Challenges Continue For a Recovery of Virginia’s Mortgage Market

Challenges ContinueFor a Recovery ofVirginia’s Mortgage Market June 2009

Virginia’s mortgage debtproblem remains substantial and will take time to unwind

Loan performance continues to deteriorate at a significant rate Source: Mortgage Bankers Association (MBA)

Credit quality has weakenedover a prolonged period of time • When long-term mortgages were mainly funded with short-term bank deposits, lenders maintained tight credit standards to off-set their interest rate risk. • Starting in the late1970’s, the sale of loans on the secondary market grew substantially • Securitization reduced interest rate risk and created latitude for lenders to progressively liberalize lending standards. • Following the Tax Act of 1986, the rapid growth of home equity borrowing to support consumer spending added another element of credit risk.

Household mortgage debt has risen much faster than national GDP Source: Bureau of Economic Analysis (BEA) and Federal Reserve

A long-term rise in household debt was masked by rising home prices • During the housing boom, steep rises in home prices allowed distressed borrowers to easily refinance their debts. • This led to a falling rate of serious mortgage delinquency despite an ongoing decline in credit quality and growing levels of household debt. • The reversal of home price appreciation eliminated refinancing as an “exit door”, and left distressed borrowers more prone to foreclosure.

A long-term decline in credit quality was masked by rising home prices Source: Federal Housing Finance Authority (FFHA) and Mortgage Bankers Association (MBA)

Virginia’s foreclosure problem first took holdin Northern Virginia

The onset of falling prices in NoVA was a trigger for rising foreclosures • In 2007, foreclosures became a problem in NoVA following the onset of widespread price declines. • The first wave of foreclosures was mainly adjustable rate subprime loans—a large share of which had their first payment reset between mid 2007 and late 2008. • Prince William, Manassas and other submarkets with high concentrations of subprime loans were impacted first and hardest.

A drop in home prices lags well behind declining home sales • Declining home sales bring an end to price appreciation. • However, most sellers will wait a long time before they are willing to significantly cut their asking price. • Not until there is a large inventory of unsold homes will competition lead to a meaningful reduction in prices. • Even then, it takes large numbers of “distressed” sales to push prices significantly lower. • In the current market, the lag time between the initial downturn in sales and beginning of a meaningful drop in prices has been two full years.

The Prince William area illustrates the pattern seen in Virginia markets Source: MRIS

At the start of 2008, foreclosureswere heavily concentrated in NoVA Source: ReatyTrac

Now, downstate markets are beginning to see significant increases in foreclosures

In 2009, foreclosures are impactinga widening number of local markets Source: RealtyTrac

The housing decline in downstate markets is trailing NoVA by a full year Source: Virginia Association of Realtors

Late 2008 marked the onset of price declines in many downstate markets • Until recently, most downstate areas with high concentrations of subprime loans experienced fewer foreclosures than NoVA because their home prices remained relatively stable. • Since late 2008, downstate housing markets have seen a steep up-tick in foreclosure activity as price declines have become prevalent. • Rising foreclosure rates reinforce declining home prices, creating a reinforcing cycle—Consequently, foreclosures will likely continue to rise until home prices stabilize

Virginia’s foreclosure problem isnow becoming more broad-based • While subprime loans remain a serious problem, a second wave of payment resets is now causing “option payment ARMs” and “alt-A” loan foreclosures to rise. • In addition, the impact of the recession is beginning to increase default levels among borrowers with traditional fixed-rate mortgage loans. • Consequently, foreclosures are no longer mainly NoVA or subprime problems. • They are now a broad-based issue impacting a wide array of communities and borrowers.

Virginia’s Northern Tieris seeing a return tomarket fundamentals

Lower-end prices—inflated by relaxed underwriting—have returned to norms Note: Tiered price breakpoints are as of March 2009

Prices appear to be stabilizing, having fallen to pre-boom levels Source: MRIS

In NoVA, falling prices have spurred a rebound in existing home sales Source: MRIS

Rising home sales are reducing unsold housing inventory Source: MRIS

A big factor in NoVA’s salesrebound is increased affordability • In 2000, affordability was a problem mainly inside the Beltway • At the peak of the boom, affordability pressures were severe even in the outer suburbs • Today, affordability in the outer suburbs has returned to pre-boom levels Historic affordability threshold Source: MRIS and Census Bureau

What does the future hold for Virginia’s foreclosure problem?

