After a year of relative price stability, the housing market appears to be at an anticipated critical moment - the moment when a small price decline could grow and becomes self sustaining, driven by homeowner "walk aways. The loss of the tax credit puts us at this critical hour and conditions should now be carefully monitored for signs of this is happening. It could potentially lead into another crisis
Six months ago preventing a “walk away” crisis didn’t seem like a problem; at the time the attitude in Washington was “do anything required to prevent another disaster.” But this attitude has changed; it’s now “no more costly programs.” This pretty much guarantees some housing crisis. Although the cost of letting it happen will be greater than preventing it, political realities require letting the disaster happen.
A Negative Feedback Price Decline
The above situation describes a negative feedback price decline; a self reinforcing selling wave that builds on itself. These are well known in capital markets and they usually stem from excessive leverage or highly illiquid pricing conditions. As prices go lower, the need or reason to sell increases, which brings on more selling and lower prices, over and over. They defy normal supply and demand and often seem like they can drive prices to zero. They can be highly destructive. The best example of one was two years ago.
The cause of our financial crisis two years ago was a negative feedback created in mortgage bonds, At the time bank balance sheets held about a trillion dollars worth, all highly leveraged. As prices declined, a few banks, with balance sheets starting to go negative, sold their bonds. This triggered even lower prices, more negative balance sheets and more required selling. Realize the selling was required by law, like a margin call; the selling wasn't by choice.
Within a few days, everyone had to sell and prices completely collapsed, going from 80 cents to 5 cents per dollar, wiping out a trillion dollars in bank capital and technically bankrupting the entire system. TARP simply took away the requirement to sell by supplying the capital needed to turn the balance sheets positive. This broke the feedback and over the next year the bonds recovered to fair value recreating much of the “lost trillion.”
A “Walk Away” Feedback Loop
According to Corelogic, in June of this year, there were 6 million homeowners with over 20% negative equity. This number is huge and represents about 8% of all homeowners in the country. These numbers do not include second mortgages or equity home loans so the'ye actually understated. By size alone it has the potential of setting off a negative feedback, “walk away” cycle in housing. Studies have already shown that when negative equity gets to this level the pressure on homeowners to walk away and rent becomes intense.
These “walk aways” are homeowners who have good jobs and can make payments but simply decide not to pay on a mortgage larger than the home is worth. The stigma of doing this is fading as banks are now perceived as creators of the price bubble and the cause of the problem.
The problem is that no one can tell a “walk away” from someone who truly can’t make the payment, so correct numbers are hard to come by. I've heard estimates that go from 15% to 35% of curent delinquincies are "walk aways" but I think it is closer to 40%. That’s because mortgage delinquencies from job losses should have peaked 17 months ago when claims for unemployment peaked. But this isn't the case; new mortgage delinquancies remain high, we think because of so many more “walk aways.”
Since the lapse of the tax credit in June, home prices have generally fallen. We think we are at the critical hour and this must be watched very carefully. I'm sure many underwater homeowners were holding back, hoping that prices would rise and things would get better. If prices reverse and dash those hopes, it could be the deciding factor that triggers many to walk. As prices decline, more negative equity is created, so more walk and the negative feedback process has begun.
No Political Capital in Preventing Disasters
There is no political capital in preventing problems or disasters, especially if preventing them costs taxpayers money. To spend five hundred billion dollars on a program to prevent a “walk away” disaster would be political suicide, even though letting it happen will end up costing taxpayers twice a much. If the program works you’ll be seen as the person who spent five hundred billion dollars and the tax payer got nothing for it. Just ask all the congressmen who were voted out because they voted for TARP. People don't see what doesn't happen; they don't see the depression that was prevented. You might have saved the world but who knows.
In a democracy politicians are forced down a different road. They must let the disaster happen, act outraged, blame others for it, and only then spend taxpayer’s money fixing the problem. That works politically. However contradictory and absurd this may sound, it is the way it is and there are countless examples of it.
Disclosure: Long QLD and SSO