With 900k record foreclosures in 2009 (but only 2.3mm since Jan 2007), 2.16mm (180k*12) needed every year for the next four years to purge the distress inventory plaguing and overhanging the market, and potentially fewer existing sales in 2010 than the 5.15 million in stimulus-driven 2009, it is easy to understand the challenge facing the housing market ex-stimulus.

I am a firm believer that the only way the housing market stands a chance of maintaining momentum post-tax credit is for Foreclosures to surge because they are what are in demand. In fact, over the past few months investor demand has waned due to the lack of Foreclosures and competition from swarms of first-timers waiving Obama coupons who they refuse to bid against. First timers, who are notorious for turning it off and on overnight, now make up some 50% of all sales according to the most recent Existing Home Sales report. That is a shaky foundation.

But surging Foreclosures — plus surging short sales in recent months — will significantly increase the distressed-to-organic sales ratio negatively impacting reported median and average house prices., which have benefited from a falling ratio over the past several months with distress sales as a percentage of total sales dropping every month in 2010.

But even at April’s 92.5k record Foreclosure pace — at a time when stimulus is ending, with sales volume set to fall and servicer’s assigning more Foreclosure resales to real estate brokers in April than in all of Q1 combined — prices stand to fall under considerable mix-shift pressure in the near-to-mid term.

At April’s Record Foreclosure Pace the Distressed Bubble Keeps Blowing

Massive-scale home retention (mortgage mod) programs have truly helped only a small slice but primarily served to slow up the pace at which foreclosures have occurred over the past year. This has created a giant bubble of distressed homeowners in the pipeline that over time will be liquidated. But in order to get through it the bubble has to quit expanding. Herein lies the challenge.

Based upon the past year’s average monthly Notices-of-Default, house retention and redefault figures taken from the MBA and OTS quarterly reports, and the Making Home Affordable monthly HAMP report, the number of loans being permanently modified each month is only 30% greater than receive an NOD each month. But after a conservative 50% redefault rate is applied to the retention actions and a 90% liquidation rate to the NOD’s, the number of NOD’s headed for liquidation outpaces retentions by 38%.

This means that the sum of all loan mod programs on the market today is not letting any air out of the massive distress loan (shadow inventory) bubble.

Findings

For the purposes of this report I assume that new permanent loan mods and new NODs stay flat going forward, despite over the past few months mods have been sharply declining and NODs rising.

In addition, I do not give the surge in short sales or the new Home Affordable Foreclosure Alternatives (HAFA) program any weighting because both are so new the results are unknowable. In addition, short sales are the ultimate in shadow inventory because they do not necessarily have to originate from the distress mortgage pipeline, therefore, do not subtract from it. Every homeowner with a first and/or second mortgage balance of 95% LTV (due to 6% Realtor fee) is a potential short-sale candidate. As short sales become the first-line liquidation method across all servicers, they will increase in volume from both current and non-current borrowers, perhaps keeping the shadow inventory liquidation time-line estimate in this report intact.

However, I am a big HAFA proponent and think it will be an overwhelming success. If I am correct, then the years of shadow inventory referred to in this report will be cleared somewhat quicker, but absolutely at the expense of the distress-to-organic sales ratio and reported median and average house prices. In fact, if prices get weak enough this actually could lead to increased delinquencies, defaults, and foreclosures none of which I account for either.

1) There are 8 million in the delinquent, default and foreclosure pipe per the most recent MBA report (14.01% of 57 million mortgages). Of these, 80%, or 6.4 million, should end up in liquidation.

2) On average over the past year 118k borrowers monthly have received an NOD. Ultimately, at least 90% of all NODs will end up with the borrower losing the house. (I use NODs in this report vs 30 or 60 day lates because once an NOD is filed few will cure naturally and a mod, Foreclosure or short sale is the most likely outcome).

3) Each month there are roughly 153.5k borrowers put into a home retention plan per the most recent OTS and Making Home Affordable reports. They consist of 53.5k HAMP Perm Mods, 46k Non-GSE Mods, and 54k Payment Plans, the latter of which are not technically a mod but I counted them anyway to be conservative. And remember two key points a) not every Mod or Payment plan has to involve a borrower in official default so the potential shadow universe is that much larger b) at least half of all mods will ultimately fail due to the average mod allowing too much DTI leverage, which I have covered on numerous occasions.

4) New monthly trial modifications are on a significant down slope — down about 50% from mid-year 2009 peak levels. For HAMP, April brought the fewest number of ‘mods offered’ and ‘trial mods started’ since the program rolled out, as some servicers began gearing up early for HAMP 2.0 beginning on June 1^st for which borrowers have to qualify up-front vs. on stated income under which HAMP 1.0 has been operating since July 2009. Trial mods feed future perm mods. Without stated income mods, half qualify – what a surprise.

There is no evidence that mod starts will meaningfully increase unless the programs are made much easier, because servicers are running out of eligible victims, as evidenced by the ever-increasing perm mod back-end debt-to-income ratios allowed (64.3% median for HAMP in April), which I have also covered on numerous occasions. This increasing DTI will also lead to increased redefaults regardless of equity (or negative-equity) position.

Lastly, it is my opinion that the HAMP 2.0, which ushers in pseudo principal balance reductions earned over a three-year period down to 115% LTV, will not change the outcome much. Most analysis agrees that this will be a panacea. But based upon my years front-line mortgage experience and research, with the median debt-to-income ratio at 64.3%, the borrower at 115% or 150% are in the same boat…both are underwater, over-levered renters who can’t sell, re-buy, refi, spend, save, or vacation.

More than likely HAMP 2.0 will have the effect of forcing borderline borrowers, who would have otherwise found a way to make their payment, into default in order to take advantage of the program. If this is the case, these strategic defaulters — who will have a better redefault rate — in theory could raise the performance level of the program.

