May 19, 2007
Bernanke on subprime mortgages
If Bernanke isn't worried about subprime mortgages, should you be?
Federal Reserve Chair Ben Bernanke this week laid out his analysis of the subprime mortgage situation:
Let me begin with some background. Subprime mortgages are loans made to borrowers who are perceived to have high credit risk, often because they lack a strong credit history or have other characteristics that are associated with high probabilities of default. Having emerged more than two decades ago, subprime mortgage lending began to expand in earnest in the mid-1990s, the expansion spurred in large part by innovations that reduced the costs for lenders of assessing and pricing risks. In particular, technological advances facilitated credit scoring by making it easier for lenders to collect and disseminate information on the creditworthiness of prospective borrowers. In addition, lenders developed new techniques for using this information to determine underwriting standards, set interest rates, and manage their risks....
The expansion of subprime mortgage lending has made homeownership possible for households that in the past might not have qualified for a mortgage and has thereby contributed to the rise in the homeownership rate since the mid-1990s. In 2006, 69 percent of households owned their homes; in 1995, 65 percent did. The increase in homeownership has been broadly based, but minority households and households in lower-income census tracts have recorded some of the largest gains in percentage terms. Not only the new homeowners but also their communities have benefited from these trends. Studies point to various ways in which homeownership helps strengthen neighborhoods. For example, homeowners are more likely than renters to maintain their properties and to participate in civic organizations.
If it were true, as Bernanke suggests, that the primary factor responsible for the increase in these loans has been technological advances in information collection, then I would have expected the default rates on such loans to have decreased rather than increased. But the Fed Chair himself acknowledges:
For these mortgages, the rate of serious delinquencies--corresponding to mortgages in foreclosure or with payments ninety days or more overdue--rose sharply during 2006 and recently stood at about 11 percent, about double the recent low seen in mid-2005.
Forget that 13% subprime delinquency number you heard about so much in the press ... I quizzed the MBA and got this in response from Jay Brinkmann, vice president of research and economics:
... our latest subprime numbers are 14.4% delinquent by at least one payment, plus another 4.5% in foreclosure, for a total of 18.9% either delinquent or in foreclosure. For just subprime ARMs that number is 21.1%...
And that is in an environment in which the unemployment rate remains below the historical average. What would we see in a full-blown recession?
Bernanke believes these problems will be self-correcting, since there would seem to be little incentive for the creditor to extend a loan with an insufficiently high probability of repayment. He acknowledges that these incentives may not provide adequate discipline for the originators of the loans themselves, since the originators quickly resell the loans to other investors:
The ongoing growth and development of the secondary mortgage market has reinforced the effect of these innovations. Whereas once most lenders held mortgages on their books until the loans were repaid, regulatory changes and other developments have permitted lenders to more easily sell mortgages to financial intermediaries, who in turn pool mortgages and sell the cash flows as structured securities....
Although the development of the secondary market has had great benefits for mortgage-market participants, as I noted earlier, in this episode the practice of selling mortgages to investors may have contributed to the weakening of underwriting standards. Depending on the terms of the sale, when an originator sells a loan and its servicing rights, the risks (including, of course, any risks associated with poor underwriting) are largely passed on to the investors rather than being borne primarily by the company that originated the loan. In addition, incentive structures that tied originator revenue to the number of loans closed made increasing loan volume, rather than ensuring quality, the objective of some lenders. Investors normally have the right to put early-payment-default loans back to the originator, and one might expect such provisions to exert some discipline on the underwriting process. However, in the most recent episode, some originators had little capital at stake and did not meet their buy-back obligations after the sharp rise in delinquencies. Intense competition for subprime mortgage business--in part the result of the excess capacity in the lending industry left over from the refinancing boom earlier in the decade--may also have led to a weakening of standards. In sum, some misalignment of incentives, together with a highly competitive lending environment and, perhaps, the fact that industry experience with subprime mortgage lending is relatively short, likely compromised the quality of underwriting.
