Sunday, May 13, 2007

Lies, Damned Lies, and Default Rates

by Tanta on 5/13/2007 09:03:00 AM

One of the more annoying memes floating around these days is a certain misuse of mortgage delinquency or default rates in support of what appears to me to be a political argument. It goes like this: “only” x percent of subprime borrowers are delinquent; therefore x percent are not delinquent. Therefore . . . subprime creates opportunity. It is a political argument insofar as what lurks within the ellipsis is the dreaded “ownership society.”

This somewhat anemic logic has appeared in some fairly respectable sources: Austan Goolsbee in the New York Times writes, “When contemplating ways to prevent excessive mortgages for the 13 percent of subprime borrowers whose loans go sour, regulators must be careful that they do not wreck the ability of the other 87 percent to obtain mortgages.” James Surowiecki in the New Yorker makes the same gambit: “But what’s often missed in the current uproar is that while a substantial minority of subprime borrowers are struggling, almost ninety per cent are making their monthly payments and living in the houses they bought.”

I’m not here today to examine in detail the logical leap from a given rate of default to an acceptable social outcome; my experience is that those who are sufficiently ideologically averse to regulation of lenders tout court will find any delinquency rate up to 49.9% be consistent with the “most people win the bet” argument, and that those who have no a priori objections to regulated lending markets do not always begin by supposing that a non-delinquent subprime mortgage is always a sign of a borrower who is better off than a renter. In the sense that it isn’t really an argument about default rates anyway, parsing numbers about default rates isn’t going to solve it.

That said, the claim that “only” 13% or so of subprime mortgages are seriously delinquent does get waved about as an “economic indicator,” at least in the comment section of this blog. As far as I can tell, this purports to be an argument about the percentage of borrowers who are surviving their mortgages, and so for that reason, if no other, I’d like to take the opportunity to remind everyone what mortgage delinquency numbers actually tell you—and what they don’t.

In general, a delinquency or default rate on a given book of mortgages is calculated as the balance of delinquent or defaulted mortgages at the end of a reporting period divided by the total balance of the book as of that reporting period. For anything other than a mortgage security with a static pool, any given reporting period will involve new loans added, old loans paid off, existing loans paid on time and catching up, and existing loans becoming or continuing as delinquent.

In a static pool, such as a REMIC, no new loans are added, and so a calculation on current balances might be useful to an investor wanting to buy a seasoned security, but is less useful to anyone who wants to use delinquency rates to answer some general question about credit quality. Therefore, with static pools, one generally needs to calculate the delinquency rate in reference to the original balance, or to apply the “pool factor” (the percent of original balance remaining) to the delinquent balance, in order to account for the effect of prepayments of performing loans, which will, over time, push up the ratio of delinquent balances to total current balances even if no more loans become delinquent.

Prepayments, of course, create their difficulties even in calculating a delinquency rate on a non-static universe of loans like a servicer’s portfolio. In a static pool, a prepayment is a net decrease in the total pool balance; in a non-static book, a prepayment can simply be a rollover within a portfolio, or a movement of a loan from X’s book to Y’s book.

It does appear, sadly, that some people think that “national delinquency rates” are based on some total database of all outstanding loans, rather than on a sample of various reporters, some of whom report on static pools and some on active pools or books. If you’ve been thinking that, please adjust: these reported rates, such as the MBA’s, are based on a sampling of servicers, and they are adjusted statistically, in some manner, for the effect of prepayments.

The point here is that all you are getting is a percent of delinquent balances to total balances as of a date. First of all, “balance” is not “units.” Without further data-crunching, you cannot leap from a balance of delinquent loans to a number of delinquent borrowers; even if you have an average balance per loan to work with, you need an average loan per borrower to work with as well. That’s not a trivial issue: not only do individuals quite frequently carry two or even three mortgages per property, individuals can own more than one mortgaged property, and what we do know so far suggests that speculators have been getting caught in a delinquency problem in droves lately. Casey Serin may be—we hope—an extreme case, but he is a case of one borrower leaving a long trail of many defaulted loans in his wake.

Second, these are not “historical” numbers. Once a loan is removed from a book, through refinance, sale, final amortization or REO liquidation, it is no longer a balance on the original lender’s book. If a servicer liquidates REO in June, there is no longer a delinquent balance to report in July. Therefore, if the delinquent balance in July is identical to June’s, you have at least one new delinquent loan.