5) If the 8 million distress pool is filing at an average pace of 118k per month, of which 106.2k will ultimately be liquidated, and these are being mitigated through perm mods with an average pace 153.5k per month, or 76.8k per month after re-defaults, then the pool of 8mm distressed homeowners is a growing by 29.4k NOD’s per month. The 29.4k monthly increase is only reduced through Foreclosures, HAFA solutions, or traditional short sales or deeds-in-lieu.

Summary

6) When factoring in April’s 92.5k record Foreclosures (not including short sales), the distressed pool shrank by only 63.1k units (92.5k Foreclosures less 29.4k remaining NOD). At this pace, it will take 101 months to clear the pool of 6.4 million loans headed for liquidation. At a pace of 180k Foreclosures per month, twice April’s record high, it will take 42 months to clear the existing distressed inventory.

On the bright side, based upon the default and Foreclosure pipe action, which I track in real-time daily in aggregate and on an originator and servicer-specific basis, it seems that over the past few months the banks have regained a mind of their own. Unlike action I tracked as early as January 10 when all the big servicer’s NOD through Foreclosure charts looked the same, most have diverged.

In fact, two of the nation’s top four servicers, which I have highlighted in many client reports over the past few months, have opened the flood gates beginning in March. And the GSE’s, who led the Foreclosure charge higher beginning in Feb, are in property liquidation mode, which could force all the big GSE servicers to quickly follow suit on their own portfolios — none expected the GSE’s to blink first and do not want to get left in the liquidation dust.

Perhaps this is the first sign in almost two years of an efficient default and Foreclosure process poking its head out. Time will tell.

Data by M Hanson Advisors, OTS, RealtyTrac, MBA

- Feb CA House Sales – SECOND Straight LOWER YoY Comp

- New Loan Defaults Continue to Outpace Sales

- Beginning in March, YoY Comps Get Really Thought to Beat

- National Existing Home Sales Preview

- The ‘Lack of Inventory’ Myth, ‘Effective’ Negative Equity, Price Tranche Bifurcation, Significantly Increased Distress Supply Coming to Market

CA housing is double-dipping right now. After surprisingly strong September through December sales due to the original Nov end date of the stimulus coupled with a sharp drop in mortgage rates in Sept, January and February CA sales have dropped sharply, both coming in below year-ago levels.

February’s 28,111 sales was slightly higher than Jan’s 27,585 but still made for the SECOND straight YoY lower sales comparable. And last Jan & Feb — coming off of a rotten 2008 — the global financial markets were imploding, QE was new, prices were still falling and sentiment was terrible. This year with sentiment measurably better across everything, lower house sales is remarkable.

Yes, sales usually fall in Jan & Feb, but with rates and tax stimulus at historic levels and most thinking both will end soon, seasonality should be somewhat muted like from Sept to Dec.

Bottom Line – Despite rates being at record lows and stimulus ending soon, sales are not picking up like they did last year three months before the Nov end of the original stimulus. Even if they do going into April, I think it will remain obvious that the stimulus driven market hand-off to a normal market has not occurred.

Organic sales — me selling a house to you and the true gauge of the health of the housing market — have stabilized at very low levels due to epidemic effective negative equity while distress-sales — what’s most in demand — languish due to the artificial lack of supply. In addition, median prices are again trending lower, as organic sales remain depressed and over the past couple of months distress sales have picked up slightly as a percentage of total sales.

In Feb, new Notices-of-Default outpaced sales by 10%, meaning the supply pool is filling quicker than it’s draining, and the mid-to-high end market continues to fall. Even if half do not make it to liquidation, which is a long shot, net inventory that left the supply pool was less than half of what sales suggest. Lastly, comps were easy in Jan and Feb and the tough comps begin in March through year-end — the first two months of 2010 were only a taster.

We are running out of sellers and buyers quickly, as HAMP has kept distress inventory at extremely low levels relative to last year and epidemic effective negative equity — not enough equity to sell (pay a Realtor and put a down payment on a new house) and re-buy — has trapped 10s of millions in their houses across the nation.

Additionally, flip-resales that have provided a noticeable boost in sales counts due to double-counting will diminish in 2010 due to the heavy handed foreclosure prevention in 2009, providing a further drag that few are looking for.

What now? With foreclosures artificially depressed for the past year due to HAMP and other aggressive initiatives, houses that are most in demand are becoming scarce.

The only way for the 2010 sales pace to keep up with the 2009 stimulus and distress driven market is for foreclosures and short sales to flood the market. This is what the two primary buyer groups — investors and first-timers — want. If foreclosures do not begin to crank up right now — or for some reason HAFA is not rolled out as it should be – house sales will disappoint for most of 2010 just like you are seeing now but worse as comps get tougher.

In fact, sales could outright collapse without abundant distressed inventory as investors and first timers do not make up a strong foundation and can literally turn it off overnight.

Yes, if distress inventory floods the market prices will be negatively effected but not like during 2007-2008 because sales will pick up sharply. And prices should not be the primary concern now anyway because they are once again under pressure even though they have been significantly restricting distressed supply.

Over the next year — with mortgage rate and tax stimulus likely waning — the health of housing will depend upon how they manage sentiment and headline risk. The most obvious headline risk, which I go over in detail in the charts below, is a string of lower monthly YoY 2010 sales comps, which infers a “double-dip”.

Turn on the Foreclosure Machine & HAFA

This can be avoided turning up the foreclosure machine and allowing servicers to run with HAFA unimpeded, but it has to start right now.

By the way, I am a big HAFA fan, am working closely with a couple of the large servicers and several outsourced loss mitigation specialty firms, and am confident that it — along with Obama’s new ’60-day late/HAMP for all loans proposal’ and June 1st HAMP rule change & portal debut — will define and streamline the foreclosure process from the mess it is today.

A defined and streamlined foreclosure process where everybody is on the same page, borrowers are being sought out many times in person at the 60-day late stage, and HAFA is in place to change the outcome of half of the foreclosures to short sales or DIL’s will result in a constant supply of the very distress supply that the primary buyer groups – investors and first timers — are demanding for at least the next few years.