The ultimate discipline, then, must come from these final holders of the mortgages. I have two concerns about whether the incentives have indeed been structured to work in society's best interests here. The first is whether these final holders of the loans perceive them to be insured through implicit government guarantees, for example through Fannie Mae and Freddie Mac or the too big to fail doctrine. If so, then there may be a serious moral hazard problem here that has promoted excessive risk-taking behavior from these final investors
My second concern is whether certain institutions such as public pension funds (, ) may in fact desire assets with low probabilities of catastrophic outcomes, with the technological advances to which Bernanke refers giving them new opportunities to assume risks that may not be desirable from the perspective of broader social goals.
For this reason, the number one question in my mind that we should be asking here is, Who is the residual holder of this risk?
And that is not a question that was addressed in Bernanke's remarks.
Posted by James Hamilton at May 19, 2007 09:35 AMdigg this | reddit
our latest subprime numbers are 14.4% delinquent by at least one payment, plus another 4.5% in foreclosure, for a total of 18.9% either delinquent or in foreclosure.
corresponding to mortgages in foreclosure or with payments ninety days or more overdue--rose sharply during 2006 and recently stood at about 11 percent,
So one question then is whether it's believable that something in the order of 8% of the mortgages are delinquent by one payment but less than three.
Your first concern is a real problem that needs to be stressed. The feeling of "playing with house money" indeed can lead to moral hazard, and I've had concerns about Fannie Mae and Freddie Mac for years.
As far as the second, I'm not sure I grasp your point. It's certainly true that there's a problem with pension funds (public or private), where the owners of the fund have a better ability to measure return than risk. The manager, with an incentive to maximize return, can easily invest in too-risky assets without the owners (and perhaps even the manager himself) knowing. And certainly if real estate investments suddenly become more risky, but the owners and/or managers don't know that (but see the larger returns), that's a real problem. Unlike the moral hazard problem, though, it's a lot more self-correcting. There's no particular reason why there can't be different classes of real estate investments, just like with bond ratings. Even if there remain risky junk bond-like real estate investments, surely there are already a large number of risky investments that pension funds could find themself in? (And have.)
Posted by: John Thacker at May 19, 2007 11:24 AM
Now, the principal agent problem (among others) for pension funds is a real problem (and part of the shift to defined contribution plans). It's not apparent to me that the emergence of more risky real estate investments is a problem of a kind different from that of more risky bond investments for pension funds, though.
Posted by: John Thacker at May 19, 2007 11:26 AM
Why do people keep saying that high delinquency rates will "self-correct?" That implies that there is something unprofitable about these high delinquency rates. You make a spread of 300 bp per year for an average of 2.5 years. You have an 18% foreclosure rate with a 40% Loss Given Default. That means you lose 720 bp in credit loss, and earn 750 bp in excess spread. If about three-quarters of all serious delinquencies went to foreclosure, that would imply a serious delinquency rate of 24%. Why does this situation imply some sort of equilibrium that needs to "self-correct"?
Posted by: mort_fin at May 19, 2007 04:02 PM
The problem is not the subprime mortgages themselves -- it's the unsustainable run-up in home prices that they fueled, by expanding the buyer pool with a cohort willing and (however temporarily) able to overpay for entry-level housing, creating in turn a cohort (the people who sold to them) willing and able to overpay for move-up housing, aided by loose "Alt-A" lending. This led also to the use of homes as ATMs through cash-out refinancing, and to a paroxysm of speculation and overbuilding.
As the resulting awesome glut of housing now on the market brings prices back into line with incomes (and overshoots them to the downside), there is going to be a real estate price slide just as unprecedented in scale as the boom. It's that 30+% slide in home prices that's going to be the real problem.
Posted by: jm at May 19, 2007 11:47 PM
Have there been any studies done on the greater impact rising local taxes and excalating utility bills have on sub-prime borrowers? In some parts of the country, at any rate, these three in combination may be the greater cause of the spike in default rates than lowered lending standards alone.
