SPECIAL GUEST FEATURE ARTICLE

Mid-to-High End Housing Market - a Slower-Moving Train Wreck

Edited and reprinted with permission of Mark Hanson, M. Hanson Advisors

One housing market segment that will not catch fire from anything being done is the mid-to-high end (MTH). This is where the next crisis is building right now. Only significant house price depreciation and low rates spur sales in this market segment.

Many are counting in large part on the MTH homeowner carrying the housing market, consumer spending, and the broader economy straight into a full-blown economic recovery. That is a lofty premise if they are talking about the same MTH borrower with whom I worked so closely with as a West Coast mortgage banker during the bubble years and whose loan performance I track daily across all originators and servicers through our proprietary data.

Contrary to a growing recent popular opinion that the MTH homeowner is feeling great, the negative wealth-effect remains powerful, increasing especially over the past few months as end-of-season price dumping and increased short sale activity continued to push prices lower.

Toll Brothers recent earnings release sealed the positive MTH housing sentiment for many. How selling a paltry 255 houses per month (75 more houses per month than last year) over the quarter at an average price of $562k with stimuli in full-effect is in any way indicative of the true health and risks in the MTH market escapes me.

The reason why the MTH has not tumbled in the same fashion as the lower price bands is simply because this group of Jumbo Prime, Pay Option and Interest Only borrowers a) have much more leverage with loans such as the Pay Option ARM, making up a large percentage of the total, b) have loans that were structured with interest only or negative-amortization teasers that typically last a minimum of five years versus two years on a Subprime loan, c) typically have more options available to them, such as cashing in retirement to keep kicking the can, d) generally have more stable employment and e) have a better chance of qualifying for a mortgage modification.

The bottom line: the MTH is a slower-moving train wreck, which in the macro may be worse than the way Subprime imploded. Subprime borrowers who got wiped out a couple of years after getting their 2/28 are way down the de-levering road - renting a property and living within their means, which is when spending can begin again, if they choose. At the end of the day, defaults and foreclosures across the MTH will be in high double digits but stretched out over a longer period of time.

This collapse will keep its borrowers financially strung out for years, as conscientious borrowers sell other assets or cash in retirement to keep making payments and others opt for a pro-bank mortgage modification in which most of their disposable income each month goes to repay their massively underwater monument to stupidity. Still, many will choose the route of default and foreclosure because with negative-equity so extreme in the MTH, they are renters anyway and foreclosure is the fastest road to household balance sheet recovery.

Price Dumping and Short Sales Destroy Values Just Like Foreclosures.

No doubt about it - peak-to-trough, the MTH has been devastated in the past year. Millions who purchased, refinanced or took out HELOCs on the way up, at the top, or moving back down the other side are in such a serious negative-equity state there is no traditional way out.

The hot period for MTH Real Estate was 2003-2007. During this time, 75%-80% of all houses either a) changed hands, b) were refinanced (including cash-out, which increased the loan balance, c) were built and purchased for the first time or d) were  leveraged further through the addition of a second or third mortgage. Yes, the potential at-risk population is the vast majority of MTH owners.

Later in the 2009 season, we finally saw more MTH houses turn-over but at sharp discounts or on short sale. Unlike the low end of the market, the increased activity was not spurredby a surge in buyer demand, but was rather due to end-of-season seller panic and increased short sale activity. That said, there is pent-up demand for this sector at the right price. The problem is that the right price on one sale destroys the net-worth of scores more. This type of increased activity in the earlier innings of the MTH collapse is not a positive market factor because it sets comps and locks-in values for everybody.

The bottom line: price dumping and short sales destroy neighborhoods just like foreclosures. In fact, they are a leading indicator to house price deflation, defaults and foreclosures. Remember that for every person who gets a "great deal," scores more are thrown into a negative-equity or greater negative equity position, exponentially increasing their likelihood of loan default. This sector is a negative-equity time-bomb across all loan types, even 30-year fixed.

A $1 Million House is Now the House of a Millionaire.

Today, these homes are the province of someone who can put down $270,000 and show proof of over $200,000 per year in income for the past few years. Oh, and a 740 credit score is paramount. Unlike the bubble years when a $1 million house could be purchased by a moderate income household (one working as a checker at Safeway and one a mailman - both great jobs with a combined gross income of over $100,000) - now, the buyers must be rich.

