Housing in a Death Spiral, Taking the Mortgage Industry with It

Imagine a different world in which financial assets were the principle asset of American households, in part because such assets had so steadily increased over the decades. Brokerage standards were significantly loosened so 2:1 margin were no longer the standard but the starting margin position is 10:1. Most people open accounts with large positions and have as much as 20:1 margin. This means people start out with $250K to $500K new accounts and put 5% to 10% down borrowing the rest. To make matters worse, the brokerage industry has no recourse against the account owner if the account were to decline in value. But don't worry, as this has never happened before. Also, so long as the account holder pays for their margin interest, there can be no margin calls so the brokerage has no way out if asset values were to decline.

Is this a train wreck waiting to happen? Would you ever invest in these brokerages?

All of a sudden the supposedly impossible happens. Financial assets start a wicked decline of 20% per year. Any new account holders within the last few years have their equity wiped out. Very few customers sell out of their position at small losses. There are no margin calls except for a small percent of people that fall behind on paying margin interest or stop paying it altogether. The brokerage firms are in a death spiral as they themselves are leveraged 20:1 and they can't get out of the spiral. The can't close the brokerage account so their losses simply mount. Nothing they can do.

The brokerage industry seeks additional capital but very quickly must resort to offshore funds as all domestic sources smell death in the air and stay clear of providing any equity to the walking dead. These offshore sources dry up. Soon enough some of the brokerages fail and the government steps in providing the first trillion dollars of support followed by another trillion then another trillion. Financial assets continue to decline so while trillions have been provided this funding only covers losses from six months back. Because 95% of all account holders continue to pay margin interest, the view is the issue is not too bad and the last trillion of support is viewed to be the right medicine to complete the cure.

Does this sound like fiction?

Well, it is not. Substitute housing assets and mortgage bankers for financial assets and brokerages and this is what we have today with the housing crisis. The most significant asset of American households, housing, is in a death spiral and it is taking the mortgage industry with it. Tuesday's Case-Shiller housing price index shows the following:

• The monthly sequential decline in the 10 and 20 city composite continues to fall at an increasing pace. The monthly decline has now increased in each of the last six months and declined 2.8% in January's results which were published today (C-20 index).
• At 2.8% monthly declines, this compounds to a 39% decline after one year.
• All 20 cities declined and only two declined at a slower pace then the previous month - so 18 are accelerating their rate of decline.
• The 2.8% sequential decline in the 20 city composite is the worst decline since housing peaked in July 2006
• The composite 20 index is back to the level in September 2003. Probably 40% of all homes were purchased after that date.
• The free fall in prices is almost at pace that is three times greater than the rate of increase in 2003 so people that purchased in December of 2002 will be underwater in three more months of reported declines - this will likely happen in 4/09 since the Case-Shiller reports on a two month lag.
• From May, 2009 to August, 2009 we will wipe out 2002's appreciation at the current pace
• Continuing with this same pace, in just two more months (10/09) we will wipe out 2001's meager appreciation adding another three years of underwater purchasers. At this point close to 2/3 of all homeowners will be underwater and this assumes no equity out refinancings or home equity loans. Talk about the negative wealth effect.
• By the end of 2009 we basically wipe out 2/3's of all homeownership equity, the previous principle asset for American households. So the seemingly fictitious beginning to this piece wasn't really far fetched afterall if one considers homeownership as a net asset.

What does this mean? For every 3% monthly decline, by my estimation, we wipe out $250 billion in equity. First this eliminates the homeowners' equity. If the homeowner is 5% to 10% underwater and keeps their job they probably stay current on their mortgage. But once they either lose their job or get to 25% or more underwater, a large number walk. With the composite index for 20 cities down 29% in January, 2009 the rate of foreclosures will increase only causing more housing declines.

Once the homeowner is underwater, the continuing decline in equity is on the backs of the banks and mortgage holders. When Geithner acknowledges the bailout funds are down to $135 billion (and, as we saw over this past weekend, will not comment on if this is enough) we know the truth and it is scary he won’t speak the truth. $135 billion is about two weeks of losses in American mortgages if fully absorbed by the banks.

We are in deep deep trouble and our government and the banks are not fully acknowledging it. Many of the large banks are insolvent. They were like the Monopoly player that plowed all their cash into buying hotels - no reserve at all.

