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September 16, 2009

The Housing Tsunami's Second Wave
by Richard Benson

Spokesmen for the Obama Administration and the Wall Street establishment refer to the slight up tic in lower-priced housing prices and existing home sales as a positive sign that we're close to a bottom. Why is it, then, that housing prices in the mid to high-end range are still crashing? Indeed, if you close your eyes and listen to the happy talk, you could be swayed into believing that the massive credit losses from housing are coming to an end and economic recovery is finally here. But before singing the chorus to "happy days are here again", you'll need to open your eyes and take a look at some facts and their relationship to mortgage defaults.

The first wave of the mortgage credit tsunami (which actually began around 2005 when loan underwriting started to unravel) was caused by hundreds of billions of sub-prime mortgages that defaulted. These loans were made to unqualified borrowers who couldn't really afford the monthly payments, even if they had a job at the time the loan was made. Because there was so little warning of the approaching tsunami, it took a few more years for the storm to develop but when it did, it bankrupted Bear Stearns and Lehman Brothers and caused the nationalization of Fannie Mae, Freddie Mac, GM and Chrysler. Moreover, the fall in housing prices and the end of consumer refinancing kicked the legs out from under consumer spending, fueling unemployment and a now grim job market. Unfortunately for all, the sub-prime disaster was not the end of the credit crisis in home mortgages, but just the first wave.

The next tidal wave of losses on home mortgages is testament to a failed housing experiment designed by the Federal Reserve under the false pretense of home ownership. In past years, mortgages were issued to responsible homeowners who took pride in home ownership and paid their mortgage on time. But when so many risky mortgage products, such as option ARMS, interest-only loans, cash out REFI's, no money down, etc., became available to practically anyone looking to buy a house, regardless of income, these products became the rage (a 20 percent down payment to bind an owner to a property was so yesterday) and home equity literally vanished.

The assumption that people will continue paying a mortgage without an equity stake in a property worth less than they paid was a false hope. Mortgage losses from sub-prime loans have now spread to Alt-A, Option ARM, and standard prime mortgages. Practically every town, city, and state has been affected in some way by the 16 million homeowners living in homes with negative equity (a home worth less than the mortgage). Buyers of property who experimented and gambled with other people's money have been caught up in an American Dream that has now become their worst nightmare.

Analysts at Deutsch Bank have forecasted that the 30 percent of underwater mortgages today could rise to 48 percent by 2011, so you won't have to look too far to see what will happen to foreclosures and mortgage losses when the number rises to 20 million people. A study done on $1.7 trillion mortgages by Fitch Ratings lays out the cold facts in black and white on how people treat their mortgages:

From 2000 through 2006 when homeowners actually had equity in their homes, and prices were rising, mortgages were paid on time. In this time frame, the mortgage "cure rate" was 19.4 percent on sub-prime loans, 30.2 percent on Alt-A loans, and 45 percent on standard prime loans.

In 2009, when housing prices had crashed and home mortgages were under water, the "cure rate" for prime loans is a pathetic 6.6 percent (barely above the "cure rates of sub-prime at 5.3 percent, and Alt-A at 4.3 percent). No wonder over 50 percent of foreclosures are now on prime mortgages!

The plan by Fannie Mae & and Freddie Mac to refinance loans up to 125 percent LTV is a failure. Very few underwater homeowners are falling for the loan modification government scheme. Even the FHA, which is now making 25 percent or more of all new home loans and will take as little as 3.5 percent as a down payment, has seen late and foreclosed loans jump from about 5 percent last year, to 8 percent today. FHA borrowers generally have lower credit scores, wages, and job skills. Since initial unemployment claims are still averaging 550,000 a week, many of these FHA borrowers will lose their jobs, causing an FHA loan default rate of well over 10 percent.

In today's world, homeowners motivated by cold hard economics and common sense are not stupid. When you don't have any real equity in your house or are underwater and out of work, it's time to mail the house keys back to the government or the bank! Foreclosures are picking up not only because mortgage holders are walking away, but when many people stop paying their mortgage, they also stop paying their property taxes. Local governments everywhere are strapped for cash and are willing to quickly sell tax liens on properties with delinquent taxes due. The buyer of a tax lien has rights to the property that come before that of the mortgage holder so if the mortgage holder doesn't pay the tax lien, they could be wiped out when the holder of the tax lien files to get clear title of the property.

So how big is the next wave in the housing mortgage disaster? Currently, one out of eight mortgages is in foreclosure or paying late, and with unemployment averaging over 9 percent for 2009 and 2010 and peaking in 2011, it's likely one in five mortgages could ultimately default. Moreover, we have seen that less than 7 percent of those mortgages that are late will get cured and stay out of foreclosure. Over the last six months, notices of home foreclosures have been running about 350,000 a month, which is over 4 million a year. A lot of homes are headed to the auction block with their mortgages headed for the shredder.

For mortgage losses we should recognize that prime mortgages on average are significantly larger than sub-prime, and it only stands to reason that the larger the house and mortgage, the bigger the loss. With over 50 percent of mortgages failing coming from prime loans, bigger loan losses lie ahead. The total losses to come is anyone's guess, but the $11 trillion in outstanding home mortgages could easily produce over $2 trillion in defaulted mortgages, and another $600 billion of credit losses! So, until this wave has crashed on the shore, I would recommend staying away from the water!

Richard Benson
Benson's Economic & Market Trends
Specialty Finance Group, LLC

Prior to founding the Specialty Finance Group in 1989, Mr. Benson acted as a trading desk economist for Chase Manhattan Bank in the early 1980's and started in the securitization business in 1983 at Bear Stearns, and helped build the early securitization businesses at Citibank and E.F. Hutton.

Mr. Benson graduated from the University of Wisconsin in 1970 in the Honors Program in Math, and did his doctoral work in Economics at Harvard University. Mr. Benson is a member of the Harvard Club of New York and Palm Beach.

The Specialty Finance Group, LLC is a Florida Limited Liability Company and is registered with the NASD/SIPC as a Broker/Dealer.

Copyright © 2004-2009 Richard Benson

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