Why Big Mortgage Losses are Here to Stay

John Hempton is doing an admirable job teasing out the dynamics of the US mortgage market, and asking whether the losses we're currently seeing are due to fraud or to broader economic stress. If it's mainly fraud, he says, that good news: the defaults come quickly, and then they're over:

Once the pig (a pile of fraudulent loans) has worked through the python (the mortgage market) then the bulge (defaults) will decline just as rapidly as it rose.

I'm more of a pessimist, even assuming that fraud (broadly defined, to include most stated-income loans) was a huge part of the problem. And I'm pessimistic because I believe non-fraudulent loans are increasingly going to behave just like fraudulent loans. Crazy subprime underwriting might be a thing of the past, along with high levels of outright fraud. But I fear the loss curve associated with those subprime loans is going to spread into the rest of the mortgage market, like a cancer.

One reason is a severe lack of human capital in the mortgage industry. Here's Hempton, describing one stereotypical borrower:

My last couple will pay (almost?) all the loan and all their loan under modified terms because they want to keep their kids in that school. But they need the loan to be modified because they are at the edge of being able to pay. Still they will cut entertainment, holidays and shrink the car to stay in the house because they want their kids in that school. If there is a recession and the husband's hours get cut - well you should probably modify the loan as that is a better outcome for the bank than foreclosure.

No doubt the bank should modify the loan. But will it? That's a very different question. The papers are full of borrowers who've done everything right, who have tried to maintain contact with their bank at all times, who have requested dialogue and loan mods, and who are faced with nothing but recorded messages and bureaucracy until they wake up one morning to find themselves in possession of a foreclosure notice.

To date, we simply haven't seen the spike in loan mods that one would have expected given the rise in borrowers facing financial difficulty. The mortgage boom was all about automation; loan mods by their nature are much more of a case-by-case phenomenon, and the struggling loan servicers don't have the manpower to do that. Something that is an obvious mod to Hempton or Tanta or you or me is just another customer to the overworked employees in telecenters who want nothing more than to pass that person on to somebody else and who in any case aren't empowered to make substantive decisions.

As a result, homes are going into foreclosure which, if there was any sense in the world, would never be foreclosed on. No one gains by this, but it happens every day. And the losses on these homes are very similar to the losses on the fraudulent loans.

The other reason for the metastasizing loss curves is something I alluded to yesterday: the increasing willingness of borrowers to default on their mortgages even if they're staying current on things like car and credit card payments -- or school fees, for that matter.

Partly, this is a function of the 2005 bankruptcy-law reform, which made it much harder to expunge credit-card debt. As a Bloomberg article last year put it in its headline, "Bankruptcy Law Backfires as Foreclosures Offset Gains":

"Be careful what you wish for," Westbrook said. "They wanted to make sure that people kept paying their credit cards, and what they're getting is more foreclosures."

The unintended consequence of the bankruptcy bill is that defaulting on a credit card is extremely painful -- more painful than defaulting on a mortgage, especially in non-recourse states like California. As one reader put it to me in an email this morning, "the ding on your credit for defaulting on a mortgage that is underwater is mild relative to what the credit card companies want to do to you now".

The result is a massive asymmetry when it comes to the cost of default. For lenders, it's never been higher; for borrowers, it's never been lower. It's a lethal combination for lenders, and they really only have themselves to blame.