Unemployment: The Other Shoe Dropping

A statistics from that paper that still shocks me: roughly 28% of all mortgages defaults, and 60% of all subprime defaults, were mortgages that started with a prime mortgage.

Approximately 30 percent of the 2006 and 2007 foreclosures in Massachusetts were traced to homeowners who used a subprime mortgage to purchase their house. However, almost 44 percent of the foreclosures were of homeowners whose last mortgage was originated by a subprime lender. Of this 44 percent, approximately 60 percent initially financed their purchase with a mortgage from a prime lender. This result implies that a large factor in the crisis stemmed from borrowers who began their home ownership with a prime mortgage, but subsequently refinanced into a subprime mortgage…For ownership experiences that begin with mortgages obtained from a prime lender, subprime refinances are often a signal of financial distress, especially for borrowers that extract equity with a subprime refinance. It is likely that in the absence of a subprime market, many of those borrowers that ended up defaulting would have defaulted on their previous prime mortgages.

This point is key. There’s a real tendency to Other subprime mortgage holders. They are idiots, crooks, dupes, minorities, single mothers, easily mislead, liars and criminals, etc. But right here, 28% of all mortgage foreclosures, and 60% of subprime foreclosures, are from people who started with a prime mortgage. Those are the Us – good credit scores, 20% down, pay the bills on time. They disappear in the data – compilations of mortgage data often don’t follow the original starting point of homeowners, just of mortgages themselves (which is why I trust the Boston Fed papers, and few others) so we don’t see their story after they replace their prime mortgage with a subprime one.

I wrote about them around 2 years ago in a guest blog post when this was first unfolding. Everyone was wondering when the Alt-As, or the prime loans were going to fall apart. They didn’t in the numbers, so that lead a lot of people into the ‘soft landing’ category on housing. The fact that lots of people were missing was that the middle class that is struggling doesn’t default from a prime or Alt-A loan, but instead refinances into a subprime loan and then perhaps defaults later.

So what happened to them? We know what this is not – it isn’t “I think I want to borrow $50,000 against my house to buy a new car, redo my kitchen and maybe buy a TV.” That’s a home equity loan, and it doesn’t show up here. Though there are exceptions, general consumption based refinances don’t tend to go subprime – the rates are too high. What we expect is what the Fed finds – prime households experiencing financial distress.

If you are familiar with Jacob Hacker, and other works from the Risk Transfer literature, you know the story. Health Care costs. Rising education cost. Income volatility. The increasing tournament-style of our ‘flexible’ labor force. Outsourcing and gated communities. The dismantling of the risk-sharing social contract. All these things make our middle class less able to handle income shocks; in place of solutions to handle unemployment spells and sudden health care costs, we got subprime.

So what about the current crisis? Back in the 3-6-3 boring banker days, the unemployment rate was the determination of necessary writeoffs for bad debt. Credit card writedowns and mortgage defaults roughly tracked unemployment. Now we’ve been overwhelmed with the trillions of subprime debt that had to be written down. But
now we have to deal with the unemployment rate again. It’s going to get a lot worse before it gets better, and underneath those numbers are some terrible duration of unemployment numbers.

Now I’ve been thinking about the shocking writedowns and loss of wealth, as well as the increase in savings, and whether that could buffer the upcoming unemployment numbers effect on housing and consumer debt. Can it really get worse, or have we done all the bleeding out we need to? The short answer, as the credit card data starts to roll in, is that the upcoming losses are going to be larger than we expected on the consumer end (my underline):

The jump in likely credit-card loan losses at Capital One Financial (COF) suggests that other major consumer lenders may be facing similar losses for the first quarter. On Apr. 15, the issuer of MasterCard and Visa credit cards reported a one-month spike of 1.27% in net charge-offs for U.S. cardholders, to 9.33%, in March, surpassing the increase in unemployment by a widening margin.

The unemployment rate rose to 8.5% in March, from 8.1% in February. Historically, the bad debt rate on credit cards has lagged unemployment, but deteriorating economic conditions have spurred growing concern that the rate would start to outpace climbing unemployment, which seems to be occurring now, according to Michael Taiano, an analyst at Sandler O’Neill & Partners in New York.

