The spreadsheets in this posting come from Calculated Risk, a superb website that does an outstanding job of collecting and analyzing the details. In short, they establish the following facts:
- There are $5.8 trillion worth of dollar-denominated mortgage bonds outstanding
- $1.4 trillion worth of mortgage bonds are less than prime grade: about half of them are "sub-prime" and about half are "alt-A," which are supposedly between prime and sub-prime in terms of their default risk
- $3.9 trillion worth of mortgage bonds are "agency" bonds, 90% of which are issued by Fannie Mae or Freddie Mac, with the other 10% issued by Ginnie Mae.
Historically speaking, home mortgages are some of the most secure loans around. Not only do people bend over backwards to pay their mortgages, but houses are usually pretty good collateral. Consequently, mortgage default rates have run well under 0.5% of the total. Investors have been willing to pay high prices for mortgage bonds, resulting in interest rates close to those of U.S. Treasury securities.
It helps that two "agencies" -- Fannie Mae and Freddie Mac -- are federally chartered corporations that issue a huge amount of debt and, as a result, enjoy a status among investors as quasi-government entities. The feds don't actually promise to repay Freddie and Fannie investors if the bonds go bad and the companies can't come up with the cash, but investors think that, if push came to shove, the feds would step in.
This is called the "implicit guarantee" behind Freddie and Fannie bonds, and most studies say it reduces mortgage rates by at least a half-point below what they'd otherwise be. (Note: Ginnie Mae is different. Ginnies are backed by FHA and VA mortgages and formally guaranteed by the U.S. government. They comprise less than 10% of the "agency" total.)
What are "trillions?"
There are nearly $6 trillion of mortgage bonds outstanding, and banks hold another $3 trillion or so worth of mortgages. In 2007, the federal government collected $2.5 trillion in taxes, and the U.S. economy will produce about $13.5 trillion worth of goods and services. Mortgage bonds outstanding are 2.5 times annual federal tax collections, and about 43% of the U.S. economy's output. If we add bank-held mortgages to the mix, housing loans outstanding are 3.6 times annual tax collections, and 67% of a year's output.
Let's look at it from a different angle. There are 120 million dwelling units in the U.S., two-thirds of which are owner-occupied. Of the 90 million owner-occupied units, one-third are actually owned: there isn't a mortgage. Of the 60 million owner-occupied, mortgaged dwellings, about 15 million are financed by risky "alt-a" and "sub-prime" loans, while the other 45 million are financed by "prime" loans.
U.S.D.A. Prime, Choice & Standard Loans?
Not quite. Let's look a bit deeper. There are three levels of mortgage debt, judged by riskiness: prime, alt-a, and sub-prime. "Agency" debt is considered prime, on account of lending standards that (we hope) are imposed by Freddie and Fannie as a condition of buying debt. The same goes for so-called "jumbo" loans, which exceed Freddie and Fannie's size limits but (supposedly) go to only creditworthy borrowers.
What does "prime" really mean? Recall that I mentioned the historic low default rates for mortgages. There are a bunch of reasons for that, one being that lending standards used to be high. Until very recently, most borrowers needed to come up with a 20% downpayment. If they couldn't do so, they had to show solid income and take out private mortgage insurance -- at considerable expense -- to further collateralize their loan.
There were some exceptions, notably VA and FHA loans. But those are a small share of the total, and they are directly guaranteed by the government. For everyone else, the rule was 20% down, or high income plus "PMI." I bought my first house with a 10% downpayment, and PMI added about $150 a month to the mortgage. Needless to say, I made extra principal payments in short order so I could remove the PMI.
Starting in the mid-1990s, lenders inaugurated two new categories of loan. One was "alt-a," for borrowers who were unable to document their income yet had sufficiently high credit scores to otherwise be considered a "prime" borrower. The other was "sub-prime," for borrowers who had bad credit histories, including prior bankruptcies and repayment problems. Included in the sub-prime category are so-called "interest-only" and "negative amortization" loans.
