Guest Post: Frank Veneroso on Mortgage Armageddon

Frank Veneroso was kind enough to write as a result of seeing a guest post “Debtor’s Revolt?” by his colleague Marshall Auerback. Veneroso also provided his latest newsletter and gave us permission to post it. It it pretty long (12 pages), I extracted the executive summary and other key bits. Be sure to read the final section, starting with the boldface heading “Why Resolving The Mortgage Armageddon Problem Will Be So Difficult:.” (Enjoy!

From Frank Veneroso:

1. Deutsche Bank now predicts that 48% of all mortgaged American homeowners will be “under water” by 2011.

2. One might assume that means that the aggregate loan-to-value ratio of all mortgaged households will be a little less than 100%.

3. I have been focusing first and foremost on the aggregate loan-to-value ratio of all households with mortgages rather than the number of mortgaged homeowners who will eventually be underwater.

4. I calculated that, on mean reversion in house prices, this aggregate loan-to-value ratio would rise to 120% to 125% — a lot worse than what the Deutsche Bank analysis seems to imply. So I studied their analysis to ascertain why I went wrong or why they went wrong.

5. Though their analysis has a somewhat different objective and employs a different methodology, their analysis in fact comes to almost exactly the same conclusion as I have reached: when one focuses not on the share of all homeowners who will be underwater but the aggregate of mortgaged home values that will be under water, on mean reversion in home prices the aggregate loan-to-value ratio will probably be north of 120%. Here is why.

6. Deutsche Bank admits that their data on total mortgage debt is incomplete. Using more complete mortgage data the percent of homeowners under water would be higher and the implied aggregate LTV might be closer to 110% than 100%.

7. Also there is skewing. Those who are underwater have negative equities that exceed in value the positive equities of those who are not underwater

8 There is skewing on more than one account. Because the highest shares of those underwater are in the regions with the highest home values and the greatest percentagehome price declines the overall skewing might be very great. And this skewing increases as home prices fall further to the Case Shiller mean.

9. When one factors in this skewing the aggregate loan-to-value ratio of all mortgaged homeowners based on the Deutsche Bank analysis probably rises to 120% or more.

Once Again, Does Debt Matter Any More?

We just received a better than expected employment report in which the unemployment rate surprisingly fell. The stock market rallied. The bond market sold off. The last holdouts who still believe the recession is not over are now few and far between. After the last Case Shiller home price report and several upticks in the various measures of home sales, the crowd believes the worst is behind us as regards housing. There may still be a lot of debt out there, but it doesn’t matter anymore.

So here I am, still concerned about all that private debt and still talking about a Mortgage Armageddon. I know, you think, having predicted the financial crisis before it came and having predicted yet more to come once it began to unfold, Frank just can’t stop forecasting more to come. It was just too much fun while it lasted, even though it is all over now.

Wrong! It isn’t an addiction to former winning ways that keeps me on this Mortgage Armageddon kick. It’s a re
view of the history of these things plus simple logic and some arithmetic. I don’t want to see Mortgage Armageddon. Now that, thanks to Geithner and Summers, Obama has assumed ownership of a national insolvency he has no responsibility for, Mortgage Armageddon could paralyze his presidency and leave us in political chaos – which I don’t want to see.

In any case, though the ranks of worrywarts like me are now a lot thinner, I still am not alone. A friend of mine who owns a lot of mortgages keeps telling me that the delinquencies on his mortgages keep going up, and quickly. Yet the foreclosures do not. It seems the financial channel has some kind of frightful constipation whereas dying mortgages keep piling up inside and somehow their elimination is obstructed.

Deutsche Bank Thinks Debt Still Matters

A week ago I quoted Josef Ackermann, head of Deutsche Bank.

This crisis has consisted of a series of earthquakes, with changing epicenters,” Ackermann said late yesterday at an event in Zurich. “Bad loans are the next wave. Banks that have fared relatively well so far will also be affected by this.

Let me explain how it is that Deutsche Bank and I are on the same page.