It’s a much bigger concern, considering that some economists think unemployment might rise to 10%. “That would be mean a bigger drag on [issuers’] earnings in those quarters where that happens,” says Taiano, who has a hold rating on Capital One’s shares.

And:

Fitch said many large credit-card issuers pointed toward “significant worsening” in second-quarter metrics as they released their first-quarter results. Few were even willing to forecast beyond the second quarter because of the economic uncertainty. As a result, Fitch said credit-card losses would be “meaningfully higher” in the second quarter.

It aint over yet. I wonder if we are going to have to have two layers of green shoots. One for the businesses, the stock market and corporate earnings, and another for the rest of America, one for unemployment and consumer losses and writedowns. I’m hoping we are turning a corner on both these months….

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14 Responses to Unemployment: The Other Shoe Dropping

  1. Steve Sailer says:

    The Boston Fed economists, Gerardi and Willens, who wrote this paper later wrote the first analysis of subprime default rates for an entire state (Massachusetts): “Subprime Mortgages, Foreclosures, and Urban Neighborhoods.”

    http://www.bos.frb.org/economic/ppdp/2008/ppdp0806.pdf

    Here’s their abstract:

    ” This paper analyzes the impact of the subprime crisis on urban neighborhoods in Massachusetts. The topic is explored using a dataset that matches race and income information from HMDA with property‐level, transaction data from Massachusetts registry of deeds offices. With these data, we show that much of the subprime lending in the state was concentrated in urban neighborhoods and that minority homeownerships created with subprime mortgages have proven exceptionally unstable in the face of rapid price declines. The evidence from Massachusetts suggests that subprime lending did not, as is commonly believed, lead to a substantial increase in homeownership by minorities, but instead generated turnover in properties owned by minority residents. Furthermore, we argue that the particularly dire foreclosure situation in urban neighborhoods actually makes it somewhat easier for policymakers to provide remedies.

    They go on to write:

    ” The first column in each panel of Table 3 shows the cumulative percentage of subprime ownerships that end in foreclosure. There are substantial differences between minority and white ownership vintages. For example, approximately 15 percent of black, subprime ownerships initiated in 2005 ended in foreclosure by December 2007, compared with 10 percent of Hispanic subprime ownerships, and 6.5percent of white subprime ownerships.

    Here’s data based on their Table 3:

    Black Hispanic White Black / White Hisp / White
    1998 8.5% 7.1% 4.1% 2.1 1.7
    1999 9.2% 5.1% 2.5% 3.7 2.0
    2000 8.1% 8.1% 5.4% 1.5 1.5
    2001 8.7% 8.3% 5.2% 1.7 1.6
    2002 8.9% 6.2% 4.8% 1.9 1.3
    2003 8.6% 6.6% 5.1% 1.7 1.3
    2004 12.9% 10.4% 6.6% 2.0 1.6
    2005 15.0% 10.3% 6.5% 2.3 1.6
    2006 10.2% 6.8% 4.1% 2.5 1.7

    Keep in mind that these are cumulative foreclosure percentages up into 2007, with the year representing their “vintage.” Normally, you would expect cumulative foreclosure percentages to decline as you get closer to the present since, say, a 2005 vintage mortgage has had less time for bad things to happen to the borrower than a 1999 vintage mortgage. But we see instead a rising cumulative rate peaking in 2004-2005. (And the 2006 ones will probably end up about as bad, or even worse, as the two previous years once their teaser provisions reset after a couple of years.)

    So, in Massachusetts, the Non-Asian Minority foreclosure rate on subprime mortgages was about twice the white rate. That didn’t change too much over the years, but the proportion of mortgages that were subprime and the proportion of mortgage dollars going to minorities changed radically in the Bush years, contributing sizably to the disastrous mortgage meltdown that began in 2007 and triggered the more general crash of 2008.

    If that two to one minority to white foreclosure ratio seen in Massachusetts holds true nationally, where minorities took out over half the subprime dollars in 2004-2007, then minorities would account for two-thirds of all defaulted subprime dollars.

