Home Mortgage Lenders Face Three Hundred Billion in Losses

May 27, 2010 - PRLog -- Merrill Lynch's $8.4 billion write-down on mortgage related securities was a surprise to most analysts. Unfortunately, I believe more losses are coming. By my calculation, the subprime mortgage meltdown could be a $300 billion problem for home mortgage lenders and holders of mortgage-related securities, almost twice the size of the savings and loan crisis that unfolded in the U.S. in the '80s and '90s.

$1.456 trillion worth of subprime mortgages. As of March 31, 2007, there was about $11.2 trillion in residential loans outstanding in the U.S. About 13% of that debt is considered subprime by Fannie Mae and another 12% of that debt is considered "Alt-A", the next riskiest category. If 13% of the total is subprime, then there is outstanding a total of $1.456 trillion in subprime mortgages. From looking at several different statistics, about $1.2 trillion of subprime debt were originated during 2005 - 2006 at the peak of the housing market.

A subprime default rate of 19%? In December 2006, the Center For Responsible Lending projected that about 19% of subprime loans originated in 2005 and 2006 would end in default. The Center argues reasonably persuasively that the combined effect of declining house prices and interest rate increases on the 80% of subprime mortgages that are adjustable rate mortgages (ARMs) will significantly reduce the ability of homeowners to sell their way out of their mortgages.

Trends support a 19% subprime default rate. I think a 19% default rate is plausible, notwithstanding the Center's reputation as a consumer advocacy group with a possible bias towards exaggerating the impact of the mortgage crisis on consumers. As of June 30, 2007, the National Delinquency Survey of the Mortgage Bankers Association indicated that 12.4% of subprime ARM loans were already seriously delinquent. Another recent Mortgage Banker Association survey found that approximately 15% of subprime loans are past due in some form. With the upcoming reset of over $1 trillion ARMs in late 2007 and through 2008, it seems likely that the past due rate will exceed 15% and that the natural progression into serious delinquency and default will follow. In 2001, the Office of Federal Housing Enterprise Oversight did a study of the worst cumulative credit losses experienced by all loans originated during a period of at least two consecutive years in contiguous states comprising at least 5% of the U.S. population. The winner was the 1983 -- 1984 period in the states of Arkansas, Louisiana, Mississippi and Oklahoma. Those loans had a cumulative default rate of 14.9% and an average loss severity of 63.3%. A 19% default rate is only 4.1 percentage points higher than the level reached in 1983-1984, an increase that seems realistic in view of unprecedented recent housing price inflation and loose underwriting.

Count on no more than a 40% recovery on a foreclosed subprime loan. According to a study cited by U.S. banking regulators, losses to banks on defaults between 1975 and 1983 ranged from about 20% of the outstanding loan balance on the better loans to about 50% of the loan balance on poorer loans. The expected loss on a loan with an 81-90% loan to value (LTV) ratio is about 34% and the expected loss is about 48% on loans with a 91-95% LTV ratio. The average loss was about 40%. Based on statistics that the average LTV on the 2005 and 2006 vintage subprime loans is about 86%, we might apply a the average loss ratio of 40%, which is well below the historical 63% loss rate recorded during the worst case 1983-1984 period. Using the 40% loss number on an assumed 19% default rate on the $1.2 trillion of 2005-2006 subprime loans, we'd have a loss of about $91 billion on just those subprime loans.

Falling home prices further reduce recoveries. Predictions range from a nationwide average decrease of 10% in housing prices to regional decreases of 25-30%. If houses have gone down at least 10% in value on average, the lenders' loss severity in the example above would be 50%, not 40% on the 19% of loans in default, or a total loss of about $114 billion on just the subprime loans originated in 2005 and 2006. If we apply a 15% default rate and a 50% loss rate to the other $256 billion of subprime loans outstanding, there would be an additional loss of $19.2 billion for a total of $133.2 billion in subprime losses.

The $9.744 trillion of non-subprime loans will be affected. There will be some spillover effects from mass subprime defaults. According to the Mortgage Bankers Association, as much as 80% of all outstanding home loans have been originated since 2002 due to the huge volume of refinancings. Many of these borrowers ended up with a riskier loan than the one they refinanced. Several facts suggest that there will be a significant nationwide uptick in the overall default rate: (1) overall past due rates have already risen to over 2% in strong markets like San Francisco and to over 5% in other markets, rates that are already much higher than the overall historical default rate of about 1%; (2) an unprecedented large number of risky Alt-A loans and other non-standard loans outstanding, and (3) dramatic increase in the U.S. home vacancy rate from about 1.5% in 1995 to over 2.7% today. If we use a 25% loss figure, the total loss on 2% of $9.744 trillion in non-subprime loans would be $48.72 billion. Thus, total loan losses, subprime and non-subprime, would be about $182 billion.

Total losses could easily exceed $300 billion. Recall that the regulators rely on the 1983 and 1984 data for their worst case projections and that the loans studied had a cumulative default rate of 14.9% and an average loss severity of 63.3%. If the U.S. experiences a modest (by those standards) 7% overall default rate on the $11.2 trillion total and a modest (by those standards) overall loss rate of 40%, total home loan losses would be $313 billion. Keep in mind that if a loan in default is worth only about 60% of its face value to someone who is willing to hold it through the foreclosure process, then a buyer of that loan will demand anywhere from 10% to 40% additional discount, meaning that a bank needing to unload a loan portfolio should not be surprised to be offered 20 to 50 cents on the dollar. If we used a 20% discount on such loan sales (in addition to the 40% loss percentage), the total loss to the current holders of mortgage debt would be about $470 billion.

For several other reasons, I think the $313 billion number will prove more realistic than the loss number based only on subprime loans or on the $182 billion I estimated above for all home loan losses. First, the sheer size of the mortgage market and the national scope of the housing downturn mean that the task of dealing with millions of problem mortgages simultaneously will be daunting indeed. Second, millions of people being harmed financially in similar ways usually leads to litigation, including class action lawsuits. Millions of loans were documented by brokers and underwriters that were not subject to strict examination by bank regulators and numerous compliance time bombs lie buried in that paperwork and will provide ammunition to homeowners defending against foreclosure. Whether or not such suits have merit, they can at least delay recovery and thus exacerbate losses.

Implications. The projected subprime loans loss of $133 billion by itself is almost as much as the total cost of the savings and loan bailout in the '80s and '90s, which the FDIC recently calculated as $153 billion. On the positive side, the loss will be absorbed by a U.S. and world economy that has grown immensely since the 1980s.

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