Even if a bank only had 20:1 leverage, assuming no offloading of mortgages (something they certainly did), if the bank was fully absorbing a 3% monthly loss like we are currently incurring, the bank's equity would be eliminated in two months. We are sixteen reported months into this decline based on Case-Shiller and eighteen months into the actual decline. How could the major banks not be insolvent?

The insolvency is spreading as predictably as darkness at dusk. Perhaps our government can declare some emergency extra day light savings extensions or do some other fancy footwork, but darkness continues unabated.

A spreadsheet for 1/09 and past months for Case-Shiller may be found here.

Disclosure: The author is currently long oil and short financials.

Comments

[Ishortyou:]

it all comes down to a very simple relation of supply and demand, unfortunately currently we have an overwhelming supply in the housing market that will take sometime to correct on itself or with help of some government intervention.

Apr 01 08:53 AM

[Allan Frain:]

Agreed. The unwinding of the largest, most leveraged credit bubble in history is far from over. Bottom calls are echoes from 1930, even as the excesses of this decade dwarf those of the 1920s. Unfortunately, we are on a policy course that bets what is left of our sovereign wealth to the contrary.

How a few days of equities bounce can draw the attention of so many from the bigger picture makes for interesting study.

Apr 01 09:39 AM

[Mad Hedge F...:]

Yuba County, California, a semi rural area in the Sierra foothills commuting distance from Sacramento, has the highest underwater rate in the nation. There, 78% of all homes have larger mortgages than the houses are worth, and the numbers are rising. Four out of the five highest negative equity counties in the US are in the Golden State’s Central Valley.

Apr 01 04:22 PM

[crewman:]

Jeez - you guys need some yellow pills and fast! I'm finding the endless doomsday talk of the housing bears has many similarities with the endless prosperity talk of the housing bulls in 2005/2006. Both disregard the gravitational forces that pull markets back to their historical mean. Here the forces will be (i) medical advances and birth rates will keep population numbers trending up (ii) this population will need somewhere to live, (iii) they don't make any more land, (iv) frankly, they don't make any more homes either (construction starts are at an all time low), (v) if you look carefully, the dramatic supply of homes and foreclosures are mostly located in outlying areas where most prefer not to live - go to core areas and you'll see that the supply of homes/foreclosures is less than the natural average, (vi) sales are up in the core areas because demand/equilibrium is slowly being achieved. These forces will keep us from enduring the doomsday that the author and the commentators are forecasting. Homeownership is not dead, its evolving...and isn't that a good thing. More homes will be smaller and closer to core areas thus reducing our country's greenhouse emissions and dependence on oil.

Apr 01 04:37 PM

[drbob66:]

"The most significant asset of American households, housing, is in a death spiral ..."

Lighten up, drama queen. House values are not going to zero...although I'm sure you'd like to see that (since you're short financials). We've got another 10-15% to go to a housing bottom....then I'll finally be ready to buy (with the cash from my home sale in 2005).

Judging by the charts, it looks like your SKF position is in a death spiral, though. Did you, by chance, buy it at $150...or $200?

Take your losses and move on.

Apr 01 08:21 PM

[Moresby:]

Not all of us are selling our houses, so a lot of the 'loss' are paper losses at the moment, if people have treated their house as a roof over their heads and a home instead of a check book, the housing bubble may not be so bad; any how these are all history now.
Will the housing market bounce back? eventually, for the right houses built in the right places.......
At the end of the day, the supply of land is finite while the population tends to grow as 'crewman' point out.
Will investing in houses be the safest investment again???? Probably in a few years time when we read how price is going up by 10% or more a year and the memory of house price doubling ever few years will wipe out the bad memory of this recession.
At least, this is what I think.

Apr 01 08:27 PM

[capitalisth...:]

Buying a house with a fixed mortgaged at 4.75% is a great hedge against inflation.

Apr 02 06:02 AM

[SoCal:]

crewman -

Here are some counter arguments to your points:

(i) medical advances and birth rates will keep population numbers trending up -- (comment) this argument is based on conjecture about future scientific advances

(ii) this population will need somewhere to live -- (comment) more conjecture..future populations may move to more affordable areas/countries

(iii) they don't make any more land -- (comment) actually they are making more land. For example, in my city Irvine, CA, there are several new high rise condo and apartment complexes. Building up will be a continuing trend in dense suburban areas.

