Falling home prices create a wide swath of problems, one of the most pressing being rising foreclosure rates. And when a foreclosed home sells for less than what the borrower owed to the mortgage lender, the lender suffers a loss. The amount of that loss is known as the "loss severity," which includes the costs to foreclose and liquidate a home securing a defaulted mortgage, as well as any decline in property value.
Standard & Poor's Ratings Services' current ratings on the 2006 subprime U.S. residential mortgage-backed securities (RMBS) vintage reflect, in part, an assumed loss severity of 45%. That assumption includes our estimate that, based on our views on the current housing market environment, foreclosure costs and market value declines account for losses of 26.3% and 18.7%, respectively, in the loan balances of these mortgages. We project a 19% aggregate loss for subprime mortgages backing U.S. RMBS sold in 2006 based on assumptions for foreclosure and loss severity. The 19% assumption is the product of projected foreclosures of approximately 42% and the assumed loss severity of 45%.
A Closer Look At House Price Declines
Standard & Poor's current house price decline assumption is 33.4%, which is a 72% increase over the maximum price decline of 19.4% observed to date (see table 1). We believe this assumption appropriately protects against forecasted price declines through the housing downturn.
Table 1
Changes In House Price By Tier As Of January 2008 (Weighted By Geographic Distribution)
Quarter
Low (%)
Mid (%)
High (%)
Aggregate (%)
Q1 2006
(16.9)
(15.2)
(10.2)
(14.3)
Q2 2006
(18.7)
(16.5)
(11.5)
(15.5)
Q3 2006
(19.4)
(16.6)
(11.6)
(15.5)
Q4 2006
(19.0)
(15.6)
(9.9)
(14.6)
Q1 2007
(18.1)
(14.6)
(8.7)
(13.3)
Q2 2007
(16.1)
(13.3)
(9.1)
(12.1)
Q3 2007
(13.2)
(11.0)
(8.5)
(10.1)
Q4 2007
(5.9)
(5.7)
(4.3)
(5.1)
Source: S&P/Case-Shiller index.
See table 2 for the ways in which the house price decline translates into losses.
Table 2
Losses Due To Market Value Decline
2006 average original house price ($)
257,000
Value after decline of 33.4% ($)
171,162
2006 average original mortgage ($)
210,634
Loss due to market value decline (mortgage less net value) ($)
39,472
Loss due to market value decline (% of loan balance)
18.7
The 33.4% house price decline takes into account the initial sale price and location of the home. We base our house price decline analysis on the Standard & Poor's/Case-Shiller Tiered Price Index. Standard & Poor's/Case-Shiller house price indices are repeat-sales indices that track the price of the same home after two or more sales. Therefore, the index reflects the relative value of a specific property over time. The tiered index follows the same 20 cities included in the Standard & Poor's/Case-Shiller House Price Index, but the index is computed for three price tiers—low, mid, and high. The price tier definitions vary by city, reflecting local market prices. For example, a $400,000 home in Phoenix is well into the "high" price tier, but would be below the "low" price tier cutoff for San Diego.
By January 2008, the aggregate 20-city price index had declined 12.5% from its June 2006 peak. Generally, home prices in the lower price tiers have declined more than the average, while those in the higher price tiers have declined less than the average.
In our analysis, the timing of origination and the price tier are important considerations when assuming market value decline. The average price of a subprime home underlying Standard & Poor's-rated RMBS in 2006 was $257,000 based on the reported average loan-to-value ratio of 82%. We calculated the weighted average price decline based on the geographic distribution of the homes securing the mortgages. Given the relatively low prices of homes securing subprime loans, we believe the appropriate measure of price decline is that corresponding to the low tier (see table 2). The largest low-price tier decline is about 19.4% from third-quarter 2006 through January 2008. Note that this is an average, and in some areas, such as San Francisco, lower-priced homes have experienced declines of more than 30%.
The loans in the 2006 subprime vintage have geographic concentrations in California, Florida, Illinois, New York, and Ohio. The tiered city indices corresponding to these states are Los Angeles, San Diego, San Francisco, Tampa, Miami, Chicago, NY-Metro, and Cleveland. Table 3 shows the price decline for low-price-tier homes in five major cities. These declines are from each city's respective peak through January 2008.
Table 3
Price Declines From Peak To January 2008 (Low-Price Tier Homes)
City
Month of peak
Decline (%)
San Francisco
August 2006
30.4
San Diego
June 2006
28.6
Los Angeles
November 2006
21.9
Miami
March 2007
11.8
New York
October 2006
6.6
Source: S&P/Case-Shiller index.
