The soothingly low mortgage delinquency rate is a deceptive
indicator: the New York Fed weighs in.
Mortgage delinquencies at all commercial banks in the US inched down to
3.14% in the second quarter, the lowest since Q2 2007, according to the Federal Reserve. But after those soothingly low
delinquency rates in 2007, something happened. By Q3 2008, the delinquency
rate hit 5.2%, and in Q4 2009, it went over 10%, and stayed in the
double-digits until Q1 2013. This was the mortgage crisis. And we’re a
million miles away from it, thank God. Or are we?
This chart compares home prices in the US (green, left scale) to
delinquency rates (red, right scale). Delinquency rates started surging after
home prices started falling. The inflection point is marked by the vertical
purple line, labeled “it starts”:
Home prices began falling in 2006. By 2008, some homeowners were seriously
“underwater” – they owed more on their house than the house was worth. When
they ran into financial trouble because they were in over their heads, or
because one of the breadwinners in the household lost their jobs, or because
they’d lied on their mortgage application and never had enough income to
begin with, or because they were investors who couldn’t make the math work
out anymore, or whatever, they were stuck.
In a rising housing market, they would just sell the home and pay off the
mortgage. But they couldn’t sell their home because it was worth less than
the mortgage, and default was the only option.
The chart above shows the relationship between home prices and
delinquencies. In a rising housing market, delinquencies will always be low
but are not an indicator of future default risks. But home prices are an
indicator of default risk.
“Borrowers’ ability to withstand economic shocks depends importantly on
housing equity,” the New York Fed explained in its new Economic Policy Review. “This dynamic played a key role
in the 2007-09 recession, when surging mortgage debt followed by falling home
prices put many homeowners ‘underwater’ on their mortgages.”
When home equity turns “negative,” that’s when serious trouble begins. The
New York Fed:
Over the first half of the 2000s, U.S. household debt, particularly
mortgage debt, rose rapidly along with house prices, leaving consumers very
vulnerable to house price declines. Indeed, as house prices fell nationwide
from 2007 to 2010 and unemployment rates soared, mortgage defaults and
foreclosures skyrocketed because many households were “underwater”…
But the national averages don’t do a good job. About a third of homeowners
own their homes free and clear, and there is no risk associated with them.
Another third of homeowners owe relatively small amounts or very manageable
amounts on their homes, after years of having made payments without cash-out
refinancing. And they’re not a risk factor either. They can always sell their
home and pay off their mortgage, even if home prices drop 40%.
The risk lies at the remaining third of the homeowners, the most
vulnerable, the most leveraged, those that bought recently at the highest
prices, those that refinanced to cash out their home equity….
Then there’s the issue of home prices dropping a lot more in some regions
– and this is averaged out in the national statistics. The New York Fed
(emphasis added):
At a more disaggregated level, the time series of our leverage metrics
clearly reflect the dramatic regional home price dynamics that others have
observed, with the widest swings in prices found in the “sand states”:
Arizona, California, Florida, and Nevada. Studying these states illustrates one
of the key lessons from our analysis: Looking at measures of leverage based
on contemporaneous housing values will often lead one to misestimate
the vulnerability of a housing market to shocks.
Homeowners in the sand states were much less levered in 2005 than those in
other regions, yet as home prices reverted to their mean, the leverage of
these homeowners rapidly increased and extremely high mortgage defaults
followed.
The paper warns: “Most importantly, higher leverage, and in particular a
household being underwater on its mortgage(s), is a strong predictor of
mortgage default and foreclosure.”
In fact, according to research cited by the paper, negative equity is a
“necessary condition” for mortgage default:
Negative-equity loans represent a pool of default risks: If the borrowers
are hit with liquidity shocks resulting from, say, a lost job, then default
may be the only viable option. Positive-equity borrowers faced with liquidity
shocks, on the other hand, are generally able to sell the property and avoid
default.
Thus, “household leverage” blowing out is not a function of the mortgage,
which doesn’t change much, but a function of the home price, which can
decline sharply. This increases household leverage due to market forces,
without even any input from the household. It happens on a case-by-case
basis, and the national averages fail to predict this condition.
Even if they don’t default, households that have become overleveraged due
to declining home prices impact the broader economy, the New York Fed points
out:
- They may cut back consumption in response to a negative
shock, in part because they lack “debt capacity” that could help them
smooth consumption.
- They’re often unable to refinance to take advantage of
lower mortgage rates.
- They may reduce spending on property maintenance or
investments.
- The may not be able to move when opportunities arise for
them elsewhere.
- High leverage in conjunction with down-payment
requirements further reduces transaction volume and prices, “thereby
generating self-reinforcing dynamics.”
And the differences, as real estate in general, are local, according to
the report: “In cities where more homeowners are highly leveraged, house
prices are more sensitive to shocks (such as city-specific income shocks).”
It all boils down to this: There can be no mortgage crisis unless home
prices decline enough in some markets. And given how inflated home prices are
in many markets, and that mortgage rates are now climbing, any reversion
toward the mean of home prices in those markets would cause the delinquency
rate to do a beautiful “déjà-vu all over again,” so to speak. That low
national delinquency rate these days, often touted as a sign of low risk in
the housing market, has zero meaning as an indicator of risk for the most
vulnerable households when the prices of their homes begin to drop.
Refinancing activity plunges to the lowest level since 2000. Read… What
Will These Mortgage Rates Do to Homeowners Trying to Refinance, Homebuyers,
and Mortgage Lenders?
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