by Calculated Risk on 3/23/2007 07:19:00 PM

"[T]he persistent imbalance in housing supply and demand ... is fueling intense competition and pricing pressure among homebuilders and other participants in the new home and resale markets."
Jeffrey Mezger, CEO, KB Home, March 22, 2007

The above comment raises the question: Why not adjust the price to balance supply and demand?

This diagram shows the normal Supply and Demand relationship. When supply shifts (dark blue to light blue) then the price falls from P0 to P1.

And when demand shifts, perhaps due to the changes in lending standards (from dark red to light red), the prices falls again, this time from P1 to P2.

So, with the current changes in supply and demand, we would expect falling prices, but no "imbalance in housing supply and demand".

In fact new home prices have been falling. KB Home reported their average selling price declined 5% in Q1 2007 (compared to Q1 2006). And most homebuilders have been providing incentives (upgrades, free landscaping, etc.) that can be viewed as price reductions too.

The above diagram works well for commodities, like corn, but the housing market is far more complicated. First, housing markets are local - most housing services aren't transportable - and one area of the country might have different dynamics than other areas. Second, there are reasonable substitute goods for new homes (mostly existing homes and some rentals) that compete with homebuilders for purchasers of housing services.

Note: usually existing homes compete directly with rentals. However this impacts new home sales too because of the typical chain reactions that occur in the housing market.

During periods of weakness, prices in the existing home market typically exhibit strong persistence and are sticky downward. Sellers tend to want a price close to recent sales in their neighborhood, and buyers, sensing prices are declining, will wait for even lower prices. This means real estate markets do not clear immediately, and what we usually observe is a drop in transaction volumes.

This sticky price phenomenon in the existing home market is actually good for new home sales. The homebuilders can lower their prices, and stimulate demand. This probably helped the builders in 2006. However when existing home supply reaches a certain point, prices start to fall in the existing home markets too. Also, when lenders start taking short sales, and banks are selling REOs (bank Real Estate Owned), this puts additional pressure on prices.

Click on graph for larger image.

This graph shows monthly existing home inventory since January 2004. The National Association of Realtors (NAR) noted today: "Raw inventories peaked last July at 3.86 million, and supplies topped at 7.4 months in October." However, NAR didn't note that inventories usually increase through mid-summer, and inventories will probably be well over 4 million this summer.

In fact, if inventories grow at the same percentage rate as last year, inventory levels will reach 4.8 million in August. If inventories grow by the same quantity as 2006, inventories will be over 4.6 million by August.

With tighter lending standards, demand will probably fall too. Credit Suisse recently estimated new home sales would fall by 21% in 2007. BofA estimated a decline of 15% for new home demand in 2007. We will probably see a similar decline in existing home sales.

This graph shows annual existing home sales and inventory for the last 30 years (2007 estimated). The graph shows an estimated inventory increase to 4.5 million units, and sales falling to 5.7 million units (my estimate is 5.6 to 5.8 million existing home sales in 2007).

Inventory of 4.5 million units, and sales of 5.7 million, means 9.5 months of supply this summer. For the more optimistic, use 4 million units of inventory, and sales only falling to 6 million units, giving 8 months of supply.

Usually 6 to 8 months of inventory starts causing pricing problems, and over 8 months a significant problem. With current inventory levels at 6.7 months of supply, inventories are now well into the danger zone. By mid-summer, months of supply will likely be a significant problem.

And this takes us back to the supply demand imbalance. The huge overhang of existing home supply makes the market appear to be out of balance to the new home builders.

by Calculated Risk on 3/23/2007 12:31:00 PM

From the NYTimes: The Subprime Loan Machine. This story describes the rise of automated underwriting; both the benefits and the pitfalls.

“Automated underwriting put the credit score on such a pedestal that it obscured the other important things, like is the income actually there,” said Professor Retsinas of Harvard. “Before there was A.U., down payment mattered a lot. Where we’ve crossed the line in recent years is to say, we don’t need down payment.”

