Economic and Real Estate Post Picks: Week of March 23, 2009

CMBS Performance Trends and Maturities: A comprehensive look at delinquency and loss trends by vintage and asset class, and upcoming maturity risk

Martin Hellwig on the Financial Crisis: A lucid account of how relatively small subprime default losses amplified into today’s financial crisis

Real Disposable Personal Income Up: For the fifth consecutive month

The State of the Economy: A great visualization of seven economic indicators showing normal levels, where we are, and the direction we’re going

Personal Consumption Expenditures Positive for February: Good news on this key indicator.

No Modification for You! Followup I

Housing Wire reports few borrowers are getting FHA Secure loans. One problem (the primary focus of the post) is that few of the borrowers who apply have been approved (266 out of 3,200). As Housing Wire says, this could be because few qualify, but it seems more likely to me that there are probably the same kind of logistical problems with the FHA program as I anticipated for the Paulson modification program in one of my previous posts.

A bigger issue is the fact that only 3,200 (out of an anticipated 240,000) borrowers have applied. Low borrower anticipation rates are to be expected, see my previous post on this topic.

Rate Resets v. Falling Home Values?

The Wall Street Examiner has a post which draws the correct conclusion about the Bush Administration modification plan and which identifies a great source of data (the GAO's "Home Mortgage Defaults and Foreclosures briefing). But, the payoff line of the post is, "The main driver of foreclosures is the change in real estate prices." I think that's wrong. The main driver of foreclosures is income curtailment. Falling real estate prices are a condition which sometimes leads to foreclosure when the driver is in effect.

I've written a previous post discussing research identifying causes of foreclosure, with Income Curtailment (most commonly loss of employment) #1 on the list. I do think there is some fuzzy thinking in the research, the surveys, and/or the minds of the people answering the surveys when it comes to other items on most of the lists. For example, #2 is typically Illness/Medical. I doubt in and of itself illness causes a whole lot of defaults ("Sorry, lender, I'm too sick to mail in my payment"). I think it's more likely people got sick and lost their job (income curtailment), had to get by on reduced disability payments (income curtailment), or they or a dependent incurred major medical expenses (income curtailment again, in the broader sense of less net income available to service debt). Similarly, #3 on most lists is Divorce. The most likely scenario here is there were two incomes available to service the debt, and post-split there's only one (income curtailment). These three causes account for 80% of defaults. Rate Resets in the research referred to in my previous post are #7 (clearly not a driver).

Where do falling home values come in? During the happy days if your income was curtailed and the value of your house was up you could refinance and pull out the cash you needed (those no doc loans were a boon for the unemployed borrower), or you could sell your house. Either way, foreclosure was avoided. As teaser rates climbed and underwriting standards tightened, the refinance option went away, but you could still sell. As home values fall to the point there's no equity the sale option goes away for more and more people, which leaves foreclosure. Two additional points:

1) Income curtailment happens to everyone in the socioeconomic spectrum; what distinguishes those who default from those who don't is whether or not they have resources (savings, insurance, etc.) to tide them over. It's a lot easier and cheaper to tweak the rate reset features of subprime loans than it is to provide an income safety net to support those whose income has been curtailed. But, don't expect big results from the tweak when the real driver is more fundamental.

2) Income curtailment is more widespread and prolonged during a recession. If we slip into a recession foreclosures will go up significantly and home values will fall faster and farther.

Subprime Borrower: No Mod for You! Part III

Parts I and II of this series have discussed the logistical and borrower related impediments to making Paulsen’s subprime modification plan work. This installment discusses the issues on the lender side.

To keep it simple for now, let's forget that the lenders on these deals are not single entities, they are multiple-personality schizophrenics consisting of servicers, subordinate tranche holders, senior tranche holders, and sometimes insurers. Let's also forget that even if these lender components wanted to behave rationally they are tied together in a web of contracts and fiduciary responsibilities that their respective legal counsels will not lightly bl0w off. Ignoring all this complexity, most commentary seems to assume that on the lender side a modification will result in a better recovery than a foreclosure. That's a pretty big assumption.

Certainly it does not take much imagination to envision how lenders foreclosing on houses dump supply on an already distressed market, creating a downward spiral in prices which contribute to more foreclosures. Yes, the way to avoid the spiral is to stop foreclosures through modifications. But, whether or not your losses are minimized by modifications depends on market conditions when the modification ends and what happens to your borrower in the meantime. If prices are even lower at the end of the modification or your borrower defaults during the term of your modification before prices have recovered you will be worse off than if you had foreclosed immediately. This is a real possibility, and if we actually slide into a recession I would argue it's a probability over the next 3 to 5 years.