1) CA Total Home Sales Down in Jan & Feb — TWO YoY lower comps in a row

The chart below is what a “double-dip” looks like – there is no arguing that. This year has not started off well with two months in a row of lower YoY comps (red & blue). And in March the real YoY comp sales trouble begins as that is when the stimulus-driven market began to take off in 2009.

2) CA Sales (Total vs Distressed vs Organic vs Flip-Adjusted) and Loan Defaults – Loan Defaults Lead Pack

A) Total CA home sales (blue) plunged in Jan & Feb putting them below year-ago levels when the global markets were imploding, QE was new, prices were still tumbling, and sentiment was terrible.

B) Organic sales (green) holding steady YoY at low levels emphasizing the epidemic effective negative equity that prevents the majority from selling and re-buying

C) Distress resales (yellow) are languishing due to continued meddling. The lack of distress supply, which is most in demand, is the primary threat to house sales in 2010 and beyond.

D) Flip-Adjusted Sales: When adjusting for flip-resales (light-blue), which make for double-counting in the monthly house sales results, CA house sales are bouncing off lows not seen in decades. It is important to note that flip-resales, which provided much of the 2009 boost in sales counts due to double-counting, will diminish sharply into 2010 due to the lack of foreclosures in 2009 caused by all of the foreclosure prevention initiatives. This is something nobody is looking for.

E) NODs: Despite being artificially lower, new loan defaults (red) are leading the pack meaning the supply pool is filling quicker than it’s draining.

3) Foreclosure-Resales Languishing – an unintended consequence of foreclosure prevention initiatives

4) Organic Sales picking up slightly, but it’s not the hand-off most expected if Foreclosures were artificially suppressed. This is due to Epidemic Effective Negative Equity that prevents 10s of millions from selling and re-buying (paying off the loan, paying the Realtor, moving expenses, and putting a down payment on the new house)

5) CA New Notice-of-Defaults Lead Sales once again in February

Even if only 33% of the 31k Feb NODs make it to foreclosure and become housing supply, which is a very aggressive estimate of foreclosure prevention, then Feb’s 28k CA sales rally did not remove 28k units from inventory. This is because another 20k units will end up as inventory 5-10 months from Feb based upon the NODs. The market can’t clear when new distressed supply is hitting faster than the distressed supply is leaving – remember less than half of CA sales in Feb were from the distressed stock.

6) As Foreclosures as a Percentage of total sales began to drop sharply at the beginning of 2009, median house prices got a boost due to the mix shift. Prices also dipped again in Jan & Feb as foreclosure resales ticked higher (blue) due to the total lack of organic demand.

If distressed properties are about to come to market fast again the 2009 peak median prices are the best we will see for a long time. I am not expecting the same cliff-dive as we saw from 2007-2008 but can easily see 5-10% per year for a number of years coming off prices as distressed sales rise as a percentage of total sales. At the mid-to-high end the downturn will be more severe, as the upper price bands have lagged on the way down, but are picking up steam.

7) Flip-Adjusted CA Sales are at the lowest point on record

When adjusting for flip-resales, which are hot and make for double-counting in the monthly house sales results, CA house sales are bouncing off lows not seen in decades. It is important to note that flip-resales, which provided much of the 2009 boost in sales counts due to double-counting, will diminish sharply into 2010 due to the lack of foreclosures in 2009 caused by all of the foreclosure prevention initiatives. This is something nobody is looking for.

2010 YoY CA Sales (red) are above 2008 when the wheels were coming off all global markets, rates were high, prices were still falling sharply and sentiment was terrible, but remain lower than any year in recent history.

National Existing Home Sales Preview

Based upon CA sales and other national sampling we perform, National Existing Home Sales released this Tuesday, should be down slightly MoM and flattish YoY on a Not-Seasonally Adjusted Basis. My estimate is for 282k sales vs 288,250 in Jan and 280k in Feb 2009.

Seeing national house sales flat when in Q1 2009 there was no tax stimulus, prices were still falling and the global financial markets were imploding is remarkable. This underscores how fundamentally weak this housing market really is…unprecedented stimulus and the market can only keep pace with the worst time in history for the financial markets.

Seasonally adjusted, it is too close to call especially with the foul weather in Feb that any sales miss will be blamed on. But consensus has dropped to 5mm units, which is below January’s levels even though Feb has a history of being up slightly, so it should be a close call. If I were forced to bet the result, I would pick the under.

Despite the voodoo seasonal adjustments, the same trend in national sales is obvious — the lack of distressed inventory is beginning to take its toll on sales and despite historical stimulus, the stimulus-driven market has not handed the baton to a more normalized market. Investors and first-timers continue to dominate due epidemic effective negative equity among organic sellers and buyers and these two groups can literally turn off the demand overnight.

Bottom line – the national housing market ‘recovery’ sits in a precarious position and ironically enough, the deciding factor will be how quickly foreclosures and HAFA liquidations can hit the market and be absorbed because that is all the buyers want.

Lastly, flip-sales double counting within the Existing Home Sales reports provided a sizeable boost to house sales counts in 2009 as shown in the chart below. When backing out flip sales double-counting the resulting ‘Flip-Adjusted’ total sales (red) in 2009 were weaker than 2008 and they continue to languish. Since July 2009, both the headline and Flip-Adjusted MoM trend in existing home sales has been lower. It is important to note that Flip-resales will diminish sharply into 2010 due to the lack of foreclosures in 2009 caused by all of the foreclosure prevention initiatives. This is something few are looking for.

The ‘Lack of Inventory’ Myth, ‘Effective’ Negative Equity, Value Tranche Bifurcation, Significantly Increased Distress Supply

Yes, “listed” inventory is way down. Pundits use this metric as leading evidence that the housing market has nowhere to go but higher. Obviously, they will not mention the millions of houses barreling down the foreclosure pipe — and the approx 125k that enter the pipe every month — of which the vast majority will end up as inventory through foreclosure, deeds-in-lieu or short sales

But aside from the shadow inventory, the lack of organic inventory (natural sellers) is not a positive. Homeowners are trapped. In strong real estate markets homeowners selling and moving drive the market but in this market, epidemic effective negative equity prevents most from selling and re-buying.

