Guest Post by Ramsey Su

Facing the Music

The last of the sub-prime loans were originated in early 2007.  Of course, had regulators not been sleeping, these loans would never have been made in the first place.  Had the various government agencies not subsequently intervened, the slate would have been wiped clean long go, even though it might have been painful.  We know that was not the case.  In fact, the opposite happened.  There have been never-ending efforts to prevent foreclosures, as if that were a good thing. All it did was to postpone the inevitable.  Is it finally time to face the music?

Leftover Junk

How much junk is left in the system?  Here is a table taken from Freddie Mac’s second quarter earnings release.

Freddie Mac’s single-family credit guarantee portfolio – click to enlarge.

It is not a pretty picture.  21% are HARP loans, which are by definition high LTV loans with some as high as over 125%.  The qualifications of the borrowers are questionable but certainly not to the underwriting standards of a new loan.  15% are peak sub-prime vintage loans, originated between 2005-2008 while 8% are pre-2005 loans.

These are borrowers who either live under rocks, or most likely, borrowers who cannot qualify to refinance into more favorable terms.  In total, 44% of Freddie’s guaranteed portfolio are at risk if housing conditions deteriorate.

Fannie Mae probably has a similar mix while FHA’s guaranteed portfolio is likely to be much worse.

Delinquencies 

In the mortgage business, the word delinquency has many different meanings, not to mention some qualitative definitions.  There are 30 days, 90 days or, as in the Freddie Mac table above, “serious delinquency”.   Furthermore, there are modifications and other form of work-outs that result in these loans being labeled re-performing, even though delinquent amounts may have been rolled into a new loan.

A delinquency may truly be a first time missed payment or may be just the beginning of a new round for a habitually delinquent borrower.  An unknown number of loans today may be classified as performing only because there are a couple of current payments, even though the loan may have been delinquent for years, or modified, or had delinquent payments forgiven.  My point is, the delinquency rate as an indicator of repayment behavior may be misleading.  In other words, the delinquency rates reported by Freddie above do not imply that the non-delinquent loans are healthy.

Toxic Waste

The disposition of non-performing loans is not uniform in degree of difficulty.  The less problematic are easier to liquidate while the residual becomes more and more difficult.  There may be legal issues, clouded titles, code violations, imperfect foreclosures or savvy borrowers who know how to play the game.  Quarter after quarter, the delinquency rate, foreclosure rate and REO inventory have been declining.  While factually true, this may not show the toxicity of the current crop of non-performing loans.  There are reasons why delinquencies remain on the lenders’ portfolios for long periods.  What remains today are most likely far more toxic loans than the generations of loans that have already been foreclosed upon, or disposed off via voluntary actions such as short sales.

Dump When You Can

For one reason or another, lenders have been delaying the disposition of non performing loans.  Finally though, a window of opportunity is here. The liquidation of sub-prime era debt has heated up recently.

From Bloomberg:  Hedge Funds Boost Bad-Loan Prices as US Sales Increase

From the New York Times:  Investors Profit from Foreclosure Risk on Home Mortgages

From Housingwire: HUD selling $2.3 billion in non-performing loans

In July, Freddie Mac offered a number of pools for sale totaling $659 million.  One “winner” took down the entire package for a reported 76 cents on the dollar.  This deal is likely going to set the benchmark for other offerings in the pipeline.

The market could not possibly be more favorable for dumping sub-prime debt. The prices paid are so rich, that not only are first time buyers, who were the originally intended users, squeezed out completely, it is now like a Sotheby’s grand auction to which only billionaires are invited to play.

Show Me The Money

On the surface, the buyers appear to be paying too much, but it is all OPM (other peoples’ money).  The deal-makers will always earn fees upon fees. Buying these bulks allow the syndicator to assemble a large portfolio very quickly, even if they are paying market price, or higher.  After that, it is just a matter of generating some cash flow.  In this desperate yield chasing environment, a few percent yield and the promise of some asset appreciation will suffice to attract all the capital needed.

Is This Finally the End of Sub-Prime?

Monumental settlements this year have extorted tens of billions from the banks. Included in the settlements are put-backs.  Sour loans are transferred from the agencies back to their originators.  HARP has just about exhausted all borrowers who may qualify and there are no new interventions planned.  In summary, ownership of all the bad debt from the sub-prime era should soon be in the hands of non-government entities.  We should be entering the final phase during which sub-prime will be wiped off the books.

What Happens Next?

1. Once the loans are in private hands, the disposition process will speed up.  The debt sale should also remove many of the artificial hurdles to foreclosure or other forms of work-outs.  I expect both delinquency and foreclosure filings to increase in coming months.
2. These loans should be concentrated in the sub-prime bubble markets.  Cities like Vegas, Phoenix and Sacramento may experience pricing pressure as the foreclosures hit the market.  They may also be flooded with rentals that may put some pressure on rent.
3. The hidden housing subsidy basically consists of free housing to households that have chosen to stop making payment on their mortgages and have avoided foreclosure.  I last tried to estimate the impact in 2012.  When these households have to start paying housing expenses, either in the form of mortgage payments or rent, it remains to be seen how this will affect the economy.

Conclusion

It is healthy for the real estate market to finally close the chapter on sub-prime. However, the conversion of large pools of starter homes to rentals cannot be good for the market in the long run.  As the ownership rate continues to decline, communities are going to lack the pride of ownership.  Assets continue to move in the wrong direction, from the have-nots to the haves.

Next time when you hear the agencies, or HUD, or FHFA touting how they are helping the masses by providing affordable housing, ask them why first time buyers are not given a chance to buy some of these houses that they are selling to the rich.

Markit ABX.HE index of sub-prime mortgage backed securities of February 2007 vintage … catching a bid (note that these once traded at or even above par).

Table by Freddie Mac, chart by Markit.