An Interesting Analysis of the Housing Crisis

Herb Greenburg, a regular commentator on the site Seeking Alpha posted a discussion piece on the mortgage crisis by a mortgage mortgage broker, Mark Hanson with whom he corresponds. Here is my commentary based on my reading of Hanson's argument. The short version is the worst is yet to come, but his detailed analysis is worth checking out for yourself. What follows here are my thoughts after reading Hanson's analysis. At the end I have excerpted Hanson's closing remarks.

While there is a lot of talk about people with poor credit who took out loans who now face foreclosure, they are only the tip of the iceberg. Many people who were ostensibly good credit risks with credit ratings above 750 can still be in trouble. One reason is that they may have had teaser rates--initially easy terms which fixed their interest at a below-market rate for several years. After which however the interest rate increases sharply, depending on the mortgage market. While the rates were artificially low, they would have had low payments but their principle was increased by the difference between the interest rate they were paying and the market rate. People chose these loans expecting that their homes would appreciate in value and interests rates would stay low. They also figured they would have opportunities to refinance and game the system. Well now things are different.

Many people have taken second mortgages on their homes as a way of cashing out, perhaps to pay off credit card debts. These rates have shot way up already. Moreover there is a strange thing about credit ratings. If you happen to have never had any debt you might think you deserve a high credit rating. Not so. In this crazy economy credit begets credit. If you have no debt you are considered a bad credit risk. The more debt you incur, provided you pay it off in timely fashion, the better your credit score becomes. So even though they had good scores they were in debt way over their heads--ie they were poor credit risks by any rational standard.

Another thing to bear in mind is that people who got second mortgages that allowed them to finance 100% of their home's assessed value (and sometimes even folded in closing costs) now owe more than the present value of their homes, because home values are depreciating in the present market. This is so even if they had not been paying teaser interest rates. This means that they are not in a position to refinance their loan under ordinary circumstnaces--ie without some kind of bailout package.

I am going to quote from Hanson's commentary now because it is not complicated and he provides a case study of the situation in California.

The 3/1, 5/1, 7/1 and 10/1 hybrid interest-only ARMS will reset in droves beginning now. These are loans that are fixed at a low introductory interest only rate for three, five, seven or 10 years — then turn into a fully indexed payment rate that adjusts annually thereafter. They first got really popular in 2003. Wells Fargo led the pack in these but many people have them. The resets first began with the 3/1 last year.

The 5/1 was the most popular by far, so those start to reset heavily in 2008. These were considered ‘prime’ but Wells and many others would do 95%-100% to $1 million at a 620 score with nearly as low of a rate as if you had a 750 score. No income or asset versions of this loan were available at a negligible bump in fee. This does not sound too ‘prime’ to me. These loans were mostly Jumbo in higher priced states such as California.

Values are down and these are interest only loans, therefore, many are severely underwater even without negative-amortization on this loan type. They were qualified at a 50% debt-to-income ratio, leaving only 50% of a borrower’s income to pay taxes, all other bills and live their lives. These loans put the borrower in the grave the day they signed their loan docs especially without major appreciation. These loans will not perform as poorly overall as sub-prime, seconds or Option ARMs but they are a perfect example of what is still considered ‘prime’ that is at risk. Eighty-eight percent of Thornburg’s portfolio is this very loan type for example.

One final thought. How can any of this get repaired unless home values stabilize? And how will that happen? In Northern California, a household income of $90,000 per year could legitimately pay the minimum monthly payment on an Option ARM on a million home for the past several years. Most Option ARMs allowed zero to 5% down. Therefore, given the average income of the Bay Area, most families could buy that million dollar home. A home seller had a vast pool of available buyers.

Now, with all the exotic programs gone, a household income of $175,000 is needed to buy that same home, which is about 10% of the Bay Area households. And, inventories are up 500%. So, in a nutshell we have 90% fewer qualified buyers for five-times the number of homes. To get housing moving again in Northern California, either all the exotic programs must come back, everyone must get a 100% raise or home prices have to fall 50%. None, except the last sound remotely possible.

What I am telling you is not speculation. I sold BILLIONs of these very loans over the past five years. I saw the borrowers we considered ‘prime’. I always wondered ‘what WILL happen when these things adjust is values don’t go up 10% per year’.