After more than a year of a housing bust, and eight months of a credit crunch, its hard to believe that the real estate market could get much worse. With suburbs turning into ghost towns, major Wall Street banks going under, and people losing their homes right and left, you would naturally think that we must be near the bottom.
And yet, if you look at the raw numbers you realize that the real estate market could get much worse. In fact, it is likely to get much worse in the coming years.
You don't have to believe me. Look at the numbers for yourself.
The Boston Federal Reserve released a working paper about five months ago that pointed out in blunt language what was the leading cause of foreclosures in this country.
homeowners who have suffered a 20 percent or greater fall in house prices are about fourteen times more likely to default on a mortgage compared to homeowners who have enjoyed a 20 percent increase.
Cash flow problems at the household level, driven by job loss, for example, play a role, but only when HPA is low. For example, in 2001, a serious recession generated record numbers of delinquencies, a sign that many households had problems making payments, and also record numbers of foreclosures. However, the records were opposites; a high number of delinquencies, but a low number of foreclosures.
The paper goes on to explain how the easy lending of 2004-2007 induced millions of risky borrowers into the housing market with little or no down payments (aka "no skin in the game"). Thus making them vulnerable to negative equity when a real estate downturn strikes.
So is negative equity a big problem? You tell me.
Homeowner equity as a percentage of household real estate in America has dropped to just 47.9% as of December 2007. That's the lowest number on record.
Moody's Economy.com estimates that 8.8 million homeowners -- about 10.3% percent of all U.S. homes -- will have zero or negative equity by the end of this month. Another 10-15 million households are at risk of becoming "upside down" if prices continue falling.
"It's grim, and it's going to get grimmer."
- Michael Youngblood, managing director at FBR Investment Management Inc.
Before I go any further, I want to point out that most of these numbers are more than four months old now. In the last four months the real estate market has gotten much worse (along with the economy). The only current numbers is this screenshot from Washington Mutual.
Notice lines 5, 6, and 7.
The trends in homeowners going delinquent on their mortgages by more than 60 days, and ending up in foreclosure, is unmistakable.
So who are these homeowners? Would you be surprised to discover that they are not subprime homeowners? They are from a strata of mortgage borrowers known as Alt-A, which is one step above subprime. (In fact, 92.6% of the mortgage pool shown above was originally rated AAA.) It is this group that I want to examine today.
"The folks who say the housing market will stabilize anytime soon must be smoking some really strong stuff."
- Dean Baker, co-director of the Center for Economic and Policy Research in Washington
First of all, let's define what Alt-A is.
"Alt-A" loans, also called "nontraditional" mortgages, are typically offered to borrowers with credit scores between 620 and 700 and include interest-only loans, option ARMs, "no-doc" loans, those requiring little if any income documentation, and others.
In other words, Alt-A loans are where the mortgage lenders were their most creative in getting risky mortgage borrowers into homes they may, or may not, be able to afford. The option ARMs are a particularly bad problem.
According to a December 2006 Fitch Ratings report, almost 90 percent of people who got an Option ARM in 2006 used little or no documentation and more than 90 percent were suffering from negative amortization.
Industry insiders estimate at least 60 percent of Option ARM borrowers make only the minimum monthly payment. A Jan 22 issue of "Mortgage Strategist" a research note from investment bank UBS, estimated up to 80 percent pay the bare minimum.
"If you continue to make the minimum payments, a $600,000 loan can become a $750,000 loan within a couple of years," Fiserv's Dombrowski said. "You may have good credit, but now you're in a trap."
Negative amortization is an even worse condition than negative equity.
With falling house prices, selling is difficult for Option ARM holders as they would net far less than they still owe their lender -- even supposing they can sell in a slow market.
As they owe far more than the house is worth and the market has been hit by a credit crunch, they also can't refinance.
"People have no idea what we're in store for. It's going to get a hell of a lot worse."
- Richard Bitner, mortgage analyst
So the next logical question is: How big is the Alt-A problem?
The best way to address that is to look at the raw numbers from the New York Federal Reserve (December 2007).
The best way to do this is to compare Alt-A numbers to subprime numbers. That way you have a reference.
Total subprime mortgages U.S.: 3,303,991
Average subprime balence U.S.: $180,872
Total subprime owner-occupied U.S.: 3,002,660
The significance of this number is to show that subprime borrowers were not speculators. Thus they are fighting to keep the roof over their head.
Percent subprime owner-occupied with at least one late payment in last 12 months U.S.: 37.6%
A huge percentage of them are having difficulty keeping current with their mortgage payments.
Total subprime with no or low documentation U.S.: 985,005
These are generally known as "liar loans".
Total subprime with cash out refinance U.S.: 1,630,869
More than half of these mortgage borrowers immediately extracted cash from their homes. That makes it hard to sympathize with these people when they ask for a bailout.
Average subprime loan to value at origination U.S.: 84.93%
Almost all of the subprime loans in recent years were 100% mortgages, or something close to that. This makes them vulnerable to negative equity.
Now let's look at Alt-A's.
Total Alt-A mortgages U.S.: 2,384,592
Slightly smaller than subprime, but...
Average Alt-A balence U.S.: $299,117
Alt-A mortgages are nearly twice as large as subprime mortgages.
Total Alt-A owner-occupied U.S.: 1,722,861
Nearly 28% of Alt-A homes are not owner-occupied (aka speculators). Only about 9% of subprime loans aren't owner-occupied. If you don't live there you are much more likely to walk away from a home you can't afford.
Number of Alt-A mortgages with a current payment U.S.: 1,499,030
This is a very scary number. This means that 37% of all Alt-A mortgages are delinquent. However, very few of them were delinquent by more than 60 days. Thus we are looking at the early stages of massive foreclosures in Alt-A's.
Percentage of Alt-A with no or low documentation U.S.: 73.1%
Alt-A is the home of the "liar loan", unlike subprime where less than 30% were liar loans.
Now put "liar loan" together with "speculator" and you get a witches brew of trouble.
Percentage Alt-A with cash out refinance U.S.: 38.2%
They didn't extract their equity quite as fast as the subprime borrower, but a large percentage of them did.
Average Alt-A loan to value at origination U.S.: 89.85%
That means that even more Alt-A borrowers, nearly all of them, used 100% mortgages than subprime borrowers did.
Putting it all together
Most variable rate subprime mortgages were 2-28's or 3-27's. That means a two or three year "teaser" rate, then their mortgages get adjusted to market rates.
The variable rates for Alt-A mortgages were generally 3-27's and 5-25's. Thus the interest rate adjustments on their mortgages haven't started hitting yet, unlike the subprime market.
So you tell me: when a bunch of large mortgage holders with liar loans on speculative homes they don't live in, that are experiencing negative amortization, have their loans reset to much higher rates in a market with falling home values, what do you think they are going to do?
This should scare everyone here, because of the real estate and mortgage bond market is already on the scary edge of bankruptcy from the subprime mess. What will the Alt-A Crisis do when it hits?