Posted by: Tom Schofield at May 20, 2007 04:52 AM
As jm points out, the big disequilibrium is in the housing market, yet BB et al keep pointing to the mortgage market, with no evidence of any serious disequilibium (personally I think spreads were at least 50 bp too tight in 2006, but that's chump change in the great scheme of things). If underwriting tightened a little, or spreads went up 50 bp (as they pretty much did in Feb 2007) that isn't a big deal. Discussion of mortgage market disequilibrium, as opposed to mortgage market innovation, smacks of misdirection. I think innovations in credit and mortgage scoring, which allowed institutions to conclude that they could accurately price higher risk mortgages (how true this conclusion is remains to be seen), which allowed them to make higher risk mortgages in greater volumes, which allowed risk to increase (no surprise on the part of market participants that innovation increased risk levels), is probably the primary cause for the housing bubble. But, sans evidence that the mortgage market is way out of eqauilibrium, I don't see any reason to think that the mortgage market will "self-correct" beyond the modest underwriting tightening and modest spread increases that we've seen in the last couple of months.
Posted by: mort_fin at May 20, 2007 05:41 AM
What I think Mort Fin is saying is that a default is no great loss to a mortgage holder and he's already priced (or will reprice) in the costs vs the interest rate given current price trends.
Is there a pile of housing sitting empty out in America? I don't think so - there are plenty of apartment renters willing to move in as always.
Are falling housing prices a worry? NOT TO ME!
I'm waiting to buy and cheaper is better when I decide where I'm going to be living and working.
Personally, the subprime story is more MSM-driven economic anxiety. If there is a moral hazard twist uncovered, by all means fix that.
Posted by: Joseph Somsel at May 20, 2007 01:29 PM
Mortfin, I disagree with you on where the bubble is.
One of the "innovations" that BB speaks of is the use of econometric models to estimate potential losses. Using empirical data from the post-war era, and the assumption of a bell-curve distribution, these models calculate that 10%+ nominal home price declines are a 3-4 sigma event -- less than 1% probability of occurring.
So let's say you're a hedge fund holding CDO's with mortgage collateral. What leverage can you employ? Well, the AAA tranche of an MBS has an extremely low probability of losses, so the answer is lever it to the hilt, and then some more.
Here's the problem. In any market, the volatility of assets rises with the leverage employed by buyers of those assets. More leverage, more chance the assets are "dumped" to meet margin calls, more chance the price suffers a steep decline.
Only the "innovators" seem to have left this out of their models. Find anyone that believes home price volatility is a function of the leverage of creditors, in this case fixed income hedge funds?
Of course the truth is these econometric models dramatically understate risk of home price declines, and this is what is so dangerous about their use.
Posted by: David Pearson at May 20, 2007 02:11 PM
Is there a pile of housing sitting empty out in America? I don't think so ...
Au contraire! Here in the Northwest suburbs of Chicago, which can't hold a candle to the notorious bubble areas like Florida, Arizona and SoCal, there's quite an impressive pile of housing sitting empty, with more empties still abuilding. There's also a very impressive glut of vacant condos downtown.
US Census Bureau stats indicate that the percentage of homes intended for ownership rather than rental now standing vacant has leapt in the last few years from a historically stable level of about 1.7% up to 2.8% nationwide, and that the rental vacancy rate is also very high.
Posted by: jm at May 20, 2007 02:29 PM
I agree with David Pearson that there is underpricing going on in the lending market. I just think there is an underappreciation of how little a margin it takes to offset credit losses, hence an exageration of how far off the mortgage market is. Even with huge price drops in highly levered markets (almost half the loans in Texas in the early 1980's were VA at zero down and FHA at 3% to 5% down) foreclosure rates don't go above 30%, and Loss Given Default doesn't get much over 50%. With a 2.5 year weighted average life (and remember that the WAL actually tends to increase when prices are falling, because no one can refi), a 30% foreclosure rate, and a 50% LGD you only need a spread of 600 bp. If, in a normal cohort, you get a 15% foreclosure rate and a 30% LGD, so you need a spread of less than 200 bp, and in an extremely bad case you need a spread of 600, and you're charging a spread of 300, you have to believe not just that the bad case is some theoretical tail probability, but that the bad case has a pretty high probability, before this looks like a bad deal. The 2002-2004 cohorts of subprime loans were wildly profitable, and not much is left of the 2004 cohort, so that's unlikely to reverse itself. 2005 may yet prove profitable, and probably won't be much worse than break-even. 2006 will be one where they lose their shirts, but how would you have known at the start of 2006 that the bubble would end later that year (and not in the middle of 2007 or the beginning of 2008 instead)? I think the buyers of the low/unrated tranches have assumed to rosy a picture, and will come to deeply regret buying stuff on mortgages with spreads of 250 bp and not 325bp, but at 325 you can cover an awful lot of credit loss. I don't think it's widely appreciated that the necessary spread to cover really high foreclosure rates isn't that big, so that the market adjustment that's necessary isn't that big (in the mortgage market) and is unlikely to be anything near the magnitude that would suggest that it would price itself out of existence, and that high expected foreclosure rate lending is just a temporary abberation.
