Archive for March, 2007
The Subprime Economy: Subprime Meltdown Spreading from Mortgages to Subprime Credit Cards, Subprime Auto Loans and Harley Davidson’s Hog Loans
Last week this blog argued that the subprime mortgage meltdown would spread to other aspects of the subprime lending: credit cards, auto loans, subprime consumer credit. Today we got news that even Harley Davidson’s motor hogs are being financed with subprime loans: 20% of their hogs loans are subprime and the 30-day delinquency rate on such loans has increased from a 3.6% between Q1 of 2005 and Q2 of 2006 to 5.18% in Q4 of 2006, an almost doubling of delinquency rates in two quarters.
Let us then consider the various aspects of this “Subprime Economy”.
First, notice that subprime credit cards are now in the tens of millions since their growth has mushroomed in the last six years (see this MarketPlace story on the problems and predatory practices related to subprime credit cards and subprime fast cash). If a subprime – in terms of credit score – individual has difficulty in servicing his/her various debt obligations the first default usually occurs on the credit card debt. Defaults on credit cards occur before defaults on mortgages because financially stressed households would not want to jeopardize their home ownership first. It is easier to somehow refinance credit card debt than try to avoid foreclosure on a home after default. So, the stress on balance sheets of subprime borrowers will first appear on their credit cards debt and their willingness to service such debt.
Next, defaulting on a home is more likely and earlier – for those who own a home – than defaulting on an auto loan because most individuals in the US need a car to drive to work. So facing debt servicing stress they are more likely to stop paying their mortgages than stop paying their auto loans as re-possessment of cars by creditors is faster than for homes. Again there are now tens of millions of subprime auto loans in the US. And there is now evidence that such subprime auto loans are also under distress. As reported by Bloomberg today under the title “Subprime Defaults May Spread to Auto Bonds, S&P Says” a study shows a sharp increase in defaults on auto loans:
Bonds backed by automobile loans may be hurt by rising subprime mortgage defaults as people with poor credit struggle with their household debt, according to Standard & Poor’s. Capital One Financial Corp., Wachovia Corp., Wells Fargo & Co., and other lenders have lent more funds to people with bad credit scores in the past few years to sustain growth, S&P said today in a report by analysts led by Mark Risi. The loans are also for longer terms, increasing the probability of default, the analysts said. About 68 percent of 2006 subprime auto loans were due in five years or more, Risi said. “There could be some fallout from subprime in auto loans,” Risi said in an interview. “We don’t have much data yet. We’re still in collection mode. It’s probably going to be hard to say for a while.” …S&P classifies asset-backed car loan securities as prime, non-prime, and subprime, Risi said. About 0.31 percent of the prime loans made in the first quarter of 2006 have defaulted a year later, according to S&P. That compares to 0.8 percent for non-prime and 3.02 percent for subprime car loans. Prime loans have cumulative losses of less than 3 percent with credit scores of 680 or more and current annual percentage rates of between 0 percent and 7 percent under S&P criteria. Non-prime pools have net losses of between 3.1 percent and 7.5 percent with credit scores of between 620 and 680 and interest rates of between 8 percent and 13 percent. Subprime securities have net losses above 7.5 percent with borrowers scoring less than 620 and annual percentage rates of more than 13 percent. About 71 percent of subprime auto loans in 2006 were used to purchase used cars and 68 percent of those loans are for more than five years, S&P said. Five years before, only 58 percent of subprime loans were for used cars and 33 percent were for more than five years. Subprime auto borrowers who are also homeowners may have “exposure to affordability products and the related payment shock,” said Risi.
But it is not just a problem of subprime mortgages, credit cards and auto loans. As reported yesterday by Douglas Kass (who has a column on street.com) there is also now evidence of a sharp increase in delinquency on the subprime loans that finance the purchase of Harley Davidson’s famous motorcycles, or “hogs” in Americana jargon. When default rates almost double in two quarters on Harley’s hogs you know that this subprime problem is a real hog for the economy. As Kass put it in sarcastic but true terms:
Born To Be Wild: The Subprime Contagion Spreads
It remains investment community’s general belief that the subprime lending mess is a fluke that will be contained…I have stressed the likelihood of contagion. After all, subprime is subprime and credit is correlated. Lower quality, more levered lending (with less collateral) is not confined to consumer loans, credit cards, homes, recreational vehicles and autos – as investors might soon find out. Even motorcycle (loans) are hitting potholes now!
