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Can 4% of Homeowners Sink the Entire Market?   (February 21, 2007)

If 4% of all American homeowners fall into foreclosure, could that "small number" cause a collapse in the entire housing market? The Pareto principle says: yes.

Despite months of suspiciously negative data--housing sales and starts sagging, cancellations of sales and foreclosures rising--housing apologists have maintained that the problems with subprime borrowers and lenders can be "contained." In other words, only those "few" who lose their homes will suffer any economic impact; Home Depot and Lowes sales will remain robust, construction activity will continue unchanged, employment in construction, home furnishings, remodeling, lending and real estate will continue to hold up with minimal declines, etc.

That's the happy story. Let's get some facts before we buy into it. Here is a recent story in the Wall Street Journal: Sharp Drop in Housing Starts Adds To Fear of Wider Economic Impact (2/17/07) (subscription required)

So far, defaults and late payments have remained very low on prime mortgages, which are made to lower-risk borrowers and account for the bulk of home loans. But late payments have risen swiftly over the past year on subprime mortgages -- those made to risky borrowers with spotty credit histories -- and on "Alt-A" mortgages, a category between prime and subprime which includes many loans for which borrowers haven't documented their income. According to trade publication Inside Mortgage Finance, 13% of mortgages outstanding are subprime.

In November, payments were at least 60 days overdue on 12.9% of subprime loans packaged into mortgage securities, up from 8.1% a year earlier, according to First American LoanPerformance, a research firm in San Francisco. For Alt-A loans, the delinquency rate jumped to 2.1% in November from 1.1% a year earlier.
But if we dig a little deeper, we find that seems to understate the true scope of delinquencies and foreclosures. Here is the Financial Services Fact Book:

Adjustable rate mortgages, loans in which the interest rate is adjusted periodically according to a pre-selected index, accounted for 31 percent of mortgage originations in 2005, up from 12 percent in 2001.
The factbook also lists some very interesting charts of delinquencies: 12.9% of all FHA loans are delinquent. Are these listed as subprime? No. These are "conventional mortgages."

The Factbook also states that 24.7 million homes are owned "free and clear," with no mortgage, and about 50 million have mortgages of one kind or another. About 10 million homeowners have equity lines of credit as well as a mortgage--in effect, second mortgages. Though rarely mentioned in all the hoopla about subprime ARM (adjustable rate) mortgages, it is important to note that equity lines of credit are adjustable-rate loans; they are not 30-year, fixed-rate "conventional" mortgages.

The upshot: 10 million homeowners who statistically have "safe" conventional mortgages are at risk of their home equity line loans re-setting to higher rates. There's about $9 trillion in home mortgages on the books, and $500 billion is due to re-set higher. More Americans are losing their homes:

Nothaft estimates that $500 billion in variable rate mortgages will reset, or rise, sometime this year, leaving many with a payment they can no longer afford. “Those would be the candidates for … delinquent status,” he said.

Foreclosures had been at historic lows in the past three years as rapidly appreciating home prices gave financially strapped owners the option to refinance, sell their house at a profit or take out a cheap home equity line of credit. But with the pace of appreciation slowing in many markets and interest rates rising, for many, these avenues have been cut off.

“You’re really out of options,” said Susan Wachter, professor of real estate at the Wharton School at the University of Pennsylvania.
Meanwhile, back at the ranch, Number of vacant homes for sale surges 34%
The number of vacant homes waiting to be sold surged 34% to 2.1 million at the end of 2006 compared with the end of 2005, by far the fastest increase ever recorded, the Census Bureau reported Monday.

"We have more than a million housing units of excess supply," said James O'Sullivan, an economist for UBS. "If you are looking for evidence that the worst is over for housing, you're not going to find it in this report. This argues that housing starts need to go down more."
According to the Financial Times, The inventory of new and existing homes waiting for buyers is now approaching 4m.
The total value of US residential property is now around $19 trillion, according to the Joint Center for Housing Studies at Harvard University. The US Census Bureau calculates that there are around 123.9m housing units in the US. (ED: this includes condos and rental apartments)
Total household debt is $11 trillion: $9 trillion in mortgages and $2 trillion in revolving credit (credit cards, etc.) That means net equity for all 75 million American homeowners is $8 trillion--including the 25 million households who own their homes free and clear. What if we subtract those folks? Since 1/3 of all homes are owned free and clear, let's assume about a 1/3 of the $19 trillion is represented by these mortgage-free homes.

