I am a big proponent of listening to the people who have been right all along about the housing bubble. One of those people is Laurie Goodman. Yesterday she warned Congress that 1 in 5 homes with a mortgage will default unless dramatic action is taken. And, if home prices fall too much more, the default rate will be even higher.
Her scenario is much more grim than others are painting. Let’s walk through her testimony and data.
One of the trends that we have documented is a very significant supply/demand imbalance in the housing market. Distressed loans are moving very slowly through the delinquency/foreclosure pipeline. These loans weigh heavily on the residential real estate market, and are often referred to as shadow inventory. In addition, many of the borrowers that are not delinquent on their loans have a tainted credit history and/or are seriously underwater, suggesting more defaults to come. Thus, there are many distressed homes that will need to change hands over the next 5–6 years. At the same time, mortgages are becoming increasingly difficult to obtain. Overall credit availability is tightening and the pool of qualified mortgage applicants is shrinking dramatically. A large number of borrowers who are delinquent on their current mortgage, and do not have the financial means to purchase another home, are likely to convert to renters. Despite this cloud surrounding the mortgage market, we see housing as very affordable by most traditional measures.
Given this backdrop, we believe that long-term investors in 1–4 family residential real estate are the key to a housing recovery: they are the only potential buyers of many distressed homes that are likely to hit the market over the next 5–6 years. Investors need to be part of the solution.
One of her key themes is that investors need to be a part of the solution and that they government needs to enact policy to get them more involved.
Many analysts looking at the housing problem mistakenly assume it is limited to loans that are currently non-performing (we use 60+ days past due as our definition of non-performing). Such borrowers have a high probability of eventually losing their homes. However, the problem also includes loans with a compromised pay history; these are re-defaulting at a rapid rate. We define these re-performers as loans that were at one point 60+ days delinquent, but no longer are.
Moreover, borrowers with good pay histories who are substantially underwater have shown that they, too, have a reasonable probability of transitioning to default (going 60+ days delinquent). Let’s review the scope of the housing problem. An understanding of this will allow market participants and policy makers to put our supply/demand imbalance numbers in perspective.
In Exhibit 1 (below) we have outlined our methodology for estimating the total supply of homes which may be subject to distressed sales over time. We show both a number we view as reasonable as well as a “lower bound” estimate. To derive these results, we classify the outstanding loans into five groups. In total, we estimate that there are approximately 80 million homes in the US, 55 million of which have a mortgage. Of these 55 million mortgages, there are 4.5 million non-performing loans (NPLs), 3.9 million re-performing loans, 2.6 million always performing loans with a mark-to-market LTV (loan-to-value) ratio >120, 5.4 million always performing loans with a mark-to-market LTV of 100-120, and 38.6 million always performing loans with a mark-to-market LTV of 100. To size the problem, we focused on the eventual default rate of each group of loans. Our methodology is detailed in the Appendix.
Our results indicate if no changes in policy are made, 10.4 million additional borrowers are likely to default under our base “reasonable” case, and 8.3 million borrowers will default under our lower bound numbers. Since there are 55 million homes carrying mortgages, 10.4 million borrowers roughly equates to 1 borrower out of every 5. This includes 4.1 million of the 4.5 million borrowers who are already non-performing; the remainder of defaults will come from borrowers current on their loans, but who are likely to eventually default. Many in this group (2.5 million) represent re-performing loans that history suggests are very prone to another default.
She believes that we have enough re-default and walk-away data to forecast the percentages of these borrowers who will lose their homes down the road. While the percentages are certainly an estimation, it makes perfectly logical sense that these percentages are in the right ballpark.
Here is Exhibit 1:
(click for a bigger view)
She figures that there will be about 10.4 million more foreclosed homes over the next 5-6 years. She assumes:
- 90% of the existing non-performing loans will eventually end in foreclosure
- 65% of the re-performing loans will end up in foreclosure (these are loans that have been modified).
- 40% of loans with 120% or more LTV will default
- 15% of loans with 100-120% LTV will default
- 5% of loans with less than 100% LTV will eventually default
Assumes no change in overall housing prices, interest rates,
or new home construction
However, the (housing) overhang means that home prices, despite being very affordable, are likely to decline further. This may recreate the housing death spiral—as lower housing prices mean more borrowers become underwater. We have determined LTV is the single most important predictor of default. So more underwater borrowers means more defaults; more defaults means more inventory, more overhang, and even further declines in home prices. While home prices can go down another 5% without re-igniting this housing death spiral, a 10% decline would certainly re-ignite the spiral in our opinion.
This “death spiral” is the doomsday scenario that Ben Bernanke and crew are doing everything they can to avoid. But Case-Shiller home prices are already declining at a healthy clip – how far away is that “death spiral” really?