**Remember, effective negative equity does not begin at the point in which somebody owes more on their house than what it’s worth. It begins at the point at which they can’t pay the Realtor and put a down payment on the new prop.

In the Jumbo market this could be 75% LTV (sales proceeds less 6% Realtor fee and 20% down payment). When calculating neg-equity like this, the figures are much greater than the popular reports suggest.

Also, this speaks to how strong foreclosure prevention has been, keeping in demand foreclosures off the market. For the latter reason, this is why creating more distress supply via significantly increased foreclosures and the new HAFA program (short sales and DILs) is beneficial to the housing market and will happen. At this point, holding back distress inventory is detrimental to the housing market.

Along the lines of lack of “listed” inventory in the state of CA is the bifurcation within the value tranches…those houses priced right vs. those priced according to what the owner owes. In any given city, half of the listings will be priced in the stratosphere relative to other current listing comps. Because everybody wants a good deal on a distress sale, the real marketable inventory is much less than the “listed” inventory would suggest. Again, this suggests that the market is ready for significantly increased foreclosures and HAFA liquidations to come post-haste.

Best Regards,

Mark Hanson

Mark@MHanson.com

www.MHanson.com

**sales data for this report provided by M Hanson, CAR, DataQuick

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.

Volumes of research have appeared over the past six months about loan modifications, why they do not work, and what makes for the optimal solution. They all agree that permanently waiving principal is the key to a successful mod. The chances of an effective wide-scale principal balance initiative are slim to none.

And I am not talking about some sort of an earn out program whereby if borrowers make three to five years of payments on time, they get a principal balance reduction. This sort of thing is not a true principal balance reduction program like the long-forgotten FHA Hope-for-Homeowners (H4H) that sends the borrower away from day one fully de-levered with a 45% back-end DTI their principal balance reduction in hand. Anything short, and more mods will continue to fail.

All of this is an exercise in futility. They are all looking in the wrong place. It is obvious that if you throw $100k in equity at a homeowner who is in default, it changes things for some. I wrote an essay on this in early 2008 when everybody still believed the crisis was contained to Subprime. Back then I was in favor of a national principal balance reduction initiative that dealt with first and second mortgages as a way to force-delever American households and slow the crash in housing in order to prevent a massive consumer led recession/depression.

In it, I hypothesized that that a targeted $2 trillion to buy down mortgage balances and then another trillion in gov’t tax breaks for those that didn’t not need help with their mortgage in order to prevent blow-back and further stimulate the economy would stop what I saw at the time to be a collapse of most of the nation’s banks if not the financial system itself. I was early. Now my $3 trillion looks like a cheap fix. But at this stage of the game, principal balance reductions are 1.5 years and 10 stimulus programs late and $3 trillion short.

Quit wasting your energy – a wide-scale principal balance reduction program is not likely. I do not think it should happen. It is questionable whether they would even make much of a difference. It surely would not be worth the 50 gallon drum of worms it would open. Reductions would only clinch the deal for those on the borderline who are defaulting purely because it makes for a good investment to exercise their option to default based upon equity.

The moral hazard this would create is huge – default rates would shoot through the roof, especially from those premeditated defaulters that can really afford to pay but just want a gov’t hand out. Or, those simply looking for an exotic rate reduction refi who can’t qualify for or benefit from today’s vanilla 30-year fixed rates loans…remember, mortgage mods are nothing more than gov’t sponsored 5-year, interest only, teaser rate, balloon exotic loans created to replace the exotic loans of yesteryear.

If is important to note, however, that some banks are offering principal reductions to certain borrowers such as Wells Fargo on select Pay Option ARM borrowers. But this is the exception and not the rule and typically reserved for loans wholly owned by the financial institution.

Bottom line.- a gov’t sponsored, wide scale principal balance reduction initiative that gives $10s or hundreds of billions to the minority 15% who are distressed and leaves the 85% who pay on time each month in the lurch would be an unmitigated disaster across many levels.

Additionally, political will is not on the side of carpet bombing stimulus plans any longer because of the blow-back and because the Administration wants to reserve what political capital they have left for the big tasks at hand, such as socialized health care. In fact, the Administration’s latest push is for a targeted jobs package, not another $800 billion across the board handout. There is just not enough of anything left for something as large and controversial as a wide-scale principal balance reduction initiative.

$300 Billion Already Committed to Principal Balance Reductions

But beyond all of this, we already have a massive principal balance reduction program in place. It’s called Hope-for-Homeowners – or the H4H — which calls for HUD to insure up to $300 billion in refi’s if the lender reduces the principal balance and the borrower qualifies under very lose standards. In fact, the guidelines were just made easier late last year. I am not necessarily a Chris Dodd fan, but this program was years ahead of its time and he knew it back in 2008.Opportunity funds that even know a little about the mortgage banking universe, warehouse lending and Ginnie Mae II securitizations could put up triple digit annualized returns — while taking virtually no credit risk and looking like heroes for coming to the aid of the housing market — utilizing the H4H in the way I believe it was intended, which is not the way anybody is working the opportunity, yet. That is all I am going to give you in a public forum.

Negative-Equity Alone is not the Primary Default Driver

For the majority, it is not about having an equity position that is 1% positive or 20% negative. It is about being over-levered in addition to being underwater relative to rents, which have consistently fallen for two years.The HAMP chart in my 1-19 research note below says it all – it also goes to show how aggressive lending really was during the bubble years. What everybody glosses right over is the fact that AFTER a HAMP mod, the median borrower has a total debt-to-income ratio of 55.1%, not the 31% that is promoted by the program. This single data point is the primary reason most mods fail, not the negative-equity on it’s own.

As a former career mortgage banker, I can guaranty that if DTI’s were brought down to around 40% or below that the re-default rate would fall sharply regardless of the equity position because it would be cheaper to stay than move and rent. And even if it was slightly more expensive to stay vs rent, most would still stay for a variety of reasons.

