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Tuesday, April 22, 2008


depression-era housing

via housing wire -- a brilliant look back at the original ratings standards for mortgage-backed securities based on the experience of the great depression of the 1930s and the regional depression which accompanied the texas oil bust of the early 1980s.

S&P originally defined its loan-loss assumptions in the mid-1970s – it rated the first private MBS in 1977. ... To develop a worst-case, benchmark scenario of mortgage foreclosures and losses, the company had to look back to the Great Depression.

Although data was very limited by contemporary standards, S&P was able to derive base foreclosure-frequency assumptions from a study of the behavior of urban mortgage loans originated by 24 life insurance companies between 1920 and 1946 (published by the NBER). Based on this study, S&P defined a AAA depression as one in which 15 percent of all borrowers in the lowest risk category will default, a AA depression as one in which 10 percent will default. (In other words, to be rated AAA, a bond would require credit support that would withstand a number of iterations of the AAA depression scenario.)

The benchmark loan is a first-lien mortgage on an owner-occupied, single-family, detached house with an original LTV of 80 percent or less. ... Foreclosure frequencies would be adjusted higher for loans with additional risk factors, including historical delinquencies and severities, lien type, loan type, geographic concentrations and borrower quality.

The other component of the loss formula is loss severity, as most in the industry know. Again, S&P’s original benchmark for market value losses was the Great Depression. In an extreme stress scenario, market value declines would be a major component of loss. (Other components include unpaid accrued interest, legal and selling costs, property maintenance, and so forth. The severity of these vary from state to state as well as with economic conditions.) Based on Depression experience, S&P had determined the market value of single-family detached properties would decline by 37 percent under the AAA depression scenario, 32 percent under the AA scenario.

fifteeen percent of prime borrowers in default, 37% decline in housing prices -- with the trends in place, even in prime mortgages, these are eminently believable destinations in the next few years. this is a reminder that what we are experiencing in housing today is very much in line with the bust seen in the great depression. as was the texas experience on a regional level:

Texas/Oil Belt experience is of particular interest in the present crisis. The Fannie study indicated lifetime default rates of 8.5 percent on Texas loans originated in 1981-1983, while other data indicated foreclosures in Houston between 1980 and 1989 amounted to 16 percent of housing stock. Houston home prices declined about 30 percent. Likewise, S&P found loss severities reported by Fannie (and largely attributed to the Oil Belt states) were easily in the ball park of Depression-based assumptions: the GSE charged off 25 percent of aggregate principal balances of foreclosed loans in 1987, 28 percent in 1988 and 31 percent in 1989.

one can certainly make the case that what we're today experiencing, while not common, is also not exactly rare and certainly not unprecedented. and considering the incredibly easy terms of the 21st century mortgage -- little if any money down, teaser rates, even negative amortization -- i think it perfectly rational to expect something greater than that, to expect the worst housing bust in american history bar none.

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