Amherst Securities: Investors Underestimating Severity of Housing Problem

Amherst Securities, whose mortgage research is well respected, published a new article on Monday which gives a sobering reading of the prospects for the housing market. It gives a detailed analysis of default rates among performing and non-performing mortgages, and concludes that the outlook is far worse than most investors assume.

The big source of risk is what they call the “non-agency” market, which is often called the “private label” market. They’ve argued in the past that 11.5 million homeowners are at risk of losing their residences. They contend that where other analysts and investors are missing the boat is by focusing primarily on loans that are already in trouble. Loans that have always been current but where the borrower has significant negative equity also have a reasonable risk of default.

Amherst Mortgage Insight January 3, 2011

One caveat about this report: it notes that once a borrower gets in arrears, the odds of the loan getting back on track, even with a mod, are low. Note that this is an indictment of the current way mods are done rather than mods in general. As Adam Levitin and Tara Twomey point out in a recent paper:

…servicers‘ compensation structures encourage them to stretch out defaults, but not too long. In other words, servicers want to keep borrowers in a default ―sweatbox to collect late fees and other junk fees, but only until the profit maximizing point. This may explain why servicers often do not vigorously pursue foreclosure at first, but instead allow foreclosure filings to lapse or defaults to linger for a year or more.

After hitting the profit-maximizing point on the cumulative net income curve (or more precisely, just before hitting it), the profit-maximizing servicer should want to foreclose and sell the property as quickly as possible before its cumulative income is eaten away by the rising cost of making servicing advances. Servicers are therefore incentivized to engage in quick foreclosure sales and REO sales, even at low prices, because they are indifferent to the amount of the sale proceeds due to the seniority of their claim while they are sensitive to the speed of the sale.

In addition, many so-called mods are mere payment catch up plans (and some require the borrower to make higher-than-normal payments). Servicers very rarely offer deep principal mods, even though that would be a win-win for the borrower and virtually all bond investors. The so-called “permanent mods” under HAMP were a mere kick-the-can-down-the-road strategy of five year payment reductions, with the shortfall typically added to principal. Why should a borrower try hard to save his house if even after his effort, he still faces a big loss upon resale?

Until investors and policymakers get out of denial and start to consider ways to cut the Gordian knot of the housing crisis, mounting foreclosures will exact a large toll on families and communities.

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  1. Conscience of a conservative

    Great Laurie Goodman piece. It’s well known in the industry that negative equity is the single largest determinant of default and recidivism always an issue for people with previous delinquency status. Moral of the story is that mortgages must be underwritten with significant down payments(equity). Not part of the piece but worth stating is the importance of dotting the i’s and crossing the t’s(full documentation). Defaulting on a mortgage is an option and it’s time more people realize this. Underwrite a loan properly and the lender is protected(lender is many cases is the tax-payer)

    1. Leviathan

      It is desirable but not sufficient that mortgages “be underwritten with significant down payments (equity).” People who did put down large down payments (20% or more) at the height of the ponzi market are now 20-30% underwater. People who put down little or nothing are 40-50% underwater. In terms of likelihood of defaulting, where is the difference?

      1. winstongator

        Your 40-50% underwater is only for the markets that have fallen to that degree, which are the bubble markets and Detroit.

    2. Jack Rip

      The whole argument is baseless. We are dealing with a downturn that comes close to a depression. To maintain any business, mortgages in particular, always ready for depression makes no sense economically, socially and politically.

      One has to remember, not only mortgages suffered. Many banks were closed; the TBTF institutions were subsidized for about $3 Trillion; many small business closed shop, etc.

  2. Diogenes

    Well, they could have prevented many of the current problems by writing principal balances down to fair market value. Perhaps starting with all mortgages issued in 2003.

    IMO, bank shareholders and bondholders could have eaten this difference…sort of the Iceland approach.

    Now, however, we are too far down the road.

    1. Eric

      Who can say whether or not a more aggressive approach would be best in aggregate? Once word got out that so-and-so got $50K off of principal on a loan he/she was current on everyone borrower would demand it. Maybe better to hold the line on the portion of the portfolio that is hopeless than end up caving on 4 times that that is still good.

      1. Ron

        The reason loan mods are not working is that housing prices are to high. Even if loan mods are provided there is no market mechanism to clear the market of the other priced homes without creating more underwater homeowners needing MODS. So even if one gets a generous mod they probably come with strings attached which makes the homeowner a glorified renter in real time with no equity anyway.

        Our economy has become addicted to excessive credit creation and nobody can figure out how to starve the beast and save it at the same time!

  3. Ron

    The problem in Calif is the mid to upper tier homes, they are to expensive for most citizens to buy. Current MLS inventory is already piling up above 450K with more inventory expected to market as the Spring selling season get going. Homes below 350K in good shape sell. The Fannie upper loan limit 729K is due to expire in Sept with the limit going down to 625K. The problem with coastal housing in Calif is the price is still locked into bubble territory and will probably come dow significantly putting pressure on higher end priced White communities. The traditional move up buyer with significant down payments are rare so the market is mostly made up of either low down FHA buyers up to the current loan limit with good incomes or cash investment buyers who buy mostly at auction.

  4. Brian Longley

    Ignorance is a national choice. They people that understand this are those it is happening to and those controlling the fraud. You don’t “create” 30 Trillion bucks without collapsing a few ivory towers in the process. In this case, it is the government or the people that gets to choose, not both. We have seen that government chooses to protect themselves.
    Since our government has chosen to ignore the simple fact that 90% of all mortgages are neither valid or salvageable, (the estimate from experts is less than 4% are legitimate) the people that are being fleeced are going to have to choose which side they are on. They are on the side of organized crime.
    When the wind shifts, and the smell of rotting carcasses finally wafts over to their elite noses, will it be too late? Of course it will.

  5. Conscience of a conservative

    Anyone taking out a mortgage without putting down a sizable down payment has no “skin in the game” and will be more prone to default than someone who has. I don’t have the data to support this, but I’m prone to believe the default experience of an underwater loan that has initial equity is worse than one that did not have initial equity.

    1. Ron

      That is common knowledge in the lending business so the next question is why would the government continue to create high leverage loans using FHA financing? Or for that matter zero down auto loans?

  6. renodino

    Those in power don’t care about defaults because as more people live in their homes rent free pending foreclosure, the more they will spend on consumer goods boosting the GDP and thus validating all the all the loses socialized by the government when they kept the big banks alive. Pretty clever, heh?

  7. 60sradical

    @ Diogenes…”too far down the road”, indeed. It is staggering to think that nobody–not hyper- “quants”,theoretical physicists,brilliant thinkers–nobody can deconstruct and unravel the unregulated trillions of $ of toxic derivatives “out there.” We don’t know when or what, but the black swans are now too damn close for comfort.

  8. Graham Cox

    Not for US readers.

    Since Alphaville for the FT picked this up and lazily did not bother to add the word USA, let me remind international readers that this finding relates to the US market where non-recourse loans are the norm ( ie where there are no significant penalties for key drops). There is no reason to assume read to a country like the UK where loans are recourse: ie where you cannot run away from the residual mortgage debt after foreclosure sale.

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