The Housing Abyss
The housing crisis is entering a new and frightening stage. On June 24, Standard & Poor's announced that the S&P/Case-Shiller 20-City Home Price Index had fallen more than 15% in April from a year earlier. Adjusted for inflation, the decline is the biggest since 1940-42, according to data collected by Yale University economist Robert Shiller.
The risk for the financial system and the economy is that the price drop, already horrifying, will start feeding on itself. When home values fall low enough, hard-pressed homeowners become less able or less willing to keep paying their mortgages. That forces lenders to repossess homes and then dump them back on the market at fire-sale prices, which depresses prices further and leads to even more foreclosures.
That process has already started in parts of Arizona, California, Florida, and Nevada. The drop in those markets "is being fueled with jet fuel," says James L. Smith, executive vice-president for portfolio services at Fiserv (FISV), a Brookfield (Wis.) company. His unit works with borrowers to restructure delinquent mortgage loans. Smith worries that instead of settling at a reasonable price level, "we're going to blow past [it] without even looking back."
Efforts by the private sector and government to stop the slide before it gets out of control haven't done the job. Poorly designed mortgage securities rife with conflicts of interest, as well as legal disputes over priority between creditors, are forcing many homes into foreclosure needlessly, accelerating the market decline.
Sure, Congress is expected soon to pass a huge legislative package aimed at preventing needless foreclosures and stimulating first-time home purchases. But many analysts and advocates are already warning that more dramatic measures will ultimately be required. "The depth of pain is not being registered in D.C.," says Mike Shea, executive director of nonprofit advocacy group ACORN Housing in Chicago.
That's not everyone's assessment, of course. Some economists and politicians say that policymakers need to focus on keeping inflation under control in the face of soaring food and fuel prices. They say that the effects of the housing bust will be modest and that low prices will attract new buyers. "We're seeing people go into the market that weren't there before," says Alfred A. DelliBovi, president of the Federal Home Loan Bank of New York. The Federal Reserve, which has already cut the federal funds rate to 2% without managing to save the housing market, hinted on June 25 that no further rate cuts are in store, warning that inflation risks have risen while the risk of slower growth has "diminished somewhat."
Still, the housing optimists have systematically misjudged the market. Some became convinced that the huge runup was justified by fundamentals such as population growth, rising incomes, and land scarcity. And because sharp national housing price declines are so rare in U.S. history, analysts assumed that prices would, at worst, flatten out for a few years.
"BUYING AND BAILING"
What they forgot was that markets can overshoot on the downside just as easily as on the upside, with both financial and psychological forces feeding the decline. On the financial side, adjustable-rate mortgages are continuing to reset upward from their cheap introductory rates, making it more difficult for homeowners to afford their loans. What's more, each month of price declines pushes more homeowners underwater on their mortgages, making it impossible for them to refinance into more affordable loans. It doesn't help, either, that as the economy weakens, larger numbers of homeowners are finding themselves out of work.
Naturally, this state of affairs is working out for buyers with ready down payments, such as George Farraye, a 53-year-old salesman of industrial filters who just paid $359,000 for a 3,500-square-foot house in Murrieta, Calif., that sold for $630,000 in 2006. Farraye says tighter lending standards "shook out all the riffraff."
At the same time, the fall in house prices is so precipitous that it is changing homeowner psychology, eroding the long-held taboo against walking away from a home. In hard-hit markets such as Las Vegas and Phoenix, many homeowners are beginning to conclude that their home purchase comes with a "put option"—the right to hand the keys back to the lender if things don't work out. Indeed, risky payment-option ARMs that allow unpaid interest to be added to the principal, 70% of which were issued in California and Florida, are going bad even before they reset upward, as homeowners see trouble ahead and bail. "Commercial real estate borrowers have always looked at things this way. Consumers simply caught on to the game," says Tom Lindmark, a managing director of Phoenix-based Metropolitan Real Estate.
Fiserv's Smith, whose unit began handling loan modifications for Countrywide Home Loans in May, attributes the rise in walkaways to "the ticked-off factor." Even homeowners with high credit scores feel cheated that they're paying more than they can afford for a house that is worth far less than the debt on it, he says. To get delinquent borrowers on the phone with a counselor, Fiserv sends some of them gasoline gift cards that must be activated by calling a toll-free number.
Steve Hawks, owner of RE/MAX Platinum real estate agency in Henderson, Nev., says he has been flooded with calls from people interested in "buying and bailing"—that is, buying an additional house while their credit is still good, then walking away from the old one unless they can cut a favorable deal with the lender. So far the number of people who have done so appears to be small. But Hawks says banks are receptive to lending for such purchases because they figure the buyer will be able to afford the new, cheaper place. Also, says Hawks, they know that, since the buyer's credit will become damaged, he or she won't pull the same trick on them, at least for a few years.
COMING CASUALTIES IN BANKING
Kim, a Las Vegas bartender who does not want her last name in print, says she and her husband are about to purchase another house in Las Vegas, move into it, and then try to get the lender on their old house to erase their mortgage for whatever they manage to sell the place for—a so-called short sale. Says Kim: "I'm going to lose the house no matter what. I just want to make sure my family's set, taken care of."
Mass foreclosures accelerate a neighborhood's decline, triggering a spiral of abandonment and decay. A survey of agents this year for Inside Mortgage Finance by Geosegment Systems and Campbell Communications found that about half of foreclosed properties have significant damage, which reduces a property's value by about 25% (e.g., $100,000 on a $400,000 house). Ruined floors and carpets, holes in walls, and missing appliances lead the list.
