Foreclosure Versus Delinquency: Either Way, Financials Will Pay

I can't believe all the bad news in the financial industry last several days. You heard Blackstone's (BSX) profit tumbled 89% for Q4 2007, Carlyle Capital (a leveraged fund linked to private equity firm Carlyle Group) faced potential insolvency, and there is even speculation that Bear Stearns (BSC) is running out of cash, something they denied immediately. Hedge funds are scrambling to meet bank demands for more money to support loans even if the investment is backed by Treasuries, by liquidating their holdings, since their lenders boosted borrowing rates and demanded extra collateral.

Credit traders are betting that MBIA (MBI) will default within the year. Citigroup (C) reached the teens (below $20) as I predicted. Barron's latest edition said Fannie Mae (FNM) may need a government bailout. There is even talk about Goldman's potential write-downs on their holdings of leveraged loans, commercial MBS and other corporate bonds which they can't hedge the risk away, unlike their MBS. Of course, JP Morgan (JPM) issued a report indicating that Wall Street banks are facing a "systemic margin call" that may deplete banks of $325 billion of capital due to deteriorating subprime U.S. mortgages.

This one is really not new though. It is the same old issue happening again and again, thus: 1) Borrowing short and lending long is always a bad thing during difficult times, since no one would be able to refinance. 2) Liquidity is always NOT there when you need it the most, and asset value becomes meaningless without liquidity.

The surprising news is the not-well-publicized report by Mortgages Bankers Association released March 6 here, indicating that delinquency rates rose to 5.82% in Q4 2007, while the foreclosure rate increased to 2.04% of ALL US mortgages (not just subprime). This seems to be shockingly high that 8% of all US mortgages including prime are in trouble, and that was for Q4 last year.

Can we imagine what the data looks like for Q1 this year? Or the Q4 when interest rates for many of the teaser ARMs are being reset? One explanation might be that some people at Q4 last year have already stopped mortgage payments, and are dumping the houses back on the banks and mortgage companies. They have already walked away with the anticipation that they would do that this year anyway. It makes sense financially, since if someone knows that he is going to default on the mortgage very soon, why would he want to make a few more monthly payments and deplete his already low cash position? It is similar to credit card use; if someone wants to default on their plastics, the tendency is to max out up to their limits before stopping the payments.

Foreclosure is to blame for the banks'' recovery rate of 50%, a very low historical rate, as indicated by Bernanke last week. It is a downward spiral; the more houses are in foreclosure, the lower the fire sale prices banks are able to recover, and the lower the recovery rate. No wonder Bernanke has asked mortgage companies to reduce principal on troubled mortgages so the surge in foreclosures can be tamed. But more often than not, when Fed tries to solve one problem, it creates another bigger problem.

The problem with his proposal is that it provides the homeowners with a very strong incentive to be delinquent so they can negotiate with banks and get reductions in their principals. This is unfair to those who are in the same situation but are still struggling to meet their payment obligations. Instead of being rewarded for their great efforts, they are actually being penalized by not getting a principal reduction relief. Also it will skyrocket the delinquency rate, but forcefully make foreclosure rate to look lower and better temporarily than it really is.

For this whole home mortgage mess, no matter how creative the Fed gets, at the end of the day, it is always a trade-off whether the financial industry pays the price now or in the future.

Comments

[Apostle]

Well said...

[Zhang Fei]

Quote: "Foreclosure is to blame for the banks'' recovery rate of 50%, a very low historical rate, as indicated by Bernanke last week."

Here's a simple-minded question - what do you mean when you write recovery rate? Is that the percentage of the principal amount of the debt recovered - i.e. a recovery rate of 50% on $1000 face value of bonds means the bondholders got $500 back?

[thomast2]

Thanks both for your comments. I think when seekingalpha moving my article over from my blog site vestopia.com, it made a minor error. What I said was "Foreclosure has already caused bank's recovery rate at 50%". What I meant was due to the increasing foreclosure with fire sale prices, lack of bidders, further deteriorating of real estate market, banks and mortgage companies can roughly recover 50% of their loans. So Zhang Fei, your interpretation is correct.