In my Mortgage Armageddon analysis I took a simple aggregative approach. I went to the U. S. flow of funds accounts to obtain the total value of owner-occupied residential property at the peak of the housing bubble. I assumed the physical value of this stock had not changed since the peak. In the first year or so after that peak new home building exceeded the scrappage rate. Since then it has been less. On balance, the net depreciated physical stock remains roughly unchanged. Whatever small change has occurred doesn’t matter. The useful life of residential real estate is very long, which means that flow supply in any year is very small relative to the value of the outstanding stock….

Of course, we are only interested in the fate of that part of the housing stock that is mortgaged. My research indicated that about two thirds of the total number of units is encumbered with debt. But I was interested in the share of total value that was encumbered by debt, not the number. Why? Because it is the implications of mortgage non-payment for the financial system and society as a whole that matters most. If the mortgage encumbered households have homes and mortgages with values far below the average, though their defaults and losses may be numerous, they may not be that damaging to the financial system.

One might argue that it is the numbers of underwater and thereby imperiled homeowners that matters from a social and political point of view. Even here I would argue that it is the aggregate value that is underwater that matters more. True, in the U. S. A. one man, one vote prevails. But in my opinion if the impoverished lumpen proletariat had all the underwater mortgages, it would matter less politically than if these mortgages were a burden chiefly to the upper and middle classes. In today’s U. S. A. socially and politically middle class man speaks louder than the lumpen. And upper class man speaks louder still….

The U. S. A. is noteworthy in having the most skewed wealth distribution among the more advanced nations of the world….To accommodate for this I considered two scenarios: one where one third of all homes had no mortgage and one where 40% had no mortgage.

To establish the denominator (residential property value) in the nation’s aggregate mortgage loan-to-value ratio I took two thirds of the residential property value in the flow of funds accounts at the 2006 peak in home prices. I then reduced this value by 41% which is my estimate of the overall home price decline that will take the Case Shiller index back to its mean in real terms assuming no inflation over the next two years. Against this I put the total household mortgage debt of all kinds — firsts, seconds, thirds, HELOCs — at the end of Q1 for which we have the latest flow of funds data. That figure on mortgage debt is down from the peak of 2006, but not by much. I should add that, owing to negative amortizations and securitizations, I believe that, if there is an error in the flow of funds data on outstanding mortgage debt, it is one of underestimation.

Now all one has to do is simple division: take the ratio of outstanding mortgage debt to the projected value of all mortgaged owner-occupied residential real estate when home prices fall by 41%. That ratio exceeds 120%.

I made the same calculation, but using the assumption that 40% and not one third of all homes have no mortgage. The resulting aggregate loan-to-value ratio for all indebted homes is 134%.

{Veneroso spends a page describing where he and Deutsche Bank agree]

From then on Deutsche Bank’s methodology departs from mine. Mine is highly aggregative, working off the flow of funds accounts; their’s is highly disaggregated, working off of data pertaining to numerous “Metropolitan Statistical Areas – MSAs” as set out by the U. S. Census Bureau.

This brings up an important difference between their data on total mortgage debt and the data I used. I went to the flow of funds accounts which provide a mortgage debt aggregate which the Fed claims is all encompassing. Deutsche Bank says that their disaggregated data on mortgage debt is not complete. They admit their numbers on second and third mortgages have omissions. They say the same of their data on home equity loans. They use the Freddie Mac database to estimate the loan-to-value ratios for FHA and VA mortgages but admit this is an underestimate since these mortgages typically have had little in the way of down payments….

I can’t estimate the difference between Deutsche Bank’s admittedly conservative bottoms up estimate for all homeowner mortgage debt and the aggregate estimate in the flow of funds accounts but, as it involves seconds, thirds, HELOCs, and VA and FHA loans, which total in the trillions of dollars, it could involve an error of omission equal to 10% of total outstanding mortgage debt of around $12 trillion.

