Is America Headed for a Depression?

by: Bill Cara

For several months, some of the U.S. homebuilder companies acknowledged abnormal supply as well as pricing pressures in the marketplace.

More recently, the sub-prime mortgage companies that recklessly financed the bulk of the industry’s business discovered a problem with delinquencies and foreclosures. This is the story that will finally push the stock market from Bull to Bear, and the economy into recession.

Traders are nervous, with the upshot being a swing to cash and gold. Why gold? Under the circumstances that exist today in the financial marketplace, any rise in interest rates will certainly pass the tipping point to where millions of Americans will be forced from their homes and put out on the street.

The whole world watched TV images of the inhumane treatment of the poor of New Orleans following Hurricane Katrina. With great respect to those couple hundred thousand disadvantaged souls (as my readers know I have), I believe those ugly TV images may even look mild compared to the scenario that would follow angry mobs across America, if market interest rates rise beyond the tipping point that would collapse the entire U.S. mortgage market.

Yes, I believe there will be a U.S. economic recession, but the elements are now in place for the first time in 80 years for America to sink into a depression. Should a depression unfold, there will be big name financial houses that will fail. Accordingly, the owners and managers of wealth ought to be researching today how to protect themselves beyond FDIC-insured accounts. I shall write a lot about this in the next month.

exhibit 1.1

Yesterday, there was much talk of the Sub-prime and Alt-A mortgage industry problems. One report I received today came from Credit Suisse, whose analysts opined that the problems will get much worse. I agree that this is a situation we must watch closely.

In the past five years, subprime purchase originations have more than doubled in share to approximately 20% of the total in 2006. Over this time period, subprime lenders eased underwriting standards in an effort to gain market share. Loans were made to first time homebuyers with little or no down payments, as 2006 subprime purchase originations posted an alarming 94% combined loan-to-value, on an average loan price of nearly $200,000. Even more distressing is the fact that roughly 50% of all subprime borrowers in the past two years have provided limited documentation regarding their incomes…

Given the recent credit deterioration in the subprime and Alt-A markets, and the likely fallout throughout the entire housing chain, we are of the opinion that there is a very real threat of “pent-up supply” that will hit the market in the next six-to-twelve months as a result of the lax underwriting standards of recent years.

The first two sections of the Credit Suisse report focused on providing a backdrop of the mortgage market, and how it has evolved in recent years. The authors discussed the mortgage products that are at greatest risk for increased scrutiny from regulators and highlighted some recent events and potential courses of regulatory action. They concluded that “while much of the focus in the next few months for the builders will likely be on credit tightening and how that will impact homebuyers’ ability to get financing, we do not want to underestimate the impact that rising foreclosures and delinquencies will have on the supply and pricing dynamics of the housing market.”

But rather than point to specific comments in the Credit Suisse report, I decided to pull a number of exhibits that hopefully will open your eyes as to the seriousness of the problem.

In a recent blog, I remarked that this data will come out and, unlike information that is produced by the U.S. Administration, it is the type of data that cannot be easily manipulated.

exhibit 14

From the list of the top sub-prime lenders of 2006 above, with over 80% market share, I created the following charts. Several lenders are units of other companies. Two of them (New Financial (NEW) and First Franklin (NASDAQ:FFHS)) ceased trading in the past few days. I suspect that the others will be examined closely, and some will also cease to trade.

From the chart below, I recall the 1990-91 period when North American banks pulled any and all non-performing loans during a similar period of credit contraction. My parent's neighbor had a country home valued at $1.1 million with a $950,000 mortgage. When he couldn't pay, the property was listed at $950,000, then $575,000 as I recall, and then my parents bought it for $300,000. I suspect the same type of thing is just starting today.

exhibit 22

Before this period is over, it will be remembered for many years in history. Long-time readers will recall what I wrote about CNBC's Real Estate Roadshow in 2Q05. I said that was the cycle top and I called myself the Rat Catcher. Look at what's happened to the homebuilders since.

America is in deep trouble because it loves a good story - Goldilocks, Pied Piper and all. For some reason, the people trust these story-tellers. Well, listen and weep.

For more charts, see Bill Cara's blog.