As Yogi Berra (may have) said, "It's tough to make predictions, especially about the future." Jim Cramer's second investment commandment is "Your first loss is your best loss" (not an original idea of Jim's). Many lenders firmly believe this is true, and that's why in previous real estate recessions you saw lenders selling pools of debt at large discounts to bottom feeders willing to work through individual deals to maximize value. Some of the parties that need to buy into the plan on the lender side to make it work will have this philosophy and won't play ball.

Subprime Borrower: No Modification for You! Part II

The first obstacle to getting a lot of subprime loan modifications done is Logistics. The second problem is the borrowers themselves. The Wall Street Journal reported on Monday (Citigroup Feels Heat to Modify Mortgages 11/26/07) ACORN and Citigroup got together and sent letters to 340 Los Angeles homeowners inviting them to a workshop to help them keep their homes, and got a dozen responses. A 3.5% response rate does not bode well for modifications as a route out of this mess, and while there could be plenty of reasons why this particular event did not come off, the reality is a lot of borrowers are not going to ask for modifications. Some won't be aware of the modification options, no matter how much effort is made to communicate it. Some will analyze the available modification options and make a rationale conclusion that based on their particular situation they are better off walking away. For those who don't participate, the biggest group will be those who just want to move on. This is not a crazy decision if you stretched to get into a house whose value has fallen and which you don't see bouncing back anytime soon.

Post Northridge earthquake (1995) I was a consultant with the City of Los Angeles trying to facilitate the reconstruction of earthquake damaged condominium projects. These were deals which had everything going for them to make a workout happen; an Act of God (so no blame game to cloud the picture), insurance proceeds sufficient to reconstruct in almost every case, and 0% 30 year loans from the City (courtesy of a Federal HOME loan grant) to cover any gaps. The borrower participation rate? Less than 50%, and almost all of them were people who had substantial equity before the earthquake. It's hard for me to see how in a situation where people almost by definition have no equity we can expect large numbers to buy in.

This is not to say a program like this is a waste of time; appropriate modifications can be good for all parties, they can create a happy ending in individual cases, and the option should be available. I am saying even if a program like this gets off the ground there will be a whole lot more foreclosures than modifications, and low borrower participation rates will be one of the reasons.

Subprime Borrower: No Modification for You! Part I

There are a lot of reasons why few borrowers are going to get modifications of their subprime loans. Although Friday's Wall Street Journal (U.S., Banks Near a Plan to Freeze Subprime Rates 11/30/07) has a front page article reporting that the Treasury Department and a number of large residential mortgage servicers are close to agreeing on a plan to freeze subprime home loans, the truth is more along the lines that they are agreeing on how to look like they're doing something to address the problem.

Problem I: Logistics. The Journal quotes Treasury Secretary Henry Paulson as saying [That it would be impossible to] "process the number of workouts and modifications that are going to be necessary doing it just sort of one-off." He's right, for reasons eloquently outlined by others (for example, Tanta: "Dear Mr. Paulson"). But, since they're working on a plan anyway, he must be thinking there's a way to modify loans in bulk. According to the Journal, the plan will be to divide the modification candidates into three groups:

1) Those who can make their payments when their rates go up. This group would not get modifications, presumably because they don't need a modification.
2) Those who can't make their payments even if their rate doesn't go up. No modifications for this group either, presumably because it wouldn't do them any good.
3) Those who can make their payments if their rate doesn't go up. These folks would get their rates frozen for a period to be determined by criteria to be worked out.

That's all well and good, except I think maybe we should exclude from Group 3 the borrowers who committed fraud to get their loans in the first place. It's hard to know exactly how big this group is, but apparently there could be quite a few members and the original loan files helpfully already identify many of them (Tanta again). Culling out these borrowers will spare Mr. Paulsen the embarrassment of the inevitable Wall Street Journal follow up story, "Treasury Secretary's Plan Aids and Abets Subprime Fraudsters."

My question is, how do you sort borrowers into these groups without resorting to "sort of one-off" analysis? By relying on the same crappy data tapes used to securitize the loans in the first place? Doing the modifications requires reunderwriting the borrowers, and the servicers don't have and are not likely to hire the people necessary to do that.