The most important factor at 40% DTI is that borrowers are much less at risk of mortgage default because they have disposable income each month to save, shop and live their lives relatively normally during their years of de-leveraging. For example, somebody earning $10k a month with a total back-end DTI of 40% and a CLTV of 120% is a much better credit risk than somebody earning the same with a back-end DTI of 60% and a CLTV of 99%.

At the present 55.1% after mod back-end DTI, modified borrowers are debt slaves. It’s that simple. A HAMP 2% rate is not aggressive enough based upon the data released by the program. The median HAMP borrower remains far too over-levered post-mod. The sad part is that most delinquent borrowers could be offered a 0% rate and they probably would still be over-levered based upon time-tested 28/36 mortgage banking DTI’s. This is why mortgage mods by and large are destined to fail.

Embracing HAFA – (Home Affordable Foreclosure Alternatives)

It is time to move on. The best solution going forward is for the banks to fully embrace Treasury’s HAFA (short sales and DIL’s) program, begin to foreclose in earnest like they started to in 2008, and get these properties into the hands of new owners. We know there is huge demand for distressed real estate from investors and those that really can afford to own a home and prices in the hardest hit regions have stabilized somewhat (at least temporarily), so the timing is good. Even though HAFA involves removing borrowers from their homes — because it is not done through the process of foreclosure — it technically conforms to present day anti-foreclosure political will.

There is a lot of excitement around this one. The initial reaction from the lenders I talk to is very positive — if forced to chose, they much rather have a short sale or DIL than a foreclosure because loss severities are much less for obvious reasons. HAFA is very well thought out — other than some tweaking that needs to be done surrounding second mortgages — and some large banks are investing a lot of energy creating detailed policy & procedure and best practices in addition to training and redeploying HAMP modification staff in order to fulfill the expected demand. Before too long, I expect the HAFA infrastructure and developed best practices to be used for non-GSE loans as well just like we saw with HAMP.

Homeowners are not being done any favors through loan mods — the distressed homeowner will be in a better position renting a property that they can really afford instead of being saddled to hundreds of thousands in debt that chews up the majority of their gross income every month. Obviously, this will be painful on many financial institutions but the fact is they can’t kick the can forever. And the longer they kick it, the greater the losses will be when the chicken finally comes home to roost.

The unintended consequences of HAMP was creating a lack of distress inventory, which is most in demand. Without REO, which made up a large percentage of total sales last year, the depressed rate of existing home sales in 2009 was as good as it gets for a lot of years. HAFA is exactly what is needed to keep sales counts from tumbling in 2010. The only negative is that because DIL’s are REO and short sales considered ‘distressed’, there will be negative housing implications from significantly increased distressed sales as a percentage of total sales.

This is why I believe that 2010 kicks off a paradigm shift from pretend and extend to the first year of a multi-year drive to finally de-lever through increased asset liquidations spearheaded by the HAFA initiative. Over a lot of years, this is exactly what is need to essentially ‘reset’ the housing market and is where my research centers this year.

Excerpt from my 1-18-2010 Mortgage Pages research note on the HAMP DTI Topic
A Making Home Affordable program update through Dec 09 came out last week (attached). The update was given kudos by many as a sign HAMP is starting to get on track due to the large number of mods that went temp to perm over the past couple of months. Others slammed the low overall temp to perm pull-through at less than 10%.

I am not going to do either, rather point out a single page in the report that highlights exactly why so many will ultimately fail and there is no place for defaults and foreclosures to go in 2010 but straight up. Within the report, there are a series of charts. The ones pertaining to house prices, sales and inventory and mortgage rates metrics…disregard them. This is because when the gov’t seizes control of the supply and demand fundamentals temporarily through artificially low rates and default and foreclosure moratoria, old-school headline metrics such as ‘months supply’ don’t mean much.

1) The Back-End Debt-to-Income Ratio Nightmare

Everybody loves to talk up the 31% HAMP DTI that is billed as the differentiating factor between HAMP and it’s predecessors. But who cares about the Front-End DTI when no concern is given to the total DTI.

As shown in the chart below, the MEDIAN post-mod Back-End DTI is a whopping 55.1%. The pre-mod Back-End DTI was a nose-bleed 72.2%. Now, that is production oriented underwriting! I have always said “mods make homeowners underwater, over-levered renters unable to sell, re-buy, refi, save or shop”. This chart proves it.

A household with a post-mod Back-End DTI of 55.1% remains in serious trouble. Remember, negative equity alone is not the primary driver to default — being in an over-leveraged household balance sheet position with negative equity is. When 55.1% of your gross income is going out to debt listed on your credit report — not including income taxes, household expenses (food, auto insurance, utilities, gas etc) and all other expenses of life — you are extremely over-levered.

My guess that the majority of mods with a total Back-End DTI of over 40% will ultimately fail. And a Back-End DTI over 40% likely represents the majority of all mods given the median is 55.1%. High Back-End DTI’s are also why at the end of the day, defaults and foreclosures will be much higher than anybody’s present estimates, as I outlined in my 12-6-09 report – “Millions More at Risk of Default Than Most Think”.

• Up to 20 Million Borrowers may be in Imminent Risk
• What 50% DTI Really Means Relative to Time-Tested 28/36
• Going Exotic in Plain Sight
• Borrower’s Always Borrowed the Max
• The GSEs – A Culture of Fraud
• Affordability – Out of Control
• HAMP – More Exotic Than Bubble-Year’s Loans

Most look to loan type and equity position as two of the most important factors when forecasting loan default. In fact, I believe that epidemic negative-equity is the overarching reason that the default, foreclosure and housing crisis remains in the early innings. But…negative-equity with a caveat.

While negative equity is a threat in and of itself, being in an over-leveraged household debt position is the true default catalyst for most in a negative-equity position. And being over-leveraged is also the primary default catalyst for those is a positive equity position. Being in a negative-equity position with lots of top line and disposable income each month is generally more of a mental burden than a reason to fly the coop.

