10-13 Inside Existing Home Sales

October, 13 2009 | markmti

This report was first published as part of The Mortgage Pages research series on 9/24/09.

In light of new housing reports coming out for September, which can have market-moving implications –and from early indications should be rather confusing to many — I thought it would be timely to publish my thoughts on last months results in order to give you an idea of what we consider most important on a go-forward basis. Mark Hanson

They missed.

Existing home sales (NSA) came in at 499k vs last month’s 532k and last year’s 489k. So, all that hullabaloo for 10k houses y-o-y. Below shows each of the past five August sales including what sales would have been without the stimulus to the far right. While this may be indeed a housing sales count bottom, it is a far stretch from the housing recovery that has become full blown consensus.

Once again seasonality fooled a lot of people, as hope springs eternal. But to get that seasonality to kick in this year it took a variety of influences all hitting at the same time — a) years of pent up demand for low priced houses by renters and investors b) historically low rates that cost over $1 trillion to getc) lots of foreclosure inventory d) the tax stimulus pulling forward demand e) prices nationally down 40% to 70% from peak levels

The chart below really tells the story of the housing bottom. Even with the stimulus, y-t-d 2009 sales are lower than 2008 by 54k sales in total. Without the incremental sales due to the stimulus, 2009 sales would have been 357k lower than 2008.

Some will view this as proof positive the stimulus was a success. Some will view at as proof of the true underlying fundamental weakness of the housing market today.

Stripping out condos the market is even weaker. The little red box on this 20-month chart is what has been portrayed as the housing bottom.

Here is another look at house (ex-condo) sales for the past three years — Jan through August. Even WITH stimulus single-family ex-condo sales are down 68k from 2008. Prices are down over 10% at the median.

Below is a chart of the past five years of sales with (green) and without (blue) the tax credit. Even with the stimulus, 2009 sales only beat 2008 sales from June through August for a total of 55k houses. If you back out the incremental sales due to the stimulus, June through August would have been lower than 2008 by 113,510 units.

Lastly, the chart below shows Existing Home Sales with foreclosure starts side by side. At the point of the Notice-of-Default, the majority is beyond cure even in the current pretend and extend environment. This shadow supply has to be considered when analyzing the housing market because it is constantly and quietly filling a pool that is trying to be drained.

Unintended Consequences of Foreclosure Moratoria & Mortgage Mods

The low foreclosure counts that are presently undermining the housing market — keeping troubled borrowers in houses and good buyers away — are an unintended consequence of the mortgage modification initiatives such as HAMP.

HAMP — and other mod initiatives and foreclosure moratoria — have effectively served as the longest foreclosure moratorium seen yet. Reducing the low-end foreclosures through mods has absolutely undermined the entire housing market because they are what are in demand.

Millions of underwater, over-levered zombie renter-homeowners squatting in their house because of a loan mod simply ensure the housing market remains a heavy and volatile asset class for years.

Another unintended consequence of HAMP will be a foreclosure surge eventually. The in-process foreclosure pipeline has never been as full and the first wave of Obama-mod three month trials are expiring now. Those that don’t make the trial go directly to foreclosure.

The number of trial mods is quickly approaching 500k. If the HAMP performs worlds better than other mods and only 33% fail their trial mod, then up to 166k foreclosures are coming soon. With foreclosures in the US average roughly 75k per month over the past 6 months — and most loan mods that fail being foreclosure-ready — this could double foreclosures over a very short period of time.

But the fact is that over the period of 9-12 months, most HAMP mods will fail based upon historic cure and re-default rates making HAMP the largest can-kicking experiment to date. When HAMP is acknowledged as a failure the only place left to go will be massive principal balance reductions, which will cause a whole new set of problems — about 3 trillion of them.

Tax Credit Does Not Create Supply – Increased Foreclosures and Short Sales Do

Bringing back the $8k does not create low-end supply, which is what is needed to sell houses. There is a ton of supply in the mid-to-upper end price bands — years of it. But the first timer and investor buyers who make up the majority of the demand are not playing in those price bands. And without exotic financing individual buyers are unable to reach out of their present affordability bands. Investors won’t reach out of their target cap return needs.

