The Fed Stops Spoonfeeding Us: A Great Depression for Housing?

You won't ever hear that the LBO boom is over or that the depreciation in housing is reaching levels not seen since the Great Depression from the Fed, or any government official for that matter.

Telling the truth might be seen as irresponsible, sending markets tumbling across the world. So, the Fed has been carefully spoonfeeding us the truth by transitioning from telling us that the subprime / housing issue was contained to finally acknowledging that the subprime and housing issue has deteriorated and is worse than expected. So Bernanke told us last week. Yesterday, the sugar coating was removed as PIMCO's Bill Gross and Countrywide Financial CEO Angelo Mozilo told us how they really feel.

From Bill Gross:

Both borrowers and lenders may have bitten off more than they can chew, and even those that swallow their hot dogs whole - Nathan's Famous Coney Island style - are having a serious bout of indigestion.

That growing lack of confidence - more so than the defaults of two Bear Stearns hedge funds and the threat of more to come - has frozen future lending and backed up the market for high yield new issues such that it resembles a constipated owl: absolutely nothing is moving.

The tide appears to be going out for levered equity financiers and in for the passive owl money managers of the debt market.

No longer therefore will stocks be supported so effortlessly by the double-barreled impact of LBOs and company buybacks. The U.S. economy in turn will not benefit from this tidal shift and increasing cost of financing. The Fed tightens credit by raising short-term rates but rarely, if ever, have they raised yields by 150 basis points in a month and a half's time as has occurred in the high yield market.

Bill Gross' entire August outlook is a good read, check it out.

. . . and from Mr. Doom, Countrywide CEO:

During the quarter, softening home prices continued to affect many areas of the country and delinquencies and defaults continued to rise across all mortgage product categories as a result. Due to these adverse conditions, the Company incurred increased credit-related costs in the quarter, primarily related to its investments in prime home equity loans.

Perhaps we can no longer call this just a subprime issue!

We are experiencing home price depreciation almost like never before, with the exception of the Great Depression.

Did he say the Great Depression? Perhaps a poor choice of words that may have spooked the markets a bit more than need be, but you get the idea . . . the housing market isn't recovering anytime soon.

Yesterday's remarks certainly instilled some fear in the minds of traders, but it really isn't anything all that new. It's just that after shrugging off bad news after bad news (which is what happens in a bull run), the bulls finally relinquished and yesterday, for whatever reason, the news mattered.

The selling was significant enough to create a change of character in this market, possibly creating a market of opportunity sellers rather than a market of dip buyers as we've seen over the past several months. That remains to be seen. It's important to realize that while technically this market has some problems, all indices retain key.

The S&P took out the 50 day moving average and dropped a hair below its upward trend line and the Russell 2000 is already fast approaching its 200 day moving average. Both the Dow and Nasdaq have a bit further to go before testing key support levels. The area around Nasdaq 2620 and Dow 13600 will certainly be watched closely.

Comments

[leojbourne]

It would be good to have objective data on housing prices and sales by region, since declines in the median sale price without respect to regional weightings are not useful data. In some markets, inventory and time on the market have greatly increased, but prices have not decreased. Other markets have been overpriced for several years, and a correction was to be expected at some point. I am not trying to minimize the large impact of housing price declines on the economy, but its deflationary effect does seem to be part of the Fed's plan to control growth.

The subprime mortgage issue has several major components: decline in real estate prices due to desperation selling, and increased risk to hedge funds owning mezzanine and equity grade mortgage backed securities or other collateralized debt obligations. Neither of these deserves the high level of worry that currently prevails.

Desperation selling and outright defaults are, in my view, largely a product of speculation. As I understand it, the numbers are growing, but the percentage of defaults in terms of total number of mortgages is still extremely low. New bankruptcy laws will assist lenders in holding many borrowers hostage to debt for the rest of their lives, if foreclosures do not bring enough money to repay the mortgage (this depends on state mortgage laws.) I expect the default numbers to level off, not accelerate, since the really bad loans go belly up first, and I think that has been done already. Interest rates are not going up. As long as homeowners have jobs, they will usually find a way to make payments on their primary residence.