How many homeowners are over-levered and at imminent risk of default? This answer is…a lot more than most think, especially those who got a loan from 2003-2007 due to a radical, yet subtle shift in loan guidelines across the mortgage spectrum that kicked-off the bubble-years.

Yes, even Prime full-doc borrowers in 30-year fixed mortgages with 20% equity who got their purchase or refi from 03-07 are at much greater risk than most think. Being over-levered was condoned – all the lenders, investors and loan programs operated in the same manner.

In my research, I often assume that everybody knows the subtle idiosyncrasies of how loans are really structured. I understand this is not the case. So, in an attempt to highlight why the total residential mortgage risk exposure is so much greater than anybody’s expectations, this report drills down on Prime, Alt-A and Subprime allowable debt-to-income (DTI) ratios that were made ridiculously lax relative to pre and post 2003 – 2007. This, in my opinion, is the real tempest in the mortgage teapot that buckets millions more loans that are still in existence today across all loan types, as risky.

- Time-Tested DTI Standards Thrown out the Window

A long time ago in a mortgage market far, far away (circa-2000 and before!) there was responsibility in lending. Age-old underwriting standards only allowed fully-documented debt-to-income ratios of 28% for housing and 36% for total debt (referred to as front and back DTI). On Jumbo loans, the ratios were 33/38 because Jumbo borrowers typically have more disposable income. On occasion, banks would make exceptions to this rule if the borrower had a large equity position or liquid reserves. At 28/36, homeowners can pay debt, shop, take their annual vacation, and even save money. At 28/36 DTI a house is a place to live first and an investment, second.

Bubble year’s loan guidelines not only pushed the boundaries of risk by exotic loan structure but also income leverage. Circa-2002, time-tested DTI standards went out the window. Allowable DTI ratios on Prime loans rose to 50% and much higher when considering that so many loans were made with limited or no income documentation. Alt-A and Subprime full-doc loans would routinely go to 55% DTI…and full-doc are supposed to be the safe loans. Given that full-doc only represented 50% of Subprime and 25% of Alt-A loans it is understandable why these two loan types are experiencing the worst trouble, even though across the Alt-A universe the average FICO was above 700 at the time of origination.

Around this same time, the investment bank’s participation and non-Agency lending and securitization began to really heat up. Guidelines expended further…hey, if the loan was going to be off the books in a few months, who cares how over-leveraged the borrower is.

- Going Exotic in Plain Sight

Before too long — circa-2003 — lending guidelines were fundamentally changing with many lenders allowing leverage through increased DTI ratios never seen before. Obviously, this expanded affordability sharply. When all of a sudden you can spend 50% of your gross income on debt vs 36% before, you can afford to buy much more house or take a much larger cash-out refi.

Subtly changing loan guidelines by raising the allowable DTI on traditional loans, such as a 30-year fixed, was a more sneaky way of easing credit and going exotic than blatantly advertising for ‘no doc’. In fact, 30-year fixed loans and the borrowers that chose them were deemed to be so safe, the underwriting was much more lax than on an exotic structured loan, such as a Pay Option ARM.

By 2004, as property values pushed house prices to levels that were unaffordable and stated income was not the norm yet, the new-normal in mortgage lending was allowing up to 50% of gross income to go to total debt. The mortgage obviously was the largest chunk.

And remember, the 50% is only mortgage PITI and other debt listed on the credit report. It does not include income taxes, auto insurance, food or all the other things that individuals spend money on over the period of a month.

And it didn’t stop there. As the mortgage credit strengthened the borrower’s credit profile, other credit was made available, including second mortgages, that could take total DTI far above 50%. Nevertheless, at 50% DTI, the house becomes the largest investment of a person’s life because there is no way for most to put out half of their gross income to debt each month and invest elsewhere.

- Borrower’s Always Borrowed the Max

When buying or refinancing, most got a purchase or refi loan for as much as their banker or Realtor said they could, which was what 50% of their gross income paid for in most cases. Most borrowers don’t say “we know we qualify for $500k but just to make sure we have some wiggle room in our budget, let’s stick to a $400k loan”. Bottom Line – everybody borrowed too much because all of the lenders and loans — from the safest full-doc Prime loans to Subprime trash — allowed it. And after the fact, most expanded their credit portfolio because all credit was so easily attained until a couple of years ago.

- GSE Loans – A Culture of Fraud

During the bubble years the GSE’s looked at DTI secondarily to credit score, LTV, and cash reserves as measured by liquid cash and 70% of retirement. Both Fannie and Freddie have automated underwriting systems called DU and LP respectively. During the bubble years, if the LTV was low enough and/or score and cash reserves high enough, the system would approve virtually anything.

Many lenders, especially the big banks, had in-house DU and LP underwriting ‘trainers’ that would go around to the various mortgage branches and teach underwriters how to ‘trip’ the systems in order to achieve automated loan approvals when a declination was certain, or simply get fewer approval conditions on a loan that was borderline. Getting a loan approval out of DU/LP on a borrower with a 100% DTI — with limited documentation required on the automated findings — was not uncommon.

In fact, many that needed to pump up a borrower’s strength who was light on income — instead of lying about the income — would pump up another aspect of the loan. The most common was to increase the borrower’s cash reserves, particularly retirement. This way, the retail sales worker buying a house well beyond their means would not need an obviously fraudulent income level, rather a believable household retirement total of maybe $100k. Doing it this way simply raised fewer red flags for the underwriter and investor.

Few Loans Were Ever Denied at First Pass

During the bubble years, very few loans were ever denied. Denying loans was not ‘production oriented’. The culture across all lenders was to ‘approve everything subject to’. If you did not do it this way, your competitors would get all of the business.

The approval process was for the underwriter to run the loan through DU/LP and if the system did not issue an approval (or an approval the borrower and the loan officer were happy with) to go back into the input file and edit the income, assets, retirement (or all three) until the system approved it. Some loans were edited 30 or 40 times until the GSE system issued an approval.