There are far more MTH houses on the market - and coming to market in the foreclosure pipeline - than there are rich buyers who a) do not already own, b) are liquid enough to buy a new house and rent their present house and c) are in the enviable equity position to be able to sell, pay a realtor and place a large down payment on their new house.

Mid-to-High End Reminiscent of 2007 Broad Market Conditions.

In the mid-to-upper end price bands, the same market dynamics are in play right now as were in the broader housing market in 2007. This market segment has absolutely gone over the top of the mountain and has begun its steep descent down the other side. The house price compression over the next year or two will be so severe that it will undermine any stability found in the low-to-low-mid bands, especially if stimuli are removed.

In the MTH, the foreclosure pipeline has never been as full. But, just like with the lower-end homes, foreclosures have been held back as banks try to retrofit every borrower with a mortgage modification. To date, most MTH foreclosures have been from a) vacant houses, b) borrowers that absolutely do not qualify for a mod or c) borrowers that turn down a mod realizing they are better off walking away or being foreclosed. This is changing fast.

The bottom line is that MTH foreclosure starts that result in actual foreclosures have been held down artificially, no doubt. This is because of the national foreclosure prevention programs but also because more Jumbo loans are owned by financial institutions as portfolio loans. This allows the bank the flexibility to do what they want (unlike Agency or Subprime loans serviced for others, such as a Mortgage Backed Securities investor). Lenders always fight harder when it's their own money on the line - think of Jumbo in the same fashion as commercial but to a lesser extent with respect to tampering.

The negative-equity across the MTH is extreme and high loan-to-value HELOCs are also common with this crowd. In fact, HELOCs behind Jumbo loans attached to MTH properties can be $250,000-$1,000,000, which is even greater motivation for the bank to kick the can as far down the road as possible.

Because of incurable negative-equity, tumbling rents, and overall harsh reality that they have become a renter in a 5,000 square foot house, premeditated defaults are a favorite among MTH homeowners. For those in a serious negative equity position, a pre-meditated loan default, short sale or deed-in-lieu is usually much better than any alternative because a) the borrower can rent the same house down the street for much less than the cost to own, b) leaving the house begins the savings, de-leveraging and credit repair clock and c) earning their way out of a $500,000 negative equity hole is simply out of the question for most.

The Argument that the Mid-to-High End Market is Isolated is hogwash.

Most think the MTH homeowner is somehow isolated from the broader housing market collapse. That's hogwash - there is extreme leverage in this sector. These borrowers are more impacted because unlike the low-end "hand-to-mouth" borrowers, MTH borrowers may have assets to attach or protect and perhaps something called a budget. Right now, in cities across America, there are married, working couples in MTH houses sitting around the dinner table saying "Honey, we make $150,000 a year. Why can't we save any money? Where does it all go each month?"

Jumbo Prime, Pay Options, Interest Only loans routinely allowed up to a 50% debt-to-income (DTI) ratio, even on a 30-year fixed loan. When purchasing a house or pulling cash out through a refinance or HELOC, most borrowed what their banker told them they could qualify for. Therefore, a large percentage of MTH owners with a mortgage are highly levered, coming out of the gate. Of the 50% DTI, most goes to the mortgage, taxes, insurance and maintenance. And of course, about half got a HELOC after the purchase, taking the DTI to 60%. That does not leave a lot for taxes, food, insurance and every other expense not listed on their credit report, let alone robust consumer spending.

In reality, the majority of MTH homeowners purchased or refinanced with a stated income or "no doc" feature, making it impossible to know the true extent of the leverage across the sector. One thing is for sure - it is higher than if it were full-doc or there would have been no reason so many used limited doc loans.

To think the MTH earner will somehow pull through this unscathed while leading high-end retail sales this holiday season is verging on laughable. Yes, stocks pulling off the bottom have likely benefited sentiment. But not to the degree that house prices plunging, their HELOC being shut down from further draws and credit card limits being slashed have hurt it. You can't easily spend an IRA or 401k. Just like everyone else, most MTH homeowners live virtually paycheck to paycheck - they just had more stuff and more debt. Without easy and available credit, this group of homeowners and spenders, by and large, is as hamstrung as the rest.

What happens to the economy when the MTH earner is knee-capped the same way the low-to-low-mid earner was knee-capped in 2007 when housing first fell off of a cliff? Stay tuned.

Mark Hanson is a mortgage banking expert who focused on residential mortgages and major Wall Street mortgage investors. Since 2006, he has been an independent real estate and finance analyst, consulting for financial services firms. He can be reached at mark@mhanson.com. 

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