How bad are defaults likely to get?

The answer is, no one knows, exactly. But they should be worst in 2008, improving thereafter.

The most vulnerable loans are subprime adjustable-rate loans issued with very low teaser rates at the peak of the housing bubble. Typically, those mortgages would reset after two years. Many of those borrowers, who had little-to-no equity in their houses, have just seen their rates reset to much higher levels, and have no hope of refinancing both because of the sharp contraction of credit for subprime borrowers, and because stagnant or falling home values mean that they have no equity to refinance with.

The refinancing problem is why we should see mortgage rates default rates rising even in the higher loan tiers. People in those mortgage classes are less likely to get into trouble because they have taken on wildly excessive financial obligations; when they default, it is almost always because someone has lost a job or the family has suffered some sort of similar financial setback. For the past few years, rising home values have given those people a financial cushion with which to ride out the storm, pushing default levels much lower than normal. That process is now reversing itself, though absent a recession, it's not clear whether the default rate in these classes will really rise higher than historical norms.

The biggest bulge of defaults should come next year, and by late 2008, the banks and the borrowers should know about most of the loans that are going to go bad. A recession would change this, of course--but unless it's deep, not by very much.