Then, the approval was sent out to the borrower and loan officer even if it required them to verify $100k more in retirement reserves than the borrower had per the original loan application. Within a few days, a new back-dated loan application and a retirement account statement reflecting adequate reserves would arrive, the underwriter would sign it off and the loan would be on its way to the doc department. There was no way to verify if the document was a fake, unless it physically looked altered. In many cases the borrower never even knew this was happening.

Note – this process was not GSE exclusive…this is just how it was done across all lenders.

- Affordability out of Control

Then circa late-2004, as affordability declined sharply even with 50% DTI the norm, stated income came into play in a big way. This super-charged affordability and house prices in ways we will never see again in our lifetime.

Stated income was around for years prior but limited to verified self-employed borrowers. The new-era Stated income loan allowed anyone with a two year job history to get a loan. All of a sudden, everybody earned $150k a year. From then on, the housing market had no shortage of purchases, cash-out refinances or HELOCs and house prices never looked back…well, until the exotic loan programs went away in late 2007.

Circa early-2006 when it became obvious that Stated income was being abused because everybody (hair dressers, public sector workers, and anyone that said they were self-employed for two-years and could provide a fraudulent CPA letter that the lender never verified) suddenly was earning $12k a month, lenders became more cautious.

What was the answer? Begin to push Pay Option ARMs with low teaser rates and payments. This way the borrowers could earn less so their fake income looked more believable. In addition, this is about the time that No Doc and No Ratio doc type options began to show up on every lender’s rate sheet, which provided the ultimate in plausible deniability.

Bottom line - 80% of all Alt-A (including Pay Options), 50% of Subprime, 50% of Jumbo Prime and 30% of Prime loans from 2003-2007 were limited documentation loans for a reason – because the borrowers didn’t even have the 50% DTI needed for full doc.

- How Big is the Total At-Risk Mortgage Universe?

Of the loans in existence today at least 75% were refinanced or attained through a purchase from 2003-2007 – the bubble years. On several occasions in the past couple of years, Jim Cramer has quantified the at-risk loan universe as being around 14 million, which represents everyone who purchased a home between 2005-2007. But then he says ‘”here is no way everybody who bought a house from 2005-2007 will ever default”. So, he pairs it back to 20% or 25% of 14 million – whatever. He is incorrect on a number of levels.

First off, the bubble years were really 2003-2007. But aside from that, the number of people who purchased a home is only a small piece of the entire pie. The bubble years was not about purchases, rather refi’s. During the bubble years refi’s, cash-out refi’s and HELOCs were at least 4:1 over purchases. A purchase is no more risky than an existing homeowner with a great payment history who pulled out 90% or 100% of their equity at a 50% DTI. In fact, the latter are more risky…purchases in general are always considered the safest loans.

This means the true potential at-risk loan universe is any Prime, Alt-A, or Subprime borrower that did a purchase or refi from 2003-2007. Obviously, not every single borrower is at-risk but we have no way of really knowing how many of the 43 million + loans from that period still in existence today are destined for trouble. This is especially true when even borrowers with 800 scores and 70% LTV’s are at risk of default because their DTI started out at 50% and after the fact, they expanded their credit portfolio because all credit was so easily attained until a couple of years ago.

- 13 to 15 Million Loans at Imminent Risk of Default

- Potentially, 20 Million Homeowners over the Next Few Years

The chart below breaks out all of the loans in existence by loan type. Of the loans originated during the trouble years, the far right columns show the conservative number of loans in which the borrowers either borrowed at 50% DTI or went Limited Doc (stated income, light doc, no doc, no ratio). The two columns are not mutually exclusive.

The last Mortgage Bankers Association report estimates that the total number of loans in some sort of delinquency, default, or foreclosure status to be about 8.2 million, or 14.41% of all loans. If the true number of Imminently at-risk loans is somewhere between 13 and 15 million, the default and foreclosure crisis is about 60% over.

The problem with the final 40% is that it crushes everyone other than Subprime households and likely happens over a longer period of time than the two-year Subprime Implosion.

In addition to the imminent defaulters, a large percentage will default for various unforeseen reasons tied to the macro. Throw in top strategic defaulters and we could easily see a situation over the next few years in which 20 MILLION homeowners are either delinquent, defaulted, or in the foreclosure pipeline.

- What a 50% DTI Really Means

- Time-tested 36% DTI Means 60% MORE Disposable Income Each Month

1) What a 50% DTI Really Means?

Borrower Earnings: $100k per year

50% Total DTI: $50,000 per year to housing PITI & all other debt on credit report

25% Fed & State Taxes: $25,000 per year

Disposable income: $25,000 per year, or $2,083 per month

How does this well-above average household SAVE MONEY AND pay for utilities (power, water, cable, garbage, insurance (car, life, health), gas, food, car payment, fuel, clothes, household maintenance and more on $2,083 per month? How do they save an emergency fund or take even a drive-away trip for the weekend?

How do they shop this holiday season when over a trillion dollar in consumer credit was taken away in the past year?

A 50% housing DTI turns the house into the largest investment of your life and ruins most household’s balance sheet at the same time unless the gross income — and disposable income — is much larger.

For most in a serious negative equity position, it is better to walk away. Earning your way out of a $200k hole is impossible with disposable income of $2,083 per month less expenses. Why not walk – the borrower’s credit will be trashed for a few years but as long as they maintain their credit rating on all other credit, their overall rating will not be damaged for as long as their house remains underwater.

2) Now, let’s look at this with 28/36 time-tested debt-to-income ratios.

Bottom Line - 60% MORE disposable income each month.

Borrower Earnings: $100k per year

36% Total DTI: $36,000 per year per to housing PITI & all other debt on credit report

25% Fed and State Taxes: $25,000 per year

Disposable income: $39,000 per year or $3,250 per month

With $3,250 per month, a $100k household can likely save $20k per year. Still, this is not enough to make a real dent in a $200k neg-equity position. But, with this much disposable income the homeowner is not missing out on much and they are saving money, meaning their house is a place to live.

