Houses of cards

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By Michael C. Schmitz | 17 October 2007

THIS SPOTLIGHT

Oct. 17, 2007

The housing correction has far-ranging implications—for consumers, insurers, and banks.

We asked Mike Schmitz, consulting actuary in Milwaukee, Wis. to weigh in on the subject.

Q: We've seen a dramatic decline in the S&P/Case-Shiller U.S. National Home Price Index. Can you explain the significance of the Index?

A: The Index is roughly analogous to the consumer price index. It measures general prices for housing in several of the major metropolitan areas. So it tracks pricing trends for house prices based on repeat sales. When I say repeat sales, I’m simply referring to the price for a house once it changes hands more than once. The Index uses a consistent stock of housing units when it's measuring those pricing trends.

There are 10 major metropolitan areas that are tracked for the Index that have futures markets tied to them; there is also a composite of those 10. The Index provides a measure of how home prices have performed to date, but beyond that it also provides a market-based forecast for how house prices might be expected to behave in the future.


Q: Are there certain areas that are seeing a larger decline than others?

A: The largest decreases are in Miami, Las Vegas, Los Angeles, San Diego, and Washington, D.C. Why is this? One reason is that, to a certain extent, the housing boom was fueled by speculation and leveraged buying, especially in certain markets. And I don't just mean leveraged buying through the use of borrowed funds or mortgages. There were also many investors purchasing multiple properties, so they're leveraged from the standpoint of having more than one property, and having debt on those properties. This resulted in the additional speculation and leveraged borrowing that often accompanies booms.

The unwinding of that leverage can often lead to the corrections and busts that frequently follow such booms. That type of activity was prevalent in markets such as Miami and Las Vegas, cities where there was significant speculative leveraged investor buying. Price declines such as those now occurring can force those leveraged investors to cover their positions by liquidating some of their properties at a loss. Florida also has the additional market pressure associated with concerns over hurricane exposure and the rising cost of insurance.


Q: So what implication does the decline in the Index have for homeowners?

A: The decline has a significant implication for homeowners. Seven out of the 10 metropolitan areas—not to mention the composite of these areas—have shown actual declines through the middle of 2007. The decline follows a housing boom where the composite more than doubled from 2000 to mid-2006 (i.e., increased more than 100%). The highest risers, if you will, were Miami and Los Angeles, which nearly tripled (i.e., they increased more than 170% to 180%).

The housing boom peaked in 2006 followed by the Index declining, so home prices have actually fallen in the majority of those large metro areas from their peaks. And home price declines have a significant implication for homeowners because they shrink their home equity, which can be the largest asset for many. For example, a homeowner who purchased a house in 2006 at the top of the market with a 5% down payment would have his entire home equity wiped out by the average declines to date in several of these markets.

The decline in housing value has important implications for consumers because so many homeowners used their home equity as an additional source of income during the housing boom. Incomes rose slowly during this period compared to home prices, which were surging. The increasing home-equity asset opened up additional sources of spending through refinancings and home-equity loans that helped keep consumers in the market. This additional source of wealth also may have also instilled a sense of prosperity in homeowners, which increased their willingness to spend.

Now the declining home prices eliminate a significant portion of the discretionary funds formerly available to consumers through their home equity. In the past, those with economic difficulties could use rising home prices to refinance; in effect, they could use their ballooning home equity to refinance their way out of difficulties. With home prices now going down, that option is not available to many and, unfortunately, it could lead to rising foreclosures, which have already occurred in some markets, including the subprime adjustable rate mortgage market.


Q: What implications does this have for insurers?

A: For general insurers, the decline in the Case-Shiller Index affects the risks on the asset side of their balance sheet. A lot of insurers hold mortgage-backed securities, which are collateralized by home values; thus, decreasing home prices put certain strains on the collateral that's backing those assets, which can lead to market value declines in such securities.

More specifically, mortgage insurers are on the front lines directly underwriting the risk of borrowers defaulting on their mortgage loans, especially on high loan-to-value ratio loans where there are smaller equity slices for the borrower. This is a big issue when it comes to mortgage insurers’ liabilities, since these insurers reserve for loans that are currently delinquent. In other words, their reserves cover their forecasted costs for defaults on loans that are currently behind on payments. Because delinquency rates have been rising, insurers have more loans in their portfolio that require reserves. Decreasing home prices and the corresponding erosion of home equity will have a significant impact on the insurers’ losses for current delinquencies.

