“Lien-ing” In: What is behind the Continued Recovery of Mortgage Default Rates?

According to a report by the Mortgage Bankers’ Association (MBA) the delinquency rate for first-lien mortgage loans on 1-4 unit residential properties decreased to a seasonally adjusted rate of 5.54% of all loans outstanding at the end of the first quarter of 2015, 14 basis points less than its level in the fourth quarter of 2014 and 57 basis points below its level one year ago. The serious delinquency rate has now reached its lowest level since the second quarter of 2007.

The 4-quarter decline in the share of mortgages past due, measured on a not seasonally adjusted basis, reflected a decline across each stage of delinquency. On a not seasonally adjusted basis, the percentage of all loans past due fell by 55 basis points over the quarter. Loans 30-59 days past due fell by 12 basis points, loans 60-89 days past due fell by 6 basis points, and loans 90 or more days past due decreased by 37 basis points. However, the foreclosure starts rate remained unchanged over the past four quarters.

Although the foreclosure starts rate remained unchanged over the past four quarters, over the past 4 years, 2011-2014, it has been steadily declining and nearing a recovery. During the period including 2002 to 2005, the foreclosure starts rate remained low and relatively steady, however, it began a sustained climb beginning in 2006, peaking at 1.27% in 2010. Since peaking in 2010, the foreclosure starts rate of mortgages secured by 1-4 unit family homes has been falling. By 2014, the foreclosure starts rate reached 0.46%, in line with the level recorded in both 2003 and 2004.

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Statistics from the Federal Deposit Insurance Corporation (FDIC) suggest that, because of their size, defaults of first-lien mortgages on 1-4 unit homes had a larger impact on the foreclosure starts rate, but the default rate on junior lien mortgages was much more severe. Liens on property represent the parties, usually financial institutions, that have a claim on the property in the event of default. Each of these parties will attempt to recover the money that they are owed if the borrower defaults. However, liens come in an order of priority. If a default occurred, the first lien holder, is the person or, typically, the financial institution, that has priority over all other claims. Junior liens are parties that have claims on the property after the debt owed to the first lien has been paid. For example, a second loan used to cover the difference between the first mortgage and the value of the home, such as a “piggy-back mortgage”, is typically placed in a junior position to the first, or primary, mortgage. If a default occurred when the homeowner is considered “underwater”, that is the value of the home was less than the total amount borrowed, then the first lien holder, relative to the junior lien holders, is more likely to recover the amount that they lent.

As Figure 2 illustrates, the default rate on first-lien mortgages varied between 0.0% and 0.1% between 2002 and 2006, but beginning in 2007, the default rate on first-lien mortgages began to rise and by 2009, the default rate peaked at 1.4%. Since 2009, the default rate on first-lien mortgages that were used to secure 1-4 unit homes has steadily declined and is now at 0.2% as of the fourth quarter of 2014.

Over the years including 2002 to 2006, the default rate on junior lien mortgages was higher than first-lien mortgages and slightly more volatile, but still relatively low. Similar to the experience of first-lien mortgages, the default rate on junior lien mortgages began to rise in 2006, soaring to 6.0% by 2009. As recently as 2012, the default rate of junior lien mortgages on 1-4 unit homes was 5.0%. By 2014, the default rate of junior lien mortgages had declined to 1.1%. However, the default rate in 2014 remains above any level recorded between 2002 and 2006.

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  1. The housing bubble was a 2002 to mid-2004 event.

    Housing prices were rising generally, faster than incomes, beginning in the mid-1990s, but the early 2000s, after Greenspan’s 5 point rate cut, was when people took advantage of the prolonged differential between short and long rates, and opted for ARMs in greater numbers, to boost the amount of debt that they could service with a given income, and bid up house prices.

    Mortgage default rates also declined from 2002-2004. This is largely driven by the number of cash out refis in 2003-2004, which left households suddenly liquid and thus able, for a few years, to meet mortgage payments without regard to income and spending habits.

    The subprime wave was a mid-2004 to mid-2007 event. Subprime mortgage volume increased before 2004, but not in proportion to overall mortgage volume, in terms of either units or dollars loaned. In fact, subprime share DIPPED from 1999-2002, before spiking in 2004.

    Alt-A was a 2004-2007 event.

    Consider that Alt-A was a reaction to rising collateral values, and subprime was a reaction to rising collateral values and the initial decline in default rates.

    Consider also that only 30% of mortgage foreclosures from 2007-2012 were of subprime loans.

    Consider that 1 in 3 Americans has a subprime FICO (a ratio that did not materially change until the crash) and the “wave” of subprime lending drove subprime mortgage volume from 1 in 10 mortgages to 1 in 5. Consider that subprime share of mortgages outstanding never got above 1 in 8. Consider that the average FICO score on an approved US mortgage declined between 2004-2007, by about 21 points – i.e., one old, since-cleared-up, 30 day past due.

    Consider that most of the leveraging up, in terms of debt-income, and debt-GDP, happened before the subprime wave.

    Consider that the housing bubble happened in a few dozen countries not all of which have securitization or subprime, but all of which have mortgages priced at short or even floating rates.

    Consider that Germany structures its prices its mortgages like commercial mortgages, on a 10/25, that the German 10 year bond yield didn’t budge from 2000-2007, and that Germany didn’t experience a housing bubble or mortgage crisis.

    Consider that home builders are financed at short rates, with carried interest, usually without a rate floor or with a rate floor at 4% all-in, meaning that their cost of capital fell from about 10% to about 5-6% from 2002-2004, enabling them to increase building by 30% in response to the rising house prices.

    Consider that home builder loan structures, underwriting parameters, credit quality didn’t change at all during the 2000-2007 period.

    Consider that the Fed sets the short rates.

    “Subprime” is the cold sore – – the STD is the Fed and ECB cutting rates to “stimulate” the economy and only “stimulating” a bubble in rate-sensitive sectors such as housing.

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