What do households spend money in every year? The U.S. Census bureau provides the answers:

• $200 billion on furniture, appliances ($1,900 per household annually)

• $400 billion on vehicle purchases ($3,800 per household annually)

• $425 billion at restaurants ($4,000 per household annually)

• $9 billion at Starbucks ($85 per household annually)

• $250 billion on clothing ($2,400 per household annually)

• $100 billion on electronics ($950 per household annually)

• $60 billion on lottery tickets ($600 per household annually)

• $100 billion at gambling casinos ($950 per household annually)

• $60 billion on alcohol ($600 per household annually)

• $40 billion on smoking ($400 per household annually)

• $32 billion on spectator sports ($300 per household annually)

• $150 billion on entertainment ($1,400 per household annually)

• $100 billion on education ($950 per household annually)

• $300 billion to charity ($2,900 per household annually)

The average homeowner household spends $22,785 per year, or $1900 per month on the above. When making an allowance for some of the items that are typically financed, the outgo is still roughly $1500 per month.

At 50% DTI, the $100k earner with a disposable income of $2083 per month will have extra monthly income of $583 based upon typical spending. That does not leave a lot for savings, or items not listed such as auto insurance, vacations, gas etc. That definitely is not enough to ‘earn their way out’ of their negative equity hole.

However, the 36% DTI borrower will have an extra $1750 month, which allows for living life and saving money, significantly reducing the chance of loan default due to negative-equity..

Bottom Line - This shows vividly why 50% DTI — even with borrowers making $100k a year and with 20% equity in their property — is in fact over-leveraged and a recipe for loan default for any number of reasons.

- HAMP — More Exotic than Bubble-Years Loans

Now you know why I have been calling HAMP “the most exotic loan ever created” since its inception.

But from the HAMP headlines you could not tell. All that is ever focused upon is the 31% DTI. But that is the front DTI…the housing-only DTI. If you read the guidelines, the back DTI (total debt) allows borrowers to go to 55%!

In fact, if the borrower’s DTI is over 55%, the borrowers are required to go to credit counseling. A little news for ya – a borrower paying out 55% of their gross income to debt does not have time for credit counseling because they have a second job.

Bottom Line: HAMP was designed to lower ‘payments’ for underwater borrowers, but also designed to suck every bit of disposable income every month to the bank. Being underwater in a high-DTI situation is the recipe for default, so it is no wonder the program is not performing as thought.

Borrower’s realize this and are simply using the HAMP multi-month processing and approval process as a way of staying in their home rent-free for a longer period of time. At the end of the day, those that do make it to a permanent mod — but have a high back DTI — will ultimately fail.

For a small percentage of those that fit the HAMP sweet-spot, it is great and absolutely the right medicine. However, at what cost? For many that can technically afford the house and would have gone on paying for 30-years — but can’t qualify for a new-vintage refi — a pre-meditated loan default and subsequent HAMP mod is an easy route to a government subsidized no cost refi.

For all of these reasons and more, I believe HAMP will be fundamentally changed in 2010, perhaps to finally include principal balance reductions. Principal reductions are the only way many modifications will stick. I hate the idea of any gov’t interference, but if they are going to be spending hundreds of billions anyway, they may as well target it.

But I think the stronger possibility is that HAMP will be wound down due to its lack of effectiveness…they have the cover to do so now, as the lion’s share of borrowers are doing a terrible job returning the required documentation in a timely manner if at all. I do not believe there will be a fundamental change in the program, such as significantly easing the qualifying guidelines or allowing borrowers to qualify without income documentation, in order to drive a larger number into the program. It is quite possible that the new HAFA program will replace HAMP as the primary focus in 2010 and beyond, as the can his been kicked so far it finally hit a brick wall. I endorse HAFA to the fullest extent.

I also believe that HAMP will be ultimately responsible for a sizable wave of foreclosures beginning in the near-term from those who do not make it through their trail period, which as of recent data, is most. With foreclosures averaging 80k a month for the past six months and 700k foreclosures held up in the pipeline due to HAMP, even a trial mod failure rate of 40k a month would increase foreclosures by 50%.

However, this is housing market bullish. The biggest threat to the housing market in 2010 is a lack of distress inventory, which is some states still makes up 70% of all sales. Foreclosures are what is in demand and the biggest unintended consequence of HAMP is that it’s keeping those who can’t afford their houses in them and others that can afford — and want to buy them — away.

- Fannie Mae to Tighten DTI Guidelines

Lastly, the following story talks about a recent move by Fannie to raise minimum credit scores and to lower the max allowable DTI to 45%. Operating in a pro-cyclical manner like this will suck major liquidity out of the mortgage and housing market, but will make for safer loans in the future. It is also validation that DTI and household leverage — something rarely focused upon any any analysis I have ever read — is beginning to get the attention it deserves.

Fannie Mae to Tighten Lending Standards: Report

Published: Thursday, 26 Nov 2009 | 6:40 AM ET

By: Reuters

Fannie Mae plans to raise minimum credit score requirements next month and limit the amount of overall debt that borrowers can carry relative to their incomes, The Washington Post reported on Thursday.

Starting Dec. 12, the automated system that the government-controlled mortgage finance company uses to approve loans will reject borrowers who have at least a 20 percent down payment but whose credit scores fall below 620 out of 850, the newspaper reported. Previously, the cut-off was 580.

Also, for borrowers with a 20 percent down payment, no more than 45 percent of their gross monthly income can go toward paying debts, the newspaper said.

A Fannie Mae spokesman told the newspaper that the limits reflect the company’s recent experience.

Loans to people with credit scores below 620 fell seriously behind at a rate approximately nine times higher than other loans purchased in the same period, Fannie Mae spokesman Brian Faith said.

Loans taken out by borrowers with lots of debt also suffer higher levels of serious delinquency, he said “It’s not enough to help borrowers buy a home — we must also ensure that they can stay in the home over the long term,” Faith said in a statement to The Washington Post.

Copyright 2009 Reuters.

http://www.cnbc.com/id/34162049

Have a great Holiday Season.

Best Regards,

Mark Hanson

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