Home Prices & Loss Severity on Defaulted Loans
A week ago, Standard & Poor’s published the November results for its Case-Shiller home price indexes. The seasonally adjusted 20 cities aggregate index is now down -25.1% since its peak in July 2006. Common sentiment on the Street is that home prices have further to fall, and the numbers cited range anywhere from an additional -10% to -40% of declines before we see a bottom. No surprise there.
It’s also no surprise that delinquencies and default rates are rising as more and more borrowers are under water on their mortgages and can’t afford the monthly payments anymore because of rate resets and rising unemployment. What is surprising, though, is the historical connection between home price appreciation (HPA) and loss severity, i.e. the actual loss incurred by a lender after foreclosure. In times of rising home prices, a lender will barely lose money even if a borrower defaults: the delinquent borrower is forced out of the house, the property is put back on the market and the lender recovers most of the unpaid loan balance through the sale of the foreclosed property in an auction. Now take a look at this chart which I found in a recent presentation by T2 Partners:
The chart shows a scary connection between home price appreciation and loss severity. With 10% HPA per annum, a lender gets 95% of his money back if the borrower defaults. With a more modest increase in house prices of 3% per year, severity is at 60% – i.e. the lender gets only 40% of his money back. The above chart should be taken with a grain of salt since it is based on only five years of data and I have not been able to confirm the loan type, but it is powerful. Based on this picture, what will the loss severity be in an environment of rapidly falling home prices?