(Editor's note: Phil Hall, whose Blog View column runs every Monday, is on vacation this week. Today's column is being guest authored by Taylor Cottam, CFA, a risk manager at a major industry participant. Hall will be back on Mortgage Orb next week.)
When I think of where we are now with the huge drop in home prices, it makes me think of a young boy peering down a deep well and shouting to hear his echo. Wanting to know just how deep the well really is, he picks up a stone, tosses it. Then he puts his head into the well to listen for a splash of water or maybe the thud of a rock. That is where we are right now with the housing crisis. The keys to the front door have been thrown into the well, and the world is listening intently.
It seems in all the hubris of blame engulfing the housing/mortgage/credit/liquidity crisis, we have been given a number of very plausible explanations as to how this happened and why. The crux of the matter is simple. Borrowers are not making their payments. This has led to foreclosures and forced sales en masse, which has led to deteriorating home prices.
Let's start out by saying the idea that there is no liquidity anywhere is an illusion. There is liquidity in abundance, but it just isn't chasing the housing market now. Look at the ‘excess liquidity’ in bubble-like commodities or Visa's recent oversubscribed initial public offering. What is happening with the credit crunch is that banks that are using mortgages or a derivative thereof to finance operations, either as collateral or on the balance sheet, are unable to receive the terms they were heretofore given. In other words, no one wants to extend credit to these institutions.
These credit investors fund the mortgage market by providing warehouse or repurchase facilities. These rational investors seek to maximize their returns while minimizing risk of loss. They understand that by extending credit to the mortgage market, they are taking a long position on the housing market, as a very significant predictor of loan losses is loan-to-value (LTV) ratio. Mortgage assets, being a derivative of the housing market decline, in line with delinquencies and defaults. If housing prices decline, the LTV increases and the risk of homeowner default increases.
This rule makes the value proposition of extending credit to the mortgage market a poor choice at best. As many loans can be warehoused from anywhere from two weeks to several months, the banks that invest in warehouse lines are ultimately investing in a deteriorating asset. What might have been funded with an 80% LTV might well be 100% LTV by the time the loan leaves the line. If the loan becomes delinquent and the lender is unable to sell in this difficult market, the credit investor faces the choices of seizing the collateral, which is worth much less than par, or demanding repurchase.
If bankruptcy is declared, losses could add up. That has caused lenders to pull credit lines or demand high yields to compensate for that risk. The bottom line is that if investors felt confident that housing prices had bottomed and they were not holding onto a deteriorating asset, they would likely feel more comfortable extending credit against mortgage collateral.
Until very recently, the model of portfolio lending had fallen out of favor as lenders depended on credit to run their business. The simple fact is that without a warehouse line, most mortgage lenders are out of business. Even with a line, higher yields on warehousing facilities have made it extremely difficult to make money off the spread between the facility and the mortgage coupon rate. In many cases, there is a negative spread, and it is actually in the lender's interest not to hold these assets on the facility.
What seems to get lost in the whole argument is that if the borrowers could, or were willing, to make their payments, all of these problems would vanish. Stepping back from the tangled string of housing and credit, we can look at the individual microeconomic decisions of homeowners to gain insight into where housing might stabilize and when the liquidity spiral might ease.
Let's start at square one. Millions of Americans own homes in this country and are making their payments. Every month, millions upon millions of payments are taken out of borrowers' bank accounts from Memphis to Portland to Pittsburgh. A small but growing percentage of borrowers are falling behind. Others have opted to ‘trade down’ in order to make monthly payments more affordable.
Oddly enough, GDP growth was still strong – 3.5% in the fourth quarter of 2006 – when defaults and delinquencies first started. Something changed so that many borrowers became unable to make their home payments, without a reduction of aggregate net income.
When one is financing a home, simple budgeting decisions dictate the amount that borrowers can spend each month on either mortgage payments or rent without causing financial stress. That amount is based upon cashflows. For a real estate investor, it is often based upon the income he receives from his tenants. For homeowners, it is based upon another source of income, usually employment. If housing increases from one year to the next without a corresponding increase in income or changing demographic, it follows that it will be more difficult for homeowners to make payments.
If we look at the places that house prices are going down the most, it is in places like California, Florida, Nevada, Ohio and Michigan. The common theme in all these places is the focus on affordability products. If affordability products allowed borrowers to buy more than what their incomes would allow, housing prices would have to rise.
During 2006, the percentage of originations that were for interest-only and pay option adjustable-rate were as high as 30% with about 20% more for subprime. If this product were now unavailable or extremely limited, housing prices would similarly decline.
It is the limitations caused by homeowners' income that are causing housing prices to drop. To attempt to estimate where housing would stabilize, I used a simple back-of-the-envelope calculation. Taking the average payment increases times an estimate of the proportion of affordability products, which would preclude a 15% to 20% drop nationwide. As all housing is local, this drop will, of course, be uneven.
If you really want to look where this housing price fall will end, start by looking at where the housing prices separated from reality, 2003. Then look at the regional popularity of the affordability products at their peak.
Living in San Diego until 2006, I saw the psychological effect of homeowners bragging about the rapid jump in equity values that translated into theoretical dollar signs and de facto early retirement accounts. At the margins, that had the effect of encouraging more leveraged buying. It also encouraged people to buy homes that were far more than what they could afford based upon their income.
So as we sit here listening for the splash at the bottom of the well, just remember that it is dark in the well and the stone has been dropping for quite some time. I can make no guarantees as to the depth of this well. Just make sure you don't fall in.
