It is more than liquidity and perception - the Housing Crisis

Implications: Stress is yet to be seen, early indicators are bad, the future is going to be worse. The actions to date have failed the test for working out of the mortgage crisis. What is yet to come on the mortgage market can be changed if acted on, current trends are leading to disaster.

Analysis: Interest rate cuts, liquidity, FHA help plans, Fannie and Freddie caps and FHA limits are all good perception builders for the market place. The bad news is that it is only perception and as to the stress test, we are failing to make changes that could bring the market to the road to recovery.

The interest rate cuts only help those individuals that already have had a rate reset. The 2 million to come are not going to benefit from those cuts, the resets are less than market rate on the first pass (initial caps) for most of them. Even if they did reset to market, most can not afford the new payment anyway.

Liquidity is also just a perception. Unless you are an institution that faces a run, it will not help. Most of the larger banks involved in the US mortgage market are limited by their asset ratios and capitalization as to the amount of new mortgage loans they can put on balance sheet.

The FHA help plan is a joke with only 80,000 (FHA estimate) being able to qualify. As just stated, most can not afford to go to the market rate and you also can not have had a mortgage delinquency.

Fannie and Freddie caps are a real issue and prevent the resurrgence of conforming loans into a secondary market. The amount of room left on these caps is less than a months originations. They are relying on run-off to give them some room to take new loans each month. However, run-off is slowing down (prepay speeds). I am mixed on expanding the caps given the agencies ability to manage their finances, but believe if proper oversight is provided it can work.

FHA increasing its loan size does help provide a new market but does nothing for the investment properties.

How bad is the problem? Well Yale professor Robert Shiller is estimating Trillions will be lost in equity on home values. That is in addtion to the hundreds of billions that will be lost in direct investment as these loans fail and go to foreclosure and ultimately liquidation.

Lets recap: millions of loans in default, excess inventory in most markets, increases in inventory expected as foreclosures are completed putting further downward pressure on prices, no new avenue to refinance, no secondary market to trade the loans, lenders not really stepping up to workout the borrowers. End result total failure of the housing market, subsequent mark to market on all performing loans as to secured nature of collateral and asset value, horrendous operating losses as the second mortgage market is wiped out as unsecured and many first mortgages are written down to only partially secured. Other industries are also brought down and those not ruined are limited in their revenues (housing goods, appliances, lumber, railroads, trucking, home improvement, etc.).  We will not even get into how the housing market has carried the US market economy for four years and the loss of the equity will impact consumer spending.

What can be done to fix the mess? First, investors and insurers need to insist that servicers start working out loans on a permanent basis. I recently learned of one international investment bank that was very upset that their servicer was averaging three workouts per year on defaulted borrowers, they were all repay plans that all failed. What is needed is modifications of interest and borrower counseling on budgets to create some value in these loans and investments. The losses are currently trending above the historic 35 % rate and are going up as length of time to liquidate goes up. A 25% defualt rate with a 50 % loss severity is going to be a 12.5 % overall loss to a pool. That is the strip traunche as well as part of the next traunche. That is just the losses and does not include the mark downs on asset values.

It takes a long time before it makes more sense to foreclose on a loan than to re-write the loan and reduce the interest rate. As a matter of fact it is at least 17 years. ($100,000 loan at 35 % loss is $65,000 which takes 18 months to get back and reinvest. Meanwhile the $100,000 at 1% continues to earn at the rate $1,000 per year.) 

If we work these loans out and create re-performing loans they will have value, if they have value, they will be traded, if they are traded we will have a marketplace for them and confidence in the performance. If we do not do this, we are going back to the days of S & L's, Credit Unions, Community and Small regional banks along with FHA as lending sources.  They will make loans and money. Wonder what the big street firms that have vertically integrated will do with their investments in orignations, securitizations and serivicng?

So the stress is seeing a recession with possible ramifications to a depression if actual remedies are not created. The test will be in the actual workouts, not the feel good actions that bolster the market until the next company fails.