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Thread: Risk Pollution and the Housing Bubble

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    Default Risk Pollution and the Housing Bubble

    Several readers who have been tracking iTulip's predictions for years sent us the Sunday New York Times article Crisis Looms in Mortgages by Gretchen Morgenson.
    On March 1, a Wall Street analyst at Bear Stearns wrote an upbeat report on a company that specializes in making mortgages to cash-poor homebuyers. The company, New Century Financial, had already disclosed that a growing number of borrowers were defaulting, and its stock, at around $15, had lost half its value in three weeks.

    What happened next seems all too familiar to investors who bought technology stocks in 2000 at the breathless urging of Wall Street analysts. Last week, New Century said it would stop making loans and needed emergency financing to survive. The stock collapsed to $3.21.

    The analyst’s untimely call, coupled with a failure among other Wall Street institutions to identify problems in the home mortgage market, isn’t the only familiar ring to investors who watched the technology stock bubble burst precisely seven years ago.
    This morning the developing mortgage debacle is front page news of the Wall Street Journal. James Hagerty, Ruth Simon, Michael Corkery and Gregory Zuckerman write:
    At a Mortgage Lender, Rapid Rise, Faster Fall
    Wall Street Fueled Growth at New Century
    A Party-Hard Culture

    Ruthie Hillery was struggling to make the $952 monthly mortgage payment for her three-bedroom home in Pittsburg, Calif., last summer when a mortgage broker called. The broker persuaded the 70-year-old Ms. Hillery to refinance into a "senior citizen's" loan from New Century Financial Corp. that she thought would eliminate the need to make any payments for several years, according to her lawyer.

    Instead, the $336,000 adjustable-rate loan started out with payments of $2,200 a month, more than double her income. In December, Ms. Hillery received notice that New Century intended to foreclose on the property. Then, earlier this month, after a formal demand by the lawyer, New Century agreed to refund all its fees and cancel the loan once Ms. Hillery gets refinancing elsewhere.

    The lawyer, Alan Ramos, says the loan never should have been made. "You have a loan application where the income section is blank," Mr. Ramos says. "How does it even get past the first person who looks at it?"
    AntiSpin: The future has arrived. A year ago when iTulip re-opened, we stated on our "About" page, "Letting millions of homeowners buy real estate they can't afford with mortgages they can never pay back is a surefire road to mass defaults that can cripple the banking system." The assertion met with derision by some in the MSM (Mainstream Media), such as in this piece by NPR. Business Week, on the other hand, was more supportive. Maybe a spirit of skepticism has worked its way into the editorial fabric there to compensate for past errors of complacency.
    "Now, of course, the crucial weaknesses of such periods–price inflation, heavy inventories, over-extension of commercial credit–are totally absent. The security market seems to be suffering only an attack of stock indigestion... There is additional reassurance in the fact that, should business show any further signs of fatigue, the banking system is in a good position now to administer any needed credit tonic from its excellent Reserve supply." Business Week, Business Outlook
    - October 19, 1929 (One week before the crash)
    Our coverage of the housing bubble story started nearly five years ago August 2002 when we explained in Yes. It's a housing bubble that housing prices rising much faster than rents and incomes indicated a bubble.

    January 2004 we explained that housing bubbles don't "pop." Housing markets first "seize up" then deflate slowly.


    January 2005 we laid out a seven step process of the housing collapse.

    June 2005, we called a top.

    As the New York Times did Sunday, back in January 2005 in Housing Bubble Correction we used home equity extraction as a yardstick to project the bust. Paul Kasriel at Northern Trust graciously provided the original data for our chart which shows home equity extraction from 1950 until 2005. We modified it to show a possible trajectory of home equity extraction decline in seven steps, A through G, from 2005 until 2020. At the time the projection was posted I said, "While I'm fairly confident in the length of the entire process, the length and timing of each step is subject to a wide range of error."
    Step A: You are here. Whether the rate of home equity extraction implodes from here (as shown) or decreases more gradually is a matter of debate, although in past boom-bust cycles, the bust rate of decline has been significantly more rapid than the boom rate of growth. What is not debatable is whether the rate of home equity extraction will revert to the mean rate of about zero, from the current rate of more than $250 billion annually. It will.