In the past, insurers could set aside a much smaller portion for reserves on current delinquencies because many of those delinquencies would resolve themselves thanks to rising home prices and refinance opportunities; even if a loan was foreclosed upon, there was enough equity that the lender was less likely to experience a financial loss from that default. With home prices coming down, and with the futures markets forecasting further declines, there is likely to be a significant change in both the frequencies and severities for loans covered by mortgage insurers’ reserves. The impact on reserves and loss payments will negatively impact the profitability of these insurers and will have important ramifications for their claim settlement practices. This will be a big issue for insurers during the next couple of years.


Q: What implications does the decline in the S&P/Case-Shiller Index have for banks?

A: Banks have portfolio loans that they keep on their balance sheets. They also keep residual interests in some of the securitizations of loans that they sell off. Decreasing home prices strain the collateral backing of the loans that they either have in their portfolios or hold a residual interest in. That collateral decline will have important financial ramifications for those banks. The banks must set aside loan loss reserves for loans in their portfolios that default. They will also be subjected to market value declines of their mortgage-backed securities. So the same types of trends that are affecting the mortgage insurers are also directly affecting the banks.

There is an alternative to mortgage insurance on loans with low downpayments; piggy-back home-equity loans have been popular in the last several years. These piggy-back loans involve a home-equity loan extended to a borrower along with a first lien loan for 80% of the property value. This home-equity loan brings the combined loan balances up to 95% or more of the home value. These home-equity loans are on the front lines, absorbing the first loss when the collateral falls below the equity of the homeowner. Home-equity loans have been a very popular product with banks over the past several years, so they represent a significant area of exposure.

Additionally, many lenders have established reinsurance subsidiaries whereby they insure a portion of the risk that mortgage insurers assume on low down-payment loans that they've originated. So reinsurance exposure is another area where banks are exposed to risk that is directly affected by decreases in home prices.

Because of the growing mortgage crisis, banks generally have reduced access to funds through the secondary market for mortgage originations. The cost of those funds has generally gone up as well. It's going to be very important for banks to analyze their loan portfolios in order to analyze the risk that they face. Many banks have a pipeline of loans that they intended to sell to investors in the secondary market. The value of these loans is significantly influenced by the impact of declining home prices on the collateral. These factors, along with the general credit crisis that has emerged, will likely lead to significant write-downs and losses for banks.

Q: The Federal Reserve has recently lowered short-term interest rates. How is this move likely to affect the housing and mortgage markets?

A: The ease in rates has a direct effect on lowering the cost of certain credit that consumers have access to, in particular the loans that respond directly to short-term rates (including adjustable-rate mortgages, home-equity lines of credit and home-equity loans). All of these sources of credit have interest rates that are closely tied to short-term interest rates. So that's going to place some additional money in consumers' pockets and alleviate some of the financial strain, helping them make their mortgage payments.

Insurers will benefit from this assistance because they are insuring against the default risk of the home borrowers, who stand to benefit from this ease in rates. Banks also benefit from a lower cost of funds, which is particularly beneficial in light of the secondary market strains mentioned above. Both insurers and banks benefit to the extent that cheaper credit boosts the consumer's ability to spend and to withstand financial stress.

Also, one of the traditional banking business models is to borrow at low short-term rates and lend at higher long-term rates. A positive yield curve with long-term rates higher than short-term rates is generally seen as an aid to banks since it helps this traditional business model.

The Fed has injected a large amount of liquidity to try to stabilize markets. Even as the Fed raised short-term interest rates from 2004 through early 2006, long-term rates stayed stubbornly low, and this caused the flattening (and occasional inversion) of the yield curve that Federal Reserve Chairman Alan Greenspan referred to as a "conundrum." Somewhat ironically, now that the Fed has lowered short-term interest rates in response to this mortgage crisis, long-term rates have actually risen a bit. So the Fed action did not result in a corresponding decrease in the traditional 30-year fixed-rate mortgage—these rates generally increased a bit following the Fed reduction.

The Fed is walking a tightrope as it tries to keep the economy at large from spilling over into a significant recession, balancing this concern against the inflation fighting that has traditionally been its primary focus. This is an immensely difficult balancing act, so stay tuned and wish Ben Bernanke the best in his challenge.

MICHAEL SCHMITZ is a principal and consulting actuary in the Milwaukee, Wis. office and has been with the firm since 1993. Mike manages a practice dedicated to financial risks such as mortgage guaranty, financial guaranty, and credit enhancement products.