The U.S. is entering a "severe recession" driven by contraction in credit and a financial crisis with few historical parallels, making it difficult to forecast its length and severity, analysts at Fitch Ratings say.
The worsening outlook for unemployment means home prices may fall harder and take longer to bottom than previously anticipated, Fitch analysts said.
In a special report assessing the outlook for structured finance — mortgage-backed securities and similar investments that fund credit-card debt, auto loans and student loans — Fitch analysts warned that problems in the labor market could seep back into housing, "further exacerbating and extending the existing economic downturn and weakening collateral performance across sectors."
Unemployment will approach 8.5 percent by 2010, and that’s likely to push national home prices down more than the previously forecast 30 percent peak-to-trough decline, Fitch analysts said.
It will also take longer for home prices to stabilize, the report warned — an event many would-be homebuyers and lenders alike are looking for before jumping back into the market.
The underlying causes of the financial crisis are rooted in poor lending practices and the steep rise and subsequent fall in home prices, the report said, which have led to escalating foreclosures and mounting losses on mortgages.
The decline in both home values and stocks has reduced household net worth, and that — along with a growing number of layoffs — has consumers spending less and saving more, Fitch analysts said.
The pace of "consumer retrenchment" has "increased dramatically" over the past quarter, the report said, and that’s got businesses cutting back in anticipation of reduced demand.
Thanks to falling home prices and stock market declines, U.S. households lost $2.8 trillion in wealth during the third quarter, the Federal Reserve reported today. Households debt shrank at an annual rate of 0.8 percent, to $13.9 trillion — the first such decline in records going back to 1952. With more homes being foreclosed on and fewer households taking on a new mortgage, mortgage debt fell at a 2.4 percent annual rate, to $10.5 trillion.
Fitch expects business investment, which grew by 5 percent in 2007, to fall by around 6 percent next year, with U.S. gross domestic product falling 1.2 percent in 2009 compared with 1.4 percent growth this year.
While Fitch analysts had previously forecast that residential investment would bottom out in 2009, a postponement of at least one year now seems likely, the report said.
It’s become more difficult for businesses or households to borrow as "deleveraging" throughout the financial system has constrained credit and restrained economic growth, the report said.
Government initiatives should help lower borrowing costs by creating liquidity in the consumer lending, residential and commercial mortgage markets. But Fitch analysts expect that rising unemployment and uncertainty will cause consumers and businesses to remain cautious and continue to pull back on spending and investment over the near term.
"Until confidence in the economy is restored, cautiousness will outweigh any benefits from the governmental and private industry efforts to stabilize the financial and housing markets," the report said.
If and when home prices stabilize and stock prices stop falling, that will stop erosion of household net worth and help restore confidence, Fitch analysts said. They expect the pace, volume and flexibility of loan modifications will pick up in 2009, helping to slow the rate of foreclosures.
But as economic conditions continue to deteriorate, Fitch forecasts U.S. home prices — already down 22 percent from their 2006 peak, according to Case-Shiller data — will decline nationally by as much as an additional 10 percent. The picture is even worse in California, where Fitch now forecasts additional declines of 25 percent from today’s values.
Home-price declines leave more homeowners without equity, and make it harder for troubled borrowers to avoid foreclosure through a short sale, refinance or loan modification. The Mortgage Bankers Association estimates 2.2 million homes will enter the foreclosure process this year, and that layoffs and the worsening economy could increase that number in 2009 (see story).
Increased foreclosures lead to greater losses for lenders and investors in the securities that fund lending, which can result in a further tightening of credit. Declining home values, cuts in consumer spending, and rising unemployment have all reduced the availability of new mortgages, Fitch analysts said, as well as the performance of outstanding mortgages and related mortgage-backed securities.
Fitch expects that financial stress for all borrowers generally will increase in 2009, leading to further deterioration in the performance of all U.S. mortgage-backed securities.
After recently downgrading many securities backed by subprime loans and issued from 2005-07, Fitch analysts have begun to review investments backed by "alt-A" loans "to bring ratings in line with revised loss expectations," the report said. Fitch also plans to review its prime portfolio in 2009.
The report noted that "significant uncertainty" remains over the impacts of loan modifications and a government program to purchase the debt and mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae.
Loan modifications are "a welcome relief to bondholders," but they are not always in the best interest of investors, the report said.
Most loan modifications being contemplated involve interest-rate reductions, longer amortization terms, and forbearance of debt, which can reduce cash flow to investors who may suffer losses in the end anyway if borrowers re-default.
Data collected by federal bank regulators suggests more than half of borrowers who were granted loan modifications during the first quarter had re-defaulted after six months (see story).
But the Federal Deposit Insurance Corp. has estimated that, based on its own experience engaging in loan modifications, two out of three loans will stay current when payments are reduced to a more affordable level.
Ocwen Financial Corp. today reported that only one in four loans modified using the company’s loan modification software are delinquent by 60 days or more six months after modification.
Principal reductions are less widely used, but consumer groups and some lawmakers want to give bankruptcy judges "cram down" power to force lenders to forgive a portion of a borrower’s debt in cases where that would help them avoid foreclosure.
Fitch analysts said the impact of principal write-downs on investors in mortgage-backed securities and other securities is difficult to assess, because the practice hasn’t been widespread and there’s little data on the subject.
Mark Dotzour, chief economist and director of research at the Real Estate Center at Texas A&M University, is among those who take a dim view of such an approach.
The fact that the government is even willing to consider freezing interest rates on mortgages and cramming down principal "is not going unnoticed by bond investors," Dotzour said in a recent position paper. Reduced investment in mortgage-backed securities drives up the cost of borrowing, and the stigma of bankruptcy and foreclosure motivates borrowers to stay current on their payments, he said.
Dotzour advocates an explicit government guarantee for mortgage bonds issued by Fannie Mae and Freddie Mac, which he said would allow borrowers to refinance into 30-year mortgages with 4.5 percent interest rates.
To increase demand for housing, Dotzour said the government could provide tax incentives for investors, such as reducing the depreciation schedule for foreclosed houses to as little as five years, and eliminating capital gains taxes when investors hold those properties for more than five years.
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