TCS Daily

Betting the House?

By Desmond Lachman - July 26, 2007 12:00 AM

Hope springs eternal on Wall Street. For despite short-lived periodic concerns about the US sub-prime mortgage lending fiasco, Wall Street analysts almost uniformly put a positive spin on the present unraveling of the US housing market. By so doing, not only do they downplay the housing market bust's likely overall macro-economic consequences. They also give one an eerie feeling of déjà vu. Were not many of those same Wall Street analysts assuring us in 2001 that there would be little macroeconomic fallout from the bursting of the equity bubble only to have to backtrack on those assurances as the year progressed?

In downplaying the seriousness of the present deepening of the mortgage market crisis, Wall Street analysts are generally making two points. First, they are arguing that sub-prime lending is a relatively small part of the US mortgage market with limited significance for the overall US economy. Second, they are arguing that even in the sub-prime mortgage market space, the problems will be contained since the US housing market is now in the process of stabilizing. Sadly these analysts would appear to be very wrong on both counts, which has to explain why they are overly sanguine about the potential impact of the housing market's present woes on the overall US economy.

Far from being a niche market, the US sub-prime mortgage market has attained major proportions over the past several years. It has done so as overall mortgage regulatory oversight was being relaxed and as an increased proportion of US mortgage lending was being securitized. By 2006, sub-prime mortgage lending accounted for as much as 20 percent of overall mortgage lending. As a result, the amount of sub-prime mortgages outstanding presently totals as much as US$1.3 trillion, or the equivalent of 10 percentage points of US GDP. Further complicating matters is the fact that there is presently an additional US$1 trillion outstanding in Alt-A mortgage loans, which are mortgages to borrowers with only a marginally better credit rating than those who borrow in the sub-prime mortgage market.

The troubling aspect of the past orgy of sub-prime mortgage market lending is that it could result in very meaningful losses for the US financial system that in turn could make US banks more reluctant to extend credit in general. The real danger of such a credit crunch is underlined by the fact that most sub-prime lending was made without income or asset verification and was made with unusually high loan-to-home value ratios. In the event that sub-prime lending was in the end to be written down by 20 percent, one could be looking at overall losses for the US financial system of anywhere up to US$250 billion. Were that to occur, the overall cost of the present US sub-prime lending crisis would exceed by a wide margin the cost of the 1981 savings and loans crisis.

The Wall Street optimists assure us that we have most likely seen the worst of the sub-prime mortgage crisis since they claim that the US housing market is now showing signs of stabilizing. In making that assertion, they happily overlook the presently very saturated state of the US housing market as indicated by historically high vacancy rates and a rapidly rising inventory of unsold homes. They also overlook the fact that housing supply is now almost certain to be substantially boosted by the increasing number of housing foreclosures already underway and by an unwinding of large speculative positions in the housing market.

More serious still perhaps is the downplaying of the series of factors presently in evidence that will be conspiring to substantially undermine housing demand in the months ahead. Among the more troubling of those factors are the recent 50 basis point back-up in long term interest rates over the past few months, the belated tightening of regulatory mortgage lending standards now underway, and the scheduled rise in the pace at which adjustable rate mortgages reset from around US$25 billion a month at present to almost US$50 billion a month by year-end.

As the US housing market crisis deepens in the months ahead, fingers will be pointed at those who might have contributed to the earlier housing bubble. What was the Federal Reserve thinking a few years ago when it was encouraging the use of adjustable rate mortgages and the development of the sub-prime mortgage market? Why have the rating agencies been so slow in downgrading sub-prime mortgages and in failing to protect less informed investors? Were the investment-banks behaving responsibly in originating mortgage loans in large quantities that they must have known were unlikely to perform in short order?

In this process of apportioning blame, questions should also be asked of the Wall Street analysts. Why did they keep on their rose tinted spectacles long after it should have been clear that the US housing market was to experience its worst downturn in the post-war period?



Wasn't the housing 'bubble' just another way for the government to inflate the dollar?

Low interest rates
Everyone in the business is huffing and puffing, hoping that home prices will go up, so they can all make more money. But there's one thing that can really create some lift-- lower interest rates.

People always buy up to their limit. And with rates low, they can afford a higher total price. It's only just a number anyway to the buyers-- what really matters is the monthly payments.

difference between this and the savings and loan bail out
The difference between this and the savings and loan bail out is that the former hurt the rich people. This crash will cause the working class to lose their houses. As much as it is claimed that the lenders don't want to repo . . .

Two years ago I was talking to a builder in California - back then he was building in the $350-400 range. He said he heard from his Bank of America guy that the BofA had set up a new department for repoing. That when the crash came the BofA would offer the losers a 2 year lease at whatever their current payment was and then they would have to have new financing or leave.