That's $6.5 trillion, which means all 50 million mortgage holders are left with a grand total of $1.5 trillion in net equity. If housing values decline 15%, that's a $2.85 trillion haircut off net equity. If we set 2/3 of that against mortgaged real estate, (the other 1/3 being a decline in the value of free and clear homes), then the decline collectively suffered by all mortgage holders is $1.9 trillion--enough to put them in a negative equity hole.

This is a staggering conclusion, for it suggests just how a "mere" 4% delinquency/foreclosure rate could trigger a "modest" 15% decline in housing values, which would put the nation's mortgage holders (if taken in aggregate) under water: the nation's household debt would exceed the value of the mortgaged residential real estate.

So let's put this together. With the Pareto Principle in hand, we can foresee the distinct possibility that when a mere 4% of outstanding mortgages enter delinquency / foreclosure, then a "tipping point" will be reached, triggering effects which far outsize the proximate causes.

Please examine the chart above carefully. Over 69% of the population are homeowners, and another 26% are in poverty. According to the FDIC, the recent surge in ownership from 64% to 69.5% has created a pool of "at-risk" borrowers who couldn't have purchased a house with a conventional mortgage. Of the remaining 4% who are not homeowners or those living below the poverty line, the recent stalling home ownership rates at about 69.1-69.7% suggests these households are just above the poverty level and unable to buy a house, not yuppies renting penthouse suites who are now ready to buy a McMansion.

There are 50 million mortgages. If 4% is the magic number, that's 2 million mortgages. In other words, when 2 million mortgages enter delinquency / default, then according to the Pareto principle, that will affect the 64% "trivial many," i.e. those holding "safe" conventional mortgages.

According to the FDIC, about 4 million recent buyers are at risk of defaulting. Recent news items suggest 1 million subprime mortgages are already in that category. There are at least 6.7 million subprime loans outstanding, and if 13% are in foreclosure, that's nearly 900,000. We can be confident that a much larger number are delinquent, and that lenders are scrambling to keep them out of foreclosure.

Also recall that 13% of FHA loans--"conventional fixed-rate mortgages"--are already in delinquency. (see Factbook link above for the chart) So while the foreclosure rate on those mortgages is still low--2% or so--the pool of potential foreclosures is large, and increasing.

How close are we to the "tipping point" where a "small" 4% (2 million defaulted mortgages) will cause 64% of the effects, i.e. declines in housing prices? If you total up delinquencies, it would seem we are already well over the 2 million mark. As for 2 million foreclosures--the clock is ticking.

Here's a question that deserves to be asked: if everyone who can afford a house--even those who stretched their credit to the breaking point--has already bought a house, then who's left to buy the 4 million empty dwellings? Please don't say someone who's selling their existing house--they're adding one unit of inventory even as they take one off.

If you add up the facts presented above, it is difficult not to reach disturbing conclusions: there is no way buyers will emerge to snap up 4 million empty homes; the number of mortgages in delinquency is large, and rising, meaning the number of foreclosures in the future pipeline must also rise; once 2 million mortgages/homes are in foreclosure, a "tipping point" may well be reached which will lead to significant declines in all housing values far in excess of the supposedly "contained" "small" number of delinquent / foreclosed loans.

Here's another way to consider the possible Pareto effects: if 20% of the housing stock in the "hot markets" of Florida and the West and East coasts declines in value, then will that cause a decline in 80% of the U.S. home market?

Some other links of interest:

Patterns of Housing Decline: "Core and Periphery"
(recommended by frequent contributor U. Doran)

After Subprime: Lax Lending Lurks Elsewhere (2/20/07)
(Wall Street Journal Online subscription required)

Foreclosures and Financial Ruin: How Bad Will It Get? (April 26, 2006)

How Many Foreclosures Will Hit the Market? (May 1, 2006)

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