Indeed, it appears that growing credit losses and delinquencies are beginning to render Harley-Davidson’s (HOG) motorcycle loans, well, increasingly like hogs (literally and figuratively).
Thirty-day delinquencies (and loss trends) in Harley-Davidson’s receivables book (courtesy of Lehman Brothers) give a clear picture that credit quality issues are broadening out as HOG’s receivable experience has begun to trace a pattern of deterioration that we first began to see in subprime mortgage loans during the first half of 2006.
Harley Davidson’s 30-Day Delinquencies
As I mentioned yesterday, Harley’s finance subsidiary (HDFS) funded almost half of Harley-Davidson’s motorcycle loans. Like subprime mortgage loans, HDFS’ hog loans are pooled and securitized to institutional buyers. Unfortunately — in credit trends and terms — HDFS is also beginning to look more and more like New Century (NCBC), Fremont and Accredited Home Lenders (LEND) did in early 2006.
In 2006-07, 28% of HDFS loans in its securitized pools had FICO scores (below 650) were considered subprime, ironically very close to the 21% subprime market share of total mortgage loans made last year! During the company’s investor day (Feb. 28), Harley acknowledged that several of the securitization pools have breached their credit quality metrics (and like subprime, the most recent pools’ credit losses and delinquencies are rising faster than expected and more rapidly than earlier pools). This is beginning to force Harley-Davidson to fund additional cushion reserves in the triggered securitization pools, much in the same way subprime mortgage originators have to buy back bad loans. (This takes a hefty bite out of HDFS’ profitability by reducing its net interest margin).
Should the recent trend of rising credit losses and delinquencies in Harley-Davidson’s loan receivable book and in the securitization pools of their financial subsidiary (HDFS) continue, tighter lending practices will likely be instituted and institutional buyers will be less receptive to buying HDFS’ securitized pools. This could serve to reduce Harley-Davidson’s sales growth and profitability.
Sound familiar? …It is beginning to look like the (motorcycle) lending markets are no longer … born to be wild. And, not surprisingly, I am still short Harley-Davidson.
importantly, the fungus of subprime is beginning to spread into asset classes other than housing and mortgages. Don’t think for a moment that Harley-Davidson’s dealers or the parent company were any less reluctant than the mortgage brokers to serve up loans for their product. And last time I looked, a motorcycle is far less secure and stable than a home.
Position: Short HOG
Kass has it right: the contagious fungus of subprime is now spreading into asset classes other than housing and mortgages, first into other types of subprime borrowing/lending and soon enough to near-prime and even some parts of prime credit markets.
Let us consider in more detail some aspects of this subprime economy and the debt trap into which millions of subprime borrowers have already fallen into or likely to fall into…
The data this morning on durable goods orders (falling 0.1% excluding the volatile transportation equipment component and falling even more (1.2%) for capital goods orders) confirm that the US will soon experience a hard landing.
Every component of investment has been already falling since Q4: residential investment; non residential structures investment; corporate investment in equipment and software; inventory investment. A key element of the soft landing consensus view is the recovery of business investment in equipment that had already started to falter in Q4. Now two months of data on capital durable goods orders have confirmed that business investment is in free fall: corporations are reducing their investment. So everyone of the four components of investment now looks simply ugly:
1. Residential investment is still falling at a 20% SAAR rate in Q1 and will not recover in Q2 given recent housing data. The idea that the housing recession was close to bottoming out has altogether collapsed under the weight of every possible recent demand and supply housing indicator. Expect this housing recession and it fallout to get much worse throughout 2007.