This article is very good, but Tanta notes that it doesn't mention Nicolas Retsinas previously "served as Assistant Secretary for Housing-Federal Housing Commissioner at the United States Department of Housing and Urban Development, and as Director of the Office of Thrift Supervision."

The following two articles look at the impact of the housing bust on communities (hat tip: Wayne):

From the NY Times: Foreclosures Force Suburbs to Fight Blight

“It’s a tragedy and it’s just beginning,” Mayor Judith H. Rawson of Shaker Heights, a mostly affluent suburb, said of the evictions and vacancies, a problem fueled by a rapid increase in high-interest, subprime loans.

“All those shaky loans are out there, and the foreclosures are coming,” Ms. Rawson said. “Managing the damage to our communities will take years.”

From the Charlotte Observer: Failed mortgages fly under the radar

An Observer analysis of county records found 35 Mecklenburg developments of low-priced homes built in the past decade with foreclosure rates of 20 percent or higher. Dozens of residents say the concentrations have damaged their communities. Prices fell. Renters moved in. Crime sometimes rose.

by Calculated Risk on 3/23/2007 10:07:00 AM

The National Association of Realtors (NAR) reports: Existing-Home Sales Rise Again in February

Click on graph for larger image.

Total existing-home sales – including single-family, townhomes, condominiums and co-ops – rose 3.9 percent to a seasonally adjusted annual rate1 of 6.69 million units in February from a downwardly revised level of 6.44 million in January, but are 3.6 percent below the 6.94 million-unit pace in February 2006.

The above graph shows NSA monthly sales for 2005, 2006 and 2007. This shows that March is the first key month of the year.

Total housing inventory levels rose 5.9 percent at the end of February to 3.75 million existing homes available for sale, which represents a 6.7-month supply at the current sales pace compared with a 6.6-month supply in January. Raw inventories peaked last July at 3.86 million, and supplies topped at 7.4 months in October.

A few key points:

1) March is the beginning of the spring selling season.

2) Inventory is at a record levels for February (30% above Feb 2006).

3) Existing home sales are reported at the close of escrow. This means these contracts were mostly signed in December and January. So these numbers are prior to the subprime implosion of mid-February.

by Tanta on 3/22/2007 10:24:00 PM

In our last episode, we found our hero, MI, throwing itself in front of our hapless lender, bravely absorbing the first impact of the real estate train wreck. Before we go on to talk about other issues, let’s make sure we understand what “loss position” means. If you’re used to thinking of insurance in terms of things like auto or health, you’re used to being "the insured." You're also in the first loss position: that’s what a “deductible” is. It means that in an insurable event, you will take the first loss up to your deductible amount, and only if the losses exceed that limit will the insurer step up and take the rest of it. MI doesn’t work that way (with the possible exception of “captive reinsurance” issues, which we’ll talk about below).

MI is designed to be the first loss position: it covers losses up to the coverage level amount, and only if losses exceed that amount will the lender (who is “the insured”) take the rest of it. It's rather like the reverse of a deductible. The lender/investor doesn’t spend its own money until the MI has spent all the money it is contractually obligated to spend first.

This may answer the questions some people had about how the insurer and the lender might be somewhat differently motivated when it comes to mitigating losses on a loan. The MI will be pushing for collection efforts, forbearance, modifications, and so on, whenever it’s prudent (in the MI’s perspective), because the MI pays first in a foreclosure and doesn't want to do so unnecessarily. The lender might want to foreclose sooner rather than later, because in an early foreclosure, most losses are likely to be covered by the MI. Who gets its way is a question of how the fine print in the policy reads. The lender/servicer is not obligated by law to follow the MI’s requirements. It is obligated by sheer self-interest: if you don’t follow the MI’s servicing rules, the MI won’t pay the claim.