In 1995, alt-A and sub-prime were only 6% of the total made that year. In 2006, they were 42% of the total. Last summer, The Wall Street Journal reported that 16% of sub-prime loans were in default or approaching default. This compares to historic mortgage default rates of less than 0.5%. In recent days, I've been reading that default rates are rising.
The Optimistic Disaster Scenario
There are $1.5 trillion in outstanding bonds backed by sub-prime and alt-a loans, and another three-quarters of a trillion in such loans that were held by banks and never turned into bonds. They are secured by 15 million houses and condos that house about 40 to 45 million people. If the current late-payment numbers are a sign of things to come, in the next few years we'll see 3 million of those houses foreclosed, and their 7.5 million or so occupants told to find other digs.
The houses will then be sold at auction, fetching maybe half of their prior value on average. Bondholders will lose $150 billion, and banks will lose $75 billion. Oops, scratch that. Uncle Sucker (meaning you and me) will pay out $225 billion to keep bondholders and banks from going under. How can we afford it, you might ask. The answer is that, in the early 1990s, the federal government spent about the same amount (maybe a little more) to bail out the banks from the crappy commercial real estate loans they made in the 1980s.
The public won't stand for it, you might exclaim. Oh, really? This is the same American public that thinks Saddam Hussein planned the 9/11 attacks. We believe in magic. If the feds can keep this problem at roughly the level I've just laid out, we'll coast on through with nary a ripple.
It Might Not Be That Easy
Imagine that you borrowed to buy a brand new $500,000 house a year ago. You wake up one day to find that a place across the street, nearly identical to yours, is on the market for $350,000. Scuttlebutt is that, next month, another half a dozen houses are going on the market at the same price. Word is that, by the time it's all over, people will be getting them for $250,000.
It seems that your neighbors weren't as prudent with their financial lives as you had been been with yours. Like good Americans they believed in magic, and look where it got you. What to do?
If you had only been a reckless fool like everyone else! Had you taken out one of those interest-only, no-downpayment loans because you'd gone bankrupt before, it'd be a no-brainer: You'd call the lender and tell them the keys will be under the front doormat. But you? You're a prime borrower. Do you call your lender and say, "You can keep my 50 grand. Come get the keys"?
I'd say the answer depends on a bunch of factors. First off, were you really a prime borrower or did you and your "mortgage broker" -- you know, that guy who sold cellphones out of his trunk in the 1980s, Internet stocks and Mercedes cars in the 1990s, and maybe some meth on the side -- phony up the loan documents? Is your house one of four that you "bought," hoping to do a quick flip during the real estate bubble?
There are 45 million houses carrying "prime" mortgages. Historically, those loans hardly ever default. But there has been rampant fraud -- oops, "moral hazard" -- in the mortgage business. And if things get weird enough, even honest people will act in ways that wouldn't normally be expected. You, for instance. You've always paid your bills. It's a point of pride. But that mortgage is killing you. The second job is a pain, and you're not sure that the first job is going to last. And you've noticed that the neighborhood is looking pretty scruffy these days, what with all those empty, bank-owned houses sitting there with untended lawns and even a broken window here and there. And here you sit, with a $450,000 loan on a $250,000 house. Hmm.
The Pessimistic Disaster Scenario
This is the nightmare scenario for bondholders and the federal government: That the non-prime mortgage crisis will spread to the so-called prime loans. Dump 3 million foreclosed dwellings on the market, and it just might happen.
And we haven't talked about the spinoff effects. Already, the problems in the non-prime sphere have begun to hurt the economy. Falling real estate values have made it impossible for many borrowers (and not just the irresponsible ones) to tap into their home equity to finance their spending. Retail sales are down, and Christmas is looking bleak. New home construction is falling sharply, and people are canceling new homes in developments all around the country.