    That would seem like an interesting finding, but few have seemed very interested in coming up with it so far.

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  3. Aki_Izayoi says:

    Say the reason Steve. Let’s patronize “human biodiversity” here at a finance site (instead of those other “human biodiversity” sites such as parapundit and halfsigma) and say that some groups such as non-Asian minorities are inferior because the have low IQs. Talk about IQ steve. Yes, IQ was the reason for the foreclosures.

    So low IQ causes forclosures.

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  6. Sue says:

    [We know what this is not – it isn’t “I think I want to borrow $50,000 against my house to buy a new car, redo my kitchen and maybe buy a TV.” That’s a home equity loan, and it doesn’t show up here. Though there are exceptions, general consumption based refinances don’t tend to go subprime – the rates are too high.]

    How do you know some prime mtg holders didn’t go for subprime Option ARMs? They may not have wanted an equity loan or line of credit (deeming it too risky but figuring they could handle a reset), nor a 2nd mortgage as rates would be higher than their first mtg, but could have chosen an Option Arm on the belief that their salary prospects were good and everyone else was doing it too and in future when the rates reset up they’d have better salary and their houses would be worth more. Additionally costs for refi into an Option Arm might have been lower than refi a prime (predatory lenders likely to give a good deal to entice borrower). I don’t think it’s carved on a stone tablet that prime borrowers always have a higher IQ than subprime.

    Possible? And we have head tales of subprime borrowers who could have qualified for prime – the usual interpretation is of predatory lending to unsophisticated borrowers (typically first time buyer, minority etc) is it posssible that some of them were dumb prime buyers just making bad decisions when seduced by the refi sales pitch.

    Or maybe these are the exceptions you mention. Would be nice if you could expand on what you think the exceptions might be.

    How valid is it to extrapolate from MA to the whole US. Are the demographics really that representative? Is Iowa MA? Texas? Florida?

  7. Aki_Izayoi says:

    I thought Steve Sailer wouldn’t be here on a finance site. And I was surprised he was on Rortybomb, but I was not surprised when he talked about Hispanics and Blacks here as one of his obsessions is race and IQ.

    I thought finance sites would be a nice refuge from the “human biodiversity” crowd. I heard all that stuff before, and don’t want to here it from finance blogs.

  8. Mike says:

    Sue,

    “Additionally costs for refi into an Option Arm might have been lower than refi a prime (predatory lenders likely to give a good deal to entice borrower).”

    Alas, This is not the case. The initial rate on a subprime loan was higher than the rate on a prime loan. As we see from the previous entry from today on this blog about resets, the subprime mortgages in question in this paper have a ‘teaser’ rate of about 8%, with a reset to about 11%. This is why resets haven’t really caused a problem, as the initial rate on subprime mortgages were higher than prime mortages, by a lot, and often too much for the people in question.

    So for someone to want to consume out of their housing with a subprime option arm, they’d have to pay extra interest upfront, and significantly more later. As you note, we don’t know specifics of course, and there are a lot of people in the world, many who do all kinds of crazy things. But as the subprime loans were worse right away than prime loans, it is unlikely you’d see the refi from prime->subprime without a credit/income shock beforehand. I believe the data bears this out.

    How to extrapolate this is a good question, one that people will work on for a decade. In general, I think it is generalizable to the country that isn’t Ca, Az or Nv. There’s also a big urban/rural distinction in the data; the data lights up differently with subprime if it is urban dwellers betting on condos versus a small town where the only factory left. There’s a lot of work to be done there.

  9. Steve Sailer says:

    Mike writes:

    “In general, I think it is generalizable to the country that isn’t Ca, Az or Nv.”

    Right, but this actuarial model of subprimes is similar to what got Wall Street into so much trouble in the first place — the Gaussian Copula and all that, where people assume that you can model the risk on mortgages like on life insurance — defaults only happen when there’s a family tragedy or a recession. Instead of a recession causing defaults, defaults pushed us into a recession.