Beyond that, foreclosures are concentrating diffuse losses on consumers' balance sheets into enormous ones on banks' balance sheets in a way that could lead to a wave of bank failures or a sharp reduction in lending. So far this year the Federal Deposit Insurance Corp. has taken over only four banks, vs. 653 in 1990 and 1991 combined at the height of the savings and loan crisis. But the FDIC is bracing for an upsurge. The division that liquidates ailing banks recently received authorization for a 50% increase in employment, to 331.
In a June 25 interview, FDIC Chairman Sheila C. Bair said, "Certainly, failures will go up," though nowhere near early 1990s levels. With delinquencies also on the rise in commercial real estate lending and consumer lending beyond housing, she says the biggest risk to the banks today may be the collateral damage that's being caused as the housing downturn affects the rest of the economy. Said Bair: "The challenge for banks now is the broader economic distress that's stemming from a slowdown which is housing-led."
Who can fix this mess? Certainly not lenders. They're part of the problem. To repair their damaged balance sheets, they're aggressively reducing lending. And they haven't geared up for the wave of defaults. "The infrastructure is just not there," says Joe Garrett, principal of Garrett Watts, a San Francisco-area advisory firm to mortgage bankers and brokers.
CONFLICTS BUT NO COMPROMISE
Even in situations where loan restructuring would limit lenders' losses and benefit homeowners, deals are being stymied by a complicated system and conflicts between investors. For example, issuers of home equity lines of credit or second mortgages are lobbying for a piece of debtors' money, even though contractually their claims have been wiped out. As creditors, they are so-called second-lien holders and stand in line behind the holders of the first loans, who themselves won't be repaid in full. The second-lien holders often refuse to sign off on restructurings that would formally erase their claims. Without the second-lien holders' approval, many homeowners who might have been able to stay in their homes with new loans are being forced out of them.
Owners of mortgage-backed securities are several steps removed from what's happening in the housing market. The securities' designers never envisioned having to cope with massive defaults, says Vincent Barberio, a managing director in the residential mortgage-backed securities group of Fitch Ratings, based in New York. For example, to preserve favorable tax treatment, most securitization deals contractually limit the number of loans that can be modified to anywhere from 2% to 7%—an unrealistically low level given that in some pools a third or more of the loans are delinquent. Insurers of mortgage-backed securities, too, can hold up restructurings that will trigger claims against them. And the terms of some servicing agreements turn out to give loan servicers a financial incentive to let loans go into foreclosure rather than be restructured, says Kathleen C. Engel, an associate professor at Cleveland-Marshall College of Law.
Industry players are well aware of the multiple problems but haven't been able to craft a compromise. In April the Treasury hosted an all-day meeting with the largest lenders and servicers, but it produced no decisive action. On June 17 the newly formed Coalition for Mortgage Industry Solutions held a loftily titled Leadership Summit in Washington but came away with little to show for it—leading some participants to speculate that the government will cram a solution down the industry's throat. Mark S. Zuckerberg, a consumer-bankruptcy attorney in Indiana who attended the summit, said: "I met some very powerful people, but the meeting itself was a complete waste of the day."
What more might government do? The Federal Reserve has already intervened heavily, of course. In addition to slashing short-term interest rates, it has extended more than $150 billion in secured loans to banks. Anything more from the Fed would leave it open to charges that it was subsidizing the banks and raising the risk of inflation.
Washington, meanwhile, has its own issues. The Treasury Dept. has made little headway in jawboning lenders into speeding up loan workouts. Reasonably enough, President George W. Bush and many congressmen on both sides of the aisle oppose using taxpayer dollars to bail borrowers and lenders out of dumb mistakes. There's also concern about overly favoring the handful of big states where the problems are worst, including Arizona, California, Florida, Michigan, Nevada, and Ohio.
The Democrats' centerpiece legislation, bills sponsored by Representative Barney Frank (D-Mass.) and Senator Chris Dodd (D-Conn.), is designed to keep creditworthy borrowers in their homes with new, more affordable loans insured by the Federal Housing Administration. By preventing some forced sales, it could help neighborhoods plagued by foreclosures. But to keep the cost down, Congress was forced to make the terms so stringent for lenders and borrowers that only a fraction of people needing help—perhaps 500,000 homeowners, by a Congressional Budget Office estimate—would likely get the loans. (The bill also permanently raises the size of mortgages that Fannie Mae and Freddie Mac can buy and has an $8,000 tax credit for first-time home buyers to stimulate sales.) "It has taken time for the pragmatists to seize the initiative over the idealists," says Jaret Seiberg, a Washington (D.C.)-based financial service analyst at Stanford Group.
If the housing market continues to weaken, action in Washington could heat up next January, when a new President and Congress take office. The next President, whether Democrat or Republican, will have more flexibility to be bold because he will be starting with a clean slate, although Barack Obama has taken a far more interventionist stance than has John McCain. One proposal Obama backs is to amend the federal bankruptcy code to let judges force mortgage lenders to take a loss on their loans as part of a Chapter 13 settlement. Or Congress could expand the Frank-Dodd plan to cover more people.
But expect strong pushback on that last idea from fiscal conservatives. The Wall Street Journal's editorial page observed on June 21 that the FHA lost $4.6 billion last year, making it a less-than-obvious candidate to guarantee billions in troubled loans. An even bigger stretch: The FDIC's Bair has begun arguing that the federal government may ultimately have to provide low-cost loans directly to borrowers to help them pay down their unaffordable mortgages.
At this stage, none of those options has much of a shot at getting enacted because the pain of the housing bust hasn't been severe enough to overcome the logical objections. But if the bust worsens—and that downward spiral is increasingly likely—lots of unappetizing ideas might suddenly seem perfectly reasonable.