The Compelling Case For A New Wave Of Mortgage Defaults And Bank Failures

Two new reports make a compelling case that the markets have not fully discounted the probability of another flood of residential foreclosures precipitated by the continuing decline in home values.  The potential impact of price depreciation on the quality of loan portfolios casts serious doubt on the notion of a long term profit recovery for the banking industry.

The two reports on the gloomy prospects for residential real estate come from Amherst Securities Group and Standard & Poor’s Rating Services.

Amherst Securities argues that the mortgage markets are not fully reflecting the risk of modified mortgage loans re-defaulting, a situation which has already received much press coverage (see Treasury’s Loan Modification Efforts a Failure).

The bigger risk, according to analysts at Amherst Securities, is the very high potential for defaults by borrowers who have never been previously delinquent.  The additional defaults will be due to negative equity, the biggest factor leading to default according to Amherst.  “Thus, even in a year with low mortgage rates at generational lows, more loans that had never before missed two payments transitioned to default than pre-paid.  No matter how you look at it, borrowers with substantially negative equity are very vulnerable to default.”

Amherst contends that the estimate of future losses on defaults is being underestimated since current estimates are based only on the amount of delinquencies.  “By focusing only on delinquent loans, the market is underestimating the size of the housing problem and the potential losses to bondholders if further policy actions are not taken.”

Complementing the Amherst report, Standard & Poor’s (S&P) predicted that the huge backlog of foreclosed properties will be a major impediment to price recoveries for many years.  The principal balance of foreclosed homes at September 30, 2010 amounted to $450 billion.  According to S&P it will take four to ten years (depending on the location) for markets to absorb these distressed properties.  Unless property prices or demand for homes increase dramatically, the large inventory overhang of foreclosed homes will continue to hinder the recovery in residential real estate.

One significant factor contributing to the slow disposition of distressed properties is the long period of time required to complete a foreclosure action.  Completing a foreclosure process can take up to three years or longer, especially in states with a judicial foreclosure process.

FDIC Chairman Bair acknowledged last year that the “the health of the real estate sector will be crucial in determining the path of the entire economy”.  Unless residential real estate values at least stabilize, the prospect of a flood of additional defaults remains a very real danger.  Additional defaults would result in a self perpetuating cycle of further price declines followed by additional defaults.

The prospect of underwater homeowners defaulting was acknowledged as being a major risk by Chairman Bair.

Some 2.4 million mortgages remained in the foreclosure process at the end of June, while another 2.7 million mortgages were at least 60 days past due. As of June, an estimated 11 million homeowners, or nearly 1 in 4 of those with mortgages, were underwater, owing more than their homes are worth. Not only are these borrowers generally unable to take advantage of today’s record low mortgage rates to refinance, but they become more likely to walk-away from their mortgages.

Many Americans still believe that property values will recover according to the Fannie Mae Housing Survey.  The survey reveals that 78% of Americans believe that the housing market has hit a bottom and that prices will either increase or remain stable over the next year.  This optimistic outlook is likely to evaporate as housing values continue to slide.

If homeowners with negative equity become convinced that housing prices will continue to decrease, the case for defaulting will become overwhelmingly compelling.  Let’s look at the example of a borrower earning $65,000 a year with a take home pay of $4300 per month.  The borrower’s home is worth $250,000 and the mortgage balance is $350,000 with a $2150 per month mortgage payment.  The home continues to slide in value with no prospect of recovery and the owner abandons the illusion of a price recovery.  The homeowner cannot move or sell the home unless he can come up with $100,000 to pay off the mortgage at closing.  The homeowner has had a decrease in his income over the past year due to less overtime at work and the monthly mortgage and other expenses consume every dollar of take home pay.  Defaulting on a mortgage carries little social stigma since so many other people have defaulted.  The risk of the bank pursuing the $100,000 loss on foreclosure is remote since the borrower lives in a nonrecourse state.

Defaulting on the mortgage immediately results in a 100% increase in monthly disposable income – $25,800 more in the homeowners pocket per year.  The odds are extremely high that the defaulting homeowner can live in the house free for at least three years, probably a lot longer with the right legal counsel.

FDIC Chairman Bair is right to worry about defaults by underwater homeowners.  If the price of housing continues to slide, underwater homeowners will have a very easy decision to make.

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