2. Non residential investment in structures – that was supposed to hold up the construction sector while residential investment was in a recession – is instead faltering too. Non residential investment was growing at a 20% SAAR rate in Q2 of 2006; then the growth slowed down to 14% in Q3 and then went into negative territory already in Q4. Expect it to fall at an annualized rate of about 5% in Q1. The reason for this faltering is obvious as this blog argued last fall: if you have entire ghost towns in the West – as the SF Fed President Yellen put it last summer – why would anyone want to build shopping centers and malls and offices in such ghost town? The wishful thinking that non residential construction would decouple from the biggest residential recession in the last 50 years had no basis and the latest numbers confirm it. Expect the free fall of housing to lead to a free fall of non-residential construction in 2007.
3. Capital spending on software and equipment by corporations has been falling since Q4 and now it is falling a much faster rate – about 8% SAAR – in Q1. This is not surprising: given the US slowdown that now it is turning into a hard landing why would corporations want to invest more? The consensus has given no clear answer to this simple question. The argument that corporations are flushed with profits and earnings and should invest is faulty in many ways. First, corporate profitability is now sharply slowing down. Second, corporates are sharply releveraging now, often with junk debt that is now sharply rising. Third, corporate default rates should be –according to the leading world expert on corporate distres,s Prof Ed. Altman – about 2.5% given firms’ and economic fundamentals, not the 0.6% observed last year. The low rate of defaults is all explained by temporary massive private equity and other levered players liquidity into the corporate sector and the risky and unsustainable out-of-court refinancings of distressed firms that are thus now avoiding Chapter 11 restructurings. Fourth, instead of investing their profits into new real capital corporations have returned them to shareholders in the biggest buyback bonanza in US history, $500 billion last year alone. Why would any corporation – that is optimistic about the economy and having profitable investment opportunities -want to return that money to shareholders rather than invest it? Simple answer: the economy looks ugly ahead.
4. Inventory investment has fallen sharply in Q4 and will fall more in Q1. The consensus hope that this deceleration in inventory investment would lead to a reduction of the now high inventory to sales ratios was conditional on aggregate demand remaining resilient. But with aggregate demand faltering (from fixed investment to even consumption now) the hope that faster inventory adjustment in Q4 would put the basis for its recovery in H1 is now faltering too.
The conclusion: the US is headed towards a hard landing recession this year, as early as Q2 as predicted by this blog in August of 2006. Why a hard landing? Several recent trends and data suggest that….
Why New Home Sales is a Much More Significant Measure of the Housing Recession than Existing Home Sales. And the Worsening Housing Recession…
There is an ongoing debate on whether the housing recession is bottoming out. The signals that have recently come from new home sales and existing homes sales have been slightly different. Existing homes sales went up 3.9% in February while new home sales – reported this morning – fell another 3.9%, after falling a whopping 16% in January. The stock market cheered on Friday the data on existing homes sales while it reacted negatively this morning to the new home sales data. The reality is that the stock market should have ignored the existing home sales data on Friday and concentrate mostly on the new home sales data. Why?
Conceptually the more relevant measure of the trouble in the housing market is new home sales rather than existing home sales. Existing home sales are mostly a measure of the “turnover” in the housing market. They are a little bit like turnover in financial markets as they measure how many already existing homes are purchased or sold. This market/turnover or market liquidity measure has some importance and during housing recession both existing home sales and new home sales fall.
But in housing – and economy wide – recessions existing homes sales do not move much downward while new home sales tend to fall in a range of 40% to 60%. New home sales are a more important measure of the state of housing as they represent the new demand for housing that is associated with new production and new supply of housing. What enters in the GDP measure is new homes production (i.e. residential investment) and new homes demand (new home sales). Thus, on the supply side the relevant measures of new housing activity are building permits, housing starts, residential construction, and housing completions.
Conversely, existing homes sales do not enter in the GDP measure as they are not related to the production or demand of new goods and services; they are just market turnover/liquidity of existing assets. Among the measures related to existing homes the price of existing homes and the supply of unsold existing homes are more interesting measures of the slack in the existing home market than the level of existing home sales. That supply of unsold existing homes depends on the existing homes that are on sale relative to the purchases of existing homes. The rising excess supply and glut of existing homes will be discussed in more detail below. But note now that with rising distressed sales of foreclosed homes and of homeowners unwilling or unable to service their mortgages, the future supply of existing homes will go up this year and next and, given downward price adjustment, the equilibrium level of existing home sales will increase over this year and next. Thus, observation of increases in the sales of existing homes over time – as long as existing home prices fall – will be signs of further distress in the housing market, not improvement. Basic economics 101 suggests that.