At this point in time a tax credit extension simply takes away the sense of urgency that is keeping the sales up and will likely do so again in September against seasonality trends.

The only way to get the low-end inventory needed to keep this housing market afloat is to build it or create it through foreclosure or increased short-sale activity. Building all the shelter-house supply needed to keep wind under this housing market in time is an impossible task.

Enough supply will not be found through organic resales either because the move-up buyer is by and large gone…due to epidemic negative equity most can’t sell for what is needed to pay the Realtor and put a down payment on the new house. The tax credit may prompt some to sell and move-up but not enough to make the difference.

Increased foreclosures and short-sales are a much easier way to get supply, but that presents all the same risks as when foreclosures first surged in 2008 — bank and financial system losses, major house price depreciation, negative sentiment etc.

Affordability is Terrible Relative to the Bubble Years

Before you get too excited about the current low supply environment…low supply and increased demand does not mean what it did from 2002-2007 for the housing market. This is because outside of the low-end sweet spot, affordability is terrible relative to the exotic loan bubble years. For more detail on this, please see my 8-11 report entitled Affordability — Housing’s Red Herring.

In a nutshell, loan types such as zero to 5% down $500k Pay Option ARMs with a payment rate of 1% and loan features such as stated income made houses very affordable. Houses were so affordable due to leverage in finance that if a buyer could only afford a $300k house on a 30-year fixed, a quick loan type change would double his buying power. This is not the case any longer — today, buyers can only buy what they can afford and qualify for based upon income, assets, debt load and credit. They can’t reach outside of their affordability bands any longer.

Most Important – It is always important to remember that the house price crash is only a symptom of losing all of the exotic loans and leverage that enabled housing to run so far so fast from 2002-2007.

Without increasingly exotic loans that allowed homeowners to easily move up, down and across or extract equity to cover the debt service, the entire country hit their debt service ceiling at once. From there, house prices quickly gravitated to what buyers could afford using new vintage, low-leverage financing. The problem is that all of the leveraged debt incurred during that time still exists but the equity is gone.

With all exotic loans gone the housing market is essentially starting over, which is what we are seeing with first timers and investors making up the majority of sales primarily at the low-end. Over a number of years, as incomes and house prices hopefully rise, first-timers will become move-up buyers and so will today’s underwater owners.

But we will never find a true bottom in the market until the 10s of millions of over-levered, underwater homeowners are adequately de-levered and are no longer a drag on the market — existing home owners have always been the driver of existing and new house sales. The only present cure for the terminally over-levered is lots of time.

Best Regards,

Mark Hanson

www.MHanson.com

Data provided by M Hanson Adv, ForeclosureRadar.com, RealtyTrac, NAR, DataQuick, and Campbell Surveys

This document is for your private information only. In publishing research, Mark Hanson and M Hanson Advisors are not soliciting any action based upon it. Mark Hanson and M Hanson Advisors publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, Mark Hanson and M Hanson Advisors does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing on Mark Hanson and M Hanson Advisors publications only. Mark Hanson and M Hanson Advisors are not liable for any loss or damage resulting from the use of its product. Mark Hanson and M Hanson Advisors are Limited Liability Corp registered in CA.

9-26 – Shadow Inventory has a Whole New Meaning

September, 26 2009 | markmti

Dear Readers,

This report was first published as part of the Mortgage Pages research series on 9/13/09. I have researched and written about the new-era housing market and its unprecedented dynamics since mid-2006. Many of you know, I have done extensive reports on shadow inventory the entire time because it is such a significant and disruptive factor for the market. However, this year shadow inventory evolved and its potential for destruction became much greater. This report highlights what shadow inventory is today and what that means for tomorrow. Mark Hanson

HAMP has Effectively Served as a Long-Term Foreclosure Moratorium Soon to End

A Second Stream of Foreclosures Will Emerge from Failed HAMP Trial Mods

Mods Made This – Shadow Inventory has a Whole New Meaning

CA Foreclosures and Shadow Inventory

The foreclosure wave is still out there…but it is more of a tsunami now. When tsunami’s build the tide (foreclosures) rolls out for a protracted period of time while the sea (foreclosures in process) swells. Due to foreclosure prevention efforts the sea of foreclosures in process has swollen larger than ever before. In the end these efforts will only serve to make the wave larger and the hit, longer in duration.

