October 22, 2008 (Housing Market Monitor)

Short Sale: The Wave of the Future

October 22, 2008

By Dean Baker

"Banks can expect write-downs on short sales of at least $60 billion a year."

Most of the discussion of the housing crash has focused on the impact of mortgage resets, with the interest rate on various types of adjustable rate loans rising to levels that homeowners cannot afford. While this is an important problem, and the immediate cause of many people losing their homes, it is actually a secondary issue. The core problem is that house prices have fallen. If house prices had not dropped, then it would generally be possible for those facing mortgage resets to refinance their loans, as many had done in the past.

The biggest wave of mortgage resets occurred over the last two years, as the 2/28s (two years at teaser rates, with the rate in the remaining 28 years fluctuating based on the Libor) subprime ARMs issued in 2005 and 2006 reset. The number of subprime ARMs issued in 2007 fell off sharply as the problems in the market finally became clear to lenders.

However, there are many other waves of resets scheduled in the future, most notably the resets after five years that were standard in many pay option ARMs. These mortgages, which were especially popular in the ALT-A market, will mostly be resetting in 2010 and 2011. Many analysts have noted these reset schedules and wrongly assumed that there would be another wave of defaults and foreclosures following in their wake.

This will not be the case for the simple reason that many of these homes will already have been sold at that point. The median period of homeownership in the United States is just over five years. It is likely to be less for these homes, most of which are located in bubble areas and many of which were bought as investments.

The problem in these cases will not be defaults after resets, but rather the losses that are incurred on short sales. In many counties in California (including Los Angeles county), close to 40 percent of the sales are now short sales. Since few sellers have tens or hundreds of thousands of dollars to make up this shortfall, banks will have to absorb this loss.

Short sales will be an ongoing source of losses to the banks over the next few years. If just one-fifth of homes sales nationwide are short sales, with an average loss of $60,000 (@25 percent of the average house price) per home, this would imply losses to the banks of $60 billion a year. These losses will be in addition to the losses that banks will incur from future defaults or write-downs. There is a long way to go before the financial system is back to normal.

The latest data from the Mortgage Bankers Association showed a sharp decline in applications for both purchase and refinance mortgages. The purchase index decreased 10.9 percent from its week ago level, while the refinance index fell by 23.5 percent. While the weekly data should always be viewed with some suspicion, there has been a consistent downward pattern over the last month.

The purchase index is close to half its level at the peak of the bubble. Since many more applications are now being refused than in 2005 and 2006, this suggests that mortgage issuances for home purchases may be far below half of their bubble peaks. This would imply sharp declines in home sales for October.

The positive side of this picture is that a plunge in sales may lead to a more rapid adjustment in house prices. Many sellers stubbornly hold on to their houses with the expectation that prices will recover. A sharp falloff in the market may be sufficient to dispel this belief and lead sellers to accept prices that are more in line with current market conditions.

The plunge in refinancing applications is consistent with other evidence showing that consumers are sharply pulling back on their spending. While this is a necessary response to the loss of $5 trillion to $8 trillion in housing bubble wealth, this rapid decline in consumption will make the recession far deeper than if it were drawn out over a more extended period of time.   

Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, D.C. CEPR's Housing Market Monitor is published weekly and provides an incisive breakdown of the latest indicators and developments in the housing sector.