In terms of defaults affecting hedge funds owning CDOs, once again I am not concerned. I believe (but could be wrong) that most at-risk portfolios are owned by under-informed and poorly-advised groups with a high greed quotient, such as pension funds, college endowments, foreign investors and wealthy individuals. I don't expect major banks and financial institutions to have risked significant portions of their business on speculative CDO ventures, especially ventures involving leverage or underwriting in return for cash flow. Major institutions that have been in business for decades are not likely to bet the farm on such risk. I expect most of the pain to fall on groups who expected something for nothing (or at least, for no risk) and who indeed made a good profit for a number of years, and probably distributed a goodly portion of it to their members. It is unlikely that many people will be bigger net losers, at the end of the day, than they would have been if they had invested in the stock market during a normal bear market period.

Some worry about the unwinding of leveraged CDO money that has been hedged incorrectly on the short side to misbehaving tracking funds or indexes. Once again, we should keep things in perspective. The loss of a few billion dollars in the global economy is no longer a big deal.

Moreover, there is an economic imperative at work now that has not previously existed in U.S. history. We are a huge debtor. Those to whom we owe money have bet their own economic welfare by recycling dollars into our treasuries to help keep interest rates low so that we will continue to prosper and to buy their exports. They cannot risk major perturbations to our economy, or else their holdings will lose a huge amount of value, and large value has already been lost due to the weakening dollar. Therefore, when push comes to shove, money will become available for major bailouts and buyouts. This won't happen for the small players, because there's not enough vested interest to help them. But if major institutions have troubles, they'll be rescued -- if no one else will do it, the Fed will.

My reasoning is based on the assumption, which I am seeing increasingly validated in recent years, that everything must happen so that the rich will get richer. Using this assumption, all else follows. Recessions and depressions are bad for business. Therefore, in this globally interconnected financial world, business (and governments -- sometimes it's hard to separate the two) won't let them happen, at least not until the big players have their money off the table.

However, when small and medium sized investors decide to play for high stakes with high risk, they usually end up getting punished. Later the high rollers come in and buy up the debris for pennies on the dollar.

This happened during the Savings and Loan fiasco, when developers made money (subsidized by the taxpayers) buying foreclosed property from the Resolution Trust Corporation. Additional taxpayer money went into salvaging or liquidating the failing Savings and Loans. Where S&Ls closed, deposits migrated to nearby banks, which saw profits rise. In retrospect, that "crisis" was barely a ripple on the pond of history. Many younger people don't even know what the RTC was.

I believe the current real estate and CDO difficulties are transient, and that real estate prices will stabilize within the next two years. The cost of construction materials has fallen dramatically. It is cheaper to build a new house today than it was two years ago. That artifact is keeping prices low on sales of existing homes. When the current investory clears, prices should reach equilibrium about 15% lower than they were two years ago, and should thereafter increase at near the rate of inflation, as they usually do.

[Paul Meisel]

Leo hits a several good points.

New housing costs should be driven by 3 things: the cost of materials (rising over time but relatively stable), the cost of construction labor (similar), and the cost of the land and developing it (varies widely geographically).

Therefore the amount of deflation is going to vary widely geographically based on the relative demand in that area, and how it compares to recent times. Some places will hold up well due to demand in that area; some places (a few rural areas I know come to mind) never experience the bubble inflation in the first place. But a lot will either drop in price dramatically or just sit in inventory until demand comes back.

Locally the trend I see is that there are some sellers willing to take a big price hit because they have owned the place awhile and are seeing decreased profit rather than losses.

[Lee Carlson]

Can't argue with the comments above ! Right now housing is in big trouble with Fl , CA, and Az leading the way. Floridas problems are primarily State Laws at work, driving up RE Taxes so high that people can't afford homes and Insurance is also to blame as we had Allstate and State Farm bailing out,..too risky they say ! Relief is on the way they say, but we have to wait until Nov. 9 ( When the tax bills come out ) and again in Jan. when issues about the taxes , which are a Constitutional problem are up for a vote to change the way Taxes are calculated.
Our only real hope, nationwide, is to have our currency devalued,..which is happening fast,..to the point that our prices become bargains to Europeans and Canadians.