A wave actually began to come ashore in Spring. In CA in March foreclosures hit a low of around 9k. In the subsequent three months they jumped to 22.5k. On a national level, they went from 64k in April to 87k in July as shown in the images below. It is important to note how quickly this wave began to ramp.

But then the President rounded up all the servicers to DC for the July 28th come to God meeting and immediately foreclosures dropped again. About the same time FHA-HAMP, which went into effect mid-August, was detailed. FHA-HAMP clearly stated that ‘loans in the process of foreclosure must be considered for FHA-HAMP before a foreclosure sale can be made’. Back to sea they went.

But actual foreclosures are a byproduct of a loan defaults and lagging indicator of the wave. Loans in the delinquency and default pipeline are the leading indicator, which is why our default and foreclosure research has always centers around the Notice-of-Default stage as a leading indicator to everything foreclosure, housing and balance sheet related. Through all the national and statewide moratoriums except SB1137 in CA in Sept 2008, the servicers kept filing Notices of Default and Trustee Sale in order to get borrowers on legal record for action in the future.

The bottom line is that the number of loans in the foreclosure pipeline — post NOD and NTS (image 1 and 2) — have never been greater. This all is future housing market supply that must be considered.

Of the four charts below, image ‘2’ represents ready-to-go second stage foreclosures — this bucket is full like never before. This is the bucket that has been held back due to the HAMP’s that could spill foreclosures at any time.

After an NTS/NFS has been filed and a few months have passed the trustee can take the house to foreclosure immediately – even 6 months or a year down the road after a failed trial mod the house can go to sale immediately in most cases. All of the other charts of the various foreclosure stages show activity at or near peak levels, other than the actual foreclosures, which dropped slightly last month.

HAMP has Effectively Served as a Long-Term Foreclosure Moratorium Soon to End

HAMP has effectively served as a long-term foreclosure moratorium. The lack of foreclosures while servicers retool their systems for HAMP, which really didn’t get rolled out until April, has created quite a back-log as the charts above show. In fact, the President first announced his foreclosure ‘plan’ in February, which is really when HAMP began interfering with the numbers. Additionally, FHA-HAMP was made known in May and recently rolled out at the beginning of August. The past six months have been a big HAMP can kicking game.

When the HAMPs were finally rolled out servicers essentially had to put hundreds of thousands of foreclosures in process on hold while they went through the entire process of contacting borrowers, aggregating paperwork, re-qualifying the borrowers under HAMP’s incredibly detailed guidelines, making a new offers, getting borrowers acceptance, signing and moving paperwork etc. This can take months – HAMP has only been around about six months.

Many HAMP-eligible borrowers may have been mostly done with an old-vintage mod and were stopped in their tracks in April. When you factor in the servicer retooling time, the couple of months for mod processing, and the new 3-month trial period before a mod is made permanent, it is obvious why foreclosures have been lower that last years peak despite defaults averaging well above. But we have an end game that has not been present in the past — borrowers are ineligible for another HAMP mod if they fail their trial. The only place to go is directly to foreclosure.

A Second Stream of Foreclosures Will Emerge from Failed HAMP Trial Mods

At present there is only one stream of foreclosures, which is why they are so low. Most foreclosures coming through now are from a) borrowers who don’t qualify for a mod b) borrowers who know they are better off losing the house and renting c) vacant houses. Very few are coming from failed HAMP 3-month trial mods because of the time line.