    In fact, the rate of home equity extraction will tend to overshoot the mean to reach an extreme negative rate of equity extraction (building equity) that's twice the rate of positive extraction that occurred during the boom phase. This relationship occurred in the previous two cycles, which bottomed in 1982 and 1995, respectively. This implies negative equity extraction of minus $500 billion per year at the cycle trough. Chart 2 shows a more optimistic prediction of negative $250 billion occurring between 2015 and 2020. This more prosaic estimate accounts for government efforts to mitigate the impact and minimize the overshoot, by offering specialized loans, making direct purchases of securitized mortgage debt, and so on.

    Step B: As housing prices begin to decline, sales will continue, though more slowly and less frequently. Old habits die slowly. One year into the decline, housing speculators will have left the market, but home owners will generally still believe that prices will either resume their rise or at least flatten out, not continue to decline. Remember the first year of the stock market bubble decline, when most people hung in there until they'd lost all of their money? The first lesson of behavioral finance is that the most common mistake made by market participants is to hang on too long and fail to cut losses.

    While home owners at this stage will borrow less against their houses, and loans will be more difficult to come by, the average home owner will still make frequent trips to Home Depot or hire contractors to make home repairs and improvements, believing they'll "get their money back" in an increase in the value of their home at least equal to the cost of fixing it. Some home owners will put their home up for sale—if they purchased early enough in the boom so that they can still realize a profit, even selling at five to twenty percent below the peak price.

    Step C: After prices have declined for two years, large numbers of buyers who purchased near the top of the market will begin to feel the psychological effects of being underwater on their mortgage. They will be less inclined to borrow money, or to spend money fixing up their home, as home improvement value increases will be swallowed up by general market price declines. There will still be profits to be made by those who bought very early in the previous boom cycle, but fewer people will have this option.

    As transaction volumes continue to fall, demand for housing-related employment will decline too. The first signs of labor market distress will start to show up, as more and more of that 43% of the private sector who found jobs in the housing industry are no longer needed. Coincidentally, major employers—such as the U.S. auto industry—will be going through major restructuring, adding to pressures on housing prices in some areas. Some home owners will need to sell at a loss in order to move to regions of the country where the labor picture is better, and will do this if they have enough equity and are not paying cash out of pocket to cover their remaining mortgage obligations. These sales will further depress home prices.

    Step D: Three years into the decline, marginal home buyers will learn what owning a home really costs, versus renting when housing prices are declining and jobs are more scarce. Rent is a fixed cost, whereas home ownership presents many variable costs, including increased interest payments on ARMs, and rising tax, insurance, and energy costs. Also, upkeep for the average home typically costs five to ten percent of the price of the home, annually. As prices fall, homeowners will have less access to home equity loans. Many will not be able to afford repair and maintenance expenses. Homes in some neighborhoods—and in some cases, entire neighborhoods—will begin to look neglected, further depressing prices.

    Step E: Five years into the downturn, rising unemployment will begin to more seriously affect the market, as indicated in Chart 1. As unemployment rises, homeowners will leave housing bust regions to move to areas where there are more jobs. Many houses will be sold at a loss, or even abandoned, as the market price falls below the loan value. Given the choice between paying cash out of pocket to sell their home or leaving the keys with the bank, many home owners will make the latter choice.

    Step F: Ten years into the downturn, real estate will be widely regarded as a terrible, "can't win" investment. McMansions will be subdivided for rental as multi-family homes.

