Housing/Credit Crisis – Why There Is More Pain To Come

Some of the slides and statements that caught my attention on T2 Partners’ Overview Of  The Housing/Credit Crisis And Why There Is More Pain To Come:

Home Equity vs. Debt:

home-equity-history
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Debt and Financial Profits:

debt-and-financial-profits
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Mortgage Delinquencies Soaring in Q1 2009:

mortgage-delinquencies-q1-2009
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Mortgage Losses To Come (note the whopping 3.5 trillion for commercial mortgages):

mortgage-losses-moving-forward
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Recent Signs of Stabilization Are Likely the Mother of All Head Fakes:

Rather than representing a true bottom, recent signs of stabilization are likely due to two short-term factors:

1. Home sales and prices are seasonally strong in April, May and June due to tax refunds and the spring selling season

2. A temporary reduction in the inventory of foreclosed homes

– Shortly after Obama was elected, his administration promised a new, more robust plan to stem the wave of foreclosures so the GSEs and many other lenders imposed a foreclosure moratorium

– Early this year, the Obama administration unveiled its plan, the Homeowner Affordability and Stabilization Plan, which is a step in the right direction – but even if it is hugely successful, we estimate that it might only save 20% of homeowners who would otherwise lose their homes

–The GSEs and other lenders are now quickly moving to save the homeowners who can be saved – and foreclose on those who can’t

–This is necessary to work our way through the aftermath of the bubble, but will lead to a surge of housing inventory later this year, which will further pressure home prices

$2.5 Trillion Alt-A Mortgage Resets Are Only Still Ahead of Us:

alt-a-resets-ahead
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Option ARMs by State (Good Night, California!):

option-arms-by-state
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Home Prices Need to Fall 5-10% to Reach Trend Line:

home-prices-trendline
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…but after they reach the trendline, what keeps them from falling deeper? Markets always overshoot in both directions.

Comments From Mark Hanson, The Field Check Group, May 5, 2009:

California housing – at the low end – is ‘bottoming’ mostly because: a) median prices are down 55% from their peak over the past two years, thereby making the low end affordable; b) foreclosures have temporarily been cut by 66% through moratoriums reducing supply; and c) demand is picking up going into the busy season.

But the moratoriums are ending and the number of foreclosures in the pipeline is massive – they will start showing themselves as REO over the near to mid-term. The Obama plan held the foreclosure wave back, creating a huge backlog and now the servicers are testing hundreds of thousands of defaults against the new loss mitigation initiatives. We presently see the Notice of Defaults at record highs and Notice of Trustee Sales back up to nine-month highs – there is no reason for a loan to go to the Notice of Trustee Sale stage if indeed it wasn’t a foreclosure. However, the new ‘batch’ are not only from the low end but a wide mix all the way up to several million dollars in present value.

Because the majority of buyers are in ultra low and low-mid prices ranges, the supply- demand imbalance from foreclosures and organic supply will crush the mid-to-upper priced properties in 2009. We already have early seasonal hard data proving this. As the mid-to-upper end go through their respective implosions this year and the volume of sales in these bands increase as prices tumble, the mix shift will raise median and average house prices creating the ultimate in false bottoms. We also have data proving this phenomenon.
After a year or so the real pain will occur when the mid to upper bands are down 40% from where they are now, and the price compression has made the low to low-mid bands much less attractive – the very same bands that are so hot right now. Rents are tumbling and those that bought these properties for investment will be at risk of default (investors have been buying all the way down). Investors have just started to get taken to the woodshed from all of the supply and this will get much worse. Mid-to- upper end rental supply is also flooding on the market making it much better to rent a beautiful million dollar house than putting $300,000 down and buying.

After investors are punished — and with move-up buyers gone for years – it will leave first-time homeowners to fix the housing market on their own. Good luck and good night. Five years from now when things look to be stabilizing, all of these terrible kick-the-can-down-the-road modifications that leave borrowers in 5-year-teaser, ultra-high-leverage, 150% LTV, balloon loans will start adjusting upward and it will be Mortgage Implosion 2.0. These loan mods will turn millions of homeowners into over-levered, underwater, renters and ensure housing is a dead asset class for years to come.

Due to a confluence of events including a national foreclosure moratorium and near-zero sales in the mid to upper end during the off season, the broader housing data show signs of stabilization. Taken in context, it is a blip. There are no silver linings or green shoots in housing whatsoever other than by these first-time homeowners – former renters – who now find it cheaper to own than rent. This is a very good thing, but it only applies to a small segment of the population and will not be able to support the market. In addition, the first-time buyers who come out of the rental market put continuous pressure on rents.

