Blinding Glimpse of the Obvious

Blinding Light

The Federal Reserve recently released an article from the forthcoming Federal Reserve Bulletin analyzing loan data from 2006 which was collected under the Home Mortgage Disclosure Act. The data comes from 8,900 lenders that account for an estimated 80% of home lending nationwide.

One of the conclusions of the article may seem obvious but its implications are worth considering carefully.  The study found that the best predictor of future loan performance on a county level was not the unemployment rate, per capita income or population growth.  The most important predictor was house-price appreciation.

Again, this may seem like a statement of the obvious.  If house prices are rising, and a borrower can’t make their loan payments, they just sell the house and payoff the loan.  Even if the property had a high LTV ratio when the loan was originated, equity has accumulated due to price appreciation and the loan(s) can be paid off in full.

 Of course the problems occur when house prices are declining.  If the borrower took out a piggyback or went with some other low-downpayment program, there is little or no equity.  The borrower can go upside-down quickly.  And if that borrower was an investor, they aren’t going to be too concerned about having a roof over their head.

 This problem will be particularly acute in states like California.  Why?  Several factors:

– High home prices mean buyers need jumbo loans which are expensive right now.

– A high percentage of loans originated in the state have been of the low doc and/or high LTV variety during the past several years.

– Falling house prices.  Often oxymoronically referred to in the industry as ‘negative price appreciation’.

– And lastly, California is a deed of trust state.  That means foreclosures are faster and cheaper for the lender since they generally are subject to non-judicial proceedings.  It also means that the lender can’t come after the borrower for any loan losses.  For many borrowers (and especially investors), it may seem better to take the hit to their credit score and throw the keys across the table than to struggle to make payments on a property whose value is plummeting. Why throw good money after bad?

This time around, I think we’re going to see a lot more problems with loans in upper credit tiers. As price depreciation continues, even borrowers with means may decide to default rather than try to keep up with an ARM payment that keeps rising.

 In the future, mortgage lenders may want to change their risk management policies to more directly consider home price trends and not just rely on borrower financials and property appraisals.  Markets with relatively high price volatility should be approached with caution in good times and bad.

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