Global Economics

Housing Liquidity Crisis Coming: Debt Deflation Follows

A liquidity crisis in housing is on the way. Non-banks are at the center of the storm.

The Brookings Institute says a Liquidity Crises in the Mortgage Market is on the way.

This is in guest post format. What follows are key snips from a 68-page Brookings PDF.

This article isn't very long. My comments follow.

Abstract

Nonbanks originated about half of all mortgages in 2016, and 75% of mortgages insured by the FHA or VA. Both shares are much higher than those observed at any point in the 2000s. We describe in this paper how nonbank mortgage companies are vulnerable to liquidity pressures in both their loan origination and servicing activities, and we document that this sector in aggregate appears to have minimal resources to bring to bear in a stress scenario. We show how these exact same liquidity issues unfolded during the financial crisis, leading to the failure of many nonbank companies, requests for government assistance, and harm to consumers. The extremely high share of nonbank lenders in FHA and VA lending suggests that nonbank failures could be quite costly to the government, but this issue has received very little attention in the housing-reform debate.

Nonbank Stress

There is now considerable stress on Ginnie Mae operations from their nonbank counterparties:

“. . .Today almost two thirds of Ginnie Mae guaranteed securities are issued by independent mortgage banks. And independent mortgage bankers are using some of the most sophisticated financial engineering that this industry has ever seen. We are also seeing greater dependence on credit lines, securitization involving multiple players, and more frequent trading of servicing rights and all of these things have created a new and challenging environment for Ginnie Mae. . . . In other words, the risk is a lot higher and business models of our issuers are a lot more complex. Add in sharply higher annual volumes, and these risks are amplified many times over. . . . Also, we have depended on sheer luck. Luck that the economy does not fall into recession and increase mortgage delinquencies. Luck that our independent mortgage bankers remain able to access their lines of credit. And luck that nothing critical falls through the cracks. . . ”

Nonbank Share in $Billions

GSEs and Ginnie Mae

Although both the GSEs and Ginnie Mae guarantee mortgage-backed securities, there are a number of essential differences. In particular, Ginnie Mae servicers are exposed to greater liquidity strains, and a greater risk of absorbing credit loss, than GSE servicers.

Guarantee and Issuance of Securities

Guarantee and issuance of securities Both the GSEs and Ginnie Mae provide a guarantee to their mortgage-backed securities (MBS) investors that they will receive their payments of interest and principal on time. One crucial difference between these institutions, though, is who issues the underlying securities. The GSEs purchase loans from mortgage originators and issue the securities themselves. For Ginnie Mae MBS, financial institutions originate or purchase mortgages and then issue securities through the Ginnie Mae platform. In both cases, the loans in the securities have to meet certain underwriting standards and other requirements. The GSEs set the standards for the loans in their pools. For Ginnie Mae pools, the standards are set by the government agency that provides the insurance or guarantee on the mortgage (Federal Housing Administration, Veterans’ Administration, Farm Service Agency, Rural Housing Service, or Office of Public and Indian Housing).

Insurance Against Credit Risk

Another crucial difference between the GSEs and Ginnie Mae is who bears the credit risk associated with mortgage default. As shown in figure 3, for loans in GSE pools, the mortgage borrower takes the initial credit loss (in the form of her equity in the house), followed by the private mortgage insurance (PMI) company (if the mortgage has PMI), and then the GSE. For loans in Ginnie Mae pools, the mortgage borrower is again in the first-loss position, followed by the government entity that guarantees or insures the loan. However, the Ginnie issuer/servicer — unlike in the GSE case — is expected to bear any credit losses that the government insurer does not cover. Ginnie Mae covers credit losses only when the corporate resources of the issuer/servicer are exhausted.

Loss Priority

Servicing Strains

Figure 12 shows the share of all mortgages in 2016 that were originated by nonbanks and insured by the FHA or VA.

Servicers with heavy concentrations may be more vulnerable to servicing-advance strains.

Consequences of a Nonbank Mortgage Company Failure

In the event of a failure of a nonbank mortgage company, there are three main types of parties who would bear losses: (1) consumers; (2) the U.S. government and, by extension, taxpayers; (3) the nonbanks, their shareholders, and their creditors.

If nonbank failure resulted in a reduction in mortgage origination capacity, it is not clear that other financial institutions would extend credit on the same terms to these borrowers, or perhaps even extend credit at all. This contraction in mortgage credit availability has the potential to be a significant drag on house prices.

Mish Comments

The Brookings article is 68 pages long. The above snips capture the essence of their liquidity crisis claim but they provide much more detail.

Shocks Coming

Nonbanks are vulnerable to macroeconomic shocks, rising interest rates, home price declines and job losses, often with a bare minimum down payment.

This is happening while debt-to-income DTI ratios are on the rise and median FICO scores are dropping.

This is hardly surprising given homes are not affordable.

