The worst of the U.S. subprime mortgage meltdown is yet to come, but losses won’t be as high as the markets have already priced-in, CIBC World Markets said today.

While the rate of U.S. mortgage defaults is surging to unprecedented levels, the market has actually overpriced the scope of the problem, it said in a report.

It forecasts the subprime default rate will reach 25%, but says the market has already priced in a rate of about 30%.

“It turns out that not only did the barrage of negative headlines of recent months raise the level of market immunity to adverse subprime news, but in fact, even after its recent improvement, the mortgage-backed market is currently pricing in a darker picture than the one likely to emerge when the smoke clears,” says Benjamin Tal, senior economist.

Roughly US$700 billion of largely subprime mortgages are due to have their rates adjusted upward by the end of 2008. The vast majority were issued in 2005 and 2006 with a two-year discounted teaser interest rate, it said. The quality of the mortgages has declined every year and subprime borrowers are increasingly finding themselves unable to secure refinancing.

The report said the biggest fallout from the crisis is yet to come, since the overall quality of the mortgages written in 2006 and the first half of 2007 are by far the worst yet due to poor underwriting, reduced prepayment activity and weaker home price appreciation. The mortgages also show a significant jump in mortgage fraud.

“Based on recent estimates, as much as 70% of early payment defaults may be linked to misrepresentation of the original loan application,” said Tal. “This is a clear reflection of the deterioration in underwriting standards and passing on the risks seen in 2006 and early 2007.”

Making matters worse, the homes that were financed in 2006 have not appreciated in value; some have declined.

“Given that most of these mortgages were taken with little to no money down, no less than one-quarter of adjustable rate mortgages originated in 2006 are now in a negative equity position. This number is based on a 3% year-over-year drop in house prices. Should there be an additional drop of 10%, the negative equity number will jump to 40%,” CIBC said in a statement.