But when borrowers begin to come off 3-month trial periods, a second stream of foreclosures will emerge from those who don’t make it. We know that re-default rates for borrowers in default prior to getting a mod is as high as 70%. Even if HAMP performs better than any other program ever has and only 40%-50% re-default, that will mean a quick surge in monthly foreclosures. Remember, after a failed trial the borrower is no longer eligible for a HAMP mod.

The chart below shows the national monthly Notice-of-Trustee Sales (late stage) vs Foreclosures (last stage) counts from March through August. In that short 6-month period, there have been 390k NTS’s that have not resulted in a foreclosure (circled in red). Many are on trial mods.

If we assume that 250k of the 390k are presently on a trial and 40% fail, then beginning shortly 100k new foreclosures will spit out over a short period of time that will be added to the foreclosures that will occur naturally for reasons mentioned previously. If 60% fail, then the number goes to 150k. With foreclosures only averaging 73k over the past six months, this new stream of foreclosures is significant — it has the potential to double foreclosures over a single month.

The bottom line is that there simply has not been enough time from April through August to incorporate HAMP and have failed trial mods spit out the other side. But this is exactly why the foreclosure wave will still happen. It is important to note, when I refer to a ‘wave’ I am simply talking getting back to levels at or above the peak and staying there for an extended period of time — exactly like we have seen with Notice-of-Defaults and Notice-of-Trustee Sales in the bubble states and nationally.

Mods Made This – Shadow Inventory has a Whole New Meeting

Shadow inventory is no longer just the foreclosures taken back by the servicer and sitting on the shelf unsold. This is because of the artificial decrease in monthly foreclosures and high demand for low end properties by first timers and investors this year. The pending foreclosures hung up due to HAMP and other initiatives are also a form of shadow inventory that must be added to the mix.

The chart below really highlights the growing spread between late stage foreclosures (blue) and actual foreclosures (red). Unless all those loans that make up the spread result in a successful mods, foreclosures will jump again in the near-term.

The gap between late stage (NTS) and actual foreclosures (highlighted in red circle) represents almost a half million foreclosures ready to go. This foreclosure-ready inventory, much of which is on HAMP trial, represents a clear and present danger to the housing market at any time. Obviously, loans at the Notice-of-Default stage that happens months before Notice-of-Trustee Sale can also be viewed as future supply, but for the purpose of this report, I chose the second stage because they are the here and now.

CA Foreclosures and Shadow Inventory

The chart below shows CA foreclosures vs. foreclosure resales for the past 20 months. There have been 364k foreclosures and 318k resales. The 46k difference is what shadow inventory used to be. Where are these houses? The shadow knows.

In the past year, approx 20k monthly foreclosure resales have occurred making for a little less than 2.5 months supply. The CA low-end housing market can handle this right now.

However, when add to the shadow inventory pool the jam-packed late-stage foreclosure pipeline things change considerably. The chart below shows that over the past 12-months, 458k NOD’s have turned into 356k NTS and only 238k foreclosures. The difference between the foreclosure-ready NTS stage and the foreclosure stage is huge at 118k.

If only 50% of those late stage foreclosures come through as foreclosures because of failed mods, then three additional months of supply appear from the shadows hanging over the market’s head at any given time. If these would have come out during the busy season with stimuli was on they may have sold but it would have made for a much sloppier market than what we saw during the season. Now we enter the slow season and an extra 60k foreclosures hitting over a short period of time on top of the average 17,500 foreclosures over the past year could seriously impact this housing market.

Because Notice-of-Defaults have not backed off from their peak levels this year, the foreclosure pipe line will remain full through early next year even if all NOD’s stopped today.

Best Regards,
Mark Hanson

9-17 Ominous Mid-to-High End Housing Data Point

September, 17 2009 | markmti

this report was first published as part of the Mortgage Pages research series on 9/3/09

A reporter from the Journal called me yesterday with a single housing data point about the July Existing Home Sales report that puts the mid-to-high end market into absolute perspective.