Posted by: mort_fin at May 20, 2007 02:41 PM
I've got to say that I find predictions of more than 30% reductions in average housing prices rather hard to believe (see jm's prediction above).
Remember it's only a small fraction of OWNERS that are sub prime. and if we are to believe the worst case scenarios, it's still less than 30% of those that are in default.
No, I believe that this will result in much higher Days On The Market, rather than lower preces. If you assume that 6% of the owner are sub prime, and 30% of those are in default, that means "only" that 2% of existing properties are being "forced" on the market. That means a glut of properties, but I don't see why that would result in a wholesale drop in the market - remember that it's unlikely that the average non-default homeowner is going to buy-down to a much smaller starter home. If anything he would buy "up" to a bigger home, and if he can't, then he'll stay where he is. Remember, housing DOES have a use, it isn't primarily an inverstment vehicle.
So, the result of this sub-prime lending, is probably that Toll Brothers will see their profit picture hurt, some sub-prime lenders will be hurt, and a lot of sub-prime borrowers will loose a lot of money, but the housing market, really won't be too much affected. (this might be a good time to pick up a starter home, though )
You might say: What about real estate investors? Well they can always reduce their negative cash flow by renting out their "under water" properties. There is great relief in reducing your losses by 80% or 90% - loosing $3000/month is much more painful than loosing $500/month
Posted by: bellanson at May 20, 2007 05:05 PM
My prediction of a 30+% fall in home prices isn't based on an assumption about the fraction of subprime owners who will default. It's based on the facts that:
(1) We don't need subprime foreclosures to have a glut of homes on the market. The glut is already here, and still growing. Moreover, it's not in low-end properties, but in high-end homes. As the prices of those high-end homes collapse, they will crush the price structure of the entire market beneath them, and destroy the belief that housing is a sure-thing investment.
(2) The percentage of households owning their residence* held steady for decades at around 64% until it rose about 0.5% annually from 1995 to its peak at 69% in 2004. When in past booms it rose above 64%, it always reverted to 64% (or lower) in the subsequent bust. I think it likely this pattern reflects deep underlying realities, and will repeat; that equates to about 4 million households reverting back to non-homeowner status. The largest rise in the ownership rate was among the young, especially those under 25; when they fall out of home-owner status, many of them will end up living in someone else's household as roommates (or go back to living with their parents). All this will further exacerbate the already severe housing glut.
*Directly measured by the Census Bureau using a fairly large sample size, not estimated or derived from other stats, as is e.g. the number of households in the nation.
Posted by: jm at May 21, 2007 02:25 AM
The re-pricing you describe helps new creditors. Previous creditors (MBS/CDO holders) are exposed to the losses, and they are highly levered. Their response to a 20% default rate is to sell assets. Unless another buyer comes in, this results in a net decline in credit available. A decline in credit supply results in more defaults, more defaults in a further decline in credit, etc. Further, the higher rates you describe reduce credit demand, which in turn results in less buyers, lower prices, more defaults, etc.
For the above process to be interrupted, you need a new buyer (not an existing holder) of mortgages and houses. Who would this be? Hedge Funds? No -- they are already overlevered holders. Foreigners? Up to their eyeballs in U.S. credit. Banks? Highest % of RE lending-to-capital in history. Pension Funds? Loaded up on mortgages. You get the picture...
Once the process begins, there is typically one thing that interrupts it: once yields on rentals reach attractive levels (say 8%), new investors come in to buy real estate, and households have a big incentive to buy vs. rent. Rental yields in the U.S. are about 4% now. That would imply a 50% drop in house prices, offset by any rental inflation (which we are seeing now).
