A Recovery That Will Lead to Relapse: Why We're Not Out of the Woods Yet
I probably don't need to recap what the past few weeks have been like for the mortgage industry, especially for those that regularly read this blog. And I probably couldn't do a recap anyway, even if I wanted to -- there's just been an overloading avalanche of information, and unfortunately most of it has been bad. Some of it very, very bad. While I'm happy to see things calming down in terms of the financial markets today (especially for the Apple stock I so proudly own), I wanted to take some time to remind HW readers that I don't think we're out of the woods yet. Not by a long shot. There is one simple, over-arching reason why this is the case, and you don't need to be an economist to understand why: outstanding 2005 and 2006 mortgage resets. HW readers know that I've been pointing to the underlying assets behind every troubled RMBS, behind every CDO -- because the structuring of these securities never was designed to account for the core characteristics of the assets that made them, but instead to account for investors' stated objectives. It worked great when homes were heading upward in price, which fed more investor demand, which fed even greater price increases, which fed still greater investor demand ... it's a cycle many have written about at this point -- and I think most of us in the mortgage industry (sans perhaps the "churn-n-burn" broker crowd) knew deep down that it was going to end badly at some point. The question was always when. And then, at some point, things went so damn well for so damn long that many of us managed to convince ourselves that maybe -- just maybe -- this time really was different. Maybe those genuises on the Street figured out a way to diversify risk away, after all. Wrong. After watching the mortgage mess spiral ever and ever larger in recent weeks, the Fed's decision to lower the discount rate signaled an important shift in strategy; the primary concern can no longer be inflation. The Fed's action also has reassured investors to a certain extent, but I'm going to go out on a limb here and say that it's a false hope -- at least as it relates to near-term performance of the mortgage banking business. The 2005 and 2006 mortgage vintage -- whatever wasn't swallowed up in the recent wave of EPDs -- is still out there. And a very large percentage of it is going to reset in the back half of this year and into next year. I speak with key contacts in the default servicing industry daily -- the people who are on the front lines of the battle to not only try to keep people in their homes, but to also protect investor returns -- and I can tell you that most aren't feeling relief at having survived the default wave thus far. What they're doing is bracing themselves for a second and much more powerful wave of borrower defaults just over the horizon. One they mostly feel powerless to stop. Let me take a step back and clear something up: most of the problems we've seen so far haven't been due to seasoned borrower defaults, although delinquencies and defaults certainly are increasing. The problems we've seen so far were driven by early payment defaults, associated forced repurchase activity, and the secondary market waking up to what's about to happen as a result -- why do you think S&P, Moody's, and Fitch have been holding a near-weekly fire sale on their mezzanine and equity tranche ratings? The ratings cuts so far have been because early losses on 2005 and 2006 vintage mortgages have accumulated to the point that the ugly future is now clear -- but not because we're actually there yet. Investors have figured it out too, and have literally put the brakes on an entire market as a result. A well-read letter from Kyle Bass at Hayman Capital puts it thusly:
If you plug in 15% depreciation in housing prices and 50% loss severities into our Subprime model, the capital structure is wiped out all the way to the â€œAAâ€? tranches.There was a time I'd have laughed at such an assessment. Now, I'm not entirely sure that doesn't accurately describe what some key markets might eventually look like -- and just for a split second, think about what the markets will look like if the entirety of existing mezzanine and equity tranches are vaporized within one year. There was also a time I laughed at the CRL and their damning report from way back in December 2006 that said 2.2 million homeowners with subprime notes will lose their homes before the end of 2007. (I'm a mortgage guy, after all, and its in my blood to scoff at consumer activists). Now, that number seems as if it might actually be too low -- because it isn't just subprime that's impacted any more, and because access to credit has gone AWOL in tandem with a softening of prices in the key markets that can least afford to have that happen. I dare you to add up all of the subprime borrowers facing a reset, a good chunk of the Alt-A borrowers facing a reset, and all of the prime borrowers that will default on their seconds -- and that's a rough order of magnitude for how many foreclosures we could be looking at within one year. That's a whole hell of a lot of borrowers, and potentially a whole hell of a lot of properties on the market. And who, exactly, is going to be there to fund the purchase of all of this suddenly-available real estate? Not Wall Street, that's for damn sure. The smartest guys on the block have learned an important lesson: a bunch of lemons, pooled together, is still most likely to end up being a bunch of lemons. Like most things in this industry, this process will unwind slowly. We've seen the financial impact of investors marking down their assets as they begin to realize what they're faced with -- we've seen the rating agencies begin to mark down RMBS and CDO ratings as they begin to realize how inadequate their original modeling really was. But that process is far from done, because the real losses haven't had a chance to materialize yet. What we haven't seen yet are the real, actual losses involved when a surge in foreclosures ends up on someone's books, a process that can take months to complete. And those foreclosures are most certainly on the way: borrower defaults have already nearly doubled from year-ago levels. And there are still more borrowers waiting in the wings for their dose of payment shock. We haven't yet felt the impact of what those actual losses will mean to the health of the overall US economy, or what else might be around in six months to exacerbate (or moderate) matters -- which is why I'm so loathe to make a prediction regarding timing for a broad-based turnaround in housing. It's natural to begin to look for the bottom at some point, since this sort of downward trend can't go on forever. Housing will recover. And now that we're getting a break from recent market movements, you'll see stories about Buffett stepping in to make a value play (so maybe you should too), you'll see stories about how the worst is over, and you might even see stories that refer to the mortgage crisis in the past tense. You'll see mortgage companies that made it through the first wave catch their breath and say that they are back on track. There are at least 2.2 million reasons why you shouldn't believe a word of it right now.