The credit/mortgage crisis has been all the rage in the news lately. I thought I'd take a quick look at the real meaning behind all the facts and figures. To start with, let's look at the Census Bureau's American Community Survey for Los Angeles County from 2005.
Number of households: 3,184,396
Owner-occupied: 1,562,853 (49.08%)
Renter-occupied: 1,621,543 (50.92%)
So what we're interested in here is the owner-occupied residences. How many of those have mortgages?
Housing units with a mortgage: 1,208,550 (77%)
Housing units without a mortgage: 354,303 (23%)
Obviously the 23% of the people without mortgages can't default. So now let's look at the 77% of the homeowners that DO have mortgages. According to la-foreclosure.net, here are the number of foreclosures in LA county in the past 7 months.
That doesn't seem like a huge number for a city the size of Los Angeles, but look at that as a percentage of the number of mortgages - 28,033 / 1,208,550 = 2.32% of all mortgages defaulted in only 7 months.
When you think about it, that's a big deal. Mortgages are LONG term loans. It can take a homeowner 30 years to pay off a house. Annualized, that works out to a 4% default rate. Banks lose money on the houses that default. According to this blog (original article gone from the news website), the average foreclosure costs banks 20-25% of the loan value, or $60,000 nationwide. What would the loss be in California?
The average California borrower took out a $436,749 mortgage during the first half of 2007, according to DataQuick Information Services -- just $19,749 over the conforming loan limit.Say we take the low end of that figure at 20%. That's a loss of $87,350 per default.
From the same article, the average interest rate for a conforming loan with a good credit score and 20% down was 6.22%. How much will the bank make from these mortgages? According to this article, Washington Mutual is projected to have a net interest margin of 2.51% in the third quarter of 2007. The net interest margin is the difference between what they have to pay depositors for checking/savings/cd/money market accounts and what the rate they can lend the money out.
The credit crunch could very well turn into a vicous cycle. Investors in mortgage backed securities will demand much higher premiums to compensate them for the increased default rate. In turn, banks will demand higher interest rates for new mortgages to keep their net interest margin at acceptable levels. These higher rates push down the affordability of a house. From the above example:
$436,749 mortgage @ 6.22% for 30 years = ($2,680.62) monthly payment
Assuming that's the max you can afford to pay per month, what amount can you borrow if the rate goes up?
7% = $402,918
8% = $365,325
9% = $333,153
10% = $305,459
Obviously, at a certain point this buyer drops out of the market because they are unable to find a house that is affordable. Supply probably drops as well, as people can't sell their homes because the value is lower than what they owe. Distressed sellers, who MUST sell due to financial hardship become more likely to default. This increases the default rate further, and results in even higher rates.
Eventually it all shakes out and we reach an equillibrium point again. I believe this is probably about 3-4 years out. In the meantime, I would expect house values to stay about the same or possibly drop a little bit in real dollars and inflation adjusted, I expect them to drop by somewhere in the 10% range.