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Projected Foreclosures A few weeks ago, the Center for Responsible Lending testified before the Joint Economic Committee of the U.S. Congress regarding prevailing conditions in the housing market. The CRL is a non-partisan organization focused on consumer protection. Among their main objectives is the establishment of a Consumer Financial Protection Agency to prevent abusive and deceptive lending practices. Among these practices in recent years was a form of mortgage broker compensation called a "yield spread premium." The YSP was an extra payment that brokers received for delivering a mortgage with a higher interest rate than one for which the borrower would usually qualify. The mortgages were then packaged up and securitized to satisfy the demand of yield-hungry lenders. The yield spread premiums typically encouraged brokers to offer "no doc" loans even when borrowers could verify their income, but also generally require the mortgage to have a prepayment penalty. A lot of these non-standard mortgages (Alt-A, Option-ARM) were written during the late stages of the housing bubble. These are precisely the mortgages that are beginning to reset, and will continue to be reset into 2012. And there is a mountain of them. Several facts are worth noting. In September 2007, about a month before the stock market peaked and well before credit strains were obvious, the CRL testified to Congress about the wave of coming subprime foreclosures, encouraging Congress to act before the crisis escalated. "As it turned out," the CRL noted in its latest testimony, "our predictions – dismissed by some as pessimistic – actually underestimated the dimensions of the crisis." This is important, because here is what the CRL is saying now. First, over 1.5 million homes have already been lost to foreclosure in the sub-prime category, and another 2 million subprime mortgages are currently delinquent. But even this figure pales in relation to their data on projected foreclosures of all types. For 2009, total foreclosures are estimated to be 2.4 million. But coupling state-by-state delinquency rates and foreclosure starts (as reported by the Mortgage Bankers Association) with other data, the CRL projects that for most states, foreclosure totals will more than triple over the coming 4 years, for a total of 8.1 million foreclosures, with only about one in ten of these being saved thanks to court-supervised modifications. These figures are consistent with the reset data I've repeatedly presented - it appears to be wishful thinking to believe that the credit crisis is over. Most likely, what we've witnessed in recent months is little more than the combination of a lull in the reset schedule coupled with a wholly unsustainable burst of deficit spending amounting to over 7% of GDP. My impression of the U.S. banking system is that it is quietly going insolvent, in a manner that will become evident only when the slack for "significant judgment" (provided by the FASB earlier this year when it altered mark-to-market rules) is taken up so tightly that the rope snaps. Presently, this slack has allowed banks some time, but the question is, time for what? The rules encourage banks to neither modify loans nor foreclose, both which would trigger a restatement of value on the mortgage asset. Meanwhile, banks are reluctant to allow "short sales" in lieu of foreclosure (where a homeowner sells a home to avoid foreclosure, but at a price less than the residual loan value, so the bank has to essentially eat the loss). This again defers the restatement of asset values for a while, but makes business sense only if home prices are expected to recover faster than the foregone interest that could be earned on new loans. So if you talk to people who oversee these assets, including people who work with the FDIC, you'll hear that there is an inventory of unrecognized losses being built up, in hopes that the underlying mortgages will turn around without the need for loss reporting. In view of the CRL foreclosure projections, all we can think is – fat chance. The FDIC itself is already essentially broke, and is looking at options like taking premium prepayments to try and shore up its own books. Last week, an FDIC spokesman offered the interesting assurance that "our ability to raise premiums essentially means that the capital of the entire banking industry -- that's $1.3 trillion -- is available for support." So the banking system, which is most likely quietly undergoing its own erosion of capital, can expect to see its capital tapped by the FDIC to pay for, well, the erosion of capital in the banking system. Still, don't blame the FDIC. Our policy makers bailed out bank bondholders instead of focusing on debt restructuring. The bad assets are still in the banking system, millions of families will still lose their homes, the Treasury and Fed have jointly issued trillions in new government obligations, but the bondholders of Bear Stearns will still get 100% of their principal and interest. Despite the current enthusiasm of Wall Street, this story has probably not ended, and the evidence suggests it will end badly.
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