Place the blame where it belongs.
The blame does not rest with Wall Street or the Government.

The blame for any type of housing market crash and subsequent increase of mortgage foreclosures lies with two groups. The lenders and the lendees/homeowners.

The Lenders deserve the blame for making rediculous loans to people who have barely enough credit to buy a used car, much less a house. The problem is compounded when the lenders do not even make sure that the property is worth enough to cover the mortgage amount as a potential foreclosure.

The Lendees/Homeowners deserver even more of the blame. How anyone with poor credit to begin with can even consider buying a house with the absolute minimum down payment, a monthly payment that they can barely afford (when interest rates are at their lowest levels in years) with an adjustable rate mortgage that is sure to increase over the time span of their loan is beyond me.

What will really get me fired up is when all these sub-prime lenders start getting massive amounts of foreclosures that they can no longer cover and they start seeking government bailout for their mistakes.

The fed can't just set interest rates where ever it feels like. Setting the rates too low will cause an increase in inflation.

I personally believe that the fed has once again over reacted and has raised interest rates more than can be justified by the current economic reality.

When lenders practically throw money at you, it's hard to refuse it.
The author of this piece has only one note, lower interest rates. The problem is that the housing bubble was caused by low interest rates. The Fed was flooding the market with low cost money and FNMA and GNMA were on a binge as well and were actually encouraging sub-prime lending. No lending agent can afford to sit on money, it must be loaned out. When lenders run out of prime customers, sub-prime is all that's left.

I had thought, though, that the Great Depression had taught us the dangers of interest only, balloon payment loans for housing.

About a year and a half ago I read an opinion-page
piece devoted to proving that the housing bubble
will burst. Only at the very end of the article
did the author state that he thought that would
have an adverse effect on the economy and thus that
that was _bad_ news. I had thought I was reading
a rosy optimistic prediction.

When you consider the alternatives to buying a house...
Unless you plan to live in your parents' basement forever, it comes down to a choice to buy some sort of house, waste roughly the same as mortgage payments on rent or live out in the weather. Not many people find living 'homeless' to be an appealling lifestyle, leaving working people the choice of buying or renting. Renting gets old quick! That leaves finding a mortgage loan & buying your house as the choice way to have a roof overhead...

Busting the bubble
"I had thought I was reading a rosy optimistic prediction."

You were right. Whenever the most expensive thing most people ever own is appreciating routinely at a rate of ten, fifteen, twenty percent per year, is there a hope of preventing inflation?

Also, when housing costs go "through the roof" don't they have to come back down again, so people can afford to buy them?

Federal Open Market Committee (FOMC)
When the FOMC meets, it decides whether to lower, raise or maintain its target for the federal funds rate. The FOMC also decides on the discount rate.

The reason we say that the FOMC sets the target for the rate is because the rate is actually determined by market forces. The Fed will do its best to influence open-market operations, but many other factors contribute to what the actual rate ends up being.

A good example of this phenomenon occurs during the holiday season. At Christmas, consumers have an increased demand for cash, and banks will draw down on their reserves, placing a higher demand on the overnight reserve market; this increases the federal funds rate. So when the media says there is a change in the federal funds rate (in basis points), don't let it confuse you; what they are, in fact, referring to is a change in the Fed's _target_.

If the FOMC wants to increase economic growth, it will reduce the target fed funds rate. Conversely, if it wants to slow down the economy, it will increase the target rate.

The Fed tries to sustain steady growth, without the economy overheating. When talking about economic growth, extremes are always bad. If the economy is growing too fast, we end up with inflation. If the economy slows down too much, we end up in recession.

Sometimes the FOMC maintains rates at current levels but warns that a possible policy change could occur in the near future. This warning is referred to as the "bias". The means that the Fed might think that rates are fine for now, but that there is a considerable threat that economic conditions could warrant a rate change soon. The Fed will issue an easing bias if it thinks the lowering of rates is imminent. Conversely, the Fed will adopt a bias towards tightening if it feels that rates might rise in the future.

If the target rate has been increased, the FOMC sells securities. If the FOMC reduces the target rate, it buys securities.

For example, when the Fed buys securities, it essentially creates new money to do so. This increases the supply of reserves in the market. Think of it this way: if the Fed buys a government security, it issues the seller a check, which the seller deposits in her bank. This check is then credited against the bank's reserve requirement. As a result, the bank has a greater supply of reserves, and doesn't need to borrow money overnight in the reserves market. Therefore, federal funds rate is reduced.

Of course, when the Fed sells securities, it reduces reserves at the banks of purchasers, which makes it more likely that the bank will engage in overnight borrowing, and increase the federal funds rate.