Our data shows that the mid-to-upper end housing market is on the precipice of the exact cliff that the market fell off of in 2007, led by new loan defaults. What happens to the economy when you hit the mid- to-upper end earners the same way the low-to-mid end was hit with the subprime implosion? We will find out soon enough. When we look back on housing at the end of 2009, anyone that made positive housing predictions this year will not believe how far off they were.

…as I already noted in March, there is a Major Collapse in High End Properties Underway.

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Delevaraging, Contraction, Imploding Consumer Credit & Increased Saving – The Long Term Outlook

Asia Times Online makes some good observations in Easy bets with other folks’ cash:

Why then are investors persisting with this course of action that adds risks? Many theories have been propounded, but a clear framing of the future outlook would help to understand the sheer “courage” that is involved in buying such assets now. To make things easier, I have used a modified decision tree wherein the basic trend has been used as the title, with financial market consequences being highlighted below each such possible trend. Such an approach is provided below:

1. Green Shoots of economic recovery are for real (hahahahahaha, but let’s take these bubble-spewers at face value for now; or else read “Truth is too hard to handle”).

a. This could only be due to the US and European consumer spending money on borrowed time; yet again
b. Over the short-term that would argue for buying risky assets such as stocks and high-yield bonds and going short US Treasuries;
c. Inflation will rise inevitably, so buy physical commodities including gold;
d. Go short anything near the government bond curve including US Treasuries and German Bunds, among others.

2. We are into a Great Depression

a. The monetization of the debt cycle would have failed for this outcome to percolate to the masses in Europe and the US;
b. Financial institutions in Group of Eight leading industrialized countries cannot raise any capital from the public;
c. Forget about stocks, high-yield bonds that will fall in price dramatically just as soon you buy them for your retirement account;
d. Buy some government bonds, but only of countries that can service their future debt obligations (that is, avoid the likes of the US and pretty much all of Europe);
e. You will need to have some stuff that has real economic value rather than the worthless IOUs issued by G-8 governments, so buy some gold;
f. This might also be a good cue to buy some weapons and ammunition.

3. We will have a Y-shaped recovery (see How about a Y-shaped recovery, Asia Times Online, February 23, 2008.)

a. The US and Europe are toast, but emerging markets will do well;
b. Financial institutions in G-8 countries cannot raise any capital from the public;
c. Buy emerging market equities and bonds, sell everything else;
d. As most emerging market currencies are quite funky and don’t really fit into your wallets, you will need some gold for your travels.

My comment: I am of the opinion that #2 is the correct assessment of the current situation and that we have a long period of debt consolidation, consumer abstention, and wealth deflation before us. We are repeating the playbook from the Great Depression. Gold and silver should continue to hold the line. Government bonds should do fine throughout this period, see Time for Treasurys. Shorting commercial property ETFs in addition to that is a decent addition to any portfolio.

What the average reader thinks for himself is one thing; what he is being told by the financial media at large (and G-8 financial media in particular) is altogether a different matter. Whilst I would normally lean towards the school of an incipient economic recovery after a couple of years of any economic bust, a number of factors conspire to deny any such notion in my mind at the moment:

1. This is very much a crisis caused by excess leverage in the US (and, less so, in Europe). Until the leverage is washed out, there is no chance of any economic recovery;
2. Governments have engaged in widespread monetization of such leverage, rather than addressing the core event itself. This has the effect of actually making the future even more uncertain. For example, General Motors or Chrysler as private companies would have entered bankruptcy many months ago; but thanks to government intervention now re-emerge as worker-owned companies that couldn’t possibly get bank financing down the road (due to the destruction of creditors’ rights by the Obama administration). Ergo, this is money wasted by the government at great cost to the average US taxpayer: not exactly the recipe for an economic recovery;
3. Then there is the question of bank funding. Most analysts point to a funding gap of around US$20 trillion for the G-8 banking system by 2011, made worse by the reduced velocity of money (that is, a lower money multiplier). This problem has not been addressed, and most likely will not be; unless banks can pledge more useless collateral with their central banks and in effect get “free” funding;
4. Export-driven markets are toast, be it China or Germany or Japan. All these countries will have to reinvest in their domestic markets: some to fruitful results (China) but others to no avail (Japan). Whatever they do, it is clear what they will NOT do – that is, they will not buy more US sovereign and state-guaranteed debt;
5. Many of the weaker emerging market countries are facing funding pressures; particularly those in Eastern Europe. The resulting increase in defaults promises to fell the rest of the European banking system that hasn’t already fallen victim to the US financial collapse. This will also divert more resources from the International Monetary Fund and so on, to the expense of the G-8;
6. Increased strategic risks: think Pakistan’s ongoing fights with the Taliban, Iran’s nuclear weapons program, Russia’s anger with the North Atlantic Treaty Organization over Georgia as just a few examples of what could go wrong in the very, very near future.Based on all this, it is clear to me that the only people who could possibly believe that risky assets such as high-yield bonds and common stocks are a good buy are either the people who currently own them (and therefore will post profits when they rise in price) or those that need to get out of their positions (that is, sell their bond positions or raise new equity).