Mortgage insurance policies can come in several flavors. The most common is the primary policy. This is a policy that insures some percent of the losses on an individual loan. Primary policies can be written on a flow basis or a bulk basis. “Flow” means that policies are written on a loan-by-loan basis, as they are originated. An originator could then take a pool of loans that have already been covered with flow primary policies, and securitize them. If the amount of coverage on the existing flow primary policies is sufficient, no further insuring of the pool of loans is necessary. “Bulk” means that policies are written to cover individual loans, but they are written all at once, after the loans have already been closed, on a big portfolio of loans.

Flow primary policies can be “borrower paid” or “lender paid.” Bulk primary policies are always “lender paid.” This part is confusing, because in real-world terms, the borrower is always paying for the MI somehow. The difference is really in how the borrower pays it (which can impact how well the risk is priced, as we’ll see).

When we use the term “borrower paid,” we mean that the mortgage insurance premium for the individual loan is set by the insurer before the loan is closed, according to the insurer’s underwriting guidelines, and is paid out of the borrower’s monthly loan payment (the “T&I” or “escrow” portion). Some premiums are paid monthly; the servicer takes the monthly part out of the borrower’s payment and remits it to the MI each month. Some are paid annually; the servicer puts the monthly part of the borrower’s payment into an escrow account, and then remits the annual premium to the MI when it is due (after sufficient funds have built up in the escrow account). The borrower never pays the MI premiums directly; this is important. The borrower is not the insured; the lender is. The servicer must collect premiums from the borrower and then send them to the MI. The borrower is not responsible for making sure that happens; the borrower is only responsible for making the MI part of the monthly payment to the servicer as specified in the loan closing documents. The MI’s job is to make sure the servicer is doing its job.

The industry term “lender-paid” refers to a situation where the borrower’s closing docs do not specify a monthly premium portion to be paid into escrow. Instead, the borrower just pays a higher interest rate on the loan, and the lender pays the MI premium out of its interest income, which (ideally) reduces the yield on a lender-paid loan to the equivalent of the yield on a borrower-paid loan. In this regard, it works like servicing fees: the servicer takes the required slice off the interest payment needed to pay the MI premiums, and then passes through the remainder to the investor. You can see why it’s still really paid by the borrower: it comes out of the interest payments the borrower makes. It’s called “lender-paid” because it does not come out of an escrow account funded directly by borrower T&I payments.

Lender-paid primary flow insurance (LPMI) got really popular for a while, because it was marketed as “tax advantaged.” (Countrywide’s product is actually called “TAMI,” Tax Advantaged Mortgage Insurance.) The idea is that mortgage interest is tax-deductible but mortgage premiums are not (although that’s changing); the borrower could make more or less the same monthly payment on the lender-paid plan, but deduct more on the tax return because it was interest instead of premium.

Some of us think this wasn’t always such a great deal for the borrower; it depends on the fine print in the closing documents. Specifically, the higher-rate lender-paid deal is OK as long as you get a nearly free option to modify your loan back to market rates once your LTV drops under 80%. (“Nearly free” would mean you paid only the cost of a new appraisal to verify LTV; you would have to pay that to cancel borrower-paid insurance, too.) If you aren’t given such an option, lender-paid MI can cost you more over time even with the deduction, since it’s costlier to get rid of it (you’d basically have to pay refinance costs and hope rates are low at the time). Anyone who wishes to insist that LPMI is a great deal for the consumer should ponder the fact that rating agencies and securitizers tend to prefer it to borrower-paid MI precisely because it is marginally more persistent, meaning that borrowers pay higher rates longer than they pay monthly insurance premiums. If and when prevailing rates rise substantially, some borrowers will find it difficult or unpleasant to try to “refi” out of LPMI.