    Unfortunately, something like 7/8ths of the defaulted dollars on all mortgages (prime and subprime) have been in the four Sand States and maybe 5/8ths of all the defaulted dollars were in California alone. So, California is the key, and the actuarial model doesn’t work well to describe what happened there.

  10. Steve Sailer says:

    Sue asks the very good question:

    “How valid is it to extrapolate from MA to the whole US?”

    I don’t know. The overall default rate in Massachusetts isn’t all that high. Moreover, I’m especially concerned that the Hispanic population isn’t very similar in country of origin to the Hispanic population in California.

    Still, if you look at the federal Home Mortgage Disclosure Act for the 20 biggest MSAs in California in 2006, there’s a high correlation between % of home purchase mortgage dollars (prime and subprime) going to Hispanics in 2006 and the MSA’s default rate in q1-2009. Similarly, if you look at neighborhoods within a single MSA, such as Los Angeles-Long Beach, you see a strong correlations between defaults rates or price declines from 2007 to 2008 and ethnicity of home purchase mortgage recipients in 2006. So, I would say that when California is finally studied as closely as Massachusetts has been, it would be surprising if Hispanic and black default rates aren’t significantly higher than Asian and white defaults.

    Similarly, a 2004 HUD study found that default rates on FHA loans in the 1990s tended to be at least double for blacks and Hispanics compared to whites.

    http://isteve.blogspot.com/2009/02/1990s-fha-mortgage-default-rates-by.html

    FHA loans have some similarities to subprime loans (e.g., aimed at lower income people) although they have a less abusive history, so FHA loans give us a pretty decent apples to apples comparison across race/ethnicity of default likelihoods.

    As the semi-berserk commenter above shows, writing about these kinds of facts tend to make a lot of people very angry at you for mentioning them in public, but our host is a good guy.

    I would look to predatory lending as one explanation, especially predatory lending where the buyer, real estate agent, and mortgage broker all spoke Spanish. (That’s one reason the Housing Bubble wasn’t really on the national media’s radar when it was happening — much of it was taking place in Spanish.) Now that I think about it, though, the term “predatory lending” might be replaced by “predatory securitizing.”

    The big crooked SoCal mortgage companies such as Countrywide invested heavily in “regulatory cover” by telling everybody in Washington that they were fighting racist redlining by helping minorities get their fair share of the American Dream. Bush, Barney Frank, and others in Washington tended to fall for this moonshine, while state Attorney Generals were rightly more skeptical.

    For example, 49 AGs teamed up to nail AmeriQuest, headed by U.S. Ambassador to the Netherlands Roland Arnall, with a big fine just before it went under. In contrast, Congress approved Arnall’s ambassadorship during the investigation.

    Other than the state Attorney Generals, it’s hard to find any good guys in this history of how people like Angelo Mozilo of Countrywide used the minority lending card to justify his boiler room operations. The Republicans were the worst — e.g., Bush’s demand for zero down mortgages to achieve his goal of adding 5.5 million minority homeowners by 2010 — but the Democrats in Washington were almost as bad. And a fair number of the leftist NGOs like Greenlining deserve blame for giving big bad lenders “regulatory cover.”

    It’s a very complicated story. As Mike says, it may take 10 years to unravel. But the pieces are starting to emerge.

  11. Mike says:

    Sue,

    The Economist has a really good post directly dealing with the issues you address, better than I have. I learned something reading their summary/synthesis about the issue, thought I’d pass it along.

    http://www.economist.com/blogs/freeexchange/2009/05/why_do_people_turn_subprime.cfm

  12. Sue says:

    Mike, thanks for the Economist link, I’ll go take a look at it. I came here to add this link from Chicago Fed

    Comparing patterns of default among prime and subprime mortgages
    Gene Amromin and Anna L. Paulson

    http://www.chicagofed.org/publications/economicperspectives/ep_2qtr2009_part2_amromin_paulson.pdf

    It seems to look at loans originated 2004-2007 but I have to find time to read it all through.

    I got there from

    http://www.chicagofed.org/economic_research_and_data/economic_perspectives.cfm

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