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The real problem in the housing crisis: Who’s going to blink first, banker or borrower?

“Treasury raps banks on home affordable modification program failings” – Wall Street Journal, June 8th, 2011

“Second-mortgage misery: nearly 40% who borrowed against homes are underwater” – Wall Street Journal, June 7th, 2011

“Don’t expect a housing market recovery until 2014” – Forbes, June 19th, 2011

With recent headlines like these it is obvious why the mortgages crisis is continuing to drain the confidence of the consumer and thus the economy of any recovery momentum. And, although recent statistics show that delinquency rates continue to drop, foreclosures are up.

The rise in foreclosures are flooding the market with what was once shadow inventory, further depressing prices and levels of negative equity, and dousing the hopes of a sustained housing market recovery that started to emerge late last year. And although many believe that the tide of strategic defaults (arising from deeply underwater mortgages which are abandoned when otherwise credit-worthy borrowers decide to stop throwing good money after bad) has ebbed (despite the fact that one-third of all defaults are considered strategic), another sustained price decline could result in a resurgence of this increasingly socially acceptable option, especially in the Sand States.

With the widely acknowledged failure of the government’s Making Home Affordable Program (HAMP) – only about 15% of the troubled borrowers targeted have been helped in the 2 years since this program was put in place, according to the Wall Street Journal article from June 8 – banks, servicers, and investors are accepting the reality that this is their problem to solve. Credit grantors, mortgage servicers, and investors know that this crisis is far from behind us and are ramping up their efforts to better predict, contain, and correct these portfolio risks.

At the center of these efforts statisticians, academics, and arbitragers are seeking better ways of predicting defaults through more creative insights into borrower and collateral behavior in this unique environment.

We have found that a more thoughtful examination of what a borrower can sustainably afford is the key to predicting stress-related defaults. Such an approach must consider the borrower’s nonmortgage obligations, which often exceed their first mortgage payments, and their life cycle situation. All else equal, borrowers who would suffer a significant deterioration in quality of life will stretch further than those who are less affected, such as flip investors, whose debt obligations exceed their rental payments and who have little emotional connection to a property.

Ensuring that a loan modification has a long enough life is also a key consideration. If the takeout loan at the end of the loan modification period cannot be serviced without repeating the stressful situation that led to delinquency, then the lender is just betting on rising real estate values to salvage the credit. This is a risky assumption given recent trends in property values. The uncertainty in aligning future affordability with market rates is why we advocate applying a continuous dynamic underwriting (CDU) process in reviewing a loan modification after it has been originated. A CDU is basically, a customized structure, unique for every borrower, which evolves as the risk of the loan (defined by the underlying asset value and the ability of the borrower to service the debt) changes. This concept embraces risk-adjusted return on capital at the instrument level but also recognizes the need to provide structural flexibility in addition to pricing variability

For non stress-related defaults, we have found the key driver in identifying a potential strategic defaulter is the relative value of the property, called real estate Beta. Applying this metric to structure a refinancing will create an attractive value proposition; equivalent to renting or buying a property similar to their current residence, without the hassle of defaulting and the adverse impact on their credit rating. Few institutions have adopted this approach to reduce strategic defaults, but the longer the real estate bottom lasts, the greater the pressure to embrace this creative solution.

For a further discussion of this topic, read: The real problem in the housing crisis: who’s going to blink first, banker or borrower?


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