Studying the details of the Deutsche Bank analysis provides an explanation for the rest of the apparent difference between my Mortgage Armageddon conclusion and their seemingly less grave one. If one looks at the details of their estimates of the present and future mortgage loan-to-value situation one sees that, on several counts, for those households who are “underwater” their negative equity is greater than the positive equities of those who are not underwater…..

Why Resolving The Mortgage Armageddon Problem Will Be So Difficult

When I discuss the Mortgage Armageddon scenario I get two types of responses:

1. You have to be wrong. It won’t happen. There won’t be mean reversion in house prices this time. Your arithmetic must be faulty. Or simply a silence that refuses to consider any fact, logic or arithmetic that might support the Mortgage Armageddon analysis.

2. Well, maybe you are right but “they” won’t let it happen, or “they” will somehow bail everyone out. Who is “they”? Apparently the authorities, some authorities. The Fed. The Treasury. The FHFA. Congress. Some or many or all the instruments of government.

I agree that response (2) will occur. But will it work?

To appreciate the intractability of the problem, one must focus on the skewing discussed above. Below I list the 10 MSAs with the highest share of mortgage households that will be “underwater” in 2011 according to Deutsche Bank. Remember, Deutsche Bank admits its numbers are conservative, as they have underestimated the level of debt. If one did the calculation with the right debt data, probably all of these MSAs would reach or exceed the 90% threshold.
Deutsche Bank doesn’t provide the data, but the degree to which these properties are underwater in these MSAs is probably every bit as striking. Perhaps for these 10 MSAs the average loan-to-value ratio is well above 150%, perhaps 200%. (click to enlarge)

What do the policymakers do when households in some parts of the country are so massively insolvent yet in many states almost all the mortgaged households remain solvent? If one lets market forces take their course, how will the financial institutions manage the foreclosure process? A huge part of all the residential real estate in such municipal districts may come up for sale. Who would be able to absorb so much distressed property, and at what price?

On the other hand if the government steps in and somehow socializes such large and pervasive losses in some districts, how does it sell such a colossal bailout to the voters in many states where borrowers and lenders were prudent rather than profligate and almost everyone remains solvent? With such huge regional differences, it seems to me that a bailout program at Federal level will face great political impediments. Yet, any such bailout program will have to be a Federal one.the

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  1. Anonymous Monetarist

    A Resolution Trust Corp type vehicle is being proposed behind the scenes for the banks but an analogous program for homeowners seems problematic even for the most aggressive of the Federales.

    I agree that it is hard to see what , other than time and price, is the best solution here although undoubtedly there will be addl programs thrown at folks that will probably serve to extend the suffering as opposed to ameliorating it.

    Of course we've been here before although in GD 1 the scale as reported here and elsewhere was much smaller than now:

    "Interest-only mortgages were the *standard mortgage in the 1920s*, but they disappeared during the Great Depression, and for good reason … the drop in real-estate values during the Depression pushed a large proportion of interest-only loans into foreclosure. Lenders switched entirely to fully amortizing loans"

  2. JO

    The ongoing "foreclosure" prevention plans and other attempts to bailout homeBUYERS, who in many cases bought homes they could not afford using the gov't "insurance" plans, have been, as predicted, disasters.

    As the greatest credit bubble ever seen progresses through its inevitable phase of debt destruction, the value of most assets, especially housing, will collapse.

    The joke has been on savers, especially those silly enough to have their money on deposit at banks rather than short term treasuries. They have, until about Oct 2007, seen the value of their money drop significantly as the gigantic bubble of credit was growing. Thanks to various factors, including pervasive interference in markets by the Fed and gov't programs, the cost of our shelter has been articially inflated.

    The only solution will be price discovery – which will be fueled heavily by debt destruction. The economy is bearing a crushing debt load (which also ariticially goosed demand/GDP and hence incomes) which will, one way or another, be reduced to the point where remaining debt can be serviced with the "normalized" GDP/income.