Bulk policies, of course, are all LPMI (since the MI is added to the loans in bulk transactions, after they’re closed, they have to be LPMI instead of borrower-paid. You can’t go back to a borrower after you’ve closed the loan and say, hey, we decided you need to start paying MI.) There are two important issues for bulk: first, these are still loan-level policies; it’s really just a matter of writing a whole lot of individual policies at once, rather than on a flow as-the-loans-close basis. Second, from the insurer’s perspective, bulk policies are nearly always of weaker average credit quality than flow policies. It’s rather like the difference between pork loin and sausages. Bulk loan portfolios are the “sausages,” and they’ll always have some percentage of “filler.” As long as they still taste something like pork loin—that is, as long as the averages across the portfolio of loans is OK—then they’re still insurable. But the premium structure for bulk is different from flow, to take the credit quality differences into account.

What is called “pool insurance” is a pig of a different color. Pool insurance is a way of covering a big group of loans, like bulk, but unlike bulk, pool insurance is not a primary policy. A primary policy covers a maximum percent of the losses on an individual loan. It is not “cross-default” insurance, meaning that if you don’t lose the whole maximum claim amount on a given loan, you can’t apply the remaining claim amount to another defaulted loan. With pool insurance, you can apply the total policy maximum to different loans. Pool insurance can be applied to a pool of loans that already have primary policies, a pool of loans that do not have primary policies, or a mixture of the two. It generally has a maximum dollar amount or percent of pool balance that it will cover; individual loan losses are applied to that limit until it is reached, and then the remaining pool balance is uninsured. When there is a loss on a loan with a primary policy, the primary policy pays first to its maximum claim amount, and then the pool insurance kicks in for any remaining loss.

So pool insurance can either supplement or replace primary coverage, depending on the pool, the agreement, and the underlying loans. Pool insurance is often called “lender paid,” but it’s really mostly used in securitizations and so it’s more properly considered “bondholder paid.” It’s a form of credit enhancement, and like any other credit enhancement, its cost comes out of the yield of the underlying loans. It is cost-effective to the bondholder only to the extent that the underlying loans 1) throw off enough income to leave a reasonable net yield after the cost of the credit enhancement and 2) are of high enough credit quality themselves to be eligible for relatively inexpensive premiums.

Bulk and pool insurance can be like a belt added to the primary flow policy suspenders. You will sometimes hear of lenders—we’re hearing quite a bit of this lately—adding MI to a portfolio of loans that they’ve held for some time. The idea is that they sniffed the wind and decided perhaps more insurance coverage would be a good idea. This may make the shareholders of those portfolio lenders feel better.

Before getting too warm and fuzzy over it, though, shareholders might remember two things: MI companies can smell change in the air just as much if not more than lenders can; being on the hook for losses does tend to sharpen one’s wits. Buying insurance while you’re young and healthy (flow primary) tends to be cheaper than buying it when you’re sicker and older (bulk or pool policies acquired after “sniffing the wind”). Furthermore, “lender-paid” MI is a profitable proposition to the lender only insofar as the lender originally set the borrower’s interest rate at closing to a level high enough to cover the insurance costs. Having to go back and insure an originally uninsured or underinsured portfolio can mean having to spend interest income that did not originally “budget” for insurance. Ouch. So a lender who announces that it has just insured (or increased the insurance on) some part of its portfolio is telling you that 1) it thinks the outlook is worse than what it predicted when it closed the loans and 2) it just reduced its income on that portfolio and 3) it thinks that loss of income is worth it, which tells you, in essence, how much worse the outlook is.

Today’s final topic is this “captive reinsurance” thing. In short, that’s a setup in which a lender forms a subsidiary which “captures” part of the mortgage insurance premium. In exchange, it agrees to take some part of the MI’s exposure. A typical arrangement might involve the lender’s captive taking 25% of the premium in exchange for covering 25% of the first loss.

The devil, with these things, is always in the details; whether this is a good deal or bad deal for either party depends on which 25% the captive is taking. It could involve a split, meaning the captive pays 25 cents for every 75 cents the insurer pays, starting with the first dollar paid. Or, it could mean the captive pays the first 25% of losses, and then the MI pays any remaining losses up to 75% of the maximum claim. Or the MI could pay the first 25%, the captive the second 25%, and the MI the last 50%. You have to read the agreement; these things aren’t exactly standardized.