Prices, of course, are a function of supply and demand. We have plenty of supply. Our problem is a lack of demand. Here, Laurie offers quite a bit of interesting data:
Household formation has been very low in recent years. Census data (The Current Population Survey/Annual Social and Economic Supplement) indicates that the rate of household formation from 2007–2010 is about 500,000 units. This is very low by historical measures. The average rate of household formation for the period 2000–2010 was 1.3 million units per year. It was 1.0 million units per year during the 1990s. We assume a more normal household formation rate of 1.2 million units annually. The Joint Center for Housing Studies of Harvard University in their State of the Nation’s Housing, 2011, has estimated that out of the nearly 12 million units of expected household formation over the 2010–2020 period, 7 out of 10 will be minorities, whose home ownership rate has been historically lower. Note that we used a very generous number (50%) for demand from new households. We add to this the 400,000 units that will become obsolete each year and 200,000 second home purchases. This gives us 1.20 million (600K + 400K + 200K) units of total annual demand. So, excess supply is 0.68 to 1.03 million units/year (1.88 to 2.23 million units of total supply—1.2 million units of total annual demand). Thus, over the next 6 years, excess supply will total 4.1–6.2 million units.
So how can we absorb 4.1-6.2 million more homes? Her answer is simple: investors.
The only way to absorb the excess supply of housing in an environment of constrained demand is to increase the demand for housing. This can come from two sources: either allow borrowers who recently defaulted on their mortgages to qualify for new mortgages, or encourage investor purchases. The problem with the former is that borrowers who have just defaulted do not have the means to make a down payment on a new home. Investors represent the most promising avenue to increase demand. It is very clear that policymakers need to aid the creation of a new asset class—investor-owned homes for rent. Thus far, the overwhelming majority of the rental units are in multi-family properties. That has to change.
It’s hard to find fault with her assumptions or methodology. My fear is that her “death spiral” is actually very close to happening. Prices are continuing to fall, confidence is quickly eroding, and another recession seems certain. Can we really prop up home prices enough over the next 5-6 years to prevent a death spiral?
September 22, 2011 at 1:17 am
The conclusion that a new class of “buy to let” investment is required is, in my opinion, very solid and should be encouraged. The Buy to let market in the UK established itself in the last housing recesssion and is booming. In fact it is a nown favourite for people looking for an alternative to state or professional pension funds (which have earned a bad reputation) in the UK. There are caveats. This investment class must be regulated to keep it stable. If it is left to its own devices individuals (who are mostly not professional investors) get carried away, buying tens of houses in a rising market which can overreach them once the market inevitably retreats. Also private investors require professional services (rental management companies) to manage the property and the risks (rent default, damage, liablity etc). Finally this class has to be kick started – this usually occurs when the rental yield (net of tax) exceeds the finance and upkeep costs by an amount sufficient to justify the risk (risk premium). Of course at the moment the risk of asset value loss is high so that net profit margin has to be high. It may be challenging to get to the point where the buy to let market will kick start. In the UK the last house market bust was around 1990 and the buy to let market really picked up in about 1995.
September 22, 2011 at 3:12 am
Mortgage Rates have hit an all time low! For many, these rates will be the lowest we see in our lifetime. Rates change several times throughout the day, so to get an accurate quote search online for “123 Refinance” learn about mortgage refi before you do refi on your home.
September 22, 2011 at 11:43 am
Don’t use this as a advertising gig for your company website. You have done this before on other blogs.
September 22, 2011 at 6:36 pm
Ben Bernanke et al cannot prop up the housing market. They have only slowed the rate of decent and prolonged the housing downturn. Attempting to keep long-term interest rates low only results in less savings and less future investment in capital formation, prolonging our economic malaise, and slowing the necessary debt deflation process. Yes, investors are the answer. The “death spiral” is nothing to fear; it is the answer to the problem of over-inflated housing prices. When housing prices fall far enough, investors will jump and housing will finally bottom. We need to fear bailing out the money-center banks yet again and the unintended consequences of government solutions.
September 24, 2011 at 7:59 pm
If you ask me this “death spiral” would be a godsend. I’d like to see houses get down to a level where ordinary people can save and put down 20% with a normal 30-year fixed rate mortgage and actually own their houses…. and have money to spend to prop up the economy. The lower house prices are, the more actual-earned-money people can spend on other things.
September 28, 2011 at 12:23 am
Agreed. It would be a “death spiral” for current owners, but would be a life spiral for buyers and for the overall economy.
September 29, 2011 at 9:03 pm
How do you account for those folks that lose their homes but immediately move into an existing rental or even maybe buy a smaller less expensive home? Most people or families that go through foreclosure do not end up doubling up with other friends our families. This scenario does not technically add to the vacant housing stock.These folks could very easily move out of their home into another recently foreclosed home that they rent or possibly buy. I have personal experience with this with several friends. There are a lot of strategic defaults going where the homeowner stops paying the mortgage and stockpiles cash to use as a downpayment on a less expensive home.