(iv) frankly, they don't make any more homes either (construction starts are at an all time low) -- (comment) why would they make new houses when there is a huge oversupply of inventory? Add to that the continuing foreclosures. Developers are abandoning projects and cutting their losses, leaving whole tracts of unfinished houses.

(v) if you look carefully, the dramatic supply of homes and foreclosures are mostly located in outlying areas where most prefer not to live - go to core areas and you'll see that the supply of homes/foreclosures is less than the natural average -- (comment) not true, the housing boom and bust affected 'core' areas. Take a look at Ladera Ranch in southern California, a massively overbuilt area smack in the middle of south Orange County. On Redfin you will see a plethora of properties for sale, every single one of which is under water.

(vi) sales are up in the core areas because demand/equilibrium is slowly being achieved -- (comment) please see this article: "O.C. ranked 8th riskiest big U.S. home market" lansner.freedombloggin.../
Orange County, CA is certainly a 'core' population area, and there is no 'demand/equilibrium' being achieved here whatsoever. Sales here have been dismal, with about 50% being 'distressed' sales.

Yes, this is all doom and gloom, bear grumbling, 'why do you have to be such a downer', kind of talk. But if you look at what's really happening, you will arrive at the same conclusions.

Apr 02 10:08 AM

[Mr Pasadena:]

It will be at least 5 - 10 years before housing prices start moving up again. I'm looking at homes in prime California areas like Pasadena, Arcadia, San Gabriel, etc. These areas still falling in prices, slowly. Pasadena is already down over 25% from 2006 prices. I know, I own a house next to two that is down that much. But Arcadia and San Gabriel has gone down much less. Historically, these three areas mirror each other in prices appreciation and decline but Arcadia is only down about 10% and San Gabriel about 15%. I expect Arcadia and San Gabriel will go down further and Pasadena stabilize. Be realistic, how many people can afford a home in the $700-$800K range with their current family income. Unless income catches up, there is no chance prices will go up anytime soon. What did I hear? Unemployment is at 10.5% in California and 11% in Los Angeles County. In the long run, I think prices will eventually move back up. That is why I'm not selling and will be leaving my house to my daughter. When she grows up, past it to her children (my grandchildren), and they can sell it at the 2006 price.

Apr 02 10:35 AM

[Angry Appra...:]

WRONG WRONG WRONG.......
put down the economic statistics crack pipe
interview some people that are in involved in real estate every day.
You might be shocked what you hear.

We are in a new paradigm, whatever rules that were applied in the past dont apply to the future.

Apr 02 12:44 PM

[HardwoodFlo...:]

Of ocurse prices are falling! Look at what people are buying- foreclosed homes and people who "have" to sell. Moreover the sales are happenign inthe overheated markets where prices have Fallen from 30-70%. Bottom feeders will seep-up the inventory over the next several months so prices will continue to fall.

Moreover, jumbo loans are impossible to get and still expensive. So the big ticket stuff isn't on the market.

There is a fair amount of backside demand out there. I agree that the job market needs to stabalize before a housing "recovery" takes place.

The truth is that 400,000 units of single family homes is a pitance of a pace for residential housing. While the remodel numbers have been in the tank for the past 3 years, as home equity lines were the first to go, people are just begining to spend real income on their up grades. I think you will see a uptick in home remodel as the consumer (M2-M3 Money Supply) retrenches.

Still, new housing contruction won't take hold for a while. When it does, there will be lot of catching up to do. Specifically, the fact that housing starts have never been this low for this long ever. It's like the remodel factor. For a while it's like pushing rope, then the slack goes out and there will be a whiplash.

The economy is so different than it was in the past. the huge amount of government workers, health care representing 30% of GDP, tech, manufacturing and the rest is so much broader now. In a way this whole cycle has seemed a bit like Y2K- with experts telling us to buy gold, stock pile guns and prepare for civil unrest- it's just crazy.

Will there be a "fast" housing recovery- no. Will there be one-yes. Will it be a more senseable recovery- yes. By all acounts 1MM single family units is below demand. That's a 100+% increase from where we are now.

Apr 02 06:05 PM