Calculated Risk posted a thought-provoking chart showing how single family mortgage delinquency rates have largely tracked changes in the U.S. unemployment rate since 2005, which we've excerpted (see above right). From that chart, it would appear that foreclosure activity in the U.S. is pretty closely tracking changes in the unemployment rate.

Whenever we see that kind of apparently close correlation, we go the extra mile and try to map out the relationship that would appear to exist between the two factors. We've presented our chart showing the correlation between the U.S. unemployment rate and the U.S. single-family mortgage 90-day delinquency rate to the left (larger version near the bottom of this post.) What's more, we've also created a tool for projecting the foreclosure rate from the U.S. unemployment rate based on the data as it's behaved since January 2004.

Running the numbers for an unemployment rate of 10%, we find that we might expect the single-family mortgage delinquency rate to increase to a level around 2.7% of all mortgages, based upon the correlation we observe in the data that appears to have existed since 2004.

The problem is that correlation between the U.S. unemployment rate and the percentage of mortgage delinquencies would appear to be something new.

We find that to be the case in an 1998 working paper from the Federal Reserve by Peter J. Elmer and Steven A. Seelig The Rising Long-Term Trend of Single-Family Mortgage Foreclosure Rates. Here, Elmer and Seelig considered the relationship between the unemployment rate and the rate of mortgage foreclosures in the United States from 1950 into 1998.

They found that, contrary to the pattern we observe today and to what people might reasonably expect, that there was no real correlation between changes in the rate of U.S. unemployment and the rate of mortgage foreclosures. The chart to the right graphically presents both rates, along with the 10-year Treasury yield for reference. [Note: We've previously featured a tool that predicts 30-year conventional mortgage rates given the 10-year U.S. Treasury yield.]

We believe the difference between how the relationship between how the rate of delinquencies and the rate of unemployment from the 1950s into the 1990s and from the 1990s to today may be attributed to changes in the mortgages themselves beginning in the 1990s. Primarily, what changed were the lending standards.

Throughout much of the late twentieth century, mortgage lenders required homebuyers to invest significant equity in their properties, requiring substantial down payments at the time of purchase. Often representing 20% of the market value of the homes being bought, this equity stake helped insulate the mortgage lenders from the employment status of the homebuyers.

Likewise, the homebuyers were in part insulated from having their home foreclosed upon during such periods of unemployment thanks to this margin of safety. They could draw upon their home equity, either through taking out home equity loans or by selling their homes, to avoid the fiscal calamity of foreclosure.

But, beginning in the 1990s, the systematic erosion of such lending standards also led to the elimination of this safety margin. As a result, the margin of safety for significant numbers of mortgages shrank, exposing both lender and borrower to an increased risk of foreclosure in the event the borrower became unemployed.

That's exactly what we're seeing play out today.

But we believe that will end, given that we see that the rate of mortgage delinquencies appears to already be slowing, even as the unemployment rate increases.

Running the numbers for higher levels of unemployment suggests that as the unemployment rate increases, the percentage of mortgage delinquencies will peak around 2.8%. Intuitively, we believe that makes sense since we would expect that as the substantial already number of foreclosed properties are sold to new buyers who are being held to higher lending standards, the loans represented by these properties will move from the numerator to the denominator in the calculation of the delinquency rate.

Consequently, we would anticipate that the apparent correlation we are currently observing between the U.S. unemployment rate and the delinquency rate of single-family mortgages will break down, even if unemployment rates continue to rise.

Data Sources

We obtained the monthly unemployment rate data for the U.S. from the BLS' Current Population Survey database. Meanwhile, we obtained the corresponding monthly single-family 90-day delinquency rate for all mortgages spanning January 2004 through May 2009 from the following Freddie Mac reports for the indicated years:

• 2004 - Table 7
  
• 2005 - Table 6
  
• 2006 - Table 6
  
• 2007 - Table 6
  
• 2008 - Table 6
  
• 2009 - Table 6 (through May 2009)

Labels: economics, real estate, tool

- posted by Ironman at 1:36 PM | Permalink | Home |