The Mortgage Muddle

I've been struggling to figure out what to say about the mortgage situation. There is so much happening that is difficult to know where to start. These are a few random notes about subprime and other loans headed for trouble, and the belated efforts by government officials to respond in some useful way.


The issues connected with subprime loans are only a part of the broader problems in the mortgage market, and mortgage finance problems are only part of the distress in the housing market. But mortgage lending was a big factor in speculative activity, housing oversupply, and inflated prices. And subprime loans accounted for a disproportionate share of recent wayward lending and current loan defaults.

The basic dynamic that led to the subprime debacle has been exposed pretty broadly already, but for a (literally) graphic exposition, you might refer to this description. Thanks to Bernie Markstein of NAHB for forwarding the link.

During the past year, particular concern has focused on the risks from imminent resets of hybrid subprime ARMs originated in 2006. A large share of subprime loans originated in 2005 and 2006 were 2/28 and 3/27 hybrids, meaning that they carried fixed rates for the first 2 or 3 years, after which the interest rate is reset every 6 months, based on a specified index and margin. The most common index is the 6-month LIBOR (London Interbank Offered Rate) – no doubt chosen because it was the rate least likely to be comprehensible to a subprime borrower. The margin is typically a whopping 600 basis points.

Although the initial fixed rates on these subprime ARMs were below the specified fully-indexed rates, they were not cheap. In some cases, the rate for the first couple of months was set very low, but during the rest of the fixed-rate period, the rates were well above prime fixed-rate loans. FDIC Chair Sheila Bair (one of the few officials to recognize the dangers before it all blew up) reported that the average for hybrid subprime ARMs in 2006 was 8.23 percent.

In early December, a program orchestrated by the Treasury Department was announced with great fanfare to defer resets for subprime borrowers who (a) were current and able to continue to make payments at the existing fixed rate and (b) would not be able to make payments after resets. It is still not clear whether the promised modifications were forthcoming, but since the announcement the 6-month LIBOR has fallen from about 5 percent to about 3 percent, implying that resets would only produce changes from 8.2 percent to about 9 percent, rather than to about 11 percent (subject to caps on per-period adjustment). Therefore, relatively few subprime borrowers can be characterized as able to pay before reset but unable to do so afterward. The reductions of the Fed funds rate and other Federal Reserve (and foreign central bank) actions have thus done much more to forestall reset payment shock than any modifications or forbearance actions.

While those factors have reduced the threat from reset payment shocks, that's not the central problem anyway. Very high shares of these loans were already in trouble before facing resets, as the sketchy underwriting that characterized subprime lending earlier in the decade became much more reckless in 2006.


Although many subprime loans had small downpayments and some had interest-only payments during the initial years, it is among the "near-prime" or "Alt-A" category that really exotic loans were most common. That's where there was the greatest concentration of loans to investors, downpayments using piggy-back loans, low-doc loans, low teaser rates, and non-fully-amortizing (interest only, option ARM, and balloon) loans. Average FICO (credit) scores of Alt-A borrowers were much closer to those of prime borrowers than to subprime borrowers, but the creative features represent risks that are hard to evaluate but (especially in combination) quite frightening.


While prime conforming loans, largely sold to Fannie and Freddie, and prime jumbo loans did not exhibit craziness comparable to the alt-A and subprime loans, even there the characteristics of loans became riskier, at the same time that inflation in house prices was adding to the potential risk in standard loans. For example, the interest-only share of loans in GSE pools jumped from about 8 percent in 2005 to about 16 percent in 2006.

The response

Two recent surveys of servicers, by the Mortgage Bankers Association and the Hope Now Alliance (with considerable overlap) attempted to measure the handling of delinquent subprime (and other) mortgages. They indicate that a substantial and growing share of lender responses involved loan modifications (new loan terms) or repayment plans (allowing more time to pay without changing terms). That was before any of the government-organized initiatives. Thus, it is unclear how much the involvement of the Treasury Department and other government entities changed things. Treasury argues anyway that it only encouraged a wholly-private effort, but encouragement from government officials with regulatory authority over your business can seem like more than casual advice.