Too many extravagant sized houses being built...
You'd think developers would build more reasonable sized homes that working people might be able to afford. Who can afford to make payments on those things in addition to the maintenance cost? The smaller houses are more affordable on both payments & upkeep, yet developers build oversized houses that almost guarantee defaults. Developments with names like 'Tiffany Highlands' or 'The Reserves' sprouting up all over the place like everybody has an executive salary & wants to spend it all on a humongous house! Maybe if they built more reasonably sized houses people could afford to buy & live in them. I doubt there are enough of the wealthy buyers to purchase all of those houses. Costs too much for heating & cooling them to make sense to rich buyers. Most wealthy buyers are very cost savvy & take the cost of ownership into consideration before buying a house which leaves the gullible getting foreclosed & losing them.

Solution: Switch to a Debt-Free Monetary System
Every responsibly managed debt-free fiat monetary system has worked.
Two examples from history,
Colonial Script -
Tally Sticks -

Some proposed monetary reforms:
Great DVD documentary on the entire subject:
As long as we keep running like hamsters in the debt spinwheel, these problems will happen again and again and again.

Great overview!
Good job - never understood how this worked until your explanation.

they build them, because that's what the customers want.
If you believe that customers are demanding smaller sized houses, and current developers are refusing to meet this demand, then why aren't you out their building houses. You could be making a fortune.

Had I been able to find a 4 bdrm rental, I'd be living in one now.

If you add up all the money, time, and effort that goes into home maintenance, yard work, and property taxes, I'm paying about triple what I'd pay in rent. I could easily invest the other 2/3 and call that my 'equity'.

It's a myth the rent and mortgage payments are close to each other.

The Federal Reserve is ANTI-RESERVING money. It is giving it out cheaply (less than it is worth) and it does this year after year. Borrowers make a perfectly rational decision to take this money now and get something now instead of waiting for the future when the thing or the money will be more expensive.

So the solution. STOP CREATING MONEY!!!! This will force interest rates up to their real values and give the proper signals to borrowers as to the current price of assets.

Not related to inflation...this time...

The recent housing boom was related to "what the market can bear" pricing, this time out, rather than inflation, hedging and speculation (with high interest rates) like we saw during the late 1970's. We simply did not have much inflation during this latest period.

Similarly, a modest correction downward regarding such prices in terms of monthly payments (including rising interest) across the entire market will not be deflationary. Inflation is not involved.

The banks are currently tinkering with increased mortgage interest rates to see if they can generate somewhat higher earnings for themselves and flowing into the secondary (collateralized debt) markets. Up to now this has been a large part of the problem. The demand for sub-prime paper.

Sub-prime lending fed its riskier, higher yielding paper into certain, eager, secondary financial markets where secured debt is necessary. But they needed to make more money. With low interest rates on standard loans during the recovery most debt secured with real estate didn't generate enough points to keep the lights on across the traditional mortgage banking industry. (Let alone the private equity and hedge funds.)

Of course, when such loans fail to perform the collateral itself is foreclosed and most of the underlying asset value continues to sit securely on someone's Balance Sheet somewhere in the system. None of that paper runs to zero as we saw during the meltdown.

Financial institutions who specialized heavily in such lending may indeed close their doors now that this particular business is no longer viable or needed. They liquidate their portfolios, lay everyone off and fold the tent.

The US economy continues to generate record, sustainable earnings, we are at full employment and everyone must live somewhere. Even if a house is on the market (unsold) the family living there is probably still paying it's mortgage or they are paying rent. If no one is making payments then the system moves quickly to foreclose and actual (cash) losses are minimized.

Some of the players are getting rich scooping up distressed properties and there is still a lot of money out there looking for a bargain. We're fine.

Hard Asset values rise in inflation, fall in delfation
period with a '.'

During times of inflation, prices skyrocket for hard assets like real estate, art objects and gold. The prices for assets for all three categories since 2005 have been rising quite a bit.

When you have deflation, those prices actually fall.

When you have a currency with a stable value, they stay pretty much neutral, with some exceptions.

So, Forest...I have yet to see how the factors you mention will have any real significance in overcoming the above rules cast-iron'ed by history. One that you don't specifically mention (but could have by inference) was the productive innovation of our economy pulling us through. That just might work. Pray that it does.

If no one is making payments then the system moves quickly to foreclose and actual (cash) losses are minimized

Uh...the forceclosure process takes 6+ months at least. In some states, longer. Unless by your own criteria, that is what you feel qualifies as 'quickly'. If so, I don't see how 6+ months of no payments minimizes cash losses to the lender.

TCS Daily Archives