The consumer credit outlook for 2007 looks benign. Although mortgage delinquencies and foreclosures are rising, they are up from exceptionally depressed levels. There was little room for them to go anywhere but higher.
According to the Mortgage Bankers Association survey, delinquencies for all mortgage types rose from a 2005 first quarter low of 4.31% to 4.67% in the fourth quarter of 2006. Default rates now hover around 1.00%. Aggregate numbers still do not fully reflect the impact of the 2005 hurricanes in disaster areas, where Fannie Mae, Freddie Mac and other large lenders directed their servicers not to report borrowers as delinquent.
"We must distinguish delinquencies from foreclosures," said Amy Crews Cutt, deputy chief economist at Freddie Mac. "If they have any equity left in their homes, people will sell rather than go through foreclosure." At what level should we start to worry? "I would be concerned if foreclosures hit about 5.00%," suggested David Wyss, chief economist at Standard & Poor's. "Right now, the direction is wrong, but we are still nowhere near that level."
All about jobs
Going forward, credit conditions will depend on interest rates, gas prices, housing prices and wealth levels (including financial assets). Optimism over consumer credit is predicated on a fairly soft landing in all those areas. However, the key factor will be employment. "As long as people have income and jobs they will keep spending," said Glenn Schultz, managing director, consumer ABS and non-performing mortgages at Wachovia Capital Markets.
In 1991to1993, the housing market in California collapsed as military bases were closing. Yet rather than sell their homes at a loss, many owner obtained Title One Housing and Urban Development loans, for 125% LTV. "Since unemployment didn't go through the roof, people were willing to double down," Schultz said.
In Texas, on the other hand, the wheels came off in the oil patch in the late 1980's, with massive job losses and bankruptcies. "For a repeat of those problems, we would expect to see home prices down by 25% and job losses affecting 23% of the population," said Crews Cutt. As a regional pattern, some alarming losses have already rocked the Midwest. Between March 2001 and November 2006, Ohio lost 139,000 jobs, for a decline of 2.49%. During that period, Michigan lost 237,000, for a decline of 5.2%. (Compare that with 10% and 13% respective gains in Arizona and Florida.)
Ultimately, home ownership carries an emotional attachment. Owners do not calculate the "in-the-moneyness of their option default," as Schultz described. Living under a bridge is not viable. Nor can they easily rent an apartment nearby, as the landlord will notice their recent default on their mortgage.
Owners will make great efforts to avoid foreclosure on a primary residence. "Yet they may not be prepared to go so far for a second home or for investment properties, like Alt A," Wyss said.
Resets and cycles
Prime and subprime ARM resets are running on different tracks. Subprime ARMs are poised for a huge volume of resets scheduled in 2007, which will not take their toll on primes until 2008. The prime ARMs are structured to reset after the initial 3, 5, 7 and 10 year periods; on the subprime side, known as 2/28, rates are fixed for the first two years, and then followed by adjustability. Since subprime borrowers are on a two-year cycle, loans taken out in 2005 are currently due to reset. On the other hand, prime loans taken out in 2003, when the yield curve bottomed, have another year's grace before their five-year reset. "Once again, aggregates tell a different tale from market specifics, and subprimes are the dominant story this year," Crews Cutt said.
The surge of borrowing in 2003 has another repercussion. Michael Fratantoni, senior director, single-family research and economics at the MBA, described some of the reasons why the age of loan portfolios often plays a role. In general, pools tend to hit peak delinquencies three to five years after origination. "At the time of a purchase, many borrowers have saved up and organized their finances in the best possible shape to qualify for a mortgage," Fratantoni said. "After several years, problems may have accumulated, amortization has kicked in and equity has built up. Borrowers may have let their credit go to some extent."
Few storm clouds brewing
Beyond mortgages, other areas of consumer credit appear healthy. Loss rates on credit cards have fallen, due in part to the 2005 revision of the bankruptcy law. "We saw a sharp spike in bankruptcies before the law went into effect, followed by a drop, as everyone who wanted to needed to declare bankruptcy had already done so," noted Wyss. "Now levels may stay a little below normal, as the Act is tougher and may encourage issuers to tighten."
Auto loan losses are lower than in the late 1990s, "reflecting more careful underwriting," Wyss said. The 2005 Highway Bill, along with tax deduction incentives, has caused a shift from loans toward leases. Lessors, who forego downpayments and pay lower monthly installments, are less likely to be squeezed.
However, over aggressive underwriting could eventually spoil the party down the road. Where an optimal rate of debt-to-income ratio for prime borrowers is 25%, today we are seeing about 32% levels in DTI. An upward migration towards 40% has been creeping into the subprime space. "For the past couple of years, we have been pushing the underwriting envelope to keep originations up," Schultz warned.
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