By Ramsey Su
We are in a bubble.
In comparison, the sub-prime bubble was easy to understand. The sub-prime real estate market was fueled by easy financing that borrowers had no ability to repay. This fatal flaw was hidden by appreciation far exceeding debt service costs. As soon as the appreciation reversed and was insufficient to cover debt service, the bubble burst.
The timing was also fairly easy to spot. Most sub-prime mortgages had a two year window that triggered a payment, or the termination of teaser rates. Therefore, when appreciation stopped, these loans had a maximum of two years before they all blew up. That is why when real estate bubble prices peaked in 2006, the bubble popped and all hell broke loose in 2008.
Today, the bubble is not as obvious because price appreciation has not been as ballistic, but today's bubble is more deadly. The current bubble is a systemic failure. By that, I mean the current real estate market survives entirely by government intervention. Furthermore, the system is unprepared to cope with any level of stress.
First, we need to take the vital signs of the real estate market. We know how important mortgage rates are and how many trillions the Fed is throwing in to keep rates from increasing. We know the agencies hold about 50% of all outstanding mortgages while, combined with FHA/VA, they have been originating over 90% of all mortgages in the recent past and will continue to do so for the foreseeable future.
How healthy is the real estate market?
Depending on the source, there are still around 10 million mortgages that are under water. The estimate is crude. I can only conclude that there are "a bunch" of loans at risk of default if economic conditions deteriorate, a condition that has never existed in the history of real estate in this country.
The FHFA presented some better measurements with its quarterly Foreclosure Prevention Report. Per the most recent report for the 3rd quarter of 2013, FHFA had:
Nearly 100,900 foreclosure prevention actions were completed during the quarter, bringing the total to more than 3 million since the start of conservatorship in September 2008. Approximately 2.5 million of these actions have helped troubled homeowners save their homes including nearly 1.5 million permanent loan modifications.
2.5 million may sound like hell of an accomplishment but is it saying that if there were no Government intervention, there would have been 2.5 million more foreclosures to date? Furthermore, are all these saved households really on the edge of default again with their modified loans that would not meet any of the underwriting standards in force today?
Speaking of delinquencies, headline news make it sound like defaults are behind us. Take a look at the actual numbers:
Mortgage performance via the FHFA
There are 2.2 million loans in various stages of default, or 7.24% of total loans serviced. These are the numbers just for Freddie and Fannie. Per the FHFA, using the >90 days delinquent numbers as comparison:
The Enterprises' serious delinquency rate fell to 2.6 percent at the end of the quarter compared with 7.2 percent for Federal Housing Administration (FHA) loans, 3.8 percent for Veterans Affairs (VA) loans and 5.7 percent for all loans (Industry average).
In other words, the overall mortgage market is performing even worse than the agencies. Putting it into perspective, it has been eight years since the sub-prime bubble peaked, and trillions have been thrown at trying to re-inflate the bubble, which should not have happened in the first place.
Why do I call this a stealth systemic failure bubble?
A strong mortgage system should be able to withstand market fluctuations without having to resort to desperate measures such as TARP, QE 1,2,3, etc. Has anything changed? The answer is a resounding yes, for the worse.
Two weeks into the new year, we already have three major events in the mortgage world. Janet Yellen has been confirmed as Fed chair, Mel Watt was sworn in and Richard Cordray has launched QM (qualified mortgage). Using QM as an example, it is supposed to be a set of rules that protects the American dream of home ownership. Bottom line, this government bureaucracy somehow determined that a 43% debt to income ratio is safe for all. In reality, using these guidelines, one mishap such as a temporary job loss would send these stretched households into default. If real estate prices do not appreciate, all the high LTV loans will be under water once the cost of buying/selling is factored in.
What happens if the borrowers default? Here is a brief article from Mortgage News Daily that provides some highlights regarding the servicing rules of today:
“[....] requires its servicers to attempt to establish live contact when a borrower misses a monthly payment .[...] A solicitation letter including a package of information relating to Fannie Mae’s workout options and requesting that the borrower supply financial information must be sent between the 31st and 35th day of delinquency with a follow-up if necessary between days 61 and 65 [......] do not allow services to refer a delinquent loan for foreclosure before the 121st day of delinquency […]
That is just the start. The next step is the actual foreclosure. If real estate prices stop appreciating in spite of the monumental efforts, there is zero chance that the Government will allow foreclosures to happen. In fact, with the agencies and the Fed in full control of the mortgage industry, they can unilaterally decide not to foreclose. Investors in these mortgage backed securities won't care, since their interests are fully guaranteed by the Treasury. I wonder who would be dumb enough to continue to make payments on their mortgages. I bet you that under today's guidelines, a defaulting borrower can easily receive >3 years of free housing before actually having to move, and most likely will get some relocation funds to boot.
In summary, even a modest decline in real estate prices would trigger a landslide of unimaginable consequences. Maybe that is what it will take to bring about meaningful reform. In the meantime, I think it is time to watch some football.