Friday, February 22, 2008

Nouriel Roubini is Suggesting That 10 – 15 Million People Could Walk Away from Their Homes

Dr. Roubini is back with some fairly pessimistic scenario on the fate of the housing market. As stated before Dr. Roubini tends to be one of the more pessimistic economist out there, but his comments have a basis in facts, and are always well presented. Whether you like it or not (or believe it or not) Dr. Roubini is painting the worst case scenario, which should directly effect your investment decisions. It does mine.

One of the issues in risk analysis is to define the worst case, determine how likely it is, and adjust your investments appropriately. The problem that Dr. Roubini, myself, and others on the internet is that we have figured out that the worst case scenario was very unlikely 12 months ago, but is now beginning to take shape and the probability of its occurrence is no longer negligible. Text in bold is my emphasis. From RGE Monitor:

The current housing recession, subprime meltdown and severe credit crunch in financial markets has many worrisome aspects. And while there is always a “crisis de jeur” - one day SIVs, the next day monolines, the next day TOBs or auction-rate securities - one needs to keep some perspective and consider which risks are first-order sources of stress for financial markets and which ones are of second or third-order concern.

I will argue that the most important first-order risk for financial markets derives from the likelihood that 10 million to 15 million households may walk away from their homes if – as likely - home prices fall another 10% in 2008 and further in 2009. When – in the summer of 2006 – this author argued that this would be the worst housing US recession in 50 years. and that home prices would fall – from their peak value – by 20% such predictions were taken as being nearly lunatic. Too bad that this author ended up being too optimistic, not too pessimistic, about the severity of this housing recession. Indeed, this will end up to likely to be the worst housing recession in US history – not just in the last 50 years – and home prices may likely eventually fall by 30%, not this author’s “optimistic” 20%. By now prices declines of the order of 20% are predicted by Goldman Sachs, Robert Shiller, MarketWatch chief economist Irwin Kellner and others; while Paul Krugman has suggested even a figure of 30%; and, according to Bob Shiller, in some markets home prices may fall by 40 to 50%.

So let us consider the implications for the household sector of price declines of the order of 20 to 30%. The math is simple as I will flesh out in this note: 10 to 15 million households will end up in negative equity territory and will be likely to default on their homes and walk away from them. Then, the losses for the financial system from this massive defaults will be of the order of $1 trillion to $2 trillion, a multiple of the $200 to $400 billion of losses currently estimated for mortgage related securities.

Let us consider next some of the details of this scenario and its consequences for the financial system…

In the last few weeks a spate of articles have appeared in the press noticing the alarming increase in default rates not just among subprime borrowers but increasingly near prime and prime borrowers. In particular it has been noted that the number of voluntary defaults, i.e. households literally walking away from their homes and mortgages has surged.

What is happening is just the consequence of rational economic behavior. In most US states mortgages are non-recourse loans; thus, if a home owner defaults on its mortgage the bank take over the collateral – the home – via foreclosure but once that happens it cannot go after the borrower for any difference between the value of the original mortgage and the current value of the property.

The fact that most mortgages are de jure non-recourse (and the fact that even those mortgages that are de-jure with recourse are de-facto non-recourse as the legal and other costs of going after the borrowers are excessive) has powerful implications: it implies that the borrower has effectively a put option that allows him or her to walk away from its home whenever the value of the home is below the value of the mortgage, what is technically referred to as negative equity.

Of course, not every home owner with negative equity will walk away from its home, i.e. send “jingle mail” (put the home keys of the home in an envelope, send it to the bank and walk away from the home). Reputational considerations and other factors may lead some home owners to keep on servicing their mortgage. But it is obvious that the larger is the negative equity in a home the greater is the incentive to do use “jingle mail”. Indeed, why should any rational agent continue to service a debt when the underlying value of the collateral for it is much lower than the value of the debt and the creditor cannot go after the debtor for the difference between the debt value and the value of the collateral?