Thus, today’s data that new home sales have fallen another 3.9% in February on top of the 16% fall in January is really ominous. It confirms that the housing recession is getting worse rather than better, as discussed and argued in a recent paper with Menegatti.
As it will be discussed in a forthcoming blog the excess supply of new and existing homes will increase over 2007 and 2008 and will put significant downward pressures on home prices this year and next with the risk of a vicious circle of falling prices, falling home equity withdrawals, falling consumption demand, falling output, rising defaults and foreclosures and further fall in new home supply and demand and, again, downward price pressure that will lead to a US hard landing. As Larry Summers correctly put it today in the FT the main potential risk now is:
a vicious cycle of foreclosures, declining property values, reduced consumption demand, rising unemployment, more delinquencies and more foreclosures.
…While it would be premature to predict a US recession, there are now strong grounds for predicting that the US economy will slow down very
significantly in 2007. Whether in retrospect 2007 will prove to have been a
“pause that refreshed” a nearly decade-long expansion like the growth
slowdowns in 1986 and 1995 or whether it will see the end of the expansion
is not yet clear. Recent developments in the subprime sector exacerbate housing’s brake on US economic growth. Foreclosures will bloat the supply overhang of houses. At the same time reductions in capital in the housing finance sector and more rigorous credit standards will reduce the demand for new homes. Even as these developments reduce housing prices and the construction of new houses, housing finance problems are likely to magnify wealth effects on consumption as consumers face upward resets on their mortgage rates and are unable to refinance as they had planned, and as home equity, car and credit card lending conditions tighten.
If consumer spending declines and interest rates fall or appear likely to fall, there is the real possibility that the foreign lending to the US that has financed imports far in excess of exports will start to dry up, leading to a combination of higher long-term interest rates and a weaker dollar. This would tend to raise inflationary pressures, transmit US weakness to the rest of the world and could, by discouraging foreign demand for US assets, lead to further downward pressure on investment in plant, equipment and commercial real estate.
These are very sobering words. Summers further correctly suggested in his column that monetary and fiscal and other policies should now be aimed at avoiding this vicious cycle, not to address now the last war, i.e. the excesses of the last few years.
But let us analyze in more detail in the rest of this blog the data on existing and new home sales as they are a key aspect of the vicious cycle that Summers is worrying about…
“I Am Shocked, Shocked to Find that Abusive Lending, Fraud, Predatory Lending Fueled the Subprime Disaster!”
In a famous scene in the classic film Casablanca the police inspector Renault – when challenged that illegal gambling was occurring right under his “inspecting” eyes – replies with some self-mocking irony, pretending he was clueless about the mischief: “”I am shocked, shocked to find that gambling is going on in here!”
Similarly today a slew of banking regulators and supervisor expressed shock, shock, surprise and dismay – as they put it only today when summoned to a Congressional hearing – that abusive lending, fraud and predatory lending was taking place on a serious scale under their regulatory and inspecting eyes. Indeed, Bloomberg titled a story today with “Abusive Lending, Fraud Fueled Subprime Loan Crisis, U.S. Comptroller Says”. The Comptroller of the Currency is now talking about “abusive lending” and “fraud”.
Similarly, a host of other regulators, who testified at a Congressional hearing, made a similar mea culpa. For example, under the headline “Fed Says It Could Have Acted Sooner to Stem Subprime Mortgage-Loan Turmoil” Bloomberg reported that “The Federal Reserve could have acted faster to prevent a meltdown in the subprime-mortgage market by curbing the lax lending standards that contributed to the crisis, the Fed’s chief bank supervisor said. “Given what we know now, yes, we could have done more sooner,” Roger Cole, the Fed’s director of banking supervision and regulation, told the Senate Banking Committee in Washington today, as regulators testified for the first time before Congress on the market rout.
