How Housing Finance Actually Works

[Monirul Islam]

I've gotten a bunch of emails this week regarding my piece on the credit outlook for the bonds that make up the 2006 ABX indices, expressing wonderment that nearly 50% the bonds have already been paid down.

"How do almost half of the sub-prime loans get 'repaid'," asks a typical correspondent. "Are these 'refinanced'?"

In a word, yes—one way or another. In the real world, the typical 30-year mortgage doesn't last anything like 30 years. Rather, people sell their houses and move--and pay off their loans with the proceeds from the sales, then take out new loans to finance their new houses. Or, if they're subprime, they might raise their FICO scores and refinance the existing property on better terms.

Regardless, the way housing finance works, the vast majority of loans are repaid with the proceeds from new loans. In all, the typical 30-year mortgage loan lasts something like seven years or less. (A lot less, depending on the rate environment.) You shouldn't be surprised that subprime mortgages tend to be repaid even faster.

Repaid = Undefaultable
Anyway, one of my points was that 2006-vinatge subprime loans that have been paid down--$282 billion of the total $600 billion originated--cannot default. It is, as they used to say on the Saturday morning political chat shows, a metaphysical impossibility. Which is one reason I believe eventual cumulative losses on 2006 subprime originations will be materially below what the conventional wisdom seems to believe.

Ah, but skeptical readers come back, all this loan-refinancing mumbo-jumbo means is that the problem isn't solved, but just being pushed into the 2007 vintage. That's where things will really get ugly.

Maybe. But that argument has a few problems. First, it implicitly agrees that, well, yes, my analysis is correct and eventual losses from the 2006 vintage won't be as high as expected. I take that as quite a concession. Thank you.

2007 Originations Much Lower
But there are other problems, too. For starters, there just isn't as much stuff to blow up among the class of 2007. Subprime originations came to just under $220 billion last year, according to Inside B&C Lending, or only a third of originations in 2006. Granted, the bonds aren't performing as well as 2006's (My own analysis, using the same bond-by-bond methodology I used to look at the 2006 vintage, shows an expected 21.2% cumulative loss on 2007 originations.) But even on that higher number, the sheer dollar amount of 2007 losses figures to be manageable assuming that 2006-vintage losses come in as I expect. For the cataclysm the bears expect to occur, both years have to blow up badly.

Source: https://seekingalpha.com/article/74227-how-housing-finance-actually-works