The real endpoint to use for house prices is rental yields and not historical price declines. You need big declines in home prices to bring yields into line, or inflation-boosting increases in rents. We all know what the latter would cause: higher rates.
Posted by: David Pearson at May 21, 2007 04:05 AM
jm As the prices of those high-end homes collapse, they will crush the price structure of the entire market beneath them, and destroy the belief that housing is a sure-thing investment.
I'm not sure I buy that, based on the Toronto experience. Even in the vicious downturn of 1989-95 (which followed a bubble) house prices - on average - were down only 35%.
Lower priced houses make up most of the market here, based on real-estate board figures. The mean average is $379,000, but the median is more like $250,000. Assuming $50,000 down payment, mortgages carry at a price not much different from rent and be affordable for middle class families. I don't believe they will be much affected by, say, the drop in price of million dollar homes to only $750,000.
Posted by: James I. Hymas at May 21, 2007 01:01 PM
How do you define yield?
If you buy a house for 500,000, put 20% down and borrow the rest at 6%, how much income do you have to see to realize a 8% yield?
Is that a positive cash flow of 8% of 200,000?
OR is it 8% of 500,000? (purchase price)?
Or is it (average annualized) appreciation plus cash flow of 8% ?
If it's the first then you should borrow as much as possible, i.e. 100% loan to value (since that would give you the lowest denominator).
Most real estate investors that I know, compute profit and yield based on their investment, i.e if you put 10% down and you get a net positive cashflow of 5,000 (on your 500,000 property) then you are getting a yield of 10%.
By that definition, then you would need for property values to drop by 5% (rather than 50%) to double the yield from 4% to 8% - if you put less than 10% down you need even smaller drops.
The concept of yield is a bit strange, I think most (single family) real estate investors are looking to positive cash flow, and then they look to appreciation to take care of the profit. Or as it's typically stated: Let someone else pay for your house, and you can pocket the gains.
Posted by: bellanson at May 21, 2007 01:51 PM
JDH: "And that is in an environment in which the unemployment rate remains below the historical average. What would we see in a full-blown recession?"
It is refreshing that you are asking this question. The problem is that the FED chairman's words can't be taken seriously. When Greenspan was the chairman, he was a cheerleader for the housing market and ARMs. At the end of his tenure, he changed his tune. Now that he is going to advise PIMCO, he is talking more about a possible recession, but does 'CYA' by saying there is 1/3 probability. What good are such pronouncements?
The approach of looking at house ownership percentages does not appear to me as a sound fundamental approach. The basics are really price/income, price/rent, savings, interest rates and credit availability, population growth and supply of housing/land.
I don't have any quantitative data handy, but my market observations show that a large number of people are paying 8-10 times price/income, with little savings. Similarly, price relative to potential rental income is a huge multiple, and it is not confined to cities like Manhattan, San Diego and San Francisco.
One really needs good quantitative data to be precise about this. But my long time observations tell me that a massive decline in prices is warranted, but unless lenders tighten further (it is crazy to approve mortgages at 8 times income and using 95--100% credit), that is not going to happen quickly.
Subprime is not really the issue--loose lending as a whole is. Many people (including some coworkers) who took 8 times income loans had good credit histories and were probably considered 'prime'. The trouble will start seriously once such buyers experience real pain in making monthly payments. That is a multi-year process (the fallout may continue for 5--8--10 years or even more) and we are only a year into this process.
I used to live in Toronto some years back and have been monitoring it. Median housing price at $250K ? That must be a joke. The real 'livable' median that matters to most people must be something like $400--450K. Perhaps a lot of decades old condos with high condo fees are there and causes the median to be $250K.
Anyway, one needs to be wary of comparing the US market with the Canadian market as the mortgage financing conditions are different, and interest on mortgage is not tax deductible in Canada.
