Recession? Maybe; Crisis? I Don't Think So

Words have the power to both destroy and heal. -The Buddha

In thinking about where the economy, Fed, and markets will be going in 2008, I find my thoughts dominated by considerations of liquidity. Readers have heard me use the term "liquidity crisis" or "credit crunch" during 2007, but have rarely (if ever) seen me use "credit crisis" or "solvency crisis." This is purposeful.

Why do I avoid calling this a credit, or solvency, crisis? Surely I am not here to downplay the problems we're having in residential lending, or even consumer finance in general. I hardly need to enumerate the many problems in consumer lending. I think mortgage foreclosures will break all records in 2008, probably by a long shot. In addition, other types of consumer lending have and will suffer as well. Consumers have been using equity in their homes to help bail them out of other types of debt for many years, but in 2008, this option will be largely unavailable. The result will be weak performance in everything from auto loans to credit cards.

So are there large numbers of insolvent consumers? Sure. Is it going to create a pretty big problem for the economy generally. Yes. Recession? Maybe, just depends on what else goes right or wrong for the economy. Crisis?

I have a hard time with the word crisis here. Maybe I'm hung up on mere semantics. In my mind, a marriage in crisis is one where divorce is an imminent possibility. Not one where the couple just had a big ugly fight. A political crisis is one where the government might collapse. Not where an election is peacefully contested in the courts. To me, that word "crisis" suggests that action must be taken to avert some sort of disaster.

But what's the disaster right now? Consider these simple facts.

1) Most subprime ARM loans had a 2 or 3 year fixed-rate period. Therefore the only loans to reset during 2007 were made in 2005. Prime ARMs typically have a 3, 5, or 7 year fixed-rate period.

2) However, the subprime delinquencies in 2006 are the real problem. 2005 isn't showing a radically different pattern than past periods.

Notice the much steeper curve displayed in the 2006 vintage, which is like nothing else on the whole board.

3) In 2006, half of all subprime purchase mortgages were made with low or no documentation of income.

4) The Case-Shiller home price index is down 6.1% YOY. It registered its first negative reading in January 2007.

5) Conditions that normally precipitate higher delinquencies, namely unemployment, are not currently a problem.

So let's try to reconcile these three facts with how we'd expect a "normal" borrower (prime or subprime) under "normal" circumstances to behave. Normal people buy a house because they want to live there. Sure the fact that homes have historically been a positive investment plays a part, but for most people, their house is their home.

There will be some "normal" borrowers looking at negative equity, either now or in the near future. Of course, if that borrower never paid any attention to home prices around him/her, and just kept paying the mortgage bill every month, the negative equity would be of no moment. Remember if a "normal" borrower living in the house decided to walk away, they'd need to find someplace else to live. Given how badly defaulting on your home will mar your credit rating, the "normal" borrower would be loathe to just walk away, even if s/he is significantly underwater, as long as s/he can make the payments.

Plus, there aren't very many "normal" borrowers who would be underwater right now. Using Case-Shiller's data, only borrowers who put less than 6% down and bought their house late in 2006 would have negative equity currently. Perhaps borrowers in the "boom then bust" areas are more likely to be in a negative equity position. But still, we're talking about a relatively small number of "normal" borrowers.

So where are all these delinquencies coming from? And what does that say about what 2008 will hold?

First I think you have people who are delinquent for "normal" reasons. They've lost their job, they've gotten sick, they gambled away their starship, whatever. This caused them to rack up some credit card debt. In the past, this borrower was able to tap home equity and get out of trouble. Unfortunately, the borrower isn't able to do this currently, both because lending conditions are very tight and because the borrower might not have adequate equity.

Like I said, this group probably isn't the lion's share of the marginal delinquencies, because we aren't seeing macro events which would cause these events to happen on a large scale.

No, I think the bigger problem is investors. If you buy a property solely for investment purposes, then all the rules of a "normal" investor are out the window. I think many investors bought properties with little to no down-payment. Investors were more likely to get involved in hot neighborhoods, where prices have probably been hit hardest lately.

