The Mortgage Morass Continues

• Mortgage credit quality weakened sharply in the third quarter of 2007, according to data from Equifax credit files.

• Delinquencies and defaults will rise strongly through 2008 and into 2009, due to falling house prices, rising mortgage payments and a weaker job market.

• The recent rally in stock and bond prices suggests investors are optimistic that these credit problems are already priced in. Maybe.

Investor sentiment has brightened markedly in recent weeks, even though the cause of the previous angst—residential mortgage quality—continues to darken. According to data from Equifax credit files for the just-ended third quarter, mortgage delinquency and defaults surged to another new record high. Given that mortgage quality is likely to erode substantially further through the coming year, investors appear overly sanguine.

The deterioration in residential mortgage quality is without precedent in the post-World War II period. An astounding number of homeowners—more than 1.5 million at an annualized rate—defaulted on their first mortgages in the third quarter. More precisely, this is the default rate as of the last week of September when a 5% random sample of the nation’s credit files was taken for the compilation of this data. This compares with 900,000 defaults in 2006 and 800,000 at the low in 2005 (see chart). Defaults are the first step in the foreclosure process, and while many borrowers will work with their lenders to remain in their homes, the current rate of defaults suggests that well over one million homeowners who default this year will ultimately lose their homes.

The increase in mortgage defaults is evident from coast to coast. The most significant problems are in the Central Valley of California from Riverside to Sacramento; South Florida; Nevada; much of the industrial Midwest; and around New York City and Boston (see chart). No region is enjoying improving mortgage quality, but some areas are holding their own, including parts of Texas, the Carolinas and the Pacific Northwest.

The near-term outlook is not encouraging. Delinquency rates are rising rapidly. The dollar delinquency rate, 30-120 days, on all mortgage debt outstanding jumped to 3.31% in the third quarter. This is up from 3.15% in the second quarter and 2.03% at the nadir in delinquency in the fourth quarter of 2005. Moreover, delinquency continues to rise across every category, including 30, 60, 90, and 120 days. With so many delinquent loans in train, it appears likely that at least another one million homeowners will default on their mortgages in 2008 and eventually lose their homes.

Most homeowners who struggle with their mortgages have three problems: falling house prices, larger monthly payments as their mortgages reset, and a softening job market. National house prices as measured by Case Shiller are off more than 3% from their peak in the second quarter of 2006, and by much more in areas where credit problems are most severe. In the Central Valley of California and the west coast of Florida, for example, they are down by double digits (see chart).

More price declines are ahead; the housing market is choking on unsold inventory that continues to rise as home sales plunge and foreclosures surge. As of the second quarter (the latest data available), there were some 2.5 million new and existing homes vacant and for sale. A balanced and well-functioning national housing market would have approximately 1.5 million units, based on long-run vacancy rates. This implies that the market is currently burdened with excess inventory of one million units. Homebuilders are slashing construction to reduce these inventories, but it won’t be enough; substantially lower house prices are required to re-establish housing affordability and stimulate sales. Peak-to-trough declines in national house prices of more than 10% are likely, implying crash-like declines in the most hard-pressed markets. If that happens, nearly all homeowners who took on subprime mortgage loans since late 2004 will soon have no equity left in their homes.

Having no equity may not by itself prompt a homeowner to default—but it almost surely will if accompanied by a substantial increase in monthly mortgage payments. The average subprime borrower facing a first payment reset this year or next will experience a $350 monthly payment increase, from $1,200 a month to $1,550. For most lower- and middle-income homeowners this is an impossible burden. The wave of adjustable mortgage resets is peaking right now, but resets will remain very high (save for a seasonal lull this winter) well into next summer.

Adding to homeowners’ financial woes is a weakening job market, due largely to layoffs in housing-related industries including construction and mortgage finance. This has added importance since most areas with severe credit problems also have job markets that are particularly reliant on housing. Nationwide, housing-related jobs account for about a tenth of all jobs, but they are nearly twice that level in South Florida, for example (see chart). The Florida, California and Nevada economies are on the edge of recession, if not already in it. With no equity, surging mortgage payments and rising unemployment, there is no doubt about the severity of the coming credit problems.

The Equifax data highlight a second growing concern, namely the apparently weakening quality of other household liabilities in areas of the country where mortgage quality is eroding. Across the 200 metro areas covered in the Equifax data, there is a strong relationship between those areas suffering increased mortgage delinquency and those with increased auto and card delinquency (see charts). It is not clear how this relationship is working: Are those households with mortgage payment problems also not making payments on their other liabilities? Or is credit quality eroding broadly as the job market feels the effects of mortgage and housing woes? Either way, it is evident that financial pressures are weighing increasingly heavily on households.

It is possible that investors have appropriately priced all this bad news into current stock and bond prices. While stock prices have rallied sharply and credit spreads have narrowed since the worst of the subprime financial shock in August, the stock market has gone nowhere since the spring and spreads are still much wider than they were before the shock. It is also possible that investors have accounted for the economic fallout from the credit problems and the financial shock that is sure to follow. However, there are good reasons to worry that investors don’t have it all figured out, and that the subprime financial shock will continue to reverberate. It wouldn’t be surprising if a few more financial aftershocks emerge, as the severity of the mortgage credit problems and their implications become more than just a forecast.