Suffice it to say that, in the boom years, they were a real money-maker for lenders, since losses were so low what with bubble prices and endless refis. Whether they will continue to be, and whether some lenders may yet re-discover the meaning of that old phrase about chickens coming home to roost, is yet to be seen. On the whole, my personal view is that if there’s a sucker at the table somewhere, it probably isn’t the MI. They are in the business of insuring against losses, and most of them have been at it long enough to have been there, done that, got scars to show for it. A few of these “new, quickly growing mortgage lenders!” who emerged more or less in the boom may not necessarily be pricing their risk quite exactly right, in my view.

So far, we haven’t addressed the big question of how, then, the MI’s underwriting guidelines stack up against everyone else’s. That’s a critical question, if you want to know how much risk the MIs have taken on, and how likely they are to withstand the losses they might have to take. But it’s also a subject for the next installment.

by Tanta on 3/22/2007 06:04:00 PM

New testimony of Roger T. Cole, Director of the Division of Banking Supervision and Regulation for the Federal Reserve, given to the Senate Banking Committee, is now available on the web here.

Most of it is quite familiar to CR readers and will hold few surprises—we’ve been on top of this story for a long time. I see nothing particularly dramatic in it; if you need to catch up on the whole context of banks, subprime lending, and new regulation, though, it’s worth a read. I found two parts of it worthy of note.

First, the message from the Fed seems to be that lenders are not going to be punished in examinations for trying to work out as much as is prudent with borrowers.

Although a rising number of borrowers are having difficulty meeting their obligations, regulated institutions do not face additional supervisory scrutiny if they pursue reasonable workout arrangements with these borrowers. Existing regulatory guidance does not require institutions to immediately foreclose on the underlying collateral when a borrower exhibits repayment difficulties. Working constructively with borrowers is typically in the long-term best interests of both financial institutions and the borrowers. Capital markets investors in securitizations have the same motivation as direct lenders in maximizing recoveries on defaulted loans. Thus, mortgage servicers will have an important role to play in working with delinquent borrowers. Established and well-rated loan servicers are usually given a range of options by investors in workout situations. These options could include modification of interest rates, payment restructuring, and extension of maturities. Working together, the federal regulatory agencies will continue to use their supervisory authority to ensure that regulated institutions have policies and procedures designed to treat borrowers fairly, both when seeking new credit and when working through financial difficulties.

I see no Fedspeak hint here of any bailout assistance to anyone; if there’s anything remarkable it is that the Fed is suggesting that depositories may not use the fear of regulatory punishment to deny reasonable workouts to borrowers, and that the Fed considers reasonable workouts to be consistent with safety and soundness. I don’t know to what extent this might be the Fed implying that banks made their beds and now have to lie in them; it’s not exactly inconsistent with the idea of potential bailouts. As stated, though, it suggests to me that banks had better give some serious thought to mitigating their losses—by taking the hit on some mods or forbearance agreements, if necessary—before they go expecting the Fed to vote for bailout relief.

The second thing I want to point out is the one place in this document where I think the Fed has really drunk a little of the Kool Aid:

Homebuyers have also benefited in this environment of financial innovation and market liquidity. More lenders are actively competing in the mortgage market, product offerings have expanded greatly, the underwriting process has
become more streamlined, borrowing spreads have decreased, and obtaining a mortgage loan has become easier. In short, securitization has helped to expand homeownership, which recently reached a record 69 percent. Not surprisingly, there have also been significant gains in homeownership for low- and moderate-income individuals. The development of the subprime mortgage market has been an integral factor in creating these homeownership opportunities for previously underserved borrowers.

It is not my purpose today to question the wisdom of uncontrolled increases in homeownership, although that’s an important debate. I am simply irritated in the extreme by the inclusion, without qualification, of “streamlined underwriting processes” and “easier” obtaining of loans under the heading of benefit to homebuyers. First, as we’ve already noted here at CR, all this streamlining and easing has often made potential homebuyers prey of unscrupulous lenders and sellers, as well as having made lenders and sellers prey of unscrupulous homebuyers. But I want us to take this a little further. What I see here is the Fed falling for advertising slogans and confusing it with public policy. Like Queen Victoria, I am not amused.

