Debt or Margin: The Housing Bubble will Function Like the Depression
There really is nothing new in the world of finance, especially when the topic is leverage.
Prior to The Great Depression, the stock market was riding on a wave of enormous debt - people were buying and selling stock and margin requirements were only 10%. When prices began to drop and margin calls were made, people had to find the remaining funds. Broker loans on call rose from $3.5b in 1927 to $8.5b in 1929
The speculation was pretty widespread, too: 1.5m investors got caught. Also, the bull run was fueled by pools of investors pumping up stocks. The result was fight and flight: some stayed in the hopes that the damage was done while others were forced to sell to cover their positions. Incredibly, big name economic and political leaders preached that the bottom was in place while it continued to collapse. The net result is that a vicious downward pricing spiral began.
A banking industry collapse followed. A run on bank accounts didn't help. Also, banks were amongst the speculators that were leveraged to the hilt. Factories began to close because people weren't spending and because they couldn't get loans from the failed banking system.
Out of this came several familiar rules: banks couldn't dabble in the stockmarket, margin limits were established, and the FDIC was created to prevent future runs on banks.
While I am not suggesting that the forthcoming debt collapse will have as severe an impact, I am saying that the similarities are striking and that helps us to be prepared.
We have:
1. Massively leveraged speculation.
2. Over production of commodities (housing stock and related items)
3. Asset price collapse
Massively leveraged speculation.
People borrowing to buy assets to sell and make a quick profit. The Great Depression and the recent Housing Boom. But the key difference is that lending requirements were stricter back then. People in the past year were able to buy property (excuse me - take on debt) with no money down. That's 100% leverage. Sometimes they even got loans for 110% of the property value. Even more leveraged speculation.
The drive to sell as much debt as possible continues. As the well of qualified debtors (excuse me, home buyers) dried up, lenders switched to unqualified debtors. FICO score requirements were lowered, stated (not proven) income was allowed. Today we are seeing unprecedented foreclosures happening almost immediately after the loan was written. What is more mindboggling - Bank of America wants to offer credit cards (excuse me - debt cards) to illegal immigrants.
As of this week, the sub-prime debt (BBB ratings) required an 11% risk premium in addition to a handling fee and LIBOR or Prime. That's 17% interest charged for sub-prime loans. Imagine what happens to better quality loans as they face the re-emergence of the risk premium. Mortgage rates will rise a bit as well, further adding pain to debt holders (excuse me, ARM mortgage holders).
How widespread is this? Roughly 60% of all homes bought in 2006 in California used an ARM. We have millions of people taking on massive debt covered only by the value of a single asset: the home.
Overproduction: home building.
The statistics are mindboggling. Las Vegas has 2.5 years of inventory but home construction continues. Foreclosures are tripling in every major metro area and homebuilding continues. Contract cancellations are ~40% at major home builders. More inventory is being dumped by shadow speculators.
The best analogy here is a BBQ where you invite 10 people over and offer 100 burgers. There is only so much people can consume.
What makes this more overproduction is that demand is false: with the massive speculation gone and lenders now passing stricter requirements, the pool of buyers is shrinking.
Asset price collapse.
It isn't happening yet, but you wouldn't expect it too. The external triggers are only now happening. The fire-selling won't start until people have to sell. A financial crisis is only now starting to erupt: HSBC announced a multi-billion dollar writedown, another few sub-prime lenders went bankrupt this weekend, H&R Block can't sell their lending company, etc. This drains away prospective buyers and squeezes sellers who are looking to re-finance.
Another external trigger is the home builders. They have lots of room to drop prices. In fact, sales volumes are collapsing much more than the 30%+ they report because those figures don't include the 40%+ cancellation rates. (Home sales are calculated based on a contract being written - and those are getting cancelled.) And they are still building! Whether you accept the 30%+ drop in sales or the higher 60%, the fact is that home builders are motivated to sell in a way they haven't been.
The loss of buyers (for financial qualification reasons or because they expect price drops) is a major nail in the coffin.
So why hasn't this happened yet? Mainly because folks expected the Springtime bounce and have accepted the cash flow hit in anticipation of a big cash out sale. Well, there hasn't been a bounce. Almost 70% of the entire year's real estate sales happen in the first 4 months of the year. Well, until this year.
Besides, there is no reason to panic. Prices have doubled in the last 5~6 years, so even a 25% haircut is not a problem for most homebuyers.
Except, we haven't started the wave of ARMs resetting. In 2006 a few hundred billion dollars of loans re-set. In 2007, forecasts are for $1.4 Trillion. With all these problems happening before the big financial crisis comes, imagine what happens next.
We see fear today, we'll see panic by the end of the Summer, and that's only 7 months away.
BOTTOM LINE
People think they own a house when in fact they bought debt. Sometimes that debt is cheap (6% fixed mortgage rate) and sometimes it is expensive (a 3 year ARM about to re-set to 10%). Some people think that they can sell an asset (a house) to payoff their debt. Many can. Anyone who bought a house pre-2003 certainly can, at least for now.
However, the international financial system can weather the storm. Our economy is large enough today to absorb a $100B loss without it bringing the system to its knees. HSBC just wrote off $12B and nobody Wall Street yawned (well outside of HSBC and their peers). That $100B is a 8% loss of all loans coming due this year. Even a $200B loss is manageable. Scary, but there it is.
The two outcomes will be:
1. widespread unemployment as the housing industry moves through a deep recession
2. Consumer spending & tightening of belts
I've spoken at length about who and what markets are most exposed, so I won't repeat myself here.
What I wanted to do was to change mindsets and help people see that this is not a housing bubble but a debt crisis. Think the S&L crisis and it's the same, except many more people are affected and to a greater degree. Coupled with that is the overproduction of housing which will have its own semi-isolated unemployment rush. Think the dot.com bust.