This is causing layoffs and putting even more on downward pressure on retail sales, as do layoffs by the retailers themselves. California is already in recession. Home repair and remodeling is down, and there have been big layoffs and income reductions among real estate agents and bankers. Soon enough, state and local governments are going to feel the pinch. Those responsible prime borrowers are going to look at their falling property values and demand that their assessments be reduced. The next set of headlines is likely to be about falling state and local tax receipts, and the cutbacks they'll force. Which will add further downward pressure on the economy, as public employees are laid off.
Even in normal recessions, default rates rise on prime mortgages. In a real estate-led recession characterized by widespread imprudence among borrowers and lenders, it could be much worse. Sub-prime defaults could easily be catalyst for what eventually turns into a tidal wave of default: 20% default rates turn into 50% in the bad-credit category, and 0.5% default rates rocket past 10% in the prime category. Foreclosed property swamps the market, and property values collapse by 75% or more in some areas. A $225 billion problem becomes a multi-trillion dollar problem, its tentacles extending everywhere you look.
You think I'm crazy, don't you?
Fine, but chew on this: Between 1969 and 1974, the U.S. stock market lost 70% of its value. How did that Internet bubble work for you? Tell the truth! The NASDAQ is currently at half the peak reached in March 2000. As a participant in the financial sector during the period, I saw stocks lose 95% or more of their value in less than two years. But you can't live in your stocks, you answer. Houses are different. They are special.
My answer is that, whether you're buying your favorite stock, a tube of toothpaste, or a new house, there are two decisions to make: Know what you like, and know what to pay. Yes, a house is special, but it's not any different. Special can get cheaper. A whole lot cheaper.
There were some exceptions, notably VA and FHA loans. But those are a small share of the total, and they are directly guaranteed by the government. For everyone else, the rule was 20% down, or high income plus "PMI." I bought my first house with a 10% downpayment, and PMI added about $150 a month to the mortgage. Needless to say, I made extra principal payments in short order so I could remove the PMI.
Starting in the mid-1990s, lenders inaugurated two new categories of loan. One was "alt-a," for borrowers who were unable to document their income yet had sufficiently high credit scores to otherwise be considered a "prime" borrower. The other was "sub-prime," for borrowers who had bad credit histories, including prior bankruptcies and repayment problems. Included in the sub-prime category are so-called "interest-only" and "negative amortization" loans.
In 1995, alt-A and sub-prime were only 6% of the total made that year. In 2006, they were 42% of the total. Last summer, The Wall Street Journal reported that 16% of sub-prime loans were in default or approaching default. This compares to historic mortgage default rates of less than 0.5%. In recent days, I've been reading that default rates are rising.
The Optimistic Disaster Scenario
There are $1.5 trillion in outstanding bonds backed by sub-prime and alt-a loans, and another three-quarters of a trillion in such loans that were held by banks and never turned into bonds. They are secured by 15 million houses and condos that house about 40 to 45 million people. If the current late-payment numbers are a sign of things to come, in the next few years we'll see 3 million of those houses foreclosed, and their 7.5 million or so occupants told to find other digs.
The houses will then be sold at auction, fetching maybe half of their prior value on average. Bondholders will lose $150 billion, and banks will lose $75 billion. Oops, scratch that. Uncle Sucker (meaning you and me) will pay out $225 billion to keep bondholders and banks from going under. How can we afford it, you might ask. The answer is that, in the early 1990s, the federal government spent about the same amount (maybe a little more) to bail out the banks from the crappy commercial real estate loans they made in the 1980s.
The public won't stand for it, you might exclaim. Oh, really? This is the same American public that thinks Saddam Hussein planned the 9/11 attacks. We believe in magic. If the feds can keep this problem at roughly the level I've just laid out, we'll coast on through with nary a ripple.
