Last week, former Federal Reserve Chairman Alan Greenspan told futures traders at a conference in Florida that if home prices would just go up 10 percent, “the subprime mortgage problem would disappear.”
You have to wonder whether Greenspan got an advance copy of one of the most sophisticated studies to date on a question that’s keeping a lot of people awake at night: how much trouble are America’s homeowners in?
Like Greenspan’s observations in Boca Raton, the study — by Christopher L. Cagan, director of research and analytics at First American CoreLogic Inc. — will undoubtedly be used as ammunition by doomsayers and optimists alike.
On the first page of the study, “Mortgage Payment Reset: The Issue and the Impact,” Cagan makes it sound simple: in the next six years, 13 percent of the 8.37 million adjustable-rate mortgages originated between 2004 and 2006 will default. That’s 1.1 million foreclosures in a six- to seven-year period, and $112 billion in equity wiped out after homes securing $326 billion in debt are repossessed and sold.
But then Cagan complicates things, with a 180-page-plus explanation of his methods and an in-depth investigation of how changes in home prices might change that picture.
Cagan’s study uses December 2006 home prices as the starting point for its assumptions. He estimates that from here on out, each 1 percent increase in home prices could save 70,000 homes from foreclosure. That supports Greenspan’s observation that if home prices went back on the upswing, the current wave of delinquencies and foreclosures could disappear.
But Greenspan also said things could get worse if home prices fall. Cagan agrees, saying each 1 percent fall in home prices will put another 70,000 homes into foreclosure.
Cagan, who holds a doctorate in mathematics from the UCLA, was more interested in crunching numbers on millions of loans in a way that allowed people to interpret them for themselves, than in making a philosophical statement.
“I was driven by my love for mathematics,” and not by anybody else’s preconceptions, Cagan said. “I wanted to get past the anecdotes, and down to the nitty gritty of the numbers. I want this to be the authoritative, definitive study. A full academic explanation, so if you want to run a different scenario, you can.”
Although Cagan does put the number of projected foreclosures in context — he thinks they won’t have a wider impact on the national economy — the study still leaves room for others to argue about whether the subprime tsunami will cause widespread destruction, or just decimate a few ill-fated villages.
Many experts on lending say one of the best predictors of a borrower’s likelihood of default is how much equity they hold in their home.
A family using a traditional loan with a 20 percent down payment has more at stake in staying current on their loan, and is less vulnerable to fluctuations in home prices if they need to refinance.
Borrowers who put little or no money down on a house, or whose loan payments only cover interest and not principal, can quickly find themselves “upside down.” When home prices stagnate or depreciate, their homes may end up being worth less than what they owe, and it can be tough to refinance on better terms. For some the best solution is to walk away.
One of the more interesting findings of Cagan’s study was that 93 percent of the homeowners in one database of 32 million loans held some equity in their homes.
If home prices fall by 10 percent, the percentage of borrowers with no (or negative) equity in their homes would grow from 6.9 percent to 15.8 percent, Cagan predicts. If home prices were to rise by 10 percent, just 2.9 percent of borrowers would have no or negative equity in their homes.
Since nobody can predict what will happen to home prices in the future, Cagan’s study is of somewhat limited utility to those hoping to, say, decide whether or not to invest in the deflated stocks of some subprime lenders.
Cagan said he wasn’t able to account for some other important variables at all, such as unemployment rates, housing inventory, death, divorce, illness or fraud.
But the study is useful for predicting what the magnitude of the problem might be, and when it will peak. Cagan said the critical year will be 2008, when 2/28 loans originated in 2006 and 3/27 loans dating to 2005 reset.
Table 29 on page 52 of the study illustrates Cagan’s point: the percentage of homeowners facing resets who have less than 20 percent equity in their homes is projected to peak at 69.5 percent in 2008, up from 40 percent in 2004.
The 20 percent equity threshold is important because those who have reached it should be able to refinance into conventional, fixed-rate loans.
A remarkable 25 percent of ARM borrowers facing an interest-rate adjustment in 2008 will have no or negative equity in their homes, compared with 12.9 percent of those facing a reset this year.
The greatest risk is for people who bought at the top of the market,” Cagan said. “It’s a truism that risky investments are more risky.”
Cagan divided loans that are scheduled to reset into three categories: teaser loans with initial interest rates under 4 percent, which usually adjust within a few months; subprime ARMs with higher initial rates of 6.5 percent or higher, which adjust in two to three years; and market-rate adjustable loans with initial rates of 4 percent to 6.5 percent.
Cagan predicted 32 percent of teaser loans will default when they reset, compared with 12 percent of subprime and 7 percent of market-rate ARMs.
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