    You can bet the despots in power will attempt to use taxpayer moneys (current and future) to somehow help bailout the debt slaves. After all, what politician cares about morality ? This ongoing, tragic debacle will see its end phase once the USD / short term treasuries collapse – then, it's game over. I am angered at the recklessness and stupidity of most of the "solutions" being used or proposed by these morons. As usual, the prudent will get the shaft.


  3. Carlosjii

    Could this possibly be the flip or psychological shadow side of Sir Alan Greenspan’s WEALTH CREATION?????????

  4. Blurtman

    Any idea on the trend in consumer credit rating destruction? If a significant percentage of underwater mortgage holders default, they will no longer be credit worthy, and so will be out of the future home buying pool. A good thing perhaps, but another contributor to a continuing depressed home market.

  5. Anonymous

    None of this is news to those who have read the work of Hyman Minsky. In a debt deflation, one round of debt defaults exposes another "layer" of unsustainable debt, which then defaults, which exposes another layer of debt.

    The question that has remained unasked herein is "what happens to the US dollar and the Federal Reserve when this cascade of defaulting mortgage debt starts to cause the Fed's rapidly expanding portfolio of MBS paper to cause more people to doubt the veracity of the Fed's balance sheet?"

  6. Yves Smith

    There is not link because there is no online version. He sent it via PDF, and he gave me permission to post it, not put it on ScribID.

  7. Hugh

    We continue to have a real economy and a paper one. In the paper economy, we hear that stock prices have made substantial gains, the banking system has stabilized, bonuses are back, etc. But in the real economy, we have continued job losses, people running out of their benefits, the ongoing collapse in mortgages, mountains of debt and decreased consumer spending. The paper economy is being sustained by the vast amounts of money that have been available to it by the Fed and Treasury. We know that they will have to pull back at some point and when they do the underlying depression in the real economy will be exposed.

  8. Anonymous

    Good comments by all above . Thank you for sharing your thoughts . I see no good end to all of this mess – would like to see it over sooner and get it over with than kicking the can for a decade more .
    But I think a decade is the plan hoping that the problems disappear magically . Wise financiers and Gov't moggles whistling in the dark as children , with no wisdom at all , expect the wisdom of greed , fleecing our nation

  9. JD

    I've criticized these measures since they started cropping up a year or so again, but I think this top 10 list shows how impossible it is to believe. How can it possibly be true that 93% of Ft Lauderdale homeowners are underwater? – that would imply that 90+% of homes there were purchased in the last 5 years!! Anybody before that, especially those from the 90s would have mortgages far below current sales prices! And of course many recent purchases would have had significant down-payments, for instance from selling homes in the Northeast!

  10. Yves Smith


    It is only one datapoint, but I have a friend who was not the sort to overpay. He bought his FL house in 1997 and he will be selling it at a loss.

    You are completely missing refis. How many people put new mortgages on? This has nothing to do with purchases but equity extraction.

    Moreover.I suggest you re-read the chart. It clearly states that it is the % of mortgage borrowers, not all homeowners. A fair number of people own their homes free and clear.

  11. Anonymous

    This is what is going to happen and is happening. The administration is e going to borrow as much money as it can from China and then either default all-together or tell them we'll make payments to principal only. Take it or leave it. The resulting currency defaluation will be worth it if we don't have to pay on the debt. Its actually quite simple and it would work. We will come out stronger and the Chinese will be left holding the bag. Kudos to the administration.

  12. Anonymous

    instead of forgiving debts why doesn't the fed give people with good credit (700)+ loans at 3.25 i would borrow 250,000 and pay all i owe send my kid to college and still have over 100k leftover to put back into the economy then let those with less better credit borrow at twice that rate as a penalty then begin weeding the unworthy by foreclosure everybody wins.

  13. unirealist

    Small quibble with Venerosa's calculations: IIRC, the value of non-mortgaged houses is significantly lower than mortgaged houses. Paid-for houses tend to be older, smaller, and in cheaper geo areas than mortgaged homes.

    So his denominator should be larger than it is, which would make for a lower LTV ratio. I think.

    Not that it makes for a prettier picture.

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