September 29, 2011 at 9:12 pm
What do you mean how do you account for it? That’s the best scenario. A family can trade a huge debt for a manageable debt.
This would encourage upside-down owners to bail – which most of them will end up doing anyway. But instead of the entire process taking another 6 years, we could get through it in 1.
September 30, 2011 at 5:29 pm
I am referring to Ms. Goodman’s calculation of additional supply of 1.38MM+ per annum in homes due to to foreclosures. I am trying to understand how she or anyone else takes into account that a large portion of those 1.38MM+ families per year move into another residential unit and in doing so, remove supply from the market at the same time as their foreclosure adds to the supply. It appears to me, and maybe I am missing something, that the actual increase in supply is not near as large as the 1.38MM+. Some people will undoubtedly “double up” which will add to the supply and most of the supply that will be absorbed in these lateral moves will be rental stock not for sale product.
September 30, 2011 at 8:11 pm
Good point. I think that the disparity can be explained, in part, by looking at the vacancy rate of homes, which is still very elevated.
http://cr4re.com/charts/chart-images/HVSHomeownerVacancyQ22011.jpg
October 7, 2011 at 12:08 am
So, if one assumes that this is correct and the prices of homes will continue to drop, should Bay Area home owners who are already 30-40% underwater consider strategic defaults before they wind up down 50%, 60% or more? Also, do you know if refi loans are being pursued after default?
October 7, 2011 at 12:34 am
Lynn,
Depending on where you are at in the Bay Area, yes, it is likely that values would continue to fall that much. And, yes, generally refi’d loans become recourse.
Your best bet may be to do a short sale, where we can negotiate with your lender that the extra debt be extinguished.
Please call me if you are in this situation and I can help you.
October 7, 2011 at 12:55 am
This excellent article is spot on. I own two homes, one is being rented for basically no gain with a LTV ratio of 135% and the home I live in has a LTV ratio of 130%. Given the fair market historical annual rate of return on a home of 1.8% per year, both of my homes should have a LTV ratio of 100%. However where I live, Boise Idaho, we are back to 1996 prices, so both of my homes are worth less than what I paid for them in 2001. I will never look at a home in the same light again. Homes are like cars, they depreciate $4000 the moment you drive off the lot. As a result, I am looking to refinance my current home if Senate Bill 170 passes and rent the home in 2012. If the bill does not pass, I will go ahead and do a strategic default on my current home but not before I purchase a foreclosed home with 20% down in 2013 for the soon to be 1990 home prices in Boise. You see, it is up to the banks. If they want to avoid a foreclosure, they will renegotiate with me on my current home so I can rent it at a breakeven point, otherwise it will end up in foreclosure.
The above story WILL be repeated again and again and the “death spiral” will come to fruition. It will take a generation for the housing problem to go away. People like me will “never forget” a poor investment such as the housing market. Most of all I will “never forget” the poor underwriting by the banks that got us into this mess in the first place. It is up to the banks to renegotiate mortgages with those of us who have been good customers OR they can watch it all go into foreclosure and have the bottom dwelling investors grab up everything and the whole country will be run by slum lords. Sounds like the fall of the Roman Empire to me with the decay of roofs, basements, siding, crawl spaces, landscapes everywhere. Good luck and God bless.
October 9, 2011 at 5:33 am
On “OR they can watch it all go into foreclosure and have the bottom dwelling investors grab up everything and the whole country will be run by slum lords. Sounds like the fall of the Roman Empire to me with the decay of roofs, basements, siding, crawl spaces, landscapes everywhere. Good luck and God bless.”
“Bottom dwelling investors” are not the only buyers. There are folks like myself who have been waiting to purchase a home for more than 8 years now. We have no interest in being slum lords. We recognized the housing bubble for what it was and are patiently waiting to purchase a home. If only the government would get out of the way and let market forces run their course, prices would decline to the point where buyers like myself would jump in and make a purchase; but that won’t happen. Politicos have too much to gain by promising more “help” to underwater homeowners, serial refinancers, and folks who plainly mistimed the market and purchased at inopportune times at high prices.
October 9, 2011 at 11:49 am
@McComic. How can a mortgage holder, default for long enough to save for a deposit on a smaller house, and with that now trashed credit history, hope to get another mortgage? An unworkable idea unless the saved money is given to a friend or family member with good credit, and have them make the new purchase.
March 10, 2012 at 4:03 am
Hey Greg Fielding, I’ve just started my own online presence for my business, but there are some great ideas in the list that I really could do and hadn’t thought of at all. I would like to add this to my real estate FB , not sure how to do it yet, but I will figure it out somehow.