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Mortgage Armageddon, American Style

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Guest Post: Frank Veneroso on Mortgage Armageddon

Frank Veneroso was kind enough to write as a result of seeing a guest post "Debtor's Revolt?" by his colleague Marshall Auerback. Veneroso also provided his latest newsletter and gave us permission to post it. It it pretty long (12 pages), I extracted the executive summary and other key bits. Be sure to read the final section, starting with the boldface heading "Why Resolving The Mortgage Armageddon Problem Will Be So Difficult:." (Enjoy!

From Frank Veneroso:

1. Deutsche Bank now predicts that 48% of all mortgaged American homeowners will be “under water†by 2011.

2. One might assume that means that the aggregate loan-to-value ratio of all mortgaged households will be a little less than 100%.

3. I have been focusing first and foremost on the aggregate loan-to-value ratio of all households with mortgages rather than the number of mortgaged homeowners who will eventually be underwater.

4. I calculated that, on mean reversion in house prices, this aggregate loan-to-value ratio would rise to 120% to 125% -- a lot worse than what the Deutsche Bank analysis seems to imply. So I studied their analysis to ascertain why I went wrong or why they went wrong.

5. Though their analysis has a somewhat different objective and employs a different methodology, their analysis in fact comes to almost exactly the same conclusion as I have reached: when one focuses not on the share of all homeowners who will be underwater but the aggregate of mortgaged home values that will be under water, on mean reversion in home prices the aggregate loan-to-value ratio will probably be north of 120%. Here is why.

6. Deutsche Bank admits that their data on total mortgage debt is incomplete. Using more complete mortgage data the percent of homeowners under water would be higher and the implied aggregate LTV might be closer to 110% than 100%.

7. Also there is skewing. Those who are underwater have negative equities that exceed in value the positive equities of those who are not underwater

8 There is skewing on more than one account. Because the highest shares of those underwater are in the regions with the highest home values and the greatest percentagehome price declines the overall skewing might be very great. And this skewing increases as home prices fall further to the Case Shiller mean.

9. When one factors in this skewing the aggregate loan-to-value ratio of all mortgaged homeowners based on the Deutsche Bank analysis probably rises to 120% or more.

Once Again, Does Debt Matter Any More?

We just received a better than expected employment report in which the unemployment rate surprisingly fell. The stock market rallied. The bond market sold off. The last holdouts who still believe the recession is not over are now few and far between. After the last Case Shiller home price report and several upticks in the various measures of home sales, the crowd believes the worst is behind us as regards housing. There may still be a lot of debt out there, but it doesn’t matter anymore.

So here I am, still concerned about all that private debt and still talking about a Mortgage Armageddon. I know, you think, having predicted the financial crisis before it came and having predicted yet more to come once it began to unfold, Frank just can’t stop forecasting more to come. It was just too much fun while it lasted, even though it is all over now.

Wrong! It isn’t an addiction to former winning ways that keeps me on this Mortgage Armageddon kick. It’s a re

view of the history of these things plus simple logic and some arithmetic. I don’t want to see Mortgage Armageddon. Now that, thanks to Geithner and Summers, Obama has assumed ownership of a national insolvency he has no responsibility for, Mortgage Armageddon could paralyze his presidency and leave us in political chaos – which I don’t want to see.

In any case, though the ranks of worrywarts like me are now a lot thinner, I still am not alone. A friend of mine who owns a lot of mortgages keeps telling me that the delinquencies on his mortgages keep going up, and quickly. Yet the foreclosures do not. It seems the financial channel has some kind of frightful constipation whereas dying mortgages keep piling up inside and somehow their elimination is obstructed.

Deutsche Bank Thinks Debt Still Matters

A week ago I quoted Josef Ackermann, head of Deutsche Bank.

This crisis has consisted of a series of earthquakes, with changing epicenters,†Ackermann said late yesterday at an event in Zurich. “Bad loans are the next wave. Banks that have fared relatively well so far will also be affected by this.


Let me explain how it is that Deutsche Bank and I are on the same page.

In my Mortgage Armageddon analysis I took a simple aggregative approach. I went to the U. S. flow of funds accounts to obtain the total value of owner-occupied residential property at the peak of the housing bubble. I assumed the physical value of this stock had not changed since the peak. In the first year or so after that peak new home building exceeded the scrappage rate. Since then it has been less. On balance, the net depreciated physical stock remains roughly unchanged. Whatever small change has occurred doesn’t matter. The useful life of residential real estate is very long, which means that flow supply in any year is very small relative to the value of the outstanding stock....

Of course, we are only interested in the fate of that part of the housing stock that is mortgaged. My research indicated that about two thirds of the total number of units is encumbered with debt. But I was interested in the share of total value that was encumbered by debt, not the number. Why? Because it is the implications of mortgage non-payment for the financial system and society as a whole that matters most. If the mortgage encumbered households have homes and mortgages with values far below the average, though their defaults and losses may be numerous, they may not be that damaging to the financial system.

One might argue that it is the numbers of underwater and thereby imperiled homeowners that matters from a social and political point of view. Even here I would argue that it is the aggregate value that is underwater that matters more. True, in the U. S. A. one man, one vote prevails. But in my opinion if the impoverished lumpen proletariat had all the underwater mortgages, it would matter less politically than if these mortgages were a burden chiefly to the upper and middle classes. In today’s U. S. A. socially and politically middle class man speaks louder than the lumpen. And upper class man speaks louder still....

The U. S. A. is noteworthy in having the most skewed wealth distribution among the more advanced nations of the world....To accommodate for this I considered two scenarios: one where one third of all homes had no mortgage and one where 40% had no mortgage.

