America's rotting foundations

With the US market closed for the Independence Day holiday, Gluskin Sheff chief economist, David Rosenberg, has sat down to do some maths on the US housing market. And the results he comes up with are far from encouraging.

Rosenberg starts by pointing out that two thirds of American homeowners have a mortgage – 56 million in total. About half of these mortgages are guaranteed by government sponsored enterprises, such as Fannie Mae and Freddie Mac, while a further 35 per cent are on the balance sheets of the banks.

The problem is that around 14 per cent of these 56 million mortgages are either already behind on their mortgage payments, or in the process of foreclosure. As he points out, this means that a  "staggering” 8 million American homeowners have stopped paying their mortgages.

Until now, banks have been extremely slow to foreclose on homes, partly due to pressure from the Obama administration, but also because the banks themselves haven't been too keen on seizing control of the troubled properties, because this would force them to recognise the losses on their loans. This has led to the extraordinary situation where 24 per cent of people who haven't made a mortgage payment in the last two years still haven't been foreclosed on.

As Rosenberg notes, when the banks finally get around to unplugging this foreclosure pipeline, the wave of properties hitting the market is likely to cause another drop in home prices.

The Obama administration did try to alleviate the foreclosure crisis with a $US75 billion mortgage modification plan. But this approach has been largely unsuccessful. As Rosenberg points out, about 50 per cent of the modified loans are re-defaulting within 12 months, despite the fact that the monthly mortgage payments have been cut by up to half. He argues that the main reason the mortgage modification plan failed was that defaulting home owners have negative equity in their homes – that is, they owe more than their homes are worth.

At present about 17 per cent of US homeowners have negative equity in their houses. If US house prices were to drop 10 per cent, the number of people "upside down” on their mortgages would jump to 27 per cent. And, of course, an increase in the number of people who are "upside down” on their mortgages will likely lead to a further dramatic increase in mortgage default rates.

More recently, the Obama administration has tried to help troubled home owners by encouraging them to sell their houses through a "short sale” process. Under this process, if troubled borrowers sell their properties for less than their mortgage, the lenders will be forced to accept the sale, and to write-off the difference between the property's sale price and what they are owed.

Rosenberg points out that if borrowers adopt this "short sale” process, then the banks will have to recognise heavy losses on their huge holdings of second mortgages. At present, the four largest US banks alone hold $842 billion in second mortgages on their books, and heavy downs on these loans will severely erode the banks' capital. "We have to be aware that the problems with housing finance are very likely to remain a huge overhang for many US banks in coming months and quarters”, he writes.

And, he warns that now that the homebuyer tax credits have expired, it's unlikely we'll see the Obama administration coming up with generous programs for saving the housing sector. "If Congress is no longer extending jobless benefits and state governments are now attacking public pensions, then it stands to reason that additional support for the housing market out of Washington is not forthcoming.

"This public backlash against more deficit finance is going to pose a big roadblock for any company linked to the housing sector, especially since whatever revival we experienced in the second half of 2009 and the opening months of 2010 was due to government intervention."