Generally, properties sold after a foreclosure experience a greater market value decline than properties whose values decline from ordinary market fluctuations, and the discount is greater when sold in an area of declining prices (see note 1). In our opinion, two factors are the primary causes of this additional decline. First, when borrowers are financially distressed and default on their mortgages, they usually don't have the financial capacity, and may not have the incentive, to maintain the property. This typically pulls down the value of the property. We believe the second key driver of an exaggerated value decline is that the servicer is motivated to sell the property and may be willing to accept a below-market price. This partially explains why losses occur on foreclosures in rising markets.
Typically, foreclosed homes make up a small percentage of homes on the market. Nonforeclosed properties generally dominate repeat-sales indices such as Case-Shiller. A foreclosure sale typically results in a "discount" over and above the market value decline assumptions. We don't believe that this "discount" applies to the current subprime foreclosure inventory. Given the large number of properties in foreclosure, we believe that the sales of foreclosed properties will have a larger influence on house price indices than in the past. Recently, the Associated Press reported that nearly 50% of home sales in California are foreclosed properties, and that a study of home sales in 2007 indicates the trend is growing (see note 2). As such, we believe that current repeat-sales indices are probably more representative of resale prices on foreclosed properties than they have been in the past.
Standard & Poor's expects house prices to decline further before leveling off in early 2009. Thus, the 33.4% assumed house price decline, which is more than 1.5 times that experienced to date, reflects our forecasted 10% additional price decline (see "Economic Research: U.S. Economic Forecast: What I Tell You Three Times Is True," published April 9, 2008, on RatingsDirect), adjusted for the distribution of the underlying subprime mortgages.
Estimating Foreclosure Costs
Some of the many costs associated with foreclosing on a mortgage are fixed charges, while others vary as a percentage of the loan balance or property value. In the end, however, these costs are stated as a percentage of the loan balance, which, when added to the loss associated with the house price decline, results in the loss severity. Foreclosure costs vary by state. In our analysis, we weight the state-specific costs by the distribution of the underlying properties supporting Standard & Poor's rated U.S. RMBS and the general loan characteristics. Some typical costs and their assumed magnitudes are shown in table 4.
Table 4
Typical Foreclosure Costs
Interest expense (% of loan balance)
13.6
Property taxes (% of property value)
3–4
Legal fees (fixed charges as % of loan balance)
1
Broker fees (% of property value)
6
Maintenance (fixed charges as % of loan balance)
3
The percentages in table 4 aren't comparable, as some are stated as a percentage of the loan balance and others are stated as a percentage of the property value. When aggregated, total foreclosure costs are about 26.3% of the loan balance, on average.
Interest expense, or the carrying cost, is typically the next-largest expense in foreclosing and liquidating a home. We assume the average amount of loss attributable to interest expense is 13.6% of the loan balance, based on an average original interest rate of 8.2% for the 2006 vintage. From the time that a mortgagor first misses a scheduled payment until the liquidation of the property, interest continues to accrue on the loan and the related U.S. RMBS that the delinquent loan is collateralizing. Typically, the servicer will advance payments due on delinquent mortgages so long as the servicer deems the advances recoverable from proceeds made on the sale of the property. The servicer advance helps to provide the U.S. RMBS with a constant uninterrupted flow of cash on the underlying mortgages. These advances are temporary, however, and the servicer typically looks to the liquidation proceeds to repay itself for any advances. In calculating the carrying cost, the two key components we look at are the interest rate on the mortgage and amount of time that the mortgage is delinquent until liquidation. State foreclosure laws largely influence foreclosure times, so Standard & Poor's generally estimates foreclosure costs on a state-by-state basis using the assumptions in table 5.
Table 5
State-Specific Foreclosure And REO Timelines (Days)
Calif.
Fla.
Ill.
N.Y.
Ohio
Interest advance (foreclosure and REO)
373
400
520
556
460
Interest advance (pre-foreclosure)
92
97
90
122
124
Interest advance for bankruptcy
45
45
45
45
45
Interest advance for evictions
30
30
30
30
30
Interest advance for redemption period
0
0
30
0
0
Total
540
572
715
753
659
In addition to lost interest, foreclosure costs include fees associated with maintaining a property to retain its marketability, legal fees, brokerage fees paid upon the sale of the property, taxes, and insurance. Standard & Poor's developed its assumptions for these other expenses by analyzing data from various servicers. Through our Servicer Evaluation process, Standard & Poor's collects these data and inputs them into our SEAM database. We believe these costs are consistent with general market experience.
Many economists expect a weak housing market for the remainder of the year. As a result, we would expect to see home prices decline further and foreclosures rise. Standard & Poor's loss projections reflect this sentiment, and, barring any significant change in the economic environment, we believe our assumptions are appropriate.
Notes
(1) Anthony Pennington-Cross, "The Value of Foreclosed Property: House Prices, Foreclosure Laws, and Appraisals," OFEHO Working Papers, Working Paper 04-1, January 2004.
(2) Alan Zibel, "Foreclosure Costs," Associated Press, Feb. 12, 2008.
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