Mar 16 2007 6:09AM | Permalink | Email this | Comments (16) |
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The accelerating collapse of lenders who emerged in 2004-05 to specialize in “non-traditional “mortgages foreshadows a huge wave of mortgage defaults and foreclosures that will toss hundreds of thousands of homes into the resale market, keep housing starts depressed for several years and reduce the margins of all suppliers to the residential housing market. As a result, supply cost will fall marginally for the rest of the construction industry but this plus will be offset by the negative impact of the housing problem on aggregate economic demand.

The Federal Reserve Board estimates that as many as 40% of the mortgage originations in 2005 were nontraditional mortgages. This includes no down payment loans, low initial rate adjustable rate loans, interest only loans, skip payment loans and subprime loans with above market rates, often with the full rate deferred for the initial loan period.

Mortgage defaults are now clearly the biggest threat to the housing market in 2007-08, possibly to the entire construction market and maybe even to the entire economy. Think S&L scandal in the 1980’s. Some estimates put the total loss, including billions in legal costs, in what will come to be known as the nontraditional mortgage scandal, nearly as high as the S&L scandal. Federal taxpayers bore most of the cost of the S&L scandal. This time the costs fall directly on the housing market. The number of households that lose their homes will likely be more than the 100,000 estimated by the National Association of Realtors but far less than the 1,000,000 plus estimated by activist groups like the Center for Responsible Lending.

Foreclosures on previously sold homes are only part of the impact on the housing industry. Already, credit standards have been tightened enough to keep 300,000-400,000 low income households who would have qualified for a nontraditional mortgage in 2004-06 from getting a standard mortgage in 2007. The depressing impact this has on home prices will reduce home purchases by move up buyers too nervous to bid on a new house when they are uncertain about the sale price and timing of their current house.

How big a negative is the mortgage problem for the housing market? It is too soon to be sure. This is not the usual mortgage problem. It is a credit quality problem not a credit cost problem. Mortgage rates will stay relatively steady in 2007-08 while credit approval standards tighten, returning to the pre-2004 practice of insisting that mortgage applicants be financially able to carry a amortizing, full market rate loan even if the initial mortgage rate is below the market rate.

How many homes are foreclosed and tossed back on the market will depend on legal and regulatory practices yet to be enacted and the amount, if any, of the federal taxpayer bailout of the impacted homeowners and lenders. The courts are just beginning to sort this mess out and the Congress is still in denial about the problem. Most homeowners with nontraditional loans will manage to hold onto their homes. The loss rate will be in the 10-25% range based on our experience with mortgage loans to bad credit risks during the “great society” period in the 1960’s. That is a big range. We will try to narrow it as events unfold in the months ahead. Reed Construction Data believes that the ultimate scale of the losses will fall near the bottom end of the current estimates. Continuing job and income growth at a sub par but still average range pace will permit hundreds of thousands of impacted homeowners to get through their financial stress, generally by switching to standard mortgages.

Unlike the S&L problem which was nationwide, the mortgage problem is intense in a few regions and minimal in most of the country. The biggest impact will be in Arizona, Nevada and south Florida with a lesser impact in the rest of the Mountain states, the Pacific states and Virginia and Maryland.

The risk to contractors and materials suppliers is not from the cost of mortgage defaults but the fallout from those defaults on the demand for new homes. We have already experienced the first phase of this — the loss of home sales to people who can only buy with a nontraditional mortgage. Phase two is now beginning. This is the depressing impact of defaults — via falling and uncertain home prices — on the home buying demand of households that can buy with a traditional mortgage - but may not be confident enough. Reed Construction Data forecasts assume that this negative impact is small enough to be contained without any further sustained decline in housing starts. This is a projection. The events that will set the scale of this problem are yet to unfold in the coming months.