Come on. How streamlined and easy does the mortgage lending process really have to be? Look, I like innovations in grocery shopping, like scanners, self-scan aisles, express lanes, debit card readers, and so on, because I have to shop for groceries a lot, and it’s drudgery. But how often do you buy a home or refinance your mortgage? Is it really such a terrible burden to you to get your documents out of your desk drawer, drive down to the local bank, and plop yourself down in a chair across the desk from Louise Loan Officer for an hour? Is saving that kind of time and effort ultimately important enough to you that you are willing to accept the risks to all of us, to our economy, of unsafe and unsound lending by federally-insured depositories that is the effect of these “benefits”? I’m not at all sure I am.

The issue of access, specifically, is certainly important. If you live in Podunk, you might not be able to drive to the office of a national lender with a really good interest rate. If you live in certain urban neighborhoods, you might not have easy access to the suburban jewel-box banks on every corner. So having kinds of telephone, internet, or brokered access to credit from depositories, with the “alternative documentation” processes they often require, may be an important part of keeping access fair.

But that’s not at all the same thing as saying that “speed” and “ease” are always true benefits to borrowers.They’re benefits to lenders. The story is that lenders pass on the efficiency savings to borrowers, in the form of lower rates and fees. Forgive me for shooting some Kool Aid out of my nose here, but I think I see these “savings” going mostly to executive bonuses, originator commissions, and investment in overcapacity, which just begs for more loose loan writing to keep the mortgage mills busy. If you agree with me on that, and you want to let your regulators know how you feel, you might want to mention to them that you don’t care to have benefits to lenders confused with benefits to borrowers, or that you’d be willing to have to use up another hour of your time and a gallon or so of your gas if it meant saner lending policy.

At some point we’ll have to let them know that marketing slogans are just marketing slogans. We don’t all secretly crave drive-up McBanks offering Happy Loans, even if the lenders’ marketing departments seem to think we do, or seem to want to convince us that we do. At least, we don't crave this so much we're willing to bet a couple hundred billion taxpayer dollars on it working out OK in the end.

Besides that, how much is Health and Human Services spending on this "war on obesity" business? Do we need to insure the risk of borrowers who are too damned lazy to dig up the W-2s? Somehow I don't think so.

by Calculated Risk on 3/22/2007 09:17:00 AM

"We entered 2007 with a backlog substantially lower than the year-earlier level and consequently delivered fewer homes in the first quarter than in the same period of 2006. ... profit margins ... were constricted due to the persistent imbalance in housing supply and demand that is fueling intense competition and pricing pressure among homebuilders and other participants in the new home and resale markets. We believe these conditions will likely continue for at least the remainder of 2007, reducing our quarterly and full-year revenues and earnings compared to 2006 results."
Jeffrey Mezger, president and chief executive officer. KB Home, March 22, 2007

From KB Home Reports First Quarter 2007 Results

by Calculated Risk on 3/22/2007 09:00:00 AM

From the Department of Labor:

In the week ending March 17, the advance figure for seasonally adjusted initial claims was 316,000, a decrease of 4,000 from the previous week's revised figure of 320,000. The 4-week moving average was 326,000, a decrease of 3,750 from the previous week's revised average of 329,750.

Click on graph for larger image.

This graph shows the four moving average weekly unemployment claims since 1968. Although the four week moving average has recently been trending upwards, the level is still low and not much of a concern.

by Tanta on 3/21/2007 02:59:00 PM

PMI is insurance against mortgage default; it insures the lender, not the borrower. I use the abbreviation “MI” instead of “PMI” because there is a company called PMI that offers insurance with which I do not want to become confused; you may, however, encounter other sources using “PMI” in the generic sense. Fair warning. The “private” part of the term means we are not talking about government-insured loans such as FHA. Such government-sponsored insurance works similarly, but not identically, to private MI.

