As a quick note, I am pleased to announce that we began a Canadian Housing, Finance & Credit coverage model in October and Australia kicks off this week.
This note below is of what I believe to be extremely important mortgage and consumer debt metrics that are often forgotten, or ignored completely, (definitely not understood as long-term structural) but that matter in a significant way when analyzing housing, MBS, banks, and the consumer particularly if the consensus “muddle through” economy in 2012 turns out to be wide eyed. This is nothing tradable per se, but things I always weigh heavily in risk/reward analysis, as they are such powerful macro consumer headwinds. This plays a very important role in our MBS analysis and strategy.
1) Banks, MBS investors, and MI companies pinning their hopes on the success of loan modifications will be sorely disappointed
I have harped on this for years in research reports and notes to clients but every time I see data that support my contrarian view I am taken aback…that the primary driver of loan default is not negative equity rather too high of debt-to-income levels, about which far less that can be done to permanently solve the problem. In part, the latter in the reason why the puppet masters want you to believe that negative equity is the primary driver of loan default.
Most analysts point to negative as the primary driver of loan default, but I think that is misguided. This is because none have current income, debt and asset documentation so by default they point to negative equity, which is present in most defaulted loans. I would concur that the success rate for modifications on two different borrowers with identical DTI might come down to the severity of negative equity. But it’s not the “driver”.
Point being, it’s much easier to point at negative equity as the boogieman than concede there are 10s of millions of legacy mortgage loan holders who are economic zombies due to debt-to-income levels that have all but removed them completely from the US housing, finance, and macro economic equation.
Median Monthly HAMP Mod Applicant Monthly Debt Payments Over 100% of Net Income / Near 100% Post-Mod
(*It is important to note that a borrowers DTI is calculated only using debt reported on the credit report plus housing related taxes and insurance. It does not include any other cost of living expense such as auto or health insurance, apparel, clothing, entertainment, food, fuel, retirement and pension allocations, savings, travel, or vacation.)
To most borrowers with sub-40% DTI’s (industry maximum was 36% for decades leading into 2000), who can save, shop and vacation, negative equity is more of a nuisance. It’s certainly not something over which most would strategically default. But to those with a 65%, 75% or 80% % DTI — before taxes – default is a given eventually; the debt load is just too high at 100%+ of net earnings. This is regardless of the severity of the negative equity. Some with sky high DTI’s have greater savings or a moral compass that points to a mortgage as being the same as a promises to country, mom, or God. They can live in debtors prison longer than others, but eventually most will break.
I think it’s safe to assume that the average earner with a DTI of over 50% DTI before taxes and all other monthly expenses not listed on a credit report (max DTI for Subprime full doc loan originations during the bubble years was only 55% by the way) needs relief. Stopping the mortgage payment is the easiest way to get that relief.
When you look at DTI as the real driver of loan default you get a much clearer picture of why loan mods don’t work — and why they will never work — and how insurmountable the problem really is…people need full debt portfolio mods not just ‘mortgage’ mods.
Bottom line, the 78.3% median pre-modification DTI across all HAMP mod applicants is most likely a fairly accurate portrayal of the typical bubble-years borrower, in default or not, that the government, banks, and MI companies have spent years so desperately trying to prevent from defaulting through increased leverage via new-vintage, high-leverage, worse-than-Subprime loans (i.e., mortgage mods). Thus, our forecast stands…after two years we believe at least 75% of mods across all mod program and loan types will experience a 30-day redefault.
(*Note how we quote “30-day redefaults” and not 60-day like everybody else. That’s because 60-day redefault rates are notably lower due to servicers having modified borrowers on a short leash and many being re-modified before the 60-day late occurs. It is my opinion that when a loan experiences a 30-day redefault the odds are greater than 90% it will ultimately lead to foreclosure status.)
In order to make these borrowers active members or our consumption driven economy once again, mortgage mods resulting in a 61.5% DTI (Sept HAMP median) is not enough relief. They need debt elimination BK’s with mortgage balance cram downs, which will never happen. Or, they need principal forgiveness to a level that brings their DTI in line, which in most cases would take their LTV way below 100%, again which will never happen.
The chart below is from the latest HAMP monthly report. The most important two metrics in my mind are circled in red. This is such a glaring example of zombie can-kicking it amazes me they publish the data.
- pre-mod, the median applicant has a PRE INCOME TAX DTI of 78.3% (half are above!)
- post-mod, the median recipient has a PRE INCOME TAX DTI of 61.5%, which is still far too high to be considered a long term solution.
When thinking about this, it is important to stress that two different borrowers — both with a 65% DTI but one with 110% LTV and one with a 150% LTV — are in the exact same position. That is neither can sell, re-buy, refi, save, shop or vacation. They are debt prisoner renters in their own home.
Principal Balance Reduction Program No Good
And even if a principal reduction program is rolled out broadly it will most likely only bring LTV’s down 115% LTV (higher CLTV when including 2nds), which doesn’t mean much. Moreover, it will require that borrowers accept a market rate or higher 30-year fixed rate loan – much higher than the ~2,5% teaser rates on a HAMP mod – meaning median DTI’s will remain sky-high.
Essentially, a widespread principal program will still leave the borrowers underwater, over-levered renters, who are unable to refi, sell, rebuy, save, shop or vacation.
2) Total Home Equity approaching Record Lows again. US housing stock debt to equity ratios at record highs.
Another tidbit in plain view most do not factor into their housing and consumer focused research is net homeowner equity. This is very important with respect to the repeat buyer, which over the past four years has seen at least half of it’s cohort disappear due to epidemic effective negative equity, sentiment, wealth effect etc. Remember, in order to sell and rebuy most homeowners need 16% to 26% equity (6% Realtor fee on the sale and 10% to 20% downpayment on the new property).
Most sell side and gov’t research likes to quote the drop in the total value of the US housing stock going from $23tt down to $16tt-ish because it doesn’t sound as bad.
But on net, it’s catastrophic particularly because the house is the largest asset of most productive members of the economy. These data show clearly how painful the house price decline really was on homeowner’s net worth and the ability to sell and re-buy. Even if lending guidelines were still as easy as 2006 – with net equity as lows as we have today – we would still be in a mortgage and housing depression.
Note, that the current estimated LTV’s of Freddie’s portfolio shown in the chart below DO NOT include second liens, which with respect to refinancing, selling, and rebuying, are just as much of a lien as a first mortgage.
Bottom line, homeowner’s equity is down 55% from the 2006 peak to $6.2tt and quickly approaching the record lows of Armageddon 2009.
3) Shown another way by Freddie, while the value of the housing stock is only down 30%, equity is down 55% and total debt is only down 3%.
Bottom line, the US housing stock is back to an Armageddon high debt-to-equity ratio.
No matter how you slice it, this puts pressure on the consumer in more places than at the margin.
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