Many investors just don't have the option of sitting on the property. If you bought an investment property but also had a house you are living in, you may not be able to afford two mortgages indefinitely. And you probably can't rent the place for the same amount as your mortgage payment. It might be that you can save your actual home by just walking away from your investment property. For the investor, the jingle mail option may just be the best of a bad situation.

So back to the "crisis" question. It is these speculators who are insolvent. So what we have are people who speculated in houses and lost. We have banks who lent to the aforementioned speculators and have lost too. Bear in mind, these banks are the ones who agreed to limited documentation of income (perhaps so the speculator could claim this would be his/her primary residence?) or minimal down-payments.

What we also have are brokerage firms who warehoused bonds backed by these speculation loans, assuming they'd be able to unload them into a CDO. They've lost too. We have banks buying AAA-rated CDO^2, who never asked why CDO^2 spreads were so much wider than other AAA products. Guess what? They've lost too. We have money markets buying securities they didn't understand. Losers. We have hedge funds who took already leveraged CDO and ABS products, and leveraged them some more! Loo--oo--oooooooser!

All this isn't a crisis. It's how the credit cycle works. When credit becomes too easy, bad loans get made. People get hurt. But that's the way of the world. You move on.

Where a crisis could develop is when the innocent are hurt just because capital becomes tight; when a good borrower can't get a mortgage loan; when a solid commercial real estate project can't roll over its bridge loan because banks are short on capital. That's where the real crisis can get going: when foreclosures happen that didn't need to happen, driving the price of assets lower; when lenders start taking losses on good loans, and suddenly are unwilling to lend to anyone; when investors struggle to value assets, not because of unknown losses, but because of unknown liquidity; when bids disappear.

That's a crisis.

Comments

[droskoph]

Mortgage delinquencies are but a symptom of the desperation to manufacture businiess, regardless of whether it can stick. It's the final iteration of equating credit to growth. Look around at just how aggressively credit is being pushed right now in an effort to dillute the morbid debt. Consumers have not only no money to buy but no desire to get further mired in more beautifully wrapped debt. I quiz credit card companies and they're consistently reporting 20% of their customers are now paying their 30%+ usory rates. We're so accustomed to the common man being wron on the economy and so sure there will be an even brightrer, shinier bauble to restore this buble. There won't but the more who think there will be a silver bullet heartens me.

[galewhitaker]

What about the energy crisis? The world economy is going to founder with oil at $100 (or maybe a lot more). The demand for oil by China and India is going to insure that the price dosen't fall!

[HARM]

I agree with the premise that what we're seeing is the market rationally reacting to the massive housing/credit bubble of the last 7 years. However, to dismiss the macroeconomic Tsunami facing us as "not a crisis" completely ignores the SCALE of today's bubble and correction cycle as compared to previous cycles.

We've seen an additional $6 Trillion in mortgage debt alone added in those 7 years, and a MEW-driven consumption economy develop. Even if a relatively small % of that evaporates, it's going to leave a nasty mark.

[GH]

Accrued Interest:

Yes, it will cause a crisis - it IS causing a crisis - and I will tell you why, in detail.

We all agree that the U.S. real estate market was a bubble that has burst. When bubbles burst, prices drop farther than they should, faster than they should. The tech stock bubble that burst 6 years ago brought pain to a lot of investors, even postponed some retirements, but didn't generate widespread damage to personal or corporate credit, or involve the biggest financial element of most people's lives (their homes). The real estate bubble was vastly bigger and more pervasive - and that is what will turn this recession into a crisis.

You mentioned the crisis criteria of innocent people being affected? I give you "Buy to Let". Many of the speculators bought homes with tiny money down, and rented them out to defray some of the mortgage payments, planning to flip them at a higher price before their teaser mortgage rate escalated. When their equity went negative they defaulted and ran, leaving the mortgage company to service the needs of their utterly innocent renters. Our local (big northern city) newspaper has regular stories of renters begging mortgage companies to fix leaky roofs and broken furnances, as sub-freezing temperatures put their health and even lives at risk.