Until recently there was a conventional wisdom and wishful thinking that home owners would not voluntarily walk away from their homes. This wishful thinking was based on a few flawed assumptions. First, most analysts did not even consider the possibility that home prices would fall so much that a large fraction of households would fall into negative equity; there was the delusion that home prices would go up forever or would never fall. Second, analysts did not consider how many of the mortgages originated in 2005-2007 were with little or zero down-payment and thus with little or no equity to begin with; the myth of the stable and non-defaulting home owner was based on a distant past when most borrowers put 10 to 20% down payment in their home and had substantial equity into it. Third, economic logic suggested that an agent with such a put option would walk away from its home and mortgage whenever in negative equity territory; so delusions that sentimental value would restrain home owners from defaulting had little economic rationale. So, now that home prices keep on falling and an increasing number of home owners end up in negative equity territory voluntary defaults and “jingle mail” are surging. Is there then anything to be surprised about?

How many households will end up in negative equity territory and will thus an incentive to walk away from their mortgages? The answer to this question of course depends on how much home prices will eventually fall from their peak. A recent analysis by Goldman Sachs suggests that if home prices fall another 10% in 2008 after having fallen by about 8% from peak in 2007 (based on the Case-Shiller/S&P index) about 15 million households will be in negative equity territory. There are other estimates that are consistent with the Goldman Sachs one. Calculated Risk
– a very well respected housing blogger – estimated that if home prices decline by 10% in 2008 the number of households with negative equity will be 10.7. But this estimate was based on a partial underestimate of the fall in home prices in 2007 relative to its 2006 peak (as the Case-Shiller data for all of 2007 were not available at the time of that estimate). Thus, the number of households with negative equity could be closer to 12 million. Calculated Risk also estimates that a cumulative fall in home prices of 20% implies 13.7 million households with negative equity while a 30% cumulative fall implies 20.3 million households with negative equity.
These figures are staggering considering that in 2006 the total number of households with mortgages was 51.2 million. So between 20% to 40% of households with mortgages may end up with negative equity in their homes and with a big incentive to walk away from their mortgages. Even the lower bound figure of 10 million households with negative equity (20% of those with mortgages) is huge.

How many additional losses will banks suffer if these many households walk away from their homes? If a bank ends up with a home that is worth less than the value of the mortgage the loss for the bank is at least as large as the difference between the mortgage value and the market value of the collateral. But losses are likely to be even larger: foreclosure is an expensive proposition for banks; and ending up with many properties that are not easily sellable in current illiquid housing markets where there is a glut of homes will imply further losses. Of course, the initial loss from a fall in home prices is taken by the household whose equity is eroded by the fall in home prices. But many of these households had very little equity to begin with; and once the fall in prices leads to negative equity and the borrower walking away from the home the further losses from falling home prices – i.e. all the negative equity in the home – is taken by the bank that originated the mortgage or – in the case of securitization – the investors that eventually bought the RMBS or CDOs related to that mortgage.

What is the size of these losses for financial institutions and investors? Again this is a complex estimate as it depends on how large in the fall in home prices and the recovery rate given default and foreclosure. The only hard estimate that I have found so far is one by Calculated Risk
. The way he puts it: “Assuming a 15% total price decline, and a 50% average loss per mortgage, the losses for lenders and investors would be about $1 trillion. Assuming a 30% price decline, the losses would be over $2 trillion. Not every upside down homeowner will use jingle mail, but if prices drop 30%, the losses for the lenders and investors might well be over $1 trillion (far in excess of the $70 to $80 billion in losses reported so far).”

What will be the consequence of losses of over $1 trillion and, possibly, as high as $2 trillion? That would wipe out most of the capital of most of the US banking system and lead most of US banks and mortgage lenders – that are massively exposed to real estate – to go belly up. You would then have a systemic banking crisis of proportions that would be several orders of magnitude larger than the S&L crisis, a crisis that ended up with a fiscal bailout cost of over $120 billion dollars. And the scary part of this scenario is that – with home prices likely to fall by 20% or more – this scenario of systemic banking crisis is becoming increasingly likely.

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