Failure is a Given

Brookings provides the failure hierarchy, and failure is a given.

To keep the latest bubble going, nonbanks kept lowering and lowering credit standards as home prices kept rising and rising.

This is a recipe for disaster, and disaster is at hand.

Housing Collapse Coming

Four days ago, before I saw the Brookings article, I commented Housing Collapse Coming Right Up.

The Brookings article reinforces my opinion.

Meanwhile, overdue debt is at a seven-year high. Distressed debt surged 11.5% in the fourth quarter.

​The Financial Times also notes "More Americans are also falling behind on their mortgages, for which problematic debt levels rose 5.2 percent over the same period to $56.7 billion."

Deflationary Debt Trap Setup

These numbers are huge deflationary. When credit expands there is inflation. When credit contracts (think defaults, bankruptcies, mortgage walk-away events), debt deflation occurs.

Here's my definition of inflation: An increase in money supply and credit, with credit marked to market.

Deflation is the opposite: A decrease in money supply and credit, with credit marked to market.

Looking Ahead

In a fiat credit-based global setup, this is how the real world works.

Unanimous Opinions

Seldom are opinions nearly unanimous. This is one of those times. Nearly everyone is looking for "inflation".

We have it! It's in home prices, junk bond prices, and equity prices.

The equity bubble is about to burst. For discussion, please see Sucker Traps and the Arithmetic of Risk.

Rear View Mirror Inflation

We have so much inflation that Inflation is in the Rear-View Mirror.

The inflation economists expect to happen, already has happened, in stocks, in home prices, in junk bonds.

They don't see it because they do not understand what inflation really is.

Debt Deflation Coming Up

I expect another round of asset-based deflation with consumer prices and US treasury yields to follow.

Mike "Mish" Shedlock

28 Responses

  • Bam_Man

    Mar 9, 2018

    Absolutely spot-on. And BTW, when was the last time the Fed didn't tighten right into a recession? I'm sorry, but I've only been following financial markets for 30+ years, so I can't answer that question.

  • MtnMan

    Mar 9, 2018

    Great Article. I'm in Canada and our housing bubble is starting to pop. Likely a recession on the way here and maybe in the US as well. Time to clean up the portfolio and ensure I only own what I want to own during a bear market.

  • AWC

    Mar 9, 2018

    Looks like the Fed is going to end up quite the MBS holder. By now they should have lots of practice. No little TARP this time. Instead it will be 3 Ring Circus Big Top.

  • SleemoG

    Mar 9, 2018

    What would a Plunge Protection Team look like under Trump? Yikes!!!

  • AWC

    Mar 9, 2018

    Contrary to a coming deflation, I would be more willing to bet on Stagflation. The Fed frantically monetizing everything in sight, while the debt monster gobbles it all up. Ala, 1970's, only turbocharged. "We have a printing press, and we know how to use it." Ben Bernanke.

  • AWC

    Mar 9, 2018

    Not to fret,,,,it will all be in the interest of "National Defense." Sells it a little easier.

  • Mike Mish Shedlock

    Mar 9, 2018

    anything for the sake of "national defense"

  • Rayner-Hilles

    Mar 9, 2018

    Wrong again Mish. Shadow banking is good for economic growth and mitigates financial crises. Alan Greenspan said so back in 1999. https://www.federalreserve.gov/boarddocs/speeches/1999/19991019.htm You are wrong to insinuate that nonbanks are responsible for intermediately fuelling another even more reckless housing bubble whilst the banks were this time around too shy to directly fuel it themselves. Nonbanks facilitate the MANAGEMENT of risk - not the taking of risks. Alan. Greenspan. Said. So.

  • MorrisWR

    Mar 9, 2018

    And we know Greenspan is the god of economics so we must follow! This was a very good article but I doubt many people see anything bad coming. I had also thought of a stagflation scenario (I remember the 70’s) but now believe it will be full on deflation. It should not be too long now before we know. Trump is moving on tariffs with extremely poor timing. We may start calling tent cities Trumpvilles.

  • Realist

    Mar 9, 2018

    I remember the 70s as well (and of course the decades since). I remember worrying about the coming collapse of the financial system. Until someone very old and wise (my grandfather) pointed out to me that the voices of doom are always there. He suggested that I ignore the voices of doom, learn as much as I could, work hard, save, invest, buy a house, marry, have kids, and enjoy living in one of the best countries in the world. I changed from an angry pessimist, to a realistic optimist. And I’ve never looked back. Even if some of the predictions of doom come true (which I often doubt) mankind has a tremendous ability to bounce back. I certainly can’t predict the future. All I can do is live my life to the fullest. I don’t ignore the prophets of doom, but I also don’t have to believe everything they say. I quite enjoy reading Mish’s blog. I just think he is a bit too pessimistic.

Join the conversation at Mish Talk...