Posted by: TedK at May 21, 2007 03:34 PM
David Pearson - If the spread on 2007 originations more than covers the expected losses, why does the fact that some investors lost money on 2006 originations enter into the picture at all? Sunk costs aren't sunk? I'm not going to believe a diminished capacity argument (diminished LENDING capacity, that is; I might buy diminished MENTAL capacity) - there are thousands of hedge funds, at least 14 GSEs, a couple of dozen flush Asian Central Banks, Warren Buffet, etc. Surely if the spreads are more than sufficient to cover the risks, someone will step in.
Posted by: mort_fin at May 21, 2007 04:48 PM
Above I predicted a 30+% fall in home prices, and James I. Hymas responded with:
I'm not sure I buy that, based on the Toronto experience. Even in the vicious downturn of 1989-95 (which followed a bubble) house prices - on average - were down only 35%.
This is certainly the first time I have experienced someone attempting to refute my 30+% fall prediction by pointing out that in another North American market the collapse of an earlier bubble brought prices down only 35%. Was that intended to be 3.5%, perhaps???
As my earlier post was interrupted by late-night demands of my "day" job, I ended up not finishing it as I had intended with a statement that I believe the recent unprecedented housing bubble will be followed by an equally unprecedented collapse which will bring prices back down at least to their historic ratios to incomes (a 30+% fall in most of the US -- especially if you weight by value). To believe otherwise is, in effect, to believe that home prices have "reached a permanently high plateau" on which they will remain despite the existence of a gargantuan market glut.
Posted by: jm at May 21, 2007 08:49 PM
Bernanke's statement that "[i]n 2006, 69 percent of households owned their homes; in 1995, 65 percent did" is true, but disguises the fact that homeownership actually peaked in 2004 and has dropped slightly since. The national homeownership rate for the 1st quarter of 2007, in fact, was the lowest since 2003/Q3. See the census bureau site.
What subprime lending giveth, subprime lending taketh away.
Posted by: pianoguy at May 21, 2007 10:15 PM
Sunk costs don't apply to hedge funds that have external funding. Once they lose capital, that funding typically gets pulled and pulled fast by "fund of funds". Do they deploy to other CDO/CDS hedge funds? Most hedge fund investors are trend followers. Sure some will step in looking for value, but that isn't the question. The question is whether you see, on a net basis, dollars pulled from CDO-owning hedge funds. Due to leverage, remember that each dollar pulled out results in a sale of 6-20 times the dollar value of CDO's.
As for GSE's, they are mandated to grow their balance sheets slowly.
The Asian banks are the ultimate trend followers, and are one of the first to pull their money once trouble starts. Also, as they are recycling the proceeds of consumer goods exports, its easy to predict that a real housing correction will be followed, on a net basis, by less dollars being recycled from Asia.
Bottom-line, Mort-fin, when everyone is on one side of a trade (and believe me, in credit-land, everyone is), and levered, their replacement by new buyers is typically not an orderly process.
Posted by: David Pearson at May 22, 2007 04:44 AM
I'm a little surprised at JM considering a 2.8% vacancy rate a "glut." Of course, I'm not an expert but that seems managable even if over long term averages.
And forgive my provincialism but I see no glut of vacant housing nor long time to sale here in the San Francisco Bay Area and Silicon Valley in particular. The market is no longer so frenzied but it is by no means a popped bubble.
So housing starts have slow, have they not? One would expect that the supply rate will dip to first work off excess inventory then rebound to better match demand.
Posted by: Joseph Somsel at May 22, 2007 08:54 AM
"Over long term averages" is one thing - highest it's ever been since the number has been tracked (beginning in 1956) is another.
It's even more startling when you consider that the vacancy rate first reached 2 percent only in the fourth quarter of 2005. If this is not a housing glut, then we have never had a glut.
Posted by: pianoguy at May 22, 2007 09:35 AM
pianoguy, has there ever been a nationwide U.S. housing boom/bust before? I am asking because I don't know - from what limited accounts I've heard of previous boom/busts were in particular areas, for example, CA and FLA.
Posted by: Charlie Stromeyer at May 22, 2007 12:38 PM
No, according to the National Association of Realtors, which predicts that housing prices will fall in 2007 for the first time since the Depression. (The article is undated, but recent.)