We often use the term “first loss” position when talking about MI, and I am going to use that term, because that’s how the industry does it. But we should always bear in mind that the true first loss position on any mortgage loan is the borrower’s, whenever there is borrower equity. Here’s how it works.

In exchange for a premium, the mortgage insurer reduces the lender’s exposure to risk. The amount of the premium is determined by the coverage level, loan type, and credit quality of the loan. There are lots of different coverage levels available; most lenders use the ones required by Fannie Mae and Freddie Mac. For instance, the standard coverage level on a 30-year loan with a 95% LTV is 30%. That means that the insurer will cover losses in the event of default up to 30% of the insured loan balance. Another way of putting that is that the lender’s original exposure is reduced to 67% LTV (95% times 70%). Standard coverage for 30-year loans in the 90.01-95% range is 30%; in the 85.01-90% range is 25%; in the 85% and under range is 12%. Less coverage (25%, 12%, and 6%, respectively) is required for loans with a 20-year or less term. Coverage for very high LTV loans (greater than 95%) is not really standard; the GSEs will require a specific coverage level for different loans they might buy in that category. You can generally assume a minimum of 35%. Here is a link to MGIC’s actual rate cards, which show how premiums are priced for different loan types, terms, and features. I expect the terminology will be gobbledygook for a lot of you, but we can get that far into the weeds later if you insist.

Specifically, in the event of default the mortgage insurer pays the lower of 1) the coverage percent (say, 30%) of the unpaid principal balance of the loan plus accrued interest and liquidation expenses or 2) the actual net loss. The MI policy generally gives the insurer the right, but not the obligation, to pay 100% of the unpaid principal balance (and any accrued interest) and take title to the property itself, if it wishes to handle the actual liquidation. It might want to do that if it believes it can recover more than the mortgage servicer can, which might well be the case with a small servicer without expertise in handling REO. What you should bear in mind is that the longer it takes to foreclose and market the REO, the more interest accrues, and the more expenses rack up, resulting in higher net losses and thus higher claims paid by the insurer. The insurer has a vested interest in making sure that the process is both timely and efficient. It controls its exposure by reserving rights to approve and regulate parts of the collections/foreclosure/ REO management processes, by having the option to bid at the foreclosure sale, and by challenging any claims that it considers excessive.

CR UPDATE: Try this link for spreadsheet.

This spreadsheet shows a simple comparison of a lender’s potential losses in the case of a 95% LTV loan with MI, and an 80% LTV loan without MI. The loan term is 30 years in all cases. Three base scenarios are presented: a fully-amortizing loan, an interest-only loan, and a negatively-amortizing loan. For each scenario, it is assumed that the loan defaults 18 months after origination; the columns show the result with no change in the property value, 10% depreciation, and 20% depreciation. The net loss is calculated assuming that it takes 6 months from default for the lender to foreclose, and 6 months from foreclosure for the REO to be sold. Total expenses (foreclosure costs, repair and maintenance of the property, force-placed hazard insurance, RE broker commission, closing costs on the final sale, etc.) are simply assumed to be 15% of the sales price in any scenario. If you’ve been wondering why the coverage level is lower on loans with a shorter term, notice how amortization of the loan balance affects the loss severity. The shorter the loan term, the faster the borrower pays down principal, and so those loans require less MI coverage. You can also see here how interest-only and neg am can get ugly, as well as how the age of a defaulted loan affects severity.

Of course, the actual net loss for any loan is dependent not just on the sales price of the REO, but also on the efficiency of the servicer (how quickly and inexpensively the servicer handles the FC and REO), the property state (which affects the FC time frame, whether FC is judicial or nonjudicial, etc.), the costs of hazard insurance and any property taxes that come due while the lender holds the REO, and so on. You may adjust the spreadsheet with your own assumptions; for many markets and properties, 15% may be a very sunny assumption.

