Karen Weaver, Deutsche Bank’s formidable global head of securitisation research, warned in a report on Wednesday that the percentage of US mortgage-holders facing negative equity would nearly double by 2011.
The term “negative equity” describes a situation currently faced by about 27 per cent of US homeowners with mortgages, who owe more than their houses are worth. According to Ms Weaver, that number will hit 48 per cent — or 25m households — within two years.
Still, Deutsche’s projections are more aggressive than most, as the following chart makes clear:
Ms Weaver further argues that the negative equity problem has, not surprisingly, hit holders of subprime and Option ARM mortgages the hardest. Why?
According to Deutsche, there are several fundamental reasons:
First, because of the relative newness of these mortgage products and the tendency of these borrowers to refinance frequently (often to cash out equity), these loans are likely to be recent vintages. This means that many subprime and Option ARM loans were originated at the peak of home prices. A loan made in California in 2003 enjoyed three years of home price appreciation before prices began to fall, cushioning the impact. A loan made in September 2006 in Los Angeles has experienced nothing but depreciation.
Option ARM mortgages have negative amortization features, so that product cohort is obviously most likely to be underwater. Moreover, the starting LTV for these loans were particularly high, since they were higher credit loans (i.e. had higher FICO scores), which was believed to offset the higher loan amounts and other risk characteristics. Lastly, the popularity of this product was greatest in the bubble markets; like subprime, Alt-A and Option ARMs were also referred to as “affordability products” because they were designed to enable borrowers to buy homes in unaffordable areas. Hence, the geography of these products was adversely selected toward bubble markets
The second-worst product type vis-à-vis negative equity is subprime. There are two drivers. Once, again, the make-up of subprime is disproportionately skewed toward more recent vintages and hence the peak of the housing market. Two, the weighted average LTVs insubprime were higher than in, say, conforming mortgages or prime.
But by Deutsche’s calculation, “the next leg of the decline will have the biggest impact on conforming borrowers” - or those borrowers with mortgages conforming to the guidelines set by mortgage giants Fannie Mae and Freddie Mac.
Deutsche estimates the per cent of conforming borrowers with negative equity will soar to 41 per cent by the first quarter of 2011, compared with just 16 per cent in the first quarter of this year. Negative equity among holders of prime jumbo mortgages — or loans above $417,000 made to borrowers with solid credit histories — will reach 46 per cent, compared with 29 per cent currently, the bank said.
And, as Deutsche points out:
The most obvious implication is for mortgage defaults; borrowers with negative equity may be forced to default after a life event (e.g. unemployment, underemployment, divorce, disability, etc.). Borrowers may also “ruthlessly” or strategically default even without such life events. Apart from default, this reversal of fortune for the middle class will surely suppress consumption. In the meantime, we don’t expect a quick turnaround of the housing market due to the weakness in labor markets, excess supply and continued un-affordability in some regions.
This is significant not just on the consumer level (and the attendant feed-through to the real economy), but because conforming loans and jumbo loans represent the biggest share of outstanding RMBS products:
In short — more writedowns ahead.
Back in January, as part of her argument opposing a “bad bank” plan that would buy distressed assets from Wall Street, banking analyst Meredith Whitney highlighted the exposure of the largest banks to residential mortgages.
As FT Alphaville noted at the time:
By Whitney’s reckoning (and others), Merrill and Citi have the biggest exposure to residential mortgages, at $44.6bn and $26.7bn respectively. Citi also has a fairly significant exposure to US ABS CDOs, at $18.9bn gross and $6.9bn net. So does Bank of America, with $11.9bn gross and $5.3bn net. (Gross means after writedowns but before hedges, in Oppenheimer parlance).
Moreover:
A large percentage of banks’ exposures are to areas with the greatest home price declines and the most vulnerable negative equity positions.
An example? Bank of America — pre Merrill acquisition — had $94bn in exposure to Californian mortgages - or five per cent of the company’s total assets.
Given that investment banks are also (if belatedly) preparing for a severe shakeout in commercial real estate and CMBS, further significant deterioration in RMBS would suggest that the pain on Wall Street is far from finished.
Related links:
The 20 worst housing markets in the US - FT Alphaville
What’s driving defaults? It’s not just negative equity - FT Alphaville
Charting the mortgage crisis - FT Alphaville