To establish the denominator (residential property value) in the nation’s aggregate mortgage loan-to-value ratio I took two thirds of the residential property value in the flow of funds accounts at the 2006 peak in home prices. I then reduced this value by 41% which is my estimate of the overall home price decline that will take the Case Shiller index back to its mean in real terms assuming no inflation over the next two years. Against this I put the total household mortgage debt of all kinds -- firsts, seconds, thirds, HELOCs -- at the end of Q1 for which we have the latest flow of funds data. That figure on mortgage debt is down from the peak of 2006, but not by much. I should add that, owing to negative amortizations and securitizations, I believe that, if there is an error in the flow of funds data on outstanding mortgage debt, it is one of underestimation.

Now all one has to do is simple division: take the ratio of outstanding mortgage debt to the projected value of all mortgaged owner-occupied residential real estate when home prices fall by 41%. That ratio exceeds 120%.

I made the same calculation, but using the assumption that 40% and not one third of all homes have no mortgage. The resulting aggregate loan-to-value ratio for all indebted homes is 134%.

{Veneroso spends a page describing where he and Deutsche Bank agree]

From then on Deutsche Bank’s methodology departs from mine. Mine is highly aggregative, working off the flow of funds accounts; their’s is highly disaggregated, working off of data pertaining to numerous “Metropolitan Statistical Areas – MSAs†as set out by the U. S. Census Bureau.

This brings up an important difference between their data on total mortgage debt and the data I used. I went to the flow of funds accounts which provide a mortgage debt aggregate which the Fed claims is all encompassing. Deutsche Bank says that their disaggregated data on mortgage debt is not complete. They admit their numbers on second and third mortgages have omissions. They say the same of their data on home equity loans. They use the Freddie Mac database to estimate the loan-to-value ratios for FHA and VA mortgages but admit this is an underestimate since these mortgages typically have had little in the way of down payments....

I can’t estimate the difference between Deutsche Bank’s admittedly conservative bottoms up estimate for all homeowner mortgage debt and the aggregate estimate in the flow of funds accounts but, as it involves seconds, thirds, HELOCs, and VA and FHA loans, which total in the trillions of dollars, it could involve an error of omission equal to 10% of total outstanding mortgage debt of around $12 trillion.

Studying the details of the Deutsche Bank analysis provides an explanation for the rest of the apparent difference between my Mortgage Armageddon conclusion and their seemingly less grave one. If one looks at the details of their estimates of the present and future mortgage loan-to-value situation one sees that, on several counts, for those households who are “underwater†their negative equity is greater than the positive equities of those who are not underwater.....

Why Resolving The Mortgage Armageddon Problem Will Be So Difficult

When I discuss the Mortgage Armageddon scenario I get two types of responses:

1. You have to be wrong. It won’t happen. There won’t be mean reversion in house prices this time. Your arithmetic must be faulty. Or simply a silence that refuses to consider any fact, logic or arithmetic that might support the Mortgage Armageddon analysis.

2. Well, maybe you are right but “they†won’t let it happen, or “they†will somehow bail everyone out. Who is “they� Apparently the authorities, some authorities. The Fed. The Treasury. The FHFA. Congress. Some or many or all the instruments of government.

I agree that response (2) will occur. But will it work?

To appreciate the intractability of the problem, one must focus on the skewing discussed above. Below I list the 10 MSAs with the highest share of mortgage households that will be “underwater†in 2011 according to Deutsche Bank. Remember, Deutsche Bank admits its numbers are conservative, as they have underestimated the level of debt. If one did the calculation with the right debt data, probably all of these MSAs would reach or exceed the 90% threshold.

Deutsche Bank doesn’t provide the data, but the degree to which these properties are underwater in these MSAs is probably every bit as striking. Perhaps for these 10 MSAs the average loan-to-value ratio is well above 150%, perhaps 200%. (click to enlarge)


What do the policymakers do when households in some parts of the country are so massively insolvent yet in many states almost all the mortgaged households remain solvent? If one lets market forces take their course, how will the financial institutions manage the foreclosure process? A huge part of all the residential real estate in such municipal districts may come up for sale. Who would be able to absorb so much distressed property, and at what price?

On the other hand if the government steps in and somehow socializes such large and pervasive losses in some districts, how does it sell such a colossal bailout to the voters in many states where borrowers and lenders were prudent rather than profligate and almost everyone remains solvent? With such huge regional differences, it seems to me that a bailout program at Federal level will face great political impediments. Yet, any such bailout program will have to be a Federal one.the

93% of Fort Lauderdale mortage owners in negative equity???? Can anyone still deny that there was no bubble in property, on both side of the Atlantic?

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Can anyone still deny that there was no bubble in property, on both side of the Atlantic?

I don't think anyone is denying it are they? Only the size of the bubble is up for debate.

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I don't think anyone is denying it are they? Only the size of the bubble is up for debate.

Well, if Hamass McTwat were still posting on this forum, you can bet your bottom dollar that a maddening, one sided debate full of dubious factoids and dodgy anecdotals would spring up to argue that there wasn't a bubble.

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I don't think anyone is denying it are they? Only the size of the bubble is up for debate.

There does seem to be some debate as to whether enough air is going to be to be pumped into the bubble to replace the air that is leaking out to prevent further collapse.

I expect a new leak to show up soon and for it to deflate further notwithstanding efforts by the autorities to prevent it.

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Most of our tory and labour MPs do, they still think '2006-7' is normality.

This is because they all have two houses+ and no ability to earn money beyond lying.

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Just maybe there's something fundamentally wrong with our monetary system?

Imagine that your gang could force a whole economy to use a means of exchange that only your gang could issue.

Imagine that you charged interest on almost every pound in circulation, always demanding more pounds back than you lent out, and that consequently the economy was trapped in perpetual and escalating debt to your gang.

Tempting, innit?

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