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FRED
09-07-06, 01:33 PM
Bubbling Credit (http://www.aei.org/publications/filter.all,pubID.24868/pub_detail.asp)
September 7, 2006 (American Enterprise Institute)

Lon Witter (Barron's "The No-Money-Down Disaster," August 21) does an excellent job of making us focus on the insidious recursiveness of credit-inflated bubbles: the flow of credit makes asset prices rise, the higher asset prices attract more credit, the prices rise more, the experience of a lengthy period of rising prices induces happy confidence among both lenders and borrowers, while calling forth greater supply of the asset to meet what becomes speculative demand. In the last stage, lenders cheerfully make new loans to pay the interest on the old ones, which is what "negative amortization" really means. Of course, this whole interaction finally goes into reverse, cycle after cycle.

Jesse Jones, the head of the Reconstruction Finance Corporation in the 1930s, vividly summed up the results in his day:
"Strewn all over was the wreckage of the banks which had become entangled in the financing of real estate promotions and had died of exposure to optimism."
AntiSpin: This Letter to the Editor from Alex J. Pollock, a resident fellow at AEI, to Barron's contains an excellent quotation from Jesse Jones of the Reconstruction Finance Corporation.

Here's more on the topic from Joseph A. Schumpeter's Business Cycles, 1939:
"Consumers' borrowing is one of the most conspicuous danger points in the secondary phenomena of prosperity, and consumers' debts are among the most conspicuous weak spots in recession and depression.

"In other words, we shall readily understand why the load of debt thus light heartedly incurred by people who foresaw nothing but booms should become a serious matter whenever incomes fell, and that construction would then contribute, directly and through the effects on the credit structure of impaired values of real estate, as much to a depression as it had contributed to the preceding booms. Nothing is so likely to produce cumulative depressive processes as such commitments of a vast number of households to an overhead financed to a great extent by commercial banks."
In the face of ovewhelming evidence that the US banking system is heading into an iceburg of defaults, what we get from the Fed is this lengthy What Me Worry? paper (Sep/Oct 2006) from David C. Wheelock of the Federal Reserve Bank of St. Louis, What Happens to Banks When House Prices Fall? U.S. Regional Housing Busts of the 1980s and 1990s (pdf). (http://www.rgemonitor.com/redir.php?sid=1&tgid=10000&clid=4440&cid=144389) In a nutshell, this ass-covering document says that US banks appear to be in better shape than they were in before the last two housing busts in the 1980s and 1990s, all without ever actually admitting that a speculative boom ever occurred. The paper lacks conviction and is filled with assertions that are later negated by counterpoints, such as:

"These simple exposure measures indicate little, however, about whether banks have become more vulnerable to a decline in house prices. Without information about the risks of specific assets held by banks, one cannot determine definitively how vulnerable banks are to a decline in house prices. However, alongside the large increase in the size of bank residential real estate portfolios has been a substantial increase in bank equity capital relative to total bank assets. The greater a bank’s capital, the larger the amount of loan defaults and other declines in asset value it can withstand before becoming insolvent. Because capital serves as a cushion against loan and security losses, the increase in real estate loans and securities as a share of bank assets is probably less worrisome than it otherwise would have been."
We all know who the banks are counting on for capital, the same folks who always bail them out: US tax payers. Unfortunately, this time around, most of them don't have much in the way of savings, unlike during previous housing bust periods. Paradoxically, the reason households have so little saved to help them ride out a housing bust based recession is their misplaced confidence in their home as a store of value. This according to another recent St. Louis Fed (http://www.stlouisfed.org/publications/re/2006/c/pages/digging.html) report (our emphasis in italics):

"Between 2001 and 2004, the median value of total financial assets for families that reported holding any kind of financial asset fell by 23 percent, to $23,000. This decline followed a 15 percent increase from 1998 to 2001. Since the surge in financial assets between 1998 and 2001 happened against the backdrop of the U.S. stock market boom, it is reasonable to conclude that the stock market bust that began in early 2000 was one reason for this decline in the real value of household financial assets.

"A second reason for the decline in median family assets may directly reflect a reduced willingness to save. Between 2001 and 2004, the percentage of families that saved any of their income declined by 5.2 percent to 56.1 percent. From a longer-term perspective, this response was broadly consistent with the responses noted before 2001, and it suggests that nearly half the population might be financially ill-equipped for retirement. It also is possible that many families view the sharp appreciation in home prices as a substitute for saving.4 (http://www.stlouisfed.org/publications/re/2006/c/pages/digging.html#) Families also are borrowing on their home equity to make discretionary purchases." Thus, many families apparently look at their increased home equity as permanent saving and spend a greater percentage of their after-tax income.
In other words, households reduced their savings during the housing bubble because they believed that housing prices never go down, a fallacy that the Fed could have discouraged with a few words of wisdom from Big Al. Instead, he was pushing ARMs (http://www.washingtonmonthly.com/archives/individual/2006_08/009281.php). Because they saved less, they will be less able to fund expenses, such as mortgage payments, out of savings should household income decline, such as if the primary wage earner in the household loses their job in the coming recession.

We had the Reconstruction Finance Corporation (http://en.wikipedia.org/wiki/Reconstruction_Finance_Corporation), formed in 1932 after the US banking system collapsed and the Resolution Trust Corporation (http://en.wikipedia.org/wiki/Resolution_Trust_Corporation), formed in 1989 after the S&L collapse.

