RSSAre mortgage holders still underestimating their default losses?
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The end of the first phase means that financial markets are clearly beginning to stabilize and have become less of a day to day problem for consumers and businesses seeking construction or real estate financing. Except for prime conforming mortgages, interest rate spreads over risk free market reference rates are now lower and more stable than during the chaotic period from August to February. This will not hold if mortgage holders have seriously underestimated their default cost. We could face a renewed liquidity crisis with the same negative impact on mortgage access and cost.
Phase two will occur in 2008 and spill over into 2009 as homeowners are actually foreclosed and evicted, walk away, get their lender to agree to a short sale or other concession or have to be expensively pursued to collect past due payments. Estimates of the amount at stake range from $400-800 billion. Hard information on the actual loss to lenders will accumulate gradually but will not be sufficient until the fall to judge if lenders have now seriously underestimated their losses.
We will monitor this closely because both the economic and construction recoveries will have to be postponed if it appears that a serious underestimate is developing. We will also watch data that could give an early signal of later foreclosure costs. This will be updates of the data that lenders used to make their recent estimates of expected losses: existing home prices, real consumer income and job count changes.,/p>
The price index has to be chosen carefully. We use the National Association of Realtors (NAR) price index and the OFHEO repeat sales price index for new mortgages both for a national summary of price changes and to identify local housing markets with stable or rising prices so that new home sales are increasing or soon will be. But the best price index to forecast default losses is the Case-Shiller repeat sales index for major cities. This index has been showing far deeper price cuts because it includes non-conforming and jumbo mortgage where the default risk is higher and also focuses on the local housing markets most at risk for default. The right markets are in this index because it was created to measure price appreciation in the booming markets in 2005-06.
We will look at local market job count changes because the markets with the deepest home price declines are also the markets where the collapse of the housing market has set off the most severe local recessions. Similarly, we will look at local changes in income. Wages, hours, contingent income and small business profits drop parallel to jobs. Also, we will keep tabs on real income changes. The recent burst of inflation is already cutting modest income gains back to negligible real income gains which reduce the ability to make monthly house payments.
There is also a potential serious impact on future default losses from the resetting on monthly mortgage payments for options ARM mortgage. The risk is highest in the same local markets that have the most risk for price drops and job and income losses. An option ARM mortgage gives the homeowner the option each month to either pay a fully amortizing amount or just pay the interest. Unpaid principle is added to the balance. If the interest rate is 6%, approximately 0.5% is added to the sum of unpaid principal each month.Most option contracts require fully amortizing monthly payments when the accumulated unpaid principal reaches 10-15% of the original principal. This typically at least double payments compared to paying interest only.
For a 6%, 20 year, $100,000 mortgage paying interest only will push the unpaid principal to 10% of the original principal in 42 months, soon if any skip payment option is exercised. This means that homeowners that got an option ARM in December 2005 and paid interest only will be forced to switch to a fully amortizing mortgage in May 2008. This problem is now beginning.
More than 25% of recent new and refinanced mortgages in California are option ARMS. The share is more than 20% in Nevada, over 15% in Arizona and over 10% in Florida but only 20% in many coastal resorts. This is where home prices are falling the most and where local economies have the most serious recessions. Many of the homeowners in these states have optioned themselves into a situation where they have little if any equity, can not afford the monthly payments and can not sell the home for enough to repay the mortgage.
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Member Comments
When Mr. Haughey throws out a figure of $400-$800 billion, he seems to be confusing loses with defaults. When a homeowner defaults, the lender usually recovers a large portion of the loan through the sale of the home. For the $800 billion figure to be an actual loss it would require well over a trillion dollars in defaults or the total collapse of the housing market. Nothing happening now would justify either scenario.
