Best of Kass: Subprime Bracketology

Several months ago, Freddie Mac(FRE Quote) forecast that mortgage equity withdrawals will drop by 20% this year and by another 30% in 2008. These projections were done before the subprime fungus spread, and I think its estimates are too high.

In 2006, subprime mortgage loans trebled (to 36%) as a percentage of all mortgages issued. "Liar loans," or non- and low-documented loans that relied on the candor of homebuyers (never an intelligent loan strategy!) doubled (to 40%) over the same time frame. Creative loans, characterized by teaser rates, negative amortization and interest-only, among others, became the New Big Thing in real estate and dominated the mortgages issued in 2006. Refinancing cashouts proliferated, and, according to BankAmerica Securities, the average loan to a subprime borrower rose from 48% of the property's value in 2000 to 82% last year.

While the media have been focused on the D.R. Horton(DHI Quote) CEO's bleak forecast, every quarterly conference call with leading homebuilders last quarter confirmed the mounting restrictions of credit by mortgage lender. Stated simply, it is growing harder and harder to get mortgages. In the interim interval, the subprime market's health has worsened and so has, on a daily basis, the availability of mortgage credit (the lifeblood of our economy's well being).

In light of the recent adverse loan experience and bad publicity, most originators are avoiding these loans like the plague. Today, no mortgage lending officer at any bank or thrift will dare stretch lending standards to home buyers, as the mandate of tightened loan-to-values and higher FICO scores are, increasingly, the directive from financial companies' management.

Moreover, the fixed income market has a diminished appetite for packaged subprime loans and a diminished appetite for any collateralized product that includes subprime loans. It is unlikely that the institutional investors will hunger for this product for some time to come and originators will be faced with the hard reality that subprime loans will face more limited demand in the primary and secondary markets.

With financial intermediaries turning off the mortgage loan spigot, first-time homebuyers and trade-up buyers -- who already are pressed by the lack of affordability (home prices divided by household incomes) -- will have markedly reduced access to the residential real estate markets. As a result, the cyclical decline in housing will be forced into another down leg, just at a time when inventories of unsold homes remain elevated and the volume of ARM resets peaks (in third-quarter 2007). As a consequence, the gradual decline in home prices seen over the last 12 months runs the risk of becoming a full-fledged waterfall slide.

The mortgage market's new reality will serve to immediately (and adversely) affect housing turnover and reduce the demand for expenditures on many products. Exacerbating the decline in personal consumption expenditures will be the virtual disappearance of mortgage equity withdrawals, which have been the straw that has stirred the drink of consumption since 2000.