A mortgage insurer is considered in “first loss” position, and so the spreadsheet shows loss to the lender (second-loss position) only after payment of the maximum MI claim amount. The MI’s exposure to loss is limited: it covers only the contractual percent of the loan balance plus accrued interest and expenses. The lender’s potential exposure has no contractual limit: it is solely a matter of how far the property value can depreciate and how expensive it can get to foreclose or liquidate REO. In a real doomsday scenario, the lender’s loss could be 100% net of the MI claim proceeds. You can build your own “doomsday” scenarios on the spreadsheet just by slashing the REO liquidation value to 50% or less of the original sales price, or increasing the default-to-liquidation period of interest accrual, or increasing expenses, or all of it at once. If you wish to play subprime lender, just up the interest rate on the loan (the spreadsheet uses 6.50%).

You will notice, of course, that the 80% LTV loan almost always results in a loss to the lender in foreclosure. Remember, though, that this spreadsheet shows loss severity. It does not address the issue of loss frequency. All other things being equal, the borrower with substantial equity will default less frequently than the borrower with minimal or no equity—the borrower, remember, is in true “first loss” position. The lower default frequency of the 80% LTV loan compensates for its higher loss severity, compared to a high-LTV insured loan. If, of course, the 80% LTV loan is really an 80/15, say, then the default frequency of the 95% MI loan is likely to be comparable to the 95% CLTV loan (which is why sane lenders—both of them—charge a higher interest rate on the first mortgage when the CLTV is that high). In the latter case, the second lien holder is in first loss position. Notice that the spreadsheet shows only one scenario in which there are any proceeds available to a theoretical second lien holder. Obviously, in most cases of foreclosure a second lien is a total charge-off. Therefore, the profitability of second-lien lending is only as good as the underwriting and pricing of the second liens, just as the profitability of insuring first mortgages is only as good as the underwriting and pricing of the premiums. (Note that a second lien holder has accrued interest and expenses, too, at least in the early months of default when it is attempting to collect on the loan. As a rule, second lien holders give up collection efforts and write off loans very quickly, compared to first lien holders, because expenses are rarely recovered.)

Our next installment of Private Mortgage Insurance for UberNerds will discuss the various ways premiums are calculated and remitted, and will explore the differences between primary, bulk, and pool insurance, which bond investors particularly will care about. Go ahead and ask all your questions in the comments anyway; you might as well let me know what you want to know in future installments (a brief explanation of why you care is optional, depending on how much of your inner Nerd you wish to reveal in the intimate setting of the internet). In the meantime, play with the spreadsheet and try not to let the suspense get too much for your blessed little hearts to bear.

by Calculated Risk on 3/21/2007 02:32:00 PM

Comparing the FOMC statement from today with January:

Economy:

Today:

"Recent indicators have been mixed and the adjustment in the housing sector is ongoing."

January:

"Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market."

Inflation:

Today:

"Recent readings on core inflation have been somewhat elevated."

January:

"Readings on core inflation have improved modestly in recent months ..."

Bias (slight change with different wording):

Today:

"... the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected."

January:

"The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth ..."

Weaker economy with more inflation.

by Tanta on 3/21/2007 12:52:00 PM

Look who just got the keys to Calculated Risk, The Blog.

And we'll have fun, fun, fun 'til the Daddy takes the Blogger password away . . .

Note: From here on out, you must actually read the name under "posted by" at the end of a post, if simple common sense does not allow you to distinguish between some long sprawling wonkery by Tanta (deputy assistant co-blogger) and a trenchant, crisp observation by CalculatedRisk (founder and CBO) accompanied by the usual beautiful charts.

The comments to this post are open to anyone who thinks he or she can discern the topic (and thus figure out a way to take them off-topic immediately). I believe Those Other Blogs call it an "open thread." This is your big chance to get as snotty as you want to with me, since this is my very first Blogger post and I haven't yet discovered how to edit your comments. In fact, I see that CR hasn't given me that ability. The man is clever.