Some servicers may not even report loans in foreclosure—a state a loan may be in for many months before it becomes REO and the REO is liquidated—in the “delinquent” category, which is why you find nerds like me getting occasionally rather anal about the terms “delinquent” and “defaulted,” or “seriously delinquent,” or “non-accrual,” or “non-performing,” or “collateral-dependent,” or any of the other categories problem loans may be found in, depending on what one is up to and whose book is involved (servicing a loan, accounting for assets or loan income, taking an impairment, etc.). Even with a "vintage anaysis" that separates loans into year of origination, you have the potential problem of a purchase loan that closed in January being refinanced in September and becoming delinquent in December. That's two loans, one early payoff, one EPD, one year, and one borrower.

Third, loans go in and out of delinquency. You need the rate of “conversion” of mildly delinquent to seriously delinquent loans, just as you need the rate of conversion of NOD to FC, to use these numbers to predict eventual loss of a home. In markets where unemployment rates are low, for instance, loans that are delinquent due to sudden job loss can catch up in a month or two when the borrower finds new work. Over time, once-delinquent loans tend to converge on foreclosure; the recovery is often only temporary. But it does mean that any given month’s delinquency rate can be the same as the prior month’s, but a new set of loans has rotated into the delinquent pool.

I anticipate some howls of outrage about now. You mean to tell me that these delinquency numbers are just ballpark estimates and are not historical? These servicers are allowed to lie to us? Scratch a free-marketer, and you’ll find someone who secretly believes that a vast, heterogenous, discontinuous, non-centrally-planned and inconsistently regulated industry with participants who enter and exit over time not only can be but has been reporting uniform historical data to some central database which is freely and unproblematically available to the public, and therefore any inconsistency or incommensurate data must be another Enron. Go figure. It’s rather like arguments over MEW; there are always those who think that number gets “pulled off reports,” or that if it isn’t just “pulled off reports,” it’s “only” an estimate, and therefore invalid. I, who have spent many years in debates over “regulatory burdens” with people who do not understand that the industry is not exactly burdened by uniform centralized data reporting regulations, am here to tell you about pointless arguments.

Using delinquency data that we have, such as it is, to make certain claims about “subprime borrowers” as such is also a bit puzzling to those of us who recognize that “subprime credit,” in general, is composed of a lot of borrowers who have defaulted on debts in the past. If you put these borrowers into a new loan, for whatever reason you might want to do that, and that loan performs, at least for a while, it is going to show up in someone’s reporting somewhere as part of the “total balance” or denominator for which delinquent balances are the numerator.

By definition, however, it used to be in someone’s “delinquent balance” reporting. This is true to some extent even in the prime world; some people do manage to re-establish themselves after a credit disaster, and eventually work their FICOs back up into prime territory. Any given performing prime loan can represent either replacement of bad debt with (heretofore) good debt, or new debt to a borrower who has somehow managed to retire or bring current old bad debt with income or asset liquidation. In any case, the credit category at origination of any loan is not necessarily the credit category at payoff, or at any point in between, and it can be better or worse.

That may sound like a trivial point, but not only do you have serious writers like Goolsbee and Surowiecki wanting to get from delinquency rates to homeowners in an unproblematic fashion, you have people tossing around originations and outstandings in a rather startling way. For instance, somewhere between $450 and $650 billion in subprime mortgages were originated in 2006—it will depend on how you define “subprime” as well as whether you look at securities only or securities plus portfolios, and no, there is no law defining “subprime,” either. That does not mean that subprime mortgages outstanding increased by that amount. Only loans to first-time homebuyers (or refinancers who are currently free and clear) generate a net increase at the level of loan count outstanding within a lien category if they exceed the count of borrowers (or estates) who pay off in cash. Only net cash-outs plus net move-ups (where the new mortgage on the new home is larger than the old mortgage paid off by the seller) plus new home purchases (where commercial, rather than residential, mortgage debt is paid off by the seller) represent a net increase at the level of outstanding balance.