But the NAR's projected .7 percent decline isn't exactly a national bust. My hope is this bust will resemble previous ones, even though its scope may be greater: There will be a series of local and regional crashes rather than a single national one. Right now, for instance, San Diego and areas of Florida are crashing while Salt Lake City, which was late to the boom, is soaring.
What's scary about this housing boom is the ways in which it differs from its predecessors. Never before have there been so many ARMs and other exotic mortgages; have there been so many houses with second and third mortgages; has there been falling homeownership during a period of easy credit and extremely low interest rates. So in this case, history may turn out to be bunk. And I don't see it turning out to be bunk in a good way.
Posted by: pianoguy at May 22, 2007 02:01 PM
The 2.8% vacancy rate is a surface manifestation of the larger glut. Note that there are about 75 million owner-occupied homes in the US, and annual sales of existing housing in the bubble years were in the area of 6.5 million, so only about 9% of the housing stock turned over even in a bubble year. According to DataQuick, sales volumes in many large cities are down 30% or more. Let's ballpark the turnover now in the area of 6% a year. Relative to 6%, an increase in the vacancy rate from 1.7 to 2.8% is quite significant, especially since the 1.7% of the past was probably mostly undesirable properties that weren't much of a drag on the market, but the percentage point increase is probably mostly new construction.
Posted by: jm at May 22, 2007 11:17 PM
David Pearson - even if I granted everything you've assumed (there's a limited number of subprime bagholders, they behave as a herd, new entrants won't happen), then you've told me that there'll be a disequilibrium in the other direction. The loans are still profitable at a 300-400 bp spread, the fixed number of subprime bagholders will eventually repair their capital positions, etc. You've just described oscillation, not a move towards an equilibrium with a smaller pool of safer subprime loans.
Posted by: Anonymous at May 23, 2007 04:40 AM
Further to my point above about the nature of vacancies and their market impact, let's take Arlington Heights, IL as an example:
Through 4/12/06 recorded sales numbered 313, through the same date this year, 279. Total in 2006 was 1203, on a base of about 24,000 owner-occupied units (from City-Data.com, i.e., about 5% of the housing stock (and in a bubble year, at that). Sales continue to decelerate, and are unlikely to be much above 1000 this year, if that. Individually examining the photos for each of the 100+ single-family-home (SFH) listings on the MLS priced above $699,000, I found that at least 70 were unquestionably vacant (almost all, new construction), and another five appeared either "staged" or occupied by housesitters. So here we have 0.3 percentage points of the "owner-occupied housing" stock (and bout 7% of the MLS listings) vacant just in the highest end of the market, in pristine new homes.
Even assuming a much lower vacancy rate among the 450+ SFH and 440+ condo/TH listings at lower prices, it's a safe bet that well over 10% of the homes on the market in this community are vacant. Since pricing is set at the margins, this would have a severe impact under any conditions, but in the current situation, with no pent-up demand (ownership rate already at historic peak among younger households), it will be especially severe; most important, the effects will break the psychology that housing is a surefire investment, and once that happens, the market will be dead for a very long time. Though the high end is only a small fraction of the market, it's the most newsworthy, and the losses that will result from the enormous glut there (multiple years of inventory) will be widely publicized.
Posted by: jm at May 23, 2007 07:26 AM
jm, if the 'psychology that housing is a surefire investment' is not broken now, it can only be that the brain housing that psychology is stone dead. Sure, these brains can be found in some sectors of DC and NY Hamptons but aside from these niche markets, investors have long since departed for greener pastures, no?
Posted by: calmo at May 23, 2007 11:52 PM
calmo, I wasn't thinking so much of "flippers" but of the populace at large. As one can see from the numerous articles (many discussed on the Calculated Risk blog) opining that subprime lending has "helped" more borrowers than it has hurt, by allowing them to become homeowners, the general psychology of the nation is still that anyone who can find a way to buy a home, no matter what the price or debt-to-income ratio, absolutely should buy one. The possibility that perhaps what we as a nation should be aiming at is an adequate supply of decent rental housing and a financial system in which someone can get a real positive after-tax return on money in a bank (with the bank supplying the expertise to lend it out to people who will actually be able to pay it back), seems not to occur to an awful lot of people.
Posted by: jm at May 24, 2007 06:58 AM