Real estate delinquencies are continuing to grow. The official delinquency rate on residential real estate at banks in the United States is nearly 10 percent. But the official numbers, which do not include mortgages that have been modified, are currently understating the level of delinquencies by nearly 25 percent.
Take a look at the picture below. The black-dashed line is the official delinquency rate. The red line uses OCC data (from the mortgage metrics report) to add modified mortgages back into the total. As of the third quarter of 2009, there was a $41 billion gap between the two lines.
I include modified mortgages in total delinquencies because almost all of these modifications are on track to fail. To date, more than 60 percent of the loans modified in 2008Q3 have redefaulted. That’s 6 times the default rate of a 2007-vintage subprime mortgage. The modifications are doing nothing more than keeping a large set of non-performing loans off the books of banks (and the FHA).
Why are mortgage modifications failing?
The following chart shows 12-month delinquency rates by payment modification. The redefault rate moves from 40 percent when the monthly payments are reduced by 20 percent or more to almost 70 percent in cases where the monthly payment actually increases.
A shockingly high percentage of modifications result in higher payments to the household – who do the banks think they are kidding here? The banks are not making a genuine effort to rework the loans. In the third quarter of 2008, about 35 percent of modifications actually increased the monthly payment of the household. Even in the latest data and after extreme (I am kidding) pressure from the OCC, 17 percent of modifications result in higher monthly payments. One cannot construct an economic model in which the household has a lower incentive to default when their principal is not changed and their payments increase. (If this fact does not make you angry, don’t forget you are subsidizing all of these modifications.)
However, even the modifications made in good faith and that substantially lower the household’s payments are seeing spectacularly high redefault rates, still four times the worst of the subprime mortgages. And, remember that these modifications are only done in the cases where the bank believed (allegedly) that the household had a good chance of making the payments.
Mortgage modifications are not working because the modifications are not hitting the key driver of foreclosures: A household with negative equity has an increased incentive to default on their mortgage.
Why do policy makers not believe this?
There have been several recent Fed studies that have shown that homeowners do not default simply because they are underwater; rather, homeowners only default when they suffer both income and price shocks. This analysis however is flawed for two reasons. First, their samples, per nature, consist of only historical data. But in every past period, household’s expected their house to rise in value, giving them a positive value to waiting. That is, if they could simply wait long enough (and if they could afford the payments in the meantime), the house would no longer be underwater. Second, the house price declines in the data are small. Households tend not to prefer default when they are barely underwater.
The following picture shows the default lines for households taken from a simple model of housing. In the model, households are given the simple choice between paying their mortgage or walking away from their mortgage and renting forever (again if you want details of the model email me). When house prices fall slightly, the household prefers to keep paying their mortgage even when they are underwater.
Take a look at the top line. A homeowner who faces even a small fall in house prices prefers to default. The more income the homeowner loses, the more they prefer to default. Eventually, at an income loss greater than 60 percent they always prefer to walk away from their mortgage – if they are also underwater, they default.
Two things made observing only one shock unlikely in historical data. First, the average tenure was longer. Notice the ten year line is well below the 2 or 5 year line. Second, house price falls were all small. Now, house price declines greater than 10 percent are not uncommon and, in large part because of the low interest rates in the last few years, the average tenure is much shorter than in historical data.
In summary, two shocks are not now nor have they ever been a necessary condition of default. It’s just that two shocks make default more likely especially when house price declines are small.
Takeaway
Because banks have become (probably correctly) convinced that they cannot fail, they will take no actions to correct their balance sheets and will continue to allow the loans to fester. Markets then cannot work out the foreclosure problem and the current round of policy-forced mortgage modifications is not working (we can debate whether or not they should have worked). It’s time for bank regulators to get off of the fence and force principal reductions. Or it’s time for the administration to admit that it wants the foreclosures to proceed, in which case it needs to grease the wheels of the legal system and get the adjustment underway.
(For the record, I think foreclosures are bad for the economy. More importantly, underwater households are reducing the flexibility of the economy, creating long-term growth problems. More on this when I next post on the labor market.)
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4 comments:
Well you scooped the NY times today! This can't be good news; the idea of walking away from your mortgage is a rational idea is in the press on a regular basis these days. Should this occur in large scale, debt to equity would have to be done in restructing balance sheets at the institutional level. I think you could kiss the MBS market goodbye if permament principal reductions are forced on lenders.
A tangental point to this piece, the housing problem stems from oversupply. It seems most of the work done compares households to housing units.