Capozza and Thomson have described how subprime lenders expect high delinquencies and have a greater incentive for forbearance than prime lenders. Compared to prime loans, the interest rates on any further payments are higher and the recovery from foreclosure and sale is likely to be lower. Ultimately, despite repayment plans and modifications, troubled subprime loans are likely to lead to forced sales or forfeitures, but only after lengthy delays. Therefore, much of the impact on the already-glutted housing market still lies ahead.

One of the least documented aspects of default and foreclosure is the fate of the residents. Do they find housing elsewhere as renters or owners, double-up with others, or become homeless? In addition to the human cost, the answer to that question has significant implications for the market.

Among the limited audience who may read this are people who know much about this subject than I. Please contribute your thoughts and correct my errors.

February 20, 2008 - Comments (2)

Let the recession begin

Payroll employment fell by 17 thousand in January, the first month-to-month decline since 2003. The downtick was led by a decline of 27 thousand in construction employment, from 7,475,000 to 7,448,000. Residential construction employment, for builders and special trades (subcontractors), fell by 28 thousand, from 3,107,700 to 3,079,600.

A big drop in construction employment was slow in coming, but declines accelerated late in 2007. Even though housing starts, completions, sales, etc., had fallen sharply, employment in residential construction has declined much more modestly. Between March 2006 and December 2007, residential construction employment fell by less than 10 percent. Single family starts fell by 50 percent during that period, and the number of single family units under construction (a more relevant measure than starts) fell by 37 percent. Total units under construction fell by 25 percent.

The number of multifamily units under construction didn’t decline, but the average multifamily unit uses only about half as much labor and material as an average single family home. As a share of new residential construction value put in place, multifamily accounts for less than one-sixth of the total, even after the single-family collapse.

Revisions in the payroll data that were included in today's release showed weaker growth in total employment as well as construction employment during the past 2 years, but the overall picture didn't change. Various hypotheses have been suggested for the disconnect between construction activity and employment, such as a failure to count illegal immigrant workers, deficiencies in the payroll survey, and confusion in distinguishing between residential and nonresidential workers, but none of those explanations was really adequate. Just as there was initially a lack of apparent impact of housing on consumption, it was mainly a question of lags, rather than the absence of a relationship. Because employment in residential remodeling is included along with new construction, however, there is some cushion.

For some of the discussion and analysis that has addressed this, see the July 2007 comments by Richard Berner of Morgan Stanley, the October 2007 BLS analysis of the construction payroll data, and the discussion of the data in the January 2008 analysis of the effect of the housing slump on productivity from the Federal Reserve Bank of Chicago.

It's not official, but......

Although recessions are commonly thought of as consisting of 2 quarters of negative GDP change, the NBER committee that is effectively the arbiter of business cycles actually uses monthly statistics and judgment to determine when recessions begin and end. Often, however, recessions are well-underway, or even over, before they declare that one has started.

As explained in a memo from October 2003, the Business Cycle Dating Committee looks primarily at 4 measures: real personal income excluding transfers, payroll employment, industrial production, and real manufacturing and trade sales. I’m not completely sure I’ve used the same series as they do, but it appears that real personal income in December (the latest number available), was down slightly from a possible peak in September 2007. Industrial production may have peaked in July. Sales are only available through November, but were down from a possible peak in October. With the January employment decline, it looks like a duck, walks like a duck, swims like a duck, and now quacks like a duck. I think it’s a duck.

February 1, 2008 - Comments (0)

No light ahead yet

The subprime mortgage meltdown, drop in confidence, credit crunch, etc., are only part of the problem with housing. The various elements come together when supply is compared to demand. The indicators of that relationship include the supply of unsold new homes, the number of existing homes for sale, and the number of vacant homes for sale.