Let me frame this…in the bubble years existing sales $500k and over were common. In CA alone, from early 2005 to late 2007, the average house price was over $450k. Total sales were huge then too…over 700k nationally in many summer months.

In July 2009 there were only 460k single family (ex-condo) sales – by the way that was down from June’s 465k, but that got lost in the housing bottom headlines. Of the 460k houses sold, only 12k or roughly 2.5% had a purchase price over $500k. I don’t have inventory numbers on houses for sale over $500k but even at 5% of the total inventory that is 1.75 years of supply. Oh, and by the way in CA alone last month there was close to 12k NODs on props over $500k.

This 2.5% sales rate goes to underscore how insignificant (and ruined in many cases) the organic move-up/across buyer has become due to epidemic negative equity and absolute lack of affordability through exotic finance. Unless he can sell and re-buy he will remain gone.

But what really is negative equity? Unlike the bubble years when zero down or a 100% HELOC after the purchase in order to replenish savings was the norm, today’s buyer has to sell for enough to cover the Realtor cost and the 20% down needed to buy most mid-to-high end houses using new vintage loans. Most analysts look at the reported negative-equity figures as the tipping point — it’s not.

If homeowners can’t sell for enough to pay a Realtor 6%, extract the down on the new property, and pay for moving costs they are effectively in a negative equity position. Homeowners know this — a homeowner that has only 15% equity knows they are trapped in their house. We are still learning what this realization does to spending habits, as the focus for many becomes ‘how do I earn or save my way out of this’.

When looking at neg-equity if you move the bar down to 90%, 80%, or even 74% (6% Realtor fee + 20% down) then it changes everything. The vast majority of homeowners in the nation become stuck (see chart below). Without these existing homeowners active in the real estate market, we will never find a true bottom.

The 2.5% sales number also highlights how devastating the Jumbo Prime, Pay Option and Alt-A implosions and subsequent foreclosure waves will be on the market even if it is kicked down the road through mortgage mod initiatives. Where are the buyers going to come from? Supply is already out of control in the mid-to-upper price bands. Unlike the low end of the market that is so hot today, investors won’t be in there buying a $600k house because they know the buyers are far and few in between. In addition, with mid-to-high end rents tumbling the cap rates make it prohibitive. You can also scratch off the list most first-time buyers.

That leaves a few different directions the mid-to-high end can go...which one sounds the most logical to you? 1) even more exotic purchase loans than we saw during the bubble — that allow over 100% LTVs and do not verify income — are created that essentially allow for easy house swapping 2) banks just never foreclose and kick the can down the road until the majority of homeowners earn their way out of their neg-equity hole 3) millions of foreigners are given immediate citizenship for a resi real estate investment over $500k 4) principal balances are forgiven allowing people without damaged credit and too much other debt to sell and rebuy 5) everyone gets a 100% raise 6) massive inflation takes the values of real property back through the roof allowing those without damaged credit and too much other debt to sell and rebuy 7) prices fall in line with the most readily available financing ($417k and below) and to levels at which the majority can afford (and at which they are buying right now).

I am sure there are others or a combination of many that could have been on the list but the most obvious is #7 — that is exactly what we have seen since 2007. This is why at the end of the day — when gov’t is gone and the ‘new normal’ can be found — a $1 million house will be the home of a millionaire — someone that can afford the $270k cash down and that has the $200k fully documented annual income needed to qualify. Most other houses will fall in the middle somewhere.

The chart below is from First American’s recent Negative Equity report. The states with stars next to them have an average LTV that is higher than the point needed to pay a Realtor and put 20% on a new house. The states with boxes to the right — the most heavily populated — are at the next level of pain. Nevada needs bulldozers, gasoline and torches.