Prior to The Great Depression, the stock market was riding on a wave of enormous debt - people were buying and selling stock and margin requirements were only 10%. When prices began to drop and margin calls were made, people had to find the remaining funds. Broker loans on call rose from $3.5b in 1927 to $8.5b in 1929
The speculation was pretty widespread, too: 1.5m investors got caught. Also, the bull run was fueled by pools of investors pumping up stocks. The result was fight and flight: some stayed in the hopes that the damage was done while others were forced to sell to cover their positions. Incredibly, big name economic and political leaders preached that the bottom was in place while it continued to collapse. The net result is that a vicious downward pricing spiral began.
A banking industry collapse followed. A run on bank accounts didn't help. Also, banks were amongst the speculators that were leveraged to the hilt. Factories began to close because people weren't spending and because they couldn't get loans from the failed banking system.
Out of this came several familiar rules: banks couldn't dabble in the stockmarket, margin limits were established, and the FDIC was created to prevent future runs on banks.
While I am not suggesting that the forthcoming debt collapse will have as severe an impact, I am saying that the similarities are striking and that helps us to be prepared.
We have:
1. Massively leveraged speculation.
2. Over production of commodities (housing stock and related items)
3. Asset price collapse
Massively leveraged speculation.
People borrowing to buy assets to sell and make a quick profit. The Great Depression and the recent Housing Boom. But the key difference is that lending requirements were stricter back then. People in the past year were able to buy property (excuse me - take on debt) with no money down. That's 100% leverage. Sometimes they even got loans for 110% of the property value. Even more leveraged speculation.
The drive to sell as much debt as possible continues. As the well of qualified debtors (excuse me, home buyers) dried up, lenders switched to unqualified debtors. FICO score requirements were lowered, stated (not proven) income was allowed. Today we are seeing unprecedented foreclosures happening almost immediately after the loan was written. What is more mindboggling - Bank of America wants to offer credit cards (excuse me - debt cards) to illegal immigrants.
As of this week, the sub-prime debt (BBB ratings) required an 11% risk premium in addition to a handling fee and LIBOR or Prime. That's 17% interest charged for sub-prime loans. Imagine what happens to better quality loans as they face the re-emergence of the risk premium. Mortgage rates will rise a bit as well, further adding pain to debt holders (excuse me, ARM mortgage holders).
How widespread is this? Roughly 60% of all homes bought in 2006 in California used an ARM. We have millions of people taking on massive debt covered only by the value of a single asset: the home.
Overproduction: home building.
The statistics are mindboggling. Las Vegas has 2.5 years of inventory but home construction continues. Foreclosures are tripling in every major metro area and homebuilding continues. Contract cancellations are ~40% at major home builders. More inventory is being dumped by shadow speculators.
The best analogy here is a BBQ where you invite 10 people over and offer 100 burgers. There is only so much people can consume.
What makes this more overproduction is that demand is false: with the massive speculation gone and lenders now passing stricter requirements, the pool of buyers is shrinking.
Asset price collapse.
It isn't happening yet, but you wouldn't expect it too. The external triggers are only now happening. The fire-selling won't start until people have to sell. A financial crisis is only now starting to erupt: HSBC announced a multi-billion dollar writedown, another few sub-prime lenders went bankrupt this weekend, H&R Block can't sell their lending company, etc. This drains away prospective buyers and squeezes sellers who are looking to re-finance.
Another external trigger is the home builders. They have lots of room to drop prices. In fact, sales volumes are collapsing much more than the 30%+ they report because those figures don't include the 40%+ cancellation rates. (Home sales are calculated based on a contract being written - and those are getting cancelled.) And they are still building! Whether you accept the 30%+ drop in sales or the higher 60%, the fact is that home builders are motivated to sell in a way they haven't been.
The loss of buyers (for financial qualification reasons or because they expect price drops) is a major nail in the coffin.
So why hasn't this happened yet? Mainly because folks expected the Springtime bounce and have accepted the cash flow hit in anticipation of a big cash out sale. Well, there hasn't been a bounce. Almost 70% of the entire year's real estate sales happen in the first 4 months of the year. Well, until this year.
Besides, there is no reason to panic. Prices have doubled in the last 5~6 years, so even a 25% haircut is not a problem for most homebuyers.
Except, we haven't started the wave of ARMs resetting. In 2006 a few hundred billion dollars of loans re-set. In 2007, forecasts are for $1.4 Trillion. With all these problems happening before the big financial crisis comes, imagine what happens next.
We see fear today, we'll see panic by the end of the Summer, and that's only 7 months away.
BOTTOM LINE
People think they own a house when in fact they bought debt. Sometimes that debt is cheap (6% fixed mortgage rate) and sometimes it is expensive (a 3 year ARM about to re-set to 10%). Some people think that they can sell an asset (a house) to payoff their debt. Many can. Anyone who bought a house pre-2003 certainly can, at least for now.
However, the international financial system can weather the storm. Our economy is large enough today to absorb a $100B loss without it bringing the system to its knees. HSBC just wrote off $12B and nobody Wall Street yawned (well outside of HSBC and their peers). That $100B is a 8% loss of all loans coming due this year. Even a $200B loss is manageable. Scary, but there it is.
The two outcomes will be:
1. widespread unemployment as the housing industry moves through a deep recession
2. Consumer spending & tightening of belts
I've spoken at length about who and what markets are most exposed, so I won't repeat myself here.
What I wanted to do was to change mindsets and help people see that this is not a housing bubble but a debt crisis. Think the S&L crisis and it's the same, except many more people are affected and to a greater degree. Coupled with that is the overproduction of housing which will have its own semi-isolated unemployment rush. Think the dot.com bust.
posted by Andrew at
3:39 PM
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