. The unpaid interest is added to the principal due on the loan, so over time borrowers can owe more than the initial loan amount. Eventually, when loans grow by 10 percent or 15 percent, the borrowers are required to start paying both the interest and principal due.

Many borrowers who got these loans during the boom had good credit scores, but many of them owe more than their homes are worth. Analysts believe that many will not be able to or want to make higher payments.

See Also: How to Fix The Housing Market? Start Demolishing Houses