Best,

Mark Hanson

9-1 Credit Scores: “Past Performance Does Not Guaranty Future Results”

September, 1 2009 | markmti

*Note – this report was first published as part of the Mortgage Pages research series on 1/30/09

– Credit Scoring Background – Bad Math, Smoke and Mirrors
- Fannie’s & Freddie’s Black Boxes – misused and manipulated for years
- ‘Beat the Computer’. Automated Decisioning – A disaster unfolding
- Buying better credit scores through more debt
- Exotic mortgages sold as a way ‘to improve credit scores’When the Dam Broke
- So, What Next — Will credit scores inhibit a recovery?

Like liquefaction following an earthquake that exposes bad math and engineering sometimes performed decades prior, the quaking of the financial markets has exposed the systemic stranglehold that credit scoring has on all lending. The lender’s, rater’s, and consumer’s universal acceptance and over-reliance upon it was in large part responsible for the ‘lapse’ in lending standards that led to the global credit crisis. On a go-forward basis, credit scoring may inhibit a robust consumer-led credit recovery despite how much money is spent to promote lending.

Finger pointing is rampant these days, and it shouldn’t be too long before some of the blame and inquiry properly flows to credit scoring and its sudden and systemic influence over all lending. Upon this realization, financial institutions will be staring into the abyss. Nothing has changed.

In past mortgage and housing cycles, credit scores were not used as they were during the bubble. Even during the 1991-1994 refi-boom and subsequent housing downturn that lasted until the late 90’s, scores were not used as a primary determinant. It was not until early this decade that credit scores evolved into what they are today to mortgage and housing.

Background

The two most important items found in every consumer loan are obviously a borrower/borrowing entity, and also a credit score. Many loans, such as credit cards, don’t even require collateral and rely solely upon the borrower’s perceived ability to repay derived mostly from a consumer credit score.

Down the road, as the crisis is analyzed to death from those looking to pin the blame on as many names as possible, perp-walks will become common. In this ‘discovery and hang ‘em phase’ it is probable that someone with power will realize that credit scores and their wide acceptance — as a primary metric when analyzing a borrower’s ability to repay — was the paper tiger that made for the start of the lapse in lending standards that has nearly taken down the entire system.

Credit scoring may also be a primary reason for banks unwillingness to lend and will lead to a continued contraction of consumer credit into the future. Because of continued over-reliance upon credit scoring and its aversion to excessive consumer debt, consumers simply don’t qualify for credit easily attainable in the past. It is now a world where those that need the credit can’t get it and those that don’t, can.

Why are the credit raters made to carry all of the blame when credit scorers that provided a primary metric used to make the loans for the securities that the raters rated, getting a free pass? Credit scorers perform their task long before the raters do on a class of loans or bonds. Without credit scoring there would be nothing to rate — or perhaps the loans they rate would have been made using time-tested forms of ability to repay such as income, cash-flow and collateral value

Credit Scoring Background – Bad Math, Smoke and Mirrors

Each of the three primary credit reporting firms, TransUnion, Equifax and Experian, has their own scoring systems. “FICO score,” incidentally, is to “credit score” much like “Xerox” is to “photocopy”. Both are cases in which proprietary corporate creations have evolved, often to the chagrin of the company’s involved, into generic terms at least in the eyes of the general public. Additionally, some banks and credit card issuers utilize their own scores and modeling.

Back in the mid-90′s when credit scoring was still nascent, the bureaus’ formulae weren’t as fine-tuned and it wasn’t uncommon for mortgage underwriters to see a high score on someone with obviously lousy credit (or visa-versa). But such anomalies didn’t much matter to the large lenders and Wall Street investors, whose high-math statisticians were able to “prove” correlations between various credit scores and default rates. “Someone with a 620 score was x% more likely to default than someone with a 680 score”, they said, and y% more likely than someone with a 720 score.

Over time, the perception built that very little mattered other than credit scores. Eventually the banks, Wall Street and the ratings agencies could point to credit scores with their corresponding “proven” default rates and risk-price their loans accordingly. But like so many other things during the bubble years, their black boxes were made of bad math, smoke and mirrors.

