I am a big proponent of listening to the people who have been right all along about the housing bubble. One of those people is Laurie Goodman. Yesterday she warned Congress that 1 in 5 homes with a mortgage will default unless dramatic action is taken. And, if home prices fall too much more, the default rate will be even higher.

Her scenario is much more grim than others are painting. Let’s walk through her testimony and data.

One of the trends that we have documented is a very significant supply/demand imbalance in the housing market. Distressed loans are moving very slowly through the delinquency/foreclosure pipeline. These loans weigh heavily on the residential real estate market, and are often referred to as shadow inventory. In addition, many of the borrowers that are not delinquent on their loans have a tainted credit history and/or are seriously underwater, suggesting more defaults to come. Thus, there are many distressed homes that will need to change hands over the next 5–6 years. At the same time, mortgages are becoming increasingly difficult to obtain. Overall credit availability is tightening and the pool of qualified mortgage applicants is shrinking dramatically. A large number of borrowers who are delinquent on their current mortgage, and do not have the financial means to purchase another home, are likely to convert to renters. Despite this cloud surrounding the mortgage market, we see housing as very affordable by most traditional measures.

 

Given this backdrop, we believe that long-term investors in 1–4 family residential real estate are the key to a housing recovery: they are the only potential buyers of many distressed homes that are likely to hit the market over the next 5–6 years. Investors need to be part of the solution.

 One of her key themes is that investors need to be a part of the solution and that they government needs to enact policy to get them more involved.

Many analysts looking at the housing problem mistakenly assume it is limited to loans that are currently non-performing (we use 60+ days past due as our definition of non-performing). Such borrowers have a high probability of eventually losing their homes. However, the problem also includes loans with a compromised pay history; these are re-defaulting at a rapid rate. We define these re-performers as loans that were at one point 60+ days delinquent, but no longer are.

 

Moreover, borrowers with good pay histories who are substantially underwater have shown that they, too, have a reasonable probability of transitioning to default (going 60+ days delinquent).  Let’s review the scope of the housing problem. An understanding of this will allow market participants and policy makers to put our supply/demand imbalance numbers in perspective.

 

In Exhibit 1 (below) we have outlined our methodology for estimating the total supply of homes which may be subject to distressed sales over time. We show both a number we view as reasonable as well as a “lower bound” estimate. To derive these results, we classify the outstanding loans into five groups. In total, we estimate that there are approximately 80 million homes in the US, 55 million of which have a mortgage. Of these 55 million mortgages, there are 4.5 million non-performing loans (NPLs), 3.9 million re-performing loans, 2.6 million always performing loans with a mark-to-market LTV (loan-to-value) ratio >120, 5.4 million always performing loans with a mark-to-market LTV of 100-120, and 38.6 million always performing loans with a mark-to-market LTV of ”100. To size the problem, we focused on the eventual default rate of each group of loans. Our methodology is detailed in the Appendix.

 

Our results indicate if no changes in policy are made, 10.4 million additional borrowers are likely to default under our base “reasonable” case, and 8.3 million borrowers will default under our lower bound numbers. Since there are 55 million homes carrying mortgages, 10.4 million borrowers roughly equates to 1 borrower out of every 5. This includes 4.1 million of the 4.5 million borrowers who are already non-performing; the remainder of defaults will come from borrowers current on their loans, but who are likely to eventually default. Many in this group (2.5 million) represent re-performing loans that history suggests are very prone to another default.

She believes that we have enough re-default and walk-away data to forecast the percentages of these borrowers who will lose their homes down the road. While the percentages are certainly an estimation, it makes perfectly logical sense that these percentages are in the right ballpark.

Here is Exhibit 1:

(click for a bigger view)

She figures that there will be about 10.4 million more foreclosed homes over the next 5-6 years. She assumes:

• 90% of the existing non-performing loans will eventually end in foreclosure
• 65% of the re-performing loans will end up in foreclosure (these are loans that have been modified).
• 40% of loans with 120% or more LTV will default
• 15% of loans with 100-120% LTV will default
• 5% of loans with less than 100% LTV will eventually default

Assumes no change in overall housing prices, interest rates,
or new home construction

 

However, the (housing) overhang means that home prices, despite being very affordable, are likely to decline further. This may recreate the housing death spiral—as lower housing prices mean more borrowers become underwater. We have determined LTV is the single most important predictor of default. So more underwater borrowers means more defaults; more defaults means more inventory, more overhang, and even further declines in home prices. While home prices can go down another 5% without re-igniting this housing death spiral, a 10% decline would certainly re-ignite the spiral in our opinion.

This “death spiral” is the doomsday scenario that Ben Bernanke and crew are doing everything they can to avoid. But Case-Shiller home prices are already declining at a healthy clip – how far away is that “death spiral” really?

Prices, of course, are a function of supply and demand. We have plenty of supply. Our problem is a lack of demand. Here, Laurie offers quite a bit of interesting data:

Household formation has been very low in recent years. Census data (The Current Population Survey/Annual Social and Economic Supplement) indicates that the rate of household formation from 2007–2010 is about 500,000 units. This is very low by historical measures. The average rate of household formation for the period 2000–2010 was 1.3 million units per year. It was 1.0 million units per year during the 1990s. We assume a more normal household formation rate of 1.2 million units annually. The Joint Center for Housing Studies of Harvard University in their State of the Nation’s Housing, 2011, has estimated that out of the nearly 12 million units of expected household formation over the 2010–2020 period, 7 out of 10 will be minorities, whose home ownership rate has been historically lower. Note that we used a very generous number (50%) for demand from new households. We add to this the 400,000 units that will become obsolete each year and 200,000 second home purchases. This gives us 1.20 million (600K + 400K + 200K) units of total annual demand. So, excess supply is 0.68 to 1.03 million units/year (1.88 to 2.23 million units of total supply—1.2 million units of total annual demand). Thus, over the next 6 years, excess supply will total 4.1–6.2 million units.

So how can we absorb 4.1-6.2 million more homes? Her answer is simple: investors.

The only way to absorb the excess supply of housing in an environment of constrained demand is to increase the demand for housing. This can come from two sources: either allow borrowers who recently defaulted on their mortgages to qualify for new mortgages, or encourage investor purchases. The problem with the former is that borrowers who have just defaulted do not have the means to make a down payment on a new home. Investors represent the most promising avenue to increase demand. It is very clear that policymakers need to aid the creation of a new asset class—investor-owned homes for rent. Thus far, the overwhelming majority of the rental units are in multi-family properties. That has to change.

It’s hard to find fault with her assumptions or methodology. My fear is that her “death spiral” is actually very close to happening. Prices are continuing to fall, confidence is quickly eroding, and another recession seems certain. Can we really prop up home prices enough over the next 5-6 years to prevent a death spiral?