Imagine a different world in which financial assets were the principle asset of American households, in part because such assets had so steadily increased over the decades. Brokerage standards were significantly loosened so 2:1 margin were no longer the standard but the starting margin position is 10:1. Most people open accounts with large positions and have as much as 20:1 margin. This means people start out with $250K to $500K new accounts and put 5% to 10% down borrowing the rest. To make matters worse, the brokerage industry has no recourse against the account owner if the account were to decline in value. But don't worry, as this has never happened before. Also, so long as the account holder pays for their margin interest, there can be no margin calls so the brokerage has no way out if asset values were to decline.
All of a sudden the supposedly impossible happens. Financial assets start a wicked decline of 20% per year. Any new account holders within the last few years have their equity wiped out. Very few customers sell out of their position at small losses. There are no margin calls except for a small percent of people that fall behind on paying margin interest or stop paying it altogether. The brokerage firms are in a death spiral as they themselves are leveraged 20:1 and they can't get out of the spiral. The can't close the brokerage account so their losses simply mount. Nothing they can do.
The brokerage industry seeks additional capital but very quickly must resort to offshore funds as all domestic sources smell death in the air and stay clear of providing any equity to the walking dead. These offshore sources dry up. Soon enough some of the brokerages fail and the government steps in providing the first trillion dollars of support followed by another trillion then another trillion. Financial assets continue to decline so while trillions have been provided this funding only covers losses from six months back. Because 95% of all account holders continue to pay margin interest, the view is the issue is not too bad and the last trillion of support is viewed to be the right medicine to complete the cure.
Well, it is not. Substitute housing assets and mortgage bankers for financial assets and brokerages and this is what we have today with the housing crisis. The most significant asset of American households, housing, is in a death spiral and it is taking the mortgage industry with it. Tuesday's Case-Shiller housing price index shows the following:
- The monthly sequential decline in the 10 and 20 city composite continues to fall at an increasing pace. The monthly decline has now increased in each of the last six months and declined 2.8% in January's results which were published today (C-20 index).
- At 2.8% monthly declines, this compounds to a 39% decline after one year.
- All 20 cities declined and only two declined at a slower pace then the previous month - so 18 are accelerating their rate of decline.
- The 2.8% sequential decline in the 20 city composite is the worst decline since housing peaked in July 2006
- The composite 20 index is back to the level in September 2003. Probably 40% of all homes were purchased after that date.
- The free fall in prices is almost at pace that is three times greater than the rate of increase in 2003 so people that purchased in December of 2002 will be underwater in three more months of reported declines - this will likely happen in 4/09 since the Case-Shiller reports on a two month lag.
- From May, 2009 to August, 2009 we will wipe out 2002's appreciation at the current pace
- Continuing with this same pace, in just two more months (10/09) we will wipe out 2001's meager appreciation adding another three years of underwater purchasers. At this point close to 2/3 of all homeowners will be underwater and this assumes no equity out refinancings or home equity loans. Talk about the negative wealth effect.
- By the end of 2009 we basically wipe out 2/3's of all homeownership equity, the previous principle asset for American households. So the seemingly fictitious beginning to this piece wasn't really far fetched afterall if one considers homeownership as a net asset.
What does this mean? For every 3% monthly decline, by my estimation, we wipe out $250 billion in equity. First this eliminates the homeowners' equity. If the homeowner is 5% to 10% underwater and keeps their job they probably stay current on their mortgage. But once they either lose their job or get to 25% or more underwater, a large number walk. With the composite index for 20 cities down 29% in January, 2009 the rate of foreclosures will increase only causing more housing declines.
Once the homeowner is underwater, the continuing decline in equity is on the backs of the banks and mortgage holders. When Geithner acknowledges the bailout funds are down to $135 billion (and, as we saw over this past weekend, will not comment on if this is enough) we know the truth and it is scary he won’t speak the truth. $135 billion is about two weeks of losses in American mortgages if fully absorbed by the banks.
We are in deep deep trouble and our government and the banks are not fully acknowledging it. Many of the large banks are insolvent. They were like the Monopoly player that plowed all their cash into buying hotels - no reserve at all.
Even if a bank only had 20:1 leverage, assuming no offloading of mortgages (something they certainly did), if the bank was fully absorbing a 3% monthly loss like we are currently incurring, the bank's equity would be eliminated in two months. We are sixteen reported months into this decline based on Case-Shiller and eighteen months into the actual decline. How could the major banks not be insolvent?
The insolvency is spreading as predictably as darkness at dusk. Perhaps our government can declare some emergency extra day light savings extensions or do some other fancy footwork, but darkness continues unabated.
A spreadsheet for 1/09 and past months for Case-Shiller may be found here.
Disclosure: The author is currently long oil and short financials.