Fannie’s & Freddie’s Black-Boxes

Fannie and Freddie’s automated underwriting systems (AUS) and risk-based pricing models, that approved trillions of dollars in loans during the bubble years, most heavily weighted credit scores when decisioning and pricing mortgages. The GSE’s black boxes were thought to be so bullet-proof that until recently everyone assumed that every loan that came out of the GSE’s was ‘Prime’. The GSE’s with their ‘implicit, now ‘effective’, government guarantee were securitized and sold across the world as debt that rivaled US Treasuries and Ginnie Mae securities.

These black-box AUS were misused and manipulated for years. And for years I have been astounded at the quality of loans that the GSE’s would buy at ‘Prime’ prices because of their AUS output that were obviously Subprime loans. Over time, I am confident that defaults across the GSE universe will reach serious double-digit percentages.

Recent, hasty roll-out of foreclosure moratoriums and mortgage modification initiatives may kick the can down the road masking the problem a while longer, but just like we have seen time and again with similar programs…ultimately they will do more harm than good and the problem comes back at a greater pace.

‘Beat the Computer’. Automated Decisioning – A Disaster Unfolding

Everybody bought into it. The GSE’s AUS were engineered to generate loan approvals with reduced documentation requirements when credit scores were sufficiently high. Loans with AUS approvals were instantly salable.

As things evolved, income and asset documentation were no longer necessary for Fannie, Freddie, or, well, anybody. Credit scores were king. Alt-A loan applications – stated income, stated assets, “No Doc” etc. – skyrocketed. Since investors believed they could price out the risk for people with low credit scores as well, the subprime universe exploded literally overnight.

The GSE’s black box mortgage underwriting and decisioning became so detached from human involvement and automated that fraud was easy and rampant. Prior to the bubble years, the mortgage underwriting process consisted of the underwriter carefully reviewing all documentation and making a list of ‘conditions’ that the borrower needed to fulfill in order to make the loan salable to its target investor.

But by 2004, GSE underwriting became a game of ‘beat the computer’. In the GSE’s automated world the underwriter enters the borrower information into the system and an instant decision is given. But during the bubble years if the loan was not approved — or if approved with conditions that the borrower was unable to fulfill — anyone up or down the lender food chain with an AUS log-in and an interest in getting the loan approved could play with the inputs in order to get the decision and list of conditions most easy to fulfill. Things work mostly the same today but access to the systems is more closely monitored.

During the bubble years — when most of the loans that the GSE presently own were originated — If the system denied the loan because it was a borderline cash-out with a high LTV, simply raising the borrower’s asset level by $50k would easily change the declination decision to an approval.

An emailed or faxed document showing $50k in retirement was easy to obtain and would satisfy the underwriter’s condition. Some loans were re-run with new inputs dozens of times in order to get a Fannie/Freddie approval with only the conditions that the borrower or loan officer knew they could fulfill.

GSE loan pricing also became so detached from reality that based upon the AUS approval a borrower with a 580 credit score would get the exact same rate a borrower with a 700 credit score for a similarly structured deal. Appropriate risk was not being priced because it was believed that the almighty GSE credit score reliant AUS systems would never approve the loan, or assign it a lower grade status requiring pricing adjustments, if the loan was indeed risky.

The GSE’s were not the only firms highly reliant on black-box AUS. By 2005, Countrywide, Indymac and Chase also had proprietary system used for non-GSE loans.

In the past couple of years, the GSEs and other lenders have done much work ‘tightening up’ their systems. They have also added lender-specific loan guideline overlays and identified “declining markets” regions in order to get ahead of risk. But still, credit scores remain the primary determinant for AUS approvals and to the extent of documentation requirements.

“Past performance does not guarantee future results” — Buying a better credit score

But what everybody forgot was the oldest caveat in the financial world: “Past performance does not guarantee future results.”

As housing prices soared to historic levels, many home owners used their homes as an ATM machine, cashing out periodically via new first and second mortgages to pay off their credit cards and buy SUVs, plasma TVs, electronic gadgets, and (most notably) second homes and investment properties — which further helped fuel the upward spiral in real estate.

