San Diego Housing Market News and Analysis
Guest Commentary: Ramsey on Foreclosure Impact
Submitted by Rich Toscano on February 14, 2007 - 9:53am
My pal Ramsey is a retired real estate broker and grizzled 1990s housing bust veteran. When he's not dragging me to Chinese restaurants on the Department of Health watchlist, he spends his time thinking about how this particular real estate cycle is going to play out, placing a special emphasis on new age lending practices. A couple weeks back Ramsey sent me an excellent (and very long) treatise on foreclosures, which I reproduce in its entirety below.
Foreclosures, Real Estate Financing, and Their Impact to the Real Estate Market
Starting from 2002, every participant in the broad real estate arena has been trained to ignore financing as an integral part of all real estate transactions. It is so easy that it seems anyone who wants a loan can get a loan. No down payment? No credit? No problem.
So where do we go from here? As most of you know, since 1982, my specialty in real estate was foreclosures. I have never seen a cycle like this before so I have no historical comparison to draw from. All I can offer is some thoughts and points to ponder over:
Time has always been kind to owners of real estate as long as they can hold indefinitely. Homeowners who live in the same house and service the same fixed rate mortgage using income from the same jobs can hold indefinitely. To them, the house is a home, a shelter. The utility of the home does not change with the value. The credit bubble has created circumstances for some homeowners that even if they remain employed and live in the same house, their debt service may rise beyond their ability to pay. Furthermore, the size of this credit bubble could trigger systemic failure, far beyond the S&L fiasco of the late 1980s.
2007 will be the year that we find out how strong the US consumers really are. We know with certainty that the builders have too much inventory in both land and specs. We know defaults are escalating and REOs from foreclosures completed a few months ago are just starting to show up as inventory. Without the fuel from the credit bubble, absorbing the estimated 1 million to 1.5 million units of excess inventory is going to be challenging.
I opine that the biggest danger lies in the complacency exhibited by economists, market participants and regulators. It is not whether they are optimistic or pessimistic; it is quite obvious that many have not given the widely available data much thought before jumping to their respective conclusions.
Does anyone have a plan in the event of a hard landing?
The following are my notes and thoughts in support of the aforementioned scenarios. They are in no particular order. Furthermore, I studied in detail two batches of REOs in SD to understand the current timeline, the reasons for default, the disposition and the estimated losses for each property. These are ongoing studies to be completed when the majority of the sample properties are disposed of .
What is different this time?
During a CSFB builders’ symposium last fall, all the old homebuilders were asked this question: What is different this cycle? One after another, the old timers repeated that they did not anticipate how fast this cycle burst, especially when economic conditions were, and still are, considered good, unemployment rate low, job creation relatively strong and interest rate low. You can say the same about the mortgage bubble.
So why is it different this time? All cycles, up or down, are created by demand/supply imbalances. Previous down cycles typically began with economic factors that changed the demand/supply equilibrium, usually on the demand side. For example, during the early 1980’s when Volcker raised rates, it was virtually impossible for buyers to qualify for 13% fixed rate mortgages. When rates came back down, the pent up demand was then responsible for the up cycle until demand/supply reached equilibrium again. Unemployment would be another common reason for down cycles. The unemployed creates a pent up demand which will materialize when employment conditions improve.
This up cycle started when the real estate market was already on an up cycle, with very healthy sales volume and price appreciation. The demand created to drive this up cycle higher was purely artificial, via the credit bubble. The excess supply created to drive this artificial demand is therefore also artificial.
Many believe that because the economy is strong and unemployment rate low, the correction is just a normalizing process. It is entirely possible the reverse is true. It is difficult to envision how the unemployment rate can be lower than the current mid 4% range. If homeowners are losing their homes while they are fully employed, what happens if they start losing their jobs? If we go down from here, as in a hard landing, the remedies are going to be very limited. Mortgage interest rate will not be something that the Federal Reserve has any control over. It will be up to the MBS market.
In the old days, Freddie Mac and Fannie Mae were the two agencies that controlled the secondary markets. The majority of real estate loans are “agency conforming”. Basically, the agencies prescribed a set of underwriting guidelines that all mortgage originators adhered to.
Today, non-traditional mortgages drive the market. The perils are:
Federal and State agencies have issued guidelines. Whether these guidelines have teeth is no long an issue. The market has clearly lost its appetite for these products.
CLTV vs LTV (combined LTV)
It was not until recent months that the average analyst had paid attention to CLTV. Lenders and the mortgage arms of homebuilders had been reporting only the LTV, without disclosing what the actual encumbrances were by not including any junior liens in their reports. My foreclosure study shows that the “C” part of these piggyback CLTV loans is resulting in 100% loss severity for the holders of these liens.
My foreclosure study further demonstrates that 100% of the foreclosures today are in one of more of the aforementioned categories, with piggybacks being the most prevalent reason.
How many piggybacks are out there?
Percentage of Mortgages with Piggyback Loans, Third Quarter 2006
Of the 40% of mortgages with piggyback loans in the United States, 69% have an 80% or higher combined LTV, while 44% have a 95% CLTV or greater.
Quantifying the market’s exposure to subprime loans
Unfortunately, there is no commonly accepted definition of a subprime loan. One researcher may call subprime the loans made to borrowers with a low FICO score while others may include all non-traditional products. With risk layering, it is very easy to double or triple count since they are not mutually exclusive; e.g. could a 80/20 piggyback loan to a low FICO borrower using stated income be counted as three non-traditional mortgages?
I tried to isolate just one component to see if I could get a rough estimate of what a quantifiable consequence may be. In this simple analysis, I took two major subprime lenders – New Century and Novastar, representing the top end and the bottom end originators respectively.