Quarterly data from the Census Bureau's Housing Vacancy Survey were released today, offering no encouragement to offset the dismal results for December new and existing home sales reported during the past week. The overall homeowner vacancy rate for the 4th quarter of 2007 was shown as 2.8 percent. That was up from 2.7 percent in the third quarter, and matched the record set in the first quarter of last year. The homeowner vacancy rate has been reported on a quarterly basis since 1956. Prior to 2006, it never exceeded 2.0 percent. That is perhaps the most graphic and disturbing measure of the extent of imbalance in the market.

The homeowner vacancy rate is defined as the number of vacant housing units for sale, divided by the sum of the vacant fior sale plus owner occupied plus sold but not yet occupied. The title is a bit of a misnomer, since many of the vacant units for sale were not previously owner-occupied and may be sold to investors rather than for owner-occupancy. Mobile homes and condos are included along with conventional single-family structures, and and the vacant-for-sale category includes both existing (previously-occupied) homes and completed new homes. Only about half of all new and existing homes being offered for sale are vacant, but they represent a greater burden than homes that are still occupied or that have not been completed.

About 15 percent of the 2.18 million vacant homes for sale were not previously occupied, according to the HVS data. That translates into a larger number than the 195 thousand completed unsold new homes reported in the new home sales report, because new condos and mobile homes are included, and because completed homes with cancelled contracts are, in theory, included in the HVS but not in the sales report. Of course, the two surveys--especially the HVS--are not sufficiently precise to justify any major inferences from the difference.

If we assume that a normal/equilibrium homeowner vacancy rate is, say, 1.7 percent (the average in 2004), then the excess number of vacant homes for sale is over 800 thousand. Even though current production is below long-term potential absorption, it would take a while to soak up that excess. Add in the possible effects of widespread foreclosures and the picture is even more dismal.

January 29, 2008 - Comments (1)

Generational Housing Bubble?

As if the current severe housing market correction were not enough, a new paper by Dowell Myers and SungHo Ryu posits that the short-term problems will be overshadowed by a "generational housing bubble" as baby boomers continue to age. This report has been given prominent attention in media such as the Wall Street Journal and the Economist.

Myers and Ryu make estimates of the rate at which people in different age brackets bought and sold homes during 1995-2000, and report that among the population up to age 65 there were more purchases than sales, but beyond that the "sell rate" exceeded the "buy rate."  Given the impending shift in the age distribution, they extrapolate from that to a glut in housing supply.  Although the article in the Journal of the American Planning Association is more nuanced than the press reports drawn from it, it is still misleading.  It indicates that a major shift is imminent and that it will occur because boomers will "retire, relocate, and eventually withdraw from the housing market."

Sales by homeowners age 60 and over in 2000 were estimated by comparing their numbers to the numbers of owners from the same cohorts in 1990, using the difference as "a measure of all the home sales that were not followed by purchasing another home, but by renting, moving to a retirement home, or death."  It is that last component that undoubtedly accounts for much of their estimate. In a key chart with the vertical axis representing persons in each age group buying and selling, the scale ranges from zero to six percent, and the "sell rate" soars off the chart for those aged 80 and over. The caption says that "8.8 percent of persons 80 and older sold homes each year."  In that context, "sold" is a euphemism. In fact, according to data from the National Center for Health Statistics, more than 11 percent of persons 80 and older died each year during that period.

As I found when I looked at this subject in 1996, most older homeowners don't move, and if they do they are unlikely to become renters, move in with their children, etc.  Indeed, they were more likely than younger movers to buy newly-built homes. In connection with a presentation I gave in April 2006, I noted reasons to expect that the leading edge of the baby boom would be even less likely to opt out of home ownership in the near term.

Extensive and thorough analysis of housing demand among the older population may be found in a series of articles about housing wealth written over the course of two decades by Steven Venti and David Wise.  The most recent paper that I have was written in 2001.  They found that "in the absence of a precipitating shock--death of a spouse or entry of a family member into a nursing home--families are unlikely to discontinue home ownership.  And even when there is a precipitating shock, discontinuing ownership is the exception rather than the rule."

There will be a negative effect on housing demand from the passing of the 1946-1964 baby boom, but it won't be soon or sudden.

January 27, 2008 - Comments (3)
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