People sufficiently savvy to reap the tax benefits by paying off their installment and revolving debts with cash out from their home actually saw their credit scores improve. This was despite the fact that many of them were living well beyond their means. Once their installment and revolving debt was paid off, they went back to using it. Within a year or two following the funding of the original 50% debt-to-income ratio mortgage, the borrowers total debt ratio was 70-80% and future ability to repay completely dependent upon house price appreciation and home equity extraction. House price appreciation and equity extraction was a second job for millions from 2003-2007.

Indeed, over the past half-dozen years or so, consumers learned they could literally ‘buy’ improved credit scores through taking on more mortgage debt. Subprime loans – especially the Pay Option ARMs which had artificially low interest rates and exceptionally low payments for two years or less – were openly sold as a way to generate a strong mortgage payment history. Once established, this would improve a borrower’s credit score allowing them to refi into an A-paper loan at better rates before the payments increased.

When the Dam Broke

Once the real estate market peaked, however, borrowers were suddenly unable to refinance out of their financial predicaments. They were over-leveraged, both with respect to LTV/CLTV parameters (the value of their home was/is worth less than what they owe, sometimes substantially) and also vis-‘a-vis their debt-to-income ratios. Many even overstated their income on purpose in order to get in the game making for an incurable situation.

So we have what we have today – a snowballing decline in values and nothing less than absolute chaos and carnage in the mortgage and housing markets. The defaults and foreclosures may have started with the low-credit score subprime borrowers, but they have made their way into the higher grades such as Alt-A, Jumbo Prime and Prime borrowers.

So, What Next — Will Credit Scores Inhibit a Recovery?

To what extent is credit scoring are at all predictive? Have the credit scoring firms adequately tweaked and re-weighted the multiple criteria that go into one’s credit score? And if so, have they done so accurately? At this stage when we are learning more each week especially on the psychology of it all, how could they know? By overlooking the role that the credit reporting agencies played in all of this, perhaps even new vintage loans made in the last year during a period of unmatched house price depreciation are also destined to fail in large numbers.

The large banks and investors remain slow on the uptake. Although income, occupancy and LTV carry the most weight in “absolute” terms, loan approvals and especially loan pricing is still very much credit score driven.

The GSE’s now have multiple credit score/pricing tranches, up from one or two back in 2007. In addition, many banks have applied overlays to the underwriting guidelines prohibiting borrowers with certain scores from getting a loan even if the investor will accept lower scores. This will prohibit many with great income and a perfect record — other than having a few credit cards proactively shut down by the bank — from buying a new home for years, further delaying the recovery.

In the past year, I have witnessed perfect credit risks denied a loan solely because of credit score. In the new-era housing market with values down to affordable levels in some areas around the nation, one could argue that many with stable jobs, good cash flow and reserves — that recently walked away from an exotic loan 50% underwater — are much better credit risks that the scores would imply because they are finally de-levered. Being backward looking will not help to solve the housing crisis.

How can the scorers model credit risk accurately enough to reflect the fundamental shift that occurred during the bubble when a home became the ‘largest investment’ of one’s life vs. ‘a place to life’? With prices off 50% at the median in the bubble states and underwriting guidelines back in check for the most part, the home has again become a place to life. Arguably new vintage borrowers will act much differently with respect to real estate as an asset class than bubble-years borrowers.

How does the shift in behavior with respect to negative-equity, or the fact that being in default or foreclosure does not carry the stigma that I call ‘The Scarlet F’ that it once did, undermine the credit scorers attempt to be predictive?

All of these questions and more make for serious doubts about a consumer-led recovery, an end to the housing crisis and the quality of present vintage lending. By default, credit scores will continue to influence the lender’s contraction or future expansion. But what if the computers are still wrong? They do not have a good track record over the past decade. The future of lending depends upon getting back to basics or lending will continue to contract and brand new problems will arise that nobody can predict.

Best Regards,
Mark Hanson

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