Issue 26 • May 27, 2009

The Next Wave of Housing Distress

Home prices are in the headlines again with yesterday’s release of the latest S&P Case-Shiller home price index through the end of March.

The latest report continues to paint a dismal picture for housing, which isn’t surprising to us.

The U.S. National Home Price Index recorded a -19.1% decline in the first quarter of 2009 compared to the same period of 2008.¹ That’s the largest decline in the 21-year history of the data. What’s more, since the peak in 2006, average home prices nationwide have plunged over -32%. The Case-Shiller data has become the most widely followed barometer of (falling) housing wealth in America and, as even the most casual observer can attest, it has been an ugly picture.²

This isn’t the only housing statistic that matters. There are others that get scrutinized and debated by pundits searching for clues of an elusive bottom in the market.

Housing starts, mortgage applications and pending home sales are among the most popular measures.

Another indicator I personally focus on is foreclosure and delinquency data. Unfortunately, this data appears to also be moving from bad to worse!

I have written frequently in Weiss Advice about the housing crisis, most recently detailing growing problems in commercial real estate. I strongly believe that we MUST see some stability in housing as a prerequisite for any lasting recovery in the banking sector or the broader economy.

Admittedly, there appears to be a lag in foreclosure and delinquency data, especially in recent months as banks and other lenders put foreclosure moratoriums in place. This was done in part at Washington’s urging — to give troubled home owners a chance to work out voluntary renegotiations with their lenders. And the banks were only too happy to comply with the moratoriums — mainly to keep them from admitting to a new flood of loan losses at a time when they were being stress tested.

But temporarily ignoring a problem does not make it go away.

Unfortunately, there is good reason to believe this mortgage “pig” may be only half way through the foreclosure “python” — with a third wave of delinquencies and foreclosures taking place now — and another poised to batter the housing sector in next year and beyond.

You Thought Last Year Was Bad?

A disturbing development was noted in a recent New York Times article which described the growing wave of foreclosures, not in terms of sub-prime toxic loans, but this time among prime mortgages given to sound borrowers with good credit.

This is, in fact, the “third wave” of foreclosures ... the result of mounting job losses due to the economic collapse.³

The first wave of foreclosures was mainly from the “flip-this-house” crowd who basically walked away from speculative real estate purchases as the market tanked.

The second wave centered on sub-prime borrowers whose low “teaser rates” adjusted sharply higher in 2007 and 2008 — making their monthly mortgages suddenly unaffordable.

Now we’re in the middle of a possibly much larger third wave, brought about by the dismal economy. This wave is still “intensifying” according to some economists. In fact, up to 60% of all home mortgage loan defaults this year will be due mainly to job losses, up from just 29% a year ago.⁴

Over all, more than four million mortgage loans worth $717 billion were classified as “distressed” in February 2008. That represents a +60% increase from a year ago. The main source of swelling foreclosures hasn’t been toxic sub-prime loans recently, but standard prime mortgage loans.⁵

Prime Loans the Main Culprit Now

The number of troubled prime mortgage loans jumped more than 473,000 from November 2008 to this February, boosting the nationwide total to 1.5 million loans that are now in some stage of foreclosure, with a total value of about $224 billion.⁶

By contrast, the number of new, sub-prime loans in trouble slowed to a relative trickle of just 14,000 over the same period.

It’s clear that as the economy worsens, the numbers of prime borrowers falling behind is quickly catching up to of the numbers of toxic, sub-prime borrowers in the first waves.⁷

A potential bright spot: A government program, announced in February, targets $75 billion in “incentives” to help borrowers and lenders work out loan modifications. The program claims it will save as many as four million homeowners from foreclosure.

But three months after the program was announced, fewer than 55,000 loans had been modified, according to the Treasury Department’s own data. Meanwhile, another 313,000 mortgages slid into foreclosure or became delinquent in the first two months of 2009 alone!⁸

Sounds like the government’s housing rescue efforts are falling into the “too little, too late” category.⁹

The Next Wave of Defaults from Option ARMs

Unfortunately, there is another reason to believe that troubles on the home front are not over, just yet. In fact, as we see it, housing may not stabilize for another couple years at best!

As I mentioned, sub-prime mortgage resets were the big problem in 2007 and 2008. That’s what triggered the financial meltdown to begin with.

Now that we’re in mid-2009, the number of toxic mortgage resets has subsided, but only temporarily.

Starting early next year, the number of rate resets will again begin to climb, and steeply.

This next wave of housing pain will be due to “option ARMs,” another type of toxic adjustable-rate mortgage. As you can see in the graph, the number of mortgage resets begins climbing again next year and won’t peak until well into 2011 – over two years from now!¹⁰

This tells me there’s a high likelihood of another wave of foreclosures ahead, triggering even more mortgage loan losses. So, if you think conditions can’t get any worse in housing, you may want to think again. The next tidal wave of loan resets could be even more devastating than what we’ve experienced so far. Stay tuned.

Good investing,

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

¹ S&P Case-Shiller Home Price Index press release, 5/26/09
² Ibid.
³ New York Times: “Job Losses Push Safer Mortgages to Foreclosure,” 5/25/09
⁴ Ibid.
⁵ Ibid.
⁶ Ibid.
⁷ Ibid.
⁸ Ibid.
⁹ Ibid.
¹⁰ Hussman Funds weekly market commentary, 3/30/09 ; graph source: Credit Suisse