We propose that the Bush administration get ahead of the collapse of many US banks, large and small, as this massive and idiotic housing bubble ends and charter the Greenspan Bubbles Reconstruction Trust Corporation (http://www.itulip.com/bankrupt.htm) now.

jeffolie
09-07-06, 01:48 PM
The subprime mortgages are bundled and sold as mortgage backed securities, bonds (MBSs).

However, some MBSs have clauses that require the originators to buy them back if the mortgages default. Countrywide just ate about $100 million in buy backs. Also the originators do not lay off all their mortgages as MBSs, they keep some.

Plus, these subprimes often are negative amortization. These permit the originators to book earnings for money (mortgage payments) they never got. Its seems like fraud but the bank regulators encourage this deception, so the assets are fake with permission.

As far as being good shorts, banks will fail by the thousands when the financial system goes down.

SeanO
09-07-06, 04:31 PM
As far as being good shorts, banks will fail by the thousands when the financial system goes down.

Yesterday, in one central valley county of California, $1.2M in 1st mortgages were sold back to the bank, and $200k in 2nd mortgages were completely wiped out. That is a typical day lately.

The most amazing part is that despite the staggering losses involved, and the downstream implications there is NO ONE accurately and timely tracking these losses. The fact that there was a foreclosure, and that the property went back to the bank will show up in time, but the junior lien losses are completely untracked until some far away day when the lender is finally required to report them.

This issue, together with things like the neg am as earnings that jeffolie mentioned, will be blamed in hindsight for no one having saw what was coming. The real problem is the lack of desire to even look.

Rajiv
09-07-06, 10:18 PM
Well here in the SF Bay Area (Cupertino,) I have seen many more 'For Sale' signs coming up. A signal that owners are unable to keep up with the mortgage payments? Also a newly developed cul de sac of McMansions came on the market in January. Only two of the six houses have sold to date -- those that were the least expensive.

SeanO
09-07-06, 11:31 PM
Well here in the SF Bay Area (Cupertino,) I have seen many more 'For Sale' signs coming up. A signal that owners are unable to keep up with the mortgage payments? Also a newly developed cul de sac of McMansions came on the market in January. Only two of the six houses have sold to date -- those that were the least expensive.

Rajiv, this follows Eric's Geographic Regions Cascade (http://www.itulip.com/housingpriceregionscascade.htm) prediction pretty well. I do a lot of business in the central valley (Tracy, Stockton, Sacramento) and the correction is well under way in these SF Bay Area "suburbs", and appears to now just be starting to appear in the Bay Area proper. I still have friends on the Peninsula who think I'm smoking crack when I tell them they're next. They're convinced it could never happen there again, too much demand. As you note it has begun, and I believe Eric is right in his prediction that as metro's are last to the party, they will also be last to stabilize.

As for the for sale's signs you are seeing now, I'd estimate that they are still primarily speculators and retirees that are starting to see the writing on the wall. I watch every foreclosure in CA, and the biggest increase in activity I'm seeing is folks who bought a year ago with 100% financing and are just walking away instead of trying to feed the beast. ARM reset issues appear to still be a coming attraction.

BK
09-08-06, 08:46 AM
We are in the very early stages of the Real Estate deflation. Retirees (they have time to pay attention) and folks selling are a home are the only folks who truely appreciate how the Real Estate Market is changing.
Here on the East Coast if you said anything about a potential Real Estate Bubble (caused by the Credit bubble) every one was convinced you were a 'Nut Job'.
Today if you speak of the Real Estate bubble at a party you are merely 'misguided'.
A year or two from today you will be despised for not being embroiled in the misery.

tree
09-08-06, 08:53 AM
In Los Angeles, I have friends whose house is not moving. Fortunately, they're not in a financial position where they have to sell--they just want to move to San Diego because they like it better there. Anyway, they couldn't get their price (not sure if they got any serious offers) and last I heard it was coming off listing and they were planning to "sell by owner" and snag, via the Internet, a rich Asian speculator. These are bright people, but does this idea have any merit?

SeanO
09-08-06, 11:00 AM
In Los Angeles, I have friends whose house is not moving. Fortunately, they're not in a financial position where they have to sell--they just want to move to San Diego because they like it better there. Anyway, they couldn't get their price (not sure if they got any serious offers) and last I heard it was coming off listing and they were planning to "sell by owner" and snag, via the Internet, a rich Asian speculator. These are bright people, but does this idea have any merit?

Anything can happen, but I think their new strategy is flawed at best. A good Realtor really does earn their commission, the problem is that there are very few good ones. Especially in CA, where lawyers aren't typically involved, it is daunting, even for "rich Asian speculators", to buy direct without assistance with contracts, disclosures and the rest. If your friends want to save money, they might consider a flat fee Realtor that at least provides contract and transaction coordination as well as MLS access.

The other thing I like to remind folks in CA, is that it really pays to stay put. Prop13 fixes your property taxes at your purchase price (with minor bumps each year).

If your willing to take the tax hit, then there really is no bad market in which to move... it all becomes funny money. Whether it's a buyers or sellers market, your both, so its a wash.

Personally if I were your friends, I'd list my house with the best Realtor I could find... note the price a Realtor thinks they can get for the house may be inversely correlated to their ability to sell it. If it doesn't sell I'd whack the price every 2 weeks until it did. I'd then move to San Diego and rent for a while. In a declining market it doesn't hurt to wait. They can make sure they actually like the area, take the time to look for the right spot, and then stay put and enjoy the advantages of Prop13.