In most cases, the answer is “both of the above”, namely US and European banks who are loading up on some securities to cause artificial shortages that in turn help to raise prices of the rest of their books. These institutions have the benefit of knowing that a good trade gets them out of jail, but bad trades only result in more government assistance being lavished on them.

They aren’t playing with their own money, but rather with yours. When you are only ever going to lose other people’s money, the rules change and an entirely different “game” takes hold. That is what you are seeing now; until the final blows of economic data help to chase these fake rallies out of the market. When that happens, the biggest losers will be the people who own these risky assets like high-yield corporate bonds in the US (or Europe) and stocks of banks across G-8.

My comment: I marked the most important point in the passage above in bold. There is no end in sight for the current correction of this business cycle so long as the bad debts on balance sheets remain overvalued and uncorrected. For a good estimation of how long this may take, we can take a look at a recent report by the San Francisco Federal Reserve Board, titled U.S. Household Deleveraging and Future Consumption Growth:

How much deleveraging?

Since the start of the U.S. recession in December 2007, household leverage has declined. It currently stands at about 130% of disposable income. How much further will the deleveraging process go? In addition to factors governing the supply and demand for debt, the answer will depend on the future growth trajectory of the U.S. economy. While it’s true that Japanese firms and U.S. households may differ in important ways regarding decisions about paying down debt, the Japanese experience provides a recent example of a significant deleveraging episode that took place in the aftermath of a major real estate bubble and is useful as a benchmark.

The Japanese stock market bubble burst in late 1989, followed soon after by the bursting of the real estate bubble in early 1991. Nearly 20 years later, stock and commercial real estate prices remain more than 70% below their peaks, while residential land prices are more than 40% below their peak.

Figure 3 compares Japan’s nonfinancial corporate sector with the U.S. household sector over 10-year periods before and after the leverage-ratio peaks. In both countries, leverage ratios rose rapidly in the years before the peak.

After Japan’s bubbles burst, private nonfinancial firms undertook a massive deleveraging, reducing their collective debt-to-GDP ratio from 125% in 1991 to 95% in 2001. By reducing spending on investment, the firms changed from being net borrowers to net savers. If U.S. households were to undertake a similar deleveraging, their collective debt-to-income ratio would need to drop to around 100% by year-end 2018, returning to the level that prevailed in 2002.

The report concludes with the following outlook:

Conclusion

More than 20 years ago, economist Hyman Minsky (1986) proposed a “financial instability hypothesis.” He argued that prosperous times can often induce borrowers to accumulate debt beyond their ability to repay out of current income, thus leading to financial crises and severe economic contractions.

Until recently, U.S. households were accumulating debt at a rapid pace, allowing consumption to grow faster than income. An environment of easy credit facilitated this process, fueled further by rising prices of stocks and housing, which provided collateral for even more borrowing. The value of that collateral has since dropped dramatically, leaving many households in a precarious financial position, particularly in light of economic uncertainty that threatens their jobs.

Going forward, it seems probable that many U.S. households will reduce their debt. If accomplished through increased saving, the deleveraging process could result in a substantial and prolonged slowdown in consumer spending relative to pre-recession growth rates. Alternatively, if accomplished through some form of default on existing debt, such as real estate short sales, foreclosures, or bankruptcy, deleveraging could involve significant costs for consumers, including tax liabilities on forgiven debt, legal fees, and lower credit scores. Moreover, this form of deleveraging would simply shift the problem onto banks that hold these loans as assets on their balance sheets. Either way, the process of household deleveraging will not be painless.

My comment: My word exactly. I call it The End of Consumerism:

We need to respond to the reality around us rather than deny it. It is time to cut back and restore sanity and balance. Individuals have realized this and are doing the right thing. The government has not understood this fact at all. It is trying to keep alive failed businesses that should release resources for more demanded projects. It is trying to make up for the “lack of consumption” in the private sector. All these attempts will fail miserably. All they will accomplish is to slow down the corrective phase and turn it into a decade of agony.

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