In what were the hottest areas (such as CA, FL, and NV), residential real estate prices have passed the tipping point at which negative equity creates a feedback loop, causing price drops to enter free fall. The effects are working backward through time: by the end of 2008, people will be affected who are rock-solid risks and put 10% down on a home in *2005*. Your scenario that these "normal" borrowers can simply ignore the falling prices and keep paying their mortgage bill every month neglects the fact that with negative equity, homeowners can no longer do things they would otherwise routinely do, on which parts of our economy depend:
* refinance, to adjust their cash flow to changing personal conditions, such as paying for college tuition
* get a home equity loan, to start a business or support one through a tough period
* get a home improvement loan
This exacerbates the pain in local businesses of all kinds, enhancing the feedback loop. Homeowners who lose their jobs as the local recession deepens aren't be able to take job offers in healthier regions because they can't afford to sell their house at a loss - and may be forced to solve that problem by walking away from their mortgage, further enhancing the feedback loop.


And so it spreads across the nation:

- Already in many areas, unusual levels of commercial real estate are sitting empty and unsaleable because of vanished liquidity and fear of recession.

- Unemployment is rising... feeding into the real estate problem.

- Consumer discretionary product companies are projecting lower earnings... which will feed into the unemployment problem.

Who is next to be sucked into the whirlpool? Maybe those with money in supposedly safe constant-$1 money market funds. Yes, many MM funds are exposed to CDOs! They're already collecting on bond insurance to stay at $1.00. How long can the insurers keep funding them? We don't know... but look at the stock charts of Ambac and MBIA, and the fact that Warren Buffet just started a bond insurance company that won't touch SIVs, for clues.


The question should be, at what point will this crisis be addressed by government, and through what mechanisms will it ultimately be brought under control? On 9/11, Bush ran and Cheney hid, doing nothing useful. Their next crisis was Katrina - and much of New Orleans is still uninhabitable. So much for this administration's competence in crises. My sympathies go to the administration coming to power in January 2009. It is clear to me that by the time they begin, they will have an unambiguous mandate for action.

[bosgouet]

I think the avoiding of a crisis assumes that there are still ever more creative ways of supporting /growing the US economy. The successful erosion of the US manufacturing base has made it even more imperative that the US continue down the "financial economy" route.
IMHO the last bullets were spent trying to "avoid deflation" after the tech bubble . 2 major components of the "financial economy" housing and the retail spending were both stimulated by the artificially low rates on offer.
Employment surged primarily on the back of real estate construction/sales/res... These jobs are now reverting back to the mean and will most probably over shoot.
Retail spending rebounded also based on MEW activity and now more recently due to negative equity, the spending is being continued by utilizing the much more expensive credit card debt. I think that this CC binge will catch up to many very soon and a contraction in retail spending will ensue, especially with the oil price at current levels.

Another ignored facet of the way the property boom will catch people other than the traditional sub prime borrowers, is the prime borrowers who over borrowed to help finance their finance.
Many people took huge bets on the "unstoppable"... property market and being otherwise intelligent people kept some of their borrowings back to help fund a "serviceability buffer" That way they could overstate their real income borrow more than they needed to fund their new property purchase, and then use those extra funds to service the debt in the short term. They figured that even if the "hot" market cooled for a few years, it would bounce back and their buffer would take care of repayments rather than their actual income in the mean time. Trouble is , as the property correction last ever longer and corrects ever deeper, these people will be running their buffers ever lower and eventually will question can they/should they have so much of their income being increasingly diverted into an underperforming asset. Eventually we will see a wave of such people selling their trophy properties as their buffers run out and their repayments start to mean material downgrades to their lifestyle.

[lefty]

Crisis! We are there but just don't know it yet. Millions of living wage jobs gone, but their mortgages are still here. Can't pay on minimum wage saleries. Even if they work at two jobs. By the way, If their unemployment has run out, they are no longer listed as unemployed.

[Kunst]

We are used to year after year of a "good" economy. Soon we will have a recession, with higher unemployment and lower economic activity, both production and consumption. We are living in a grass hut with a hurricane bearing down. Too many people assumed summer would last forever.

BTW, commercial real estate has a lot bigger problem than liquidity -- it's called vacancies, lots of them and long lasting. Those who are overleveraged will be bought out cheap by the more prudent.