    Step G: Ten to fifteen years after the start of the decline in housing values, prices will bottom out, setting the stage for the next boom. Time to buy.
    Where are we in the housing correction process? Let's compare the New York Times' actual home equity extraction chart to our forecast from January 2005.


    iTulip's Home Equity Projection, January 2005


    New York Time's Home Equity Extraction Actuals, March 2007


    The New York Times article shows that the market is correcting more slowly than we predicted, arriving at
    Step C as we near the two year mark in the housing bubble decline. We predicted that by now the market would be approaching Step D and zero home equity extraction.

    Let's skip right to the end, the final Step G: "Ten to fifteen years after the start of the decline in housing values, prices will bottom out, setting the stage for the next boom. Time to buy."

    Ten to fifteen years from 2005 is 2015 to 2020. At the current rate of decline, the housing market will be looking up again around 2018.

    Five years after iTulip started to report the housing bubble, and two years after it started to collapse, the MSM is on the story. Bad lending practices may be the world's most predictable financial scandal, but before you bash the MSM for being slow on the uptake, keep in mind that the New York Times and Wall Street Journal are in the news business, not the prognostication business, and it ain't news until it happens. (Tip for James Hagerty, Ruth Simon, Michael Corkery, Gregory Zuckerman, and Gretchen Morgenson: Contact the owners of this site where over 9500 appraisers have signed an online petition and learn about the equally predictable scandal that has been brewing for seven years as lenders bully home appraisers into inflating home prices.)

    But the real housing bubble story is not the terrible loans made to old ladies and drug addicts without jobs, the bullying of appraisers to commit felonies, and other shenanigans that typify any government-enabled systemic market fraud, whether in housing or dot com stocks. The real scandal, the one that will have us all digging deep into our wallets for bail out money, is the story of Risk Pollution.
    For several decades, unregulated chemical companies polluted the ecosystem with toxic chemicals. One well-publicized ecological mishap was the Seveso dioxin disaster in Seveso, Italy in 1976 where 3,000 pets and farm animals died and 70,000 animals were slaughtered later to prevent dioxin from entering the food chain. When first confronted with the prospect of government regulation, the chemical industry took the position that the cost of environmental protection cannot be born by chemical companies without reducing the incentive to produce these beneficial products. There will be less investment in R&D, less innovation. Without a constant stream of new chemical products, society will suffer.

    There is a seed of truth in any truly great lie. These toxic chemicals do help society. Thanks to DDT, for example, malaria was eradicating from Europe and North America in the 1950s. But that’s not why chemical companies produce these chemicals. They produce them to make money. Nothing wrong with that unless a meaningful portion of profitability depends on keeping the economic costs of environmental damage and cleanup off their balance sheets and on the backs of taxpayers.

    First generation government pollution control policy in the U.S. was, no kidding, "The solution to pollution is dilution." Mix enough air and water with pollutants then toxicity is reduced enough to make them nontoxic. This policy did not take into account that many pollutants are extremely toxic and tend to concentrate in the food chain (e.g., dioxin), and as the economy and population grew, the sheer quantity of pollutants overwhelmed the environment; there is not enough air and water to dilute the volume of pollutants produced. Worse, allowing corporations to externalize the social costs of pollution made the business appear to be more profitable than it actually was when all the costs are taken into account, leading to, in effect, a tax-payer sponsored boom in the toxic chemicals business and a corresponding increase in pollution.

    Hard to believe today that anyone ever seriously considered "the solution to pollution is dilution" as a practical approach by government regulators to protect the environment and the public from the chemical industry. But that’s the essence of the concept driving government regulation of many financial innovations today. As a result, various financial risk “toxins” pose the same threat to our financial system and economy as chemical toxins did to our environment forty years ago.
    The financial markets are polluted with risk. A massive government bailout will be required to clean them up. Bail out the GSEs. Bail out the banks. Bail out the borrowers. Yet even the larger Risk Pollution story is only a part of the whole story. Where will the housing, stock, and commodity markets and economy be five years from now? We are working up a new five year forecast which will be summarized for all to read. The detailed forecast will be available to iTulip Select subscribers.
    Last edited by FRED; 03-12-07 at 11:47 PM.

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