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Sunday, August 20, 2006

RE: The Contagion Effect

I am republishing a public comment sent to the FRB regarding the proposed guidance on non-traditional mortgages by the Mortgage Insurance Companies of America (MICA). All comments submitted on this proposal can be found here. They are in pdf format.

First, a brief discussion of MICA's points:
MICA is correct that highly risky mortgages continue to be written and that through most of 2006, the number of these loans has continued to increase. Bond-rating agencies have responded, and as I have recently blogged, companies with large portfolios appear to be trying to adjust their risks, including by measures such as selling these business units.

MICA's reference to the "contagion effect" means this: It is well documented that an area experiencing high foreclosures will also see a drop in home prices. It has recently been estimated that in certain areas high foreclosures alone can drop home prices (in the same market segment) by as much as 10%. MICA's concern is that although it can and will refuse to insure risky loans, it cannot control the overall effect of high foreclosures, which then change MICA's potential exposure. Since mortgage insurers have to pay the difference when insured loans default and the entire principal amount is not recovered (the rule, not the exception for foreclosures), MICA is concerned that that these extremely risky loans will default in high numbers, causing a significantly higher level of traditional mortgage defaults. In Miami, recent foreclosure sales have recently been reported to average about 50% of the median Miami price.

What this means for the average homeowner is that even though you did not, by usual standards, overpay for your home, and got a traditional 30-year fixed-rate mortgage paying 10% down, the overall mortgage industry has changed in ways that seem likely to produce home price drops more than 10% in many areas. If then, you run into some significant life risks that are not controllable (illness, relocation, job loss), you may be driven into foreclosure because you cannot refinance and cannot sell, due to having a mortgage balance higher than the current resale value of your home.

Finally, you should understand that it is unlikely that the Fed's action will have much effect. Since many of the risky mortgages have been underwritten by non-banks, such as REITs, the Fed has little ability to regulate them. It could require new disclosures, but most of the Fed's and other regulatory agencies ability to meddle with banking practices is inherent in its "Safety and Soundness" standards. These do not apply to non-banks. Congress would have to pass new legislation to make REIT's subject to meaningful supervision.

Finally, the last time large numbers of mortgages were underwritten in this way occurred in the 1920's. The financial crash that followed caused the federal government to set up the current mortgage financing agencies such as FNMA, because banks had almost ceased lending for mortgages. Unfortunately, within the last five years the traditional mortgage underwriting system has declined in market share, and now seems to underwrite only about half of all purchase money loans. Think about the implications of that.

MICA's comment:
The Mortgage Insurance Companies of America (MICA) has long been strongly supportive of the banking agencies' work to ensure appropriate prudential standards for mortgage risk. Mortgage insurers of course have all of their risk concentrated in this area, and we are deeply concerned about the potential contagion effect from poorly-underwritten or unsuitable mortgages and home-equity loans. We hope the agencies will soon finalize the draft guidance released last December on nontraditional mortgages [70 FR 77249], in part because the most recent market trends show alarming signs of ongoing undue risk-taking that puts both lenders and consumers at risk.

Below, I would like quickly to note some recent mortgage-market data that support the proposed guidance and argue for rapid action. MICA has been particularly concerned that the guidance make clear that loans with simultaneous second liens are risky in and of themselves, with these risks of course heightened when they are "layered" with other non-traditional features such as payment-option and interest-only structures. Key recent findings include:

In June, Standard and Poors (S&P) decided to revise its ratings criteria for mortgages with simultaneous second liens, often called "piggyback" mortgages. footnote 1 This decision brings the S&P rating into alignment with the more conservative one by Moody's and confirms the higher risks posed by these structures. S&P based its decision on research confirming that, holding credit scores equal, mortgages in which the borrower finances the down payment are more likely to default than loans with cash down payments. S&P also concluded that housing markets are likely to experience more stress than originally anticipated, heightening the risk for borrowers with no cash downpayment and, therefore, no equity in their homes.
• The most recent data available from a survey conducted by the National Association of Realtors footnote 2 shows that first-time homeowners - 40% of all borrowers in 2005 - had an average down payment of only 2% on homes costing $150,000, but 43% of these homeowners had no down payment at all.
• In general, non-traditional mortgages have become a still more significant part of the market, despite the cautionary note in the proposed guidance. footnote 3 First-quarter data indicate that interest-only and payment-option products now account for 26% of mortgage loan originations - a sharp increase from last year. footnote 4 Even more striking, a recent Fitch report notes that 40-year mortgages with payment-option features now account for 8% of total securitized mortgage volume, up from 2% for all of last year. footnote 5 Subprime mortgages with fixed rates for two years and variable ones for the following 38 years account for 8% of total subprime originations in the first quarter of 2006, up from 2% in all of 2005. footnote 6 Fitch notes particular concern with loans like this because of "double-teaser" clauses.

MICA has noted that industry practice did not change as significantly as required following the final guidance in 2005 on home-equity loans. footnote 7 Although the non-traditional guidance is now only in draft form, one would have expected a far slower growth in industry reliance on non-traditional products in anticipation of final standards with far-reaching market impact. The fact that this did not occur reinforces the suggestion in our earlier comment letter footnote 8 that the final guidance be accompanied by clear language regarding not only consistent enforcement by the agencies, but also clear penalties for those who disregard it.

We would be pleased to provide additional background on the findings noted above or any other market analysis that would be of assistance as your agencies finalize the nontraditional mortgage guidance.
The slowdown in home sales is already producing regional layoffs in industries such as plumbing. Loan officers, mortgage brokers and realtors have been losing their jobs for months already. Within four months these second-tier job losses will begin to radiate throughout the economy, and by the first quarter of 2007 this will produce the second reinforcing wave on this economic downturn, shortly followed by a third wave as banks call in business loans secured by homes (a very large segment of the small business sector not guaranteed by the SBA). The credit contraction that will occur in 2007 will be fierce, and the effects will be felt for years to come. In the meantime, a dimwitted and delusive Congress has been discussing shutting down the SBA program. Words fail me.

I would highly recommend reading about a week's worth of posts at The Housing Bubble Blog to get a true perspective on what's happening. The comments posted are just as important a source of information as the posts themselves.


Comments:
I got a kick out of the entry about realtors starting to buy St Joseph statues by the case.

(Among a lot of Catholics, there's a superstition that if you bury a statue of St Joseph upside-down on your property, the property will sell.)

The Headless Unicorn Guy
 
Well, did you read about the disappearing St. Joseph? The realtor went back to dig him up, and he was gone.

Why upside-down? I wouldn't want to irk St. Joseph that way!

(But don't you think nabbing other people's statues is even more problematic? Is that supposed to bring you luck?)
 
Seriously? They're so cheap they're actually stealing each others' statues?

Somebody contact Parker & Stone over at South Park...
 
Apparently so! I've heard of dog-eat-dog, but realtor-steal-statue?
 
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