Bill Gross on the Housing Market and Subprime Lending

From PIMCO bond manager Bill Gross' latest monthly essay:

Long ago and far away there used to be an old “20% down” reality that morphed somehow into a subprime/Alt A cyberspace free-for-all (literally “free for all”). Talk about a second life! U.S. homeownership has expanded from 65% to 69% of households since the turn of the century, in part because it became so easy, and so cheap to finance a home. No avatars in that bunch – they were living, breathing U.S. citizens who yes, might knowingly or unknowingly have taken advantage of “low doc” or “no doc” applications, who might have taken out a “liar loan” in the face of “full disclosure” documentation required of their mortgage lenders, or who simply might just have jumped on board the 1% Fed Funds financing train of 2003. No matter. They bought a house, began living the American dream by making money with someone else’s money, and expected to live happily ever after. Well, not so fast, at least for some of them, it seems. Home prices, as measured by the National Association of Realtors, have gone down by 2% nationally over the past 15 months and there’s fear in the air that it could get worse. It most assuredly will.

The problem with housing, however, is not the frequently heralded increase in subprime delinquencies or defaults. Of course write-offs, CDO price drops, and even corporate bankruptcies of subprime originators and servicers will not help an already faltering U.S. economy. But foreclosure losses as a percentage of existing loans will be small and the majority of homeowners have substantial amounts of equity in their homes. Because this is the reality of our U.S. housing market, analysts and pundits now claim we’re out of the woods: the subprime crisis is or has been isolated and identified for what it is – a small part of the U.S. economy.

It will not be loan losses that threaten future economic growth, however, but the tightening of credit conditions that are in part a result of those losses. To a certain extent this reluctance to extend credit is a typical response to end-of-cycle exuberance run amok. And if one had to measure this cycle’s exuberance on a scale of 1-10, double-digits would be the overwhelming vote. Anyone could get a loan because shabby credits were ultimately being camouflaged within CDOs that in turn were being sold to unsophisticated foreign lenders in need of yield as opposed to ¼% bank deposits (read Japan/Yen carry trade). But there is something else in play now that resembles in part the Carter Administration’s Depository Institutions and Monetary Control Act of 1980. Lender fears of potential new regulations can do nothing but begin to restrict additional lending at the margin, as will headlines heralding alleged predatory lending practices in recent years. After doubling over 18 months between 2005 and the first half of 2006, non-traditional loan growth has recently turned negative, and lenders’ attitudes are turning decidedly conservative...

Comments

[Michael Raf...:]

good points

2007 Apr 13 10:28 AM

[georgeragsdale:]

It's not only housing. The same thing has been going on in the financing of commercial realestate.

2007 Apr 13 10:51 AM

[wixeywaxy:]

The real scam was the financial people who knowing that the sub prime loans were a house of cards packaged them to sell to unsophisticated investors. It never ceases to amaze me how they come up with one after another way to enrich themselves by squeezing the gulliblity of the public. The Savings & Loan scandal, rip off of the public utilities by selling them stock in trash companies, Enron, Billy Sol Estes, Whoops, junk bond losses by California's yuppie county and on and on. There has been a new scam about every couple of years. Unbelievably I saw articles in finacial publications stating that the Enron scandal was historically exceptional. Where have they been? I'm 77 years old and there have been so many of these events I can't even rememeber the details. The bottom line is, these have a lot in common, they aren't possible without participation of many powerful collaborators who enrich themselves from them. The present problem included. Our markets are based on trust and the abuse may one day go too far. Vic. Van Walleghem

2007 Apr 13 03:40 PM

[georgeragsdale:]

I agree with Van Walleghem. Sub prime loans are set up to fail and generate fees to the mortgage brokers and lenders. The typical mortgage does not have a prepayment penalty, and unlike subprime escrows for realestate taxes and insurance. A sub prime borrower is thus hit not only with a rate increase after expiration of the low introductory interest rate but tax and insurance bills that were probably not budgeted for,thus requiring another refinance and more fees to the mortgage brokers.

2007 Apr 13 06:15 PM

[Paul Meisel:]

My guess is that there will be a "floor" for housing in most areas at about 80% of the cost of new construction. For many locations, that is not very far down.... but for some it will be like bungee jumping with a lot of slack line.....

2007 Apr 14 11:33 AM

[Rob Knapp:]

We are always going to have periods of restrictive lending followed by periods of easing. We are also going to have excesses at the margins. At the margins during these periods of easing you are also going to breed groups of unethical players who will take advantace of the public. This is where maintaining the integrity of the best brands is critical for the public trust and the vigorous prosecution of those institutions that violate that trust is imperitive. The marginal players will come and go, but the major players must police themselves as well as be police by the regulators.

2007 Apr 15 11:22 AM