It Might Not Be That Easy
Imagine that you borrowed to buy a brand new $500,000 house a year ago. You wake up one day to find that a place across the street, nearly identical to yours, is on the market for $350,000. Scuttlebutt is that, next month, another half a dozen houses are going on the market at the same price. Word is that, by the time it's all over, people will be getting them for $250,000.
It seems that your neighbors weren't as prudent with their financial lives as you had been been with yours. Like good Americans they believed in magic, and look where it got you. What to do?
If you had only been a reckless fool like everyone else! Had you taken out one of those interest-only, no-downpayment loans because you'd gone bankrupt before, it'd be a no-brainer: You'd call the lender and tell them the keys will be under the front doormat. But you? You're a prime borrower. Do you call your lender and say, "You can keep my 50 grand. Come get the keys"?
I'd say the answer depends on a bunch of factors. First off, were you really a prime borrower or did you and your "mortgage broker" -- you know, that guy who sold cellphones out of his trunk in the 1980s, Internet stocks and Mercedes cars in the 1990s, and maybe some meth on the side -- phony up the loan documents? Is your house one of four that you "bought," hoping to do a quick flip during the real estate bubble?
There are 45 million houses carrying "prime" mortgages. Historically, those loans hardly ever default. But there has been rampant fraud -- oops, "moral hazard" -- in the mortgage business. And if things get weird enough, even honest people will act in ways that wouldn't normally be expected. You, for instance. You've always paid your bills. It's a point of pride. But that mortgage is killing you. The second job is a pain, and you're not sure that the first job is going to last. And you've noticed that the neighborhood is looking pretty scruffy these days, what with all those empty, bank-owned houses sitting there with untended lawns and even a broken window here and there. And here you sit, with a $450,000 loan on a $250,000 house. Hmm.
The Pessimistic Disaster Scenario
This is the nightmare scenario for bondholders and the federal government: That the non-prime mortgage crisis will spread to the so-called prime loans. Dump 3 million foreclosed dwellings on the market, and it just might happen.
And we haven't talked about the spinoff effects. Already, the problems in the non-prime sphere have begun to hurt the economy. Falling real estate values have made it impossible for many borrowers (and not just the irresponsible ones) to tap into their home equity to finance their spending. Retail sales are down, and Christmas is looking bleak. New home construction is falling sharply, and people are canceling new homes in developments all around the country.
This is causing layoffs and putting even more on downward pressure on retail sales, as do layoffs by the retailers themselves. California is already in recession. Home repair and remodeling is down, and there have been big layoffs and income reductions among real estate agents and bankers. Soon enough, state and local governments are going to feel the pinch. Those responsible prime borrowers are going to look at their falling property values and demand that their assessments be reduced. The next set of headlines is likely to be about falling state and local tax receipts, and the cutbacks they'll force. Which will add further downward pressure on the economy, as public employees are laid off.
Even in normal recessions, default rates rise on prime mortgages. In a real estate-led recession characterized by widespread imprudence among borrowers and lenders, it could be much worse. Sub-prime defaults could easily be catalyst for what eventually turns into a tidal wave of default: 20% default rates turn into 50% in the bad-credit category, and 0.5% default rates rocket past 10% in the prime category. Foreclosed property swamps the market, and property values collapse by 75% or more in some areas. A $225 billion problem becomes a multi-trillion dollar problem, its tentacles extending everywhere you look.
You think I'm crazy, don't you?
Fine, but chew on this: Between 1969 and 1974, the U.S. stock market lost 70% of its value. How did that Internet bubble work for you? Tell the truth! The NASDAQ is currently at half the peak reached in March 2000. As a participant in the financial sector during the period, I saw stocks lose 95% or more of their value in less than two years. But you can't live in your stocks, you answer. Houses are different. They are special.
My answer is that, whether you're buying your favorite stock, a tube of toothpaste, or a new house, there are two decisions to make: Know what you like, and know what to pay. Yes, a house is special, but it's not any different. Special can get cheaper. A whole lot cheaper.
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