The Mortgage Market Bubble

The sub-prime bubble was obvious.  The current mortgage bubble is much harder to define and understand.  I call it a bubble because these conditions are not based on market fundamentals. They are the result of manipulation by policy makers and are unsustainable.

 

Weekly Mortgage Applications

MND plots weekly mortgage applications against 30 year fixed rate mortgage rates.  The message is pretty obvious.  The first chart is the refinance index.  Mortgage rates dropped almost 2% as a result of the original QE operation.  As expected, a refinance wave followed.  By the time QE3 rolled around, everyone who was able to refinance had already refinanced.  Rates would have to drop substantially in order to trigger another round of refinancing.

 

Chart-1-refi indexRefi index vs. 30 year fixed mortgage rate – click to enlarge.

 

The purchase index is even more distressing.  Its downtrend has been unresponsive to all stimulus attempts.  I have to wonder how low the index would be if not for easy financing.  In spite of purchasing $788 billion of agency MBS in 2013, and $372 billion to date in the “tapering year” of 2014, lower rates have had no stimulating effect whatsoever.

 

Chart-2-Purchase IndexPurchase index vs. 30 year fixed rate – click to enlarge.

“Credit is unreasonably tight.”

Just repeat that often enough and it may sound believable.  Unfortunately, that has to be the most repeated false statement pertaining to housing today.  Credit has never been easier.  Allow me to illustrate:

 

Down payment – 3% down for FHA loans is as low as it has ever been.

Debt-to-income Ratio – >50% – that is unheard of.

Credit Score – FHA set the limit at 580.  When has that bar been set lower?

Mortgage Rates – at sub 4%, payments have never been lower.

 

In fact, credit is easier to obtain today than during the sub-prime era.  Here is why.  While some sub-prime borrowers were suckered into taking out loans that they did not qualify for by lying on their loan applications (stated income, stated assets, no verifications), the majority of borrowers did apply for mortgages using more normal underwriting guidelines.  With mortgage rates about 1/3 lower today than prior to the Fed’s QE operations and home prices not artificially inflated, it is accordingly much easier for truly responsible and creditworthy borrowers to qualify for a mortgage.  These borrowers are still the majority.

FHFA is trying to make it even easier to qualify, with lower downpayments, higher DTI ratios, while providing safe harbors to lenders who would only be too happy to originate these high risk loans with no put back liabilities.  The correct description of the current mortgage market should be:

 

There has never been a more unqualified pool of borrowers who cannot even take advantage of the most accommodating financing terms ever.”

So why do I call this a bubble?

The sub-prime loans had a two year fuse.  Most sub-prime loans were written with a two year term.  As long property values appreciated faster than the cost of a roll over refinance, and sub-prime mortgages continued to be available, all was well.  We know what happened when the music stopped.

The current mortgage bubble also relies on price appreciation to hide its deficiencies.  There are two triggers:  higher mortgage rates and/or price depreciation.  The first would make financing even more difficult while the second would send millions of households into the negative equity cesspool.  Too many loans are already in high risk categories:

 

FHA loans with the minimum downpayment.

Negative equity loans.

TARP refinances with no underwriting standards.

Loans that have gone through generations of defaults, cures, re-defaults and cures.

 

Will the bubble pop?

The market is not healthy.  Black Knight (formerly LPS) has a wealth of loan performance data in their Mortgage Monitor.  Here is an excellent chart.

 chart-3-loan performanceLoan performance data – click to enlarge.

 

Look at the left side of the chart, up until ~2006.  This is how mortgages should perform, especially foreclosures.  Look at how stable the end result was, averaging less than 1% of all active loans.  The free market made the necessary adjustments to loosen and tighten standards in reaction to prevailing market conditions.  That had worked pretty well even with the Volcker tightening and the S&L/RTC fiasco (both events happened too long ago to be depicted on the chart, but take my word for it). The sub-prime bubble resulted in an unprecedented level of defaults starting around 2006.  Consider the amount of intervention and costs involved in bringing the non performing rate down since the 2010 peak. And yet, not only are we far from the norm, non-performing loans are heading back up again.

The following chart illustrates how lax underwriting is currently, not “tight”, as is widely claimed.

 

 

chart-4-delinquenciesDelinquencies, credit scores 620-659, FHA – click to enlarge.

 

Think about what this chart is telling us.  For example, of the FHA loans originated during 2012, with a credit score of 620-659, over 10% are already delinquent by their 30th payment.  Similarly, 2013 vintage loans are following the same path by their 18th payment.  Most alarming is the current vintage.  Look at the percentage of delinquencies for just the first 6 months.  Don’t forget that delinquency is the second step, after non-current.  In other words, a loan that was originated 6 months ago and is delinquent today implies a non-payment during the first or second month of the loan.  You call that tight credit?  To make matters worse, underwriting standards are even more lax today than in 2012.

Blind bulls would say that current vintages are performing much better than previous vintages.  Think of loans originated in 2008.  Property values were tanking and 97% LTV loans soon became 125% LTV loans, putting the borrowers way under water.  On the other hand, Case-Shiller told me that property values have been appreciating across the board since 2012.  Why would over 10% of these borrowers not pay?  Why not just sell and take the profit?

In conclusion, the current mortgage bubble is not that obvious.  When it pops, it is likely to be a surprise that will result in more weekend meetings in that big Federal Reserve conference room.  In the meantime, pay attention to mortgage rates and house prices.  Either of them could provide enough of a red flag.

 

 

Charts by: Mortgage News Daily, Black Knight

 

 

 

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