Source: company press releases
This is a distribution of the subprime loans originated. Though the chart is for 2005, 2006 should not be much different. As you can see, New Century and Novastar alone originated almost $100 billion in these so called 2/28 ARMs in the last two years. There are easily over $500 billion of these 2/28s originated during the last 24 months, ticking away like time bombs.
Distribution of Subprime MBS Purchase Loans by Loan Type, 2005
Subprime originators are scrambling to alter underwriting standards to reduce defaults. As a result, many subprime borrowers looking to roll their old 2/28s into new ones find the loan program that they previously qualified under had been eliminated. Without price appreciation, these borrowers are left with few options.
At this writing, the default rate of these 2/28s is spiraling out of control. This is a brand new product that has never been stress tested in previous cycles. We do know that these products had been sold to investors at such narrow spreads which may not accurately and adequately compensate for the risk involved.
Hybrid recast is likely a much bigger problem than subprimes that no one is paying attention to, though hybrid and subprime are not mutually exclusive. While the hybrid recast may not cause a wave of defaults, they will increase household mortgage debt.
Most of the hybrids have a 2.5% interest cap at recast. Since the current fully indexed rate is likely to be at least 2.5% over the rate at origination, I am going to use 2.5% to illustrate the impact. The 3/1 ARMs that originated in 2004 are all facing recast this year.
Original Loan amount - $300,000
Recast interest rate - 6.75% (4.25% + 2.5%)
Principal remaining for originally amortized hybrid - $284,160
Principal remaining for original I/O hybrid - $300,000
After the 3/1 ARMs, the wave of the 5/1 ARMs is coming.
Whether foreclosures will result is not going to change the financial burden of those facing recast. Using the current rates, here are the alternatives in the order of the lowest impact to monthly payments:
Refinance into a new ARM.
As an example, Thornburg Mortgage (TMA) is salivating over the up coming recast. I suppose they are counting on their borrowers having no option but to pay.
This is why refinancing volume is an extremely important indicator; an indicator that is not receiving the deserved attention. With interest rates relatively stable, and higher than a couple of years ago, there should be very little refinancing today. The MBAA refinance application index today should be similar to that of the low points during early 1990s, 1995 and 2000. Yet, as of last week, refinance applications per MBAA are responsible for 47.8% of all applications. Obviously, these were for the purpose of rolling over subprime 2/28 loans, hybrid recasts or just cashing out equity for living expenses. A high refinance volume, especially from ARMs to FRMs, would be a strong indicator that the recast problem is being resolved in an orderly manner. The confirmation would be a stabilization of defaults, if not an outright decline. If the refinance volume does not stay up, that implies borrowers facing recast are forced to pay a much higher rate. Defaults should follow.
MBA Refinance Application Index, January 1990 through Present
This is what happened in 2006 per FreddieMac.
(For those who have access to analysts’ reports, the best and most recent data can be found in Bank of America’s December 15, 2006 – Specialty and Mortgage Finance Weekly by Robert Lacoursiere. It is the only report that I know of which factored out the percentage of homeowners with NO MORTGAGE in the overall analysis.)
Wall Street’s Moral Hazard
Non-traditional mortgages were Wall Street’s money making dream. A year ago, the game plan was still to vertically consolidate so the big firms would own every branch of this money tree. They already controlled the beginning via warehouse lines of credit and the end via the MBS markets. They were in the process of taking over the middle by buying up all the originators and servicers before the loans started to sour.
Wall Street did not realize the moral hazard they created in the process. As long as OPM was used to buy their junk loans, the originators would gladly make those loans, reaping huge profits in the process. Underwriting standards were based on what Wall Street would buy rather than the qualifications of the borrowers. When these loans turned sour, the originators simply closed their doors temporarily , especially when repurchase obligations became too high. If you dig into the background of the executives of Argent, New Century, Option One, Novastar, I am certain you will find previous employment at companies such as Associated First, Conti, South Pacific Fundings, and many other subprime lenders who folded in the 1990s.
This website, though simplifying some things, serves as an excellent illustration of current conditions in the subprime market.
Will it blow up? No one knows. Derivatives are traded in unknown quantities in unclear products. Paper thin margins made enormous profits possible only via huge leveraging. We may see a sequel to LTCM.
Though short sales are commonly attempted, my foreclosure study revealed a major hurdle that would likely prevent them from happening in volume – the piggyback loans. In order for a short sale to happen, the lender has to agree to a lesser amount than the encumbrance. In the event of a piggyback loan, the junior lien holder has no incentive in accommodating the borrower since they are going to suffer a total wipeout anyway. Short sales are overall positive for the market because they would not drive the price as low as a foreclosed REO would. Without a short sale, defaulting borrowers have no choice but to let it go to full foreclosure.
Unfortunately, I know of no good source for timely nationwide foreclosure data. MBAA provides some good data but their report is not only quarterly but about two months after the end of the quarter. By default, Realtytrac may be the best available.
PMI provides a good heads up for the major MSAs via their monthly report.
Regionally, DQN has the best and timeliest.
Source: DQN and Calculated Risk
Locally, I have weekly updates that are 100% accurate but only for San Diego. Though a major MSA, it is not big enough a sample for the nation.
REO study #1 – updated Jan 23, 2007
22 of the 26 REOs have 2nd liens that are totally wiped out – 100% losses . In terms of dollars, the loss amounts to $2,046,500 or $93,000 per property . This loss was already realized the moment the 1st completed foreclosing on their liens.
With only 9 closings, the average loss severity is not very meaningful. It is estimated at 49.4% based on preliminary analysis. This is obviously an on going study that will be updated till the majority of the sample is disposed of.
REO study #2 – updated Jan 23, 2007
22 of the 28 REOs have 2nd liens that are totally wiped out – 100% losses .
With only 1 sale, there not enough data to analyze the loss severity now.
~Active forum topics~