There is no law of nature that says that a subprime mortgage originated in 2006—or any year—replaced a previous subprime mortgage loan, either. A traditional use of subprime financing is to refinance a loan that started out “prime” and went downhill from there. And since mortgage debt is frequently used to replace non-mortgage debt, one cannot be sure that subprime mortgage originations are not a matter of moving delinquent debt off a credit card or auto book onto a mortgage book. This can happen in non-obvious ways. “Debt consolidation” mortgages are obvious, if not always easy to “read off a report” (see Greenspan and Kennedy’s major data problems). A refinance that merely extends the mortgage term to 40 or 50 years, without adding to the balance, can represent a freeing up of cash-flow that is redirected to retiring or bringing current delinquent non-mortgage debt. Once the market conditions are created whereby the mortgage book becomes the eventual home of a lot of consumer debt via refinance, and once mortgage refinance upfront costs become negligible in a way that vastly speeds them up—so that you can see a mortgage loan refinancing in its first year—delinquency patterns across debt types need very careful analysis.

One excellent counter to the argument that homeownership is always a better deal for lower-income wage-earners is the problem of immobility of labor: it’s a lot harder and more expensive to move to where the jobs are if you own a home. Another problem is the immobility of secured debt: you can transfer a credit card balance or an auto loan to a mortgage loan, but it’s rather difficult to transfer a mortgage balance to a credit card or do a cash-out refi on a car to retire that HELOC. Once you’ve secured non-purchase-money debt by a lien on your home, you have further immobilized not just your income capacity but your housing asset: one definition of a “lien” is non-transferability of the collateral under any circumstance except paying off the lienholder, and one definition of “innocence lost” is someone in shock over having to bring cash to closing in order to sell a home.

Furthermore, you might be able to improve your future access to unsecured credit by improving things you can to some extent control, like your payment history, income, and cash assets, but you can’t always improve your future access to a HELOC that way unless you can also do something about your local real estate market. If in the boom we tended to substitute quality of collateral for quality of borrower, we may find in the bust that quality of borrower cannot be substituted for quality of collateral. That may strike you as obvious, but apparently not everybody got that memo.

A “credit crunch” is a crunch: the famous immovable object meets the irresistible force, and the sound you hear is not a pleasant one. A rising delinquency rate can mean that more borrowers are delinquent than in the past; it can mean that fewer delinquent loans are rolling over into new loans as refi opportunities diminish; it can mean that fewer first-time homebuyers and less MEW are impacting the denominator. We may be seeing record delinquencies of subprime credit borrowers who got purchase mortgage loans they shouldn’t have gotten, and we may be seeing the bottom of the cascade, as many years’ worth of failing but not yet utterly failed mortgages, substantial numbers of which started out “prime” and many of which accreted a fair amount of consumer debt balances along the way, sift down into the subprime bucket, from which there is now a nasty line at the exit.

There is no particular reason to think any of this is good news, just because it may mean that the absolute number of delinquent borrowers at the moment is less than the current delinquency rate might imply. This is not a new problem. Subprime lending has never made any sense at all as a business proposition outside of expectations of continuing liquidity of the collateral; that’s why it periodically blows up in ways that prime lending historically has not. The question is whether prime has finally fallen into the old liquidity trap.

We are, therefore, back to using delinquency rates in the only way they make analytic sense, which is to look at the rate of increase as an indicator of distress without trying to map delinquent balances onto homeowner units, and to watch the relative mix of new prime and subprime originations. The “subprime contagion” meme is, in my view, creating analytic confusion in part because we are thinking about growth in prime delinquency as a matter of deterioration in the ability of some static pool of prime borrowers to manage their mortgage payments. What an increase in prime delinquencies may tell you, though, is that the cascade stopped or slowed significantly. A delinquent prime borrower is, ipso facto, a member of the subprime customer base. If the subprime lenders are not taking new customers at the moment, there’s a problem.

Without more data than a simple delinquency rate, one cannot rule out the possibility that the distress in prime has been there for some time, but the ability of delinquent prime to cascade into current subprime via refinance, and delinquent subprime to exit via sale of the home to a new prime or subprime borrower, have been sharply curtailed. Something, in other words, has plugged up the drain. Pick your metaphor—infection or hairball, they’re equally unappealing topics of Mother's Day dinner table conversation. Just don’t use the percentage of non-delinquent mortgages alone to “prove” anything unproblematic about the health of the consumer or the wisdom of homeownership.