However, the average size of a home has risen. Is there merit in studying the relative supply of the actual sq footage in aggregate? If the economy weakens further, people will simply move in with each other creating more supply?
Not that anyone is counting but here is the link to the NY Times story: http://www.nytimes.com/2010/02/03/business/03walk.html?ref=business.
At some point, barring a levels recovery in the housing market, large scale walk outs will be a problem. That's why this problem has to be dealt with now. Ignoring it will not go away; waiting will make it grow bigger.
When I first pedalled my foreclosure plan in early 2007, I was told nobody is in the mood for a bailout. Then, a bailout happened but no help for the mortgage market.
I don't know if we force the principal reductions on the MBS market or if we pay for the reductions. But it has to happen. The interests of the U.S. comes before the interests of the market -- although here they coincide the market just doesn't believe it.
There is merit in studying square footage but mostly only for prices. Until we start subdividing houses into duplexes, triplexes, and quadplexes, it's still one (perhaps extended) household per house.
Yes, people will move in together but that is not a function of house size. That is a function of being poor. Larger houses perhaps make this easier but not that much. A single-family home still has shared spaces even when those spaces are big.
The growth rate of the population implies housing starts in the long run of at least 1.3 million units per year unless persons per houshold rises above its post-war high -- possible but unlikley.
It’s a cliché, but do the interests of 7.6 mio people controlling $30-40 trio of other people’s money, pocketing a slice for themselves just for getting out of bed every morning to gamble with the rest, with a taxpayer backstop if things go too wrong – do THOSE interests really coincide with those of everyone getting paid by the hour? I don’t think it’s a matter of making the market BELIEVE that’s true but rather changing the market to make it true.
I’m no optimist, but maybe that will happen. Maybe a lot of the right things will happen eventually, we just need a long time given the magnitude of the problem and the resulting fragility. But I think we may have missed the chance when we didn’t oust the vested interests that will oppose such changes when they were on their knees.
And speaking of getting banksters up off their knees, it seems to me we’ve been paying to AVOID – even reverse – principal reductions, not FOR them. Principal reductions WERE forced on the MBS market: in 2007-2008 they were “priced in” by the marks-to-market MBS holders had to take when everyone started defaulting. But then the government decided it was better to have assets whose prices went up than assets that were actually worth their price. Those reductions were paid for: by the end of 2008 more than $800 bio of market cap had been wiped out (from Fannie, Freddie and the 17 of the 19 stress-test banks that are still public). As we discussed before, I think your foreclosure prevention plan could be implemented for somewhere between $400-650 bio, you think even less. But instead of taking the opportunity (if the market’s wiped out a paper $800 bio, wipe out $400-650 bio of actual principal to help get things started again), the government just swept the asset-quality issue out of sight. Instead of wiping out the last $1.02 of Citi Group equity “value” (at the low on March 5, 2009) and maybe few points off the bonds in order to do some meaningful debt restructuring, the government chose to make bank securities traders' playthings and reflate Citi Group’s stock to $3.00 (you can see there’s still an opportunity here - we're still more than $500 bio off June 2007), doing nothing about asset quality and it’s impact on employment and growth.
That the government sees this as the way to restore CONFIDENCE, and that extra $2 as “wealth” shows one of two things (probably a bit of both): (1) how pervasively the financial sector mentality has infected government and how badly misaligned that mentality is with national prosperity in any meaningful sense; and/or (2) how serious those who have been allowed behind the curtain know our troubles to be – so serious that it is a legitimate policy response to spend this much time, effort and money to do little more than try to get people to stop thinking and asking questions.
I think there’s more of the former in the mix. Government and the market are the same people. Those people are understandably over-prioritizing the financial system in an environment where everyone wants to pay off or default on debt, not borrow more; and especially those parts of the system that continue to pay banksters the most in this environment (trading) relative to the parts we really need (payment clearing, some revolving credit for working capital). Personally, I think the zombie banks should have been placed into receivership, cleaned up and set free again as quasi-public utilities (with anyone who preferred to run a hedge fund free to do so without a public safety-net); and/or the crap assets should have been nationalized – not purchased – and restructured to make the debt sustainable. Rather than giving the government shares in the banks, I might have given the banks some kind of subordinated claim in an RTC-like asset management company, run by regulators, not PIMCO. The banksters could have back anything left after taxpayers earned an appropriate return for their risk. Provided: each share comes with tar and feathers, starting at the top of the org chart. Next crisis, maybe.
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