Ed. Note: This is an excerpt from Whitney Tilson’s presentation to the Value Investing Congress in Pasadena, California on May 5, 2010. Whitney Tilson is the founder and Managing Partner of T2 Partners LLC and the Tilson Mutual Funds.
Two years ago, we stood up here on this exact stage and delivered a very downbeat presentation on the US housing market. We return today to provide an update…and a new forecast.
In early May of 2008 housing prices had already been declining for two years. The Bear Stearns hedge funds had blown up a year earlier. NovaStar and New Century Financial had also blown up a year earlier. The subprime crisis was well upon us. And many, many people thought that this was going to be contained to subprime.
But we announced that the data led us to believe the contrary and we delivered our analysis in a presentation entitled, “Why We’re Still in the Early Innings of the Bursting Housing and Credit Bubbles.” We concluded that things were terrible and that there was no sign of a bottom. Obviously, that forecast was on target.
So where are we today?
Two thirds of American homes have mortgages – 56 million mortgages outstanding. A little over half are owned or guaranteed by government entities. 35% are held on the balance sheets of banks and thrifts, and 15% are so-called private label securities that went to Wall Street. This last piece was the sub-prime stuff that was some of the very worst mortgage debt ever written.
It’s very easy to get complacent about the mortgage market, as housing prices have stabilized and foreclosures have stabilized, you know, ‘we don’t have to worry about that anymore.’ But I’d argue to the contrary, let me show you why.
Fourteen percent of America’s 56 million mortgages are already delinquent or in foreclosure. So if you multiply 56 million by 14%, that means that 7.8 million people right now are not paying their mortgages. 7.8 million homeowners have been delinquent for 30, 60 or 90 days…or are in foreclosure already. 91% of the people who are currently not paying are never going to get back to current, according to recent statistics. So that means that of 7.8 million people not paying their mortgage, 7.2 million are never going to get back. So that’s a problem. 7.2 million homes. 7.2 million mortgages will go into foreclosure…eventually.
And the real story is even worse than the nearby chart suggests. Because of loan modification programs, the government, banks and servicers have dramatically slowed down the foreclosure process. The banks have been modifying everybody, slowing down the foreclosure pipeline and not taking properties onto their books.
So what this means is that the rate of NON-foreclosure on delinquent borrowers is climbing sharply. As the nearby chart illustrates, 24% of the people who have not made a mortgage payment during the last two years have still not been foreclosed on. That’s how clogged the foreclosure pipeline is.
So what’s going on? Well, there are a lot of modifications going on the past year. But modifications don’t really work very well. It turns out that even when you cut someone’s mortgage payment by 50% or more, half of them still default within 12 months. The re-default rate is astronomical…even when you cut the monthly payments dramatically.
So why is that? Because the real driver is people being under water, people who have no ‘skin in the game.’ Basically what we did in this crisis is we gave American homeowners a $2 trillion “call option” on home price appreciation. But when the value of their properties fell below their debt levels, they handed the keys to the lender; that’s what people do. And that’s what American homeowners have done.
To some extent American homeowners are now minimizing the human toll of losing homes and so forth. Purely as a group, on an economic basis, they’re the only rational players in this bubble. They’ve pocketed $2 trillion in cash and now, when the value of the property falls below their debt, they’re walking away. As it turns out, the unemployment rate isn’t really much of a driver of default rates. Instead, it’s all about home equity…or the lack thereof.
So what does the future hold? Foreclosures are starting to spike back up as the trial ‘mods’ are failing and moving into foreclosure. If we’re very lucky, home prices will stabilize here. But if interest rates go up, and if we don’t properly deal with those 7.85 million people who aren’t paying their mortgages and those delinquent mortgages turn into foreclosures, look out below!
Today about 17.2% of homeowners are underwater. But if home prices drop 10% from here, 27% of homeowners would go underwater. In other words, a 10% drop in home prices would cause a 56% increase in the number of people underwater…which would almost certainly lead to another surge in defaults.
So I really think the housing market is on a precipice right now, where we need some very strong intervention by the government, by the banks and the servicers to offset what, in the absence of strong action, would be a resurgence of foreclosures, which would lead to a fresh drop in home prices, which will lead to even more defaults… And you can get into the vicious cycle that we were in back in ’07 through ’08.
One big problem in all of this is second liens. You have $842 billion in second liens outstanding and the majority of them are owned by the Big 4 banks. And you have this bizarre situation where American consumers are not making the $1,200 monthly payment on their first lien, but maybe just to prevent harassing phone calls from debt lenders, they are paying the $150 second lien. Well, that means that the banks are looking at this and they’re holding all of these second liens at par, even if the first lien has already gone bad.
This situation makes the banks very reluctant to approve a short sale, since that would completely wipe out the second lien. Because if you write down the first lien, the second lien is a zero. Of course, banks just don’t want to do that because it’s a huge amount of money that would wipe out the equity of these Big 4 banks, if they were to mark these second liens to zero. This is a big problem.
Then there’s commercial real estate. The majority of commercial real estate loans that are coming due, nothing is happening on them. They don’t get refinanced, but they don’t get foreclosed on either. It’s “extend and pretend” or “delay and pray.” That’s what’s going on with commercial real estate.
Net-net, there’s more pain to come in the real estate market.
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