Problem loans and unemploymentwill keep defaults high for some time • The huge wave of defaults due to payment resets on subprime loans is now waning. • However, a second wave of payment resets on “option payment ARMs” and “alt-A” loans will begin in late 2009 and extend through 2011. • This second wave of potential defaults will coincide with the likely impact of rising unemployment on borrowers’ ability to repay.

The wave of subprime resets is ending, but other loan types are now at risk Source: Credit Suisse, IMF Global Financial Stability Report, September 2007

Foreclosures are stabilizing in areas hard-hit by subprime defaults in 2008, but are increasing in other markets Source: RealtyTrac

Now, foreclosures are rising in areas with concentrations of “alt-A” loans Source: RealtyTrac

Fixed-rate loan defaults are also rising due to unemployment and falling equity Source: Mortgage Bankers Association (MBA)

Unemployment has increased substantially throughout Virginia Source: Virginia Employment Commission

Historically, rising unemployment leads to increased loan defaults • Unemployment is strongly correlated with rising mortgage defaults. • Usually, there is a lag between the initial rise in unemployment and an increase in default rates, because borrowers first exhaust public benefits and savings before they miss payments. • There is often a longer lag between the peak in default rates and the peak in unemployment, because at the highest levels of unemployment people are out of work for an extended time.

Default rates may continue to riseeven past the peak in unemployment Source: Bureau of Labor Statistics (BLS) and Mortgage Bankers Association (MBA)

Prices have not yet fully correctedin some downstate market areas • Despite recent declines, home prices remain high relative to incomes in some downstate areas • During 2009, historically low interest rates will provide temporary price support to offset otherwise weak demand • Nevertheless, downward price pressure should continue to be felt—especially in the Hampton Roads and Charlottesville, market areas Historic affordability threshold Source: VAR and Census Bureau

The downstate share of foreclosure auctions is rising, but there continues to be a lesserbuild-up of foreclosed homes than in NoVA Source: RealtyTrac

Foreclosed homes remain a major drag on NoVA’s market recovery • In 2008, NoVA’s inventory of foreclosed homes increased rapidly and dominated sales activity. • The inventory has dropped since December but is still extremely high. Source: MRIS and RealtryTrac

Rising foreclosures are slowingthe decline in lender-owned homes Source: RealtyTrac

The impact of foreclosed homes on local communities is expected to be concentrated in the Northern Tier Eligibility based on foreclosures reflects several risk factors as well as actual current foreclosed home inventories. ________________________________________________________________________ Source: U.S. Department of Housing and Urban Development (HUD)

The following factors will contributeto how quickly markets rebound • An upturn in sales marks the bottom of the market— As unsold inventory declines, prices will stabilize. • In NoVA, steep price cuts have contributed to a rebound in sales activity, declining inventory, and a bottoming-out of prices. • However, most downstate markets are still experiencing declining home sales and prices. • Price stability will ease foreclosures, but high default rates are likely to continue until the second wave of loan resets is past and unemployment levels begin to fall. • Increased sales will not significantly reduce the inventory of foreclosed homes until the default rate declines • Therefore, continued high inventories of foreclosed homes remain the primary obstacle to market recovery

What further risks lie ahead? • The length and severity of the recession remains an unknown. A layering of unemployment on top of current default factors will compound defaults. • A continued build-up of lender-owned homes will reinforce current price declines, destabilize neighborhoods, and inhibit market recovery. • There is the ongoing risk of further trauma in the credit markets that would significantly reduce the availability of affordable home financing. It is essential that an adequate supply of affordable mortgage funds remain available to enable increased sales.

Challenges Continue For a Recovery of Virginia’s Mortgage Market