How did this failure of supervision and regulation occur? The Wall Street Journal, in its lead article this morning, has a long and excellent analysis on how a web of overlapping – and some times contradictory – regulatory authorities (half a dozen ones at the federal level, and a few dozens at the state level) failed to properly perform their jobs. Part of the problem was that many of the new sub-prime lenders were not under the regulatory jurisdiction of the Fed or the FDIC but rather of state level regulators. But, as the WSJ puts it, federal level regulators cannot just blame the state-level regulators as the climate of the last six years was one of pushing a systematic federal agenda against meaningful regulation and supervision of the financial system. As the WSJ aptly put it:
Federal regulators over the past decade issued rules to tighten standards for making loans to borrowers with blemished credit or low incomes. Yet standards still declined and the volume of loans surged in the past two years. One reason: Changes in the lending business and financial markets have moved large swaths of subprime lending from traditional banks to companies outside the jurisdiction of federal banking regulators…Yet even where federal regulators have jurisdiction, they sometimes have been slow to grapple with the explosive growth in especially risky practices and quick to shield federally regulated banks from states and private litigants. The underlying belief, shared by the Bush Administration, is that too much regulation would stifle credit for low-income families, and that capital markets and well-educated consumers are the best way to curb unscrupulous lending.[bold added]
So, indeed a high level federal attitude that stressed self-regulating market rather than sensible and appropriate regulation and supervision of the financial system is at the core of this regulatory failure.
Let us consider this latter issue in more detail:
From the Subprime Mortgage Carnage to the Coming Subprime Credit Cards and Subprime Auto Loans Meltdown
At this point all the mainstream press and analysts add the terms “meltdown” or “carnage” next to almost any subprime story or analysis. But, as predicted by a few, the subprime carnage/meltdown is now spreading to other parts of the mortgage market and to other components of consumer credit.
See for example the story by Bloomberg below. According to that article the subprime contagion is now seriously spreading to near-prime Alt-A loans that, as discussed before, had the same reckless features as the subprime one. As Bloomberg put it:
The subprime credit crunch is beginning to ensnare even borrowers with good credit.
Lenders are increasingly refusing to lend to homebuyers who can’t make a down payment of more than 5 percent, especially if they won’t document their income. Until recently such borrowers qualified for so-called Alt A mortgages, which rank between prime and subprime in terms of risk. Last year the category accounted for about 20 percent of the $3 trillion of U.S. mortgages, about the same as subprime loans, according to Credit Suisse Group.
“It’s going to be very difficult, if not impossible, to do a no-money-down loan at any credit score,” said Alex Gemici, president of Parsippany, New Jersey-based mortgage bank Montgomery Mortgage Capital Corp. Companies that buy the loans “are all saying if they haven’t eliminated them yet, they’ll eliminate them shortly.”
Tighter lending standards may slash subprime mortgage sales in half this year and Alt A mortgages by a quarter, according to Ivy Zelman, a Credit Suisse analyst in New York who covers homebuilders. The new requirements will force some prospective homebuyers to save more money for a down payment or risk being denied credit.
But the problem is not just subprime and nearprime (Alt-A) that, by themselves, accounted for 40% of originations in 2005-2006. It is also a problem with home equity loans, piggyback loans and also a problem for a significant part of near-prime and “prime” ARMs that are resetting to the tune of $1 trillion alone this year. So, the contagion will soon spread to those parts of the mortgage market too.
More importantly, the contagion will further spread to other components of consumer debt. While everyone is now obsessed with subpime mortgages – while most analysts ignored the problem for almost a year – no one has even started to talk about a much bigger subprime problem: in the last few years in addition to an explosive growth of subprime mortgages we also saw a massive a growth of subprime auto loans and subprime credit cards.
Lets discuss now some of the severe problems with these other components of subprime lending and why we will soon see a subprime credit cards meltdown and a subprime auto loans meltdown.
Here is a seven points take on this emerging meltdown:
As reported by Bloomberg the Fed kept the Fed Funds rate at 5.25% but abandoned the tightening bias. In a hour long interview on Bloomberg TV earlier this morning I suggested that the Fed should at least move to a balanced/neutral bias (as they did now) if not even move to an easing bias (that […]
Who is to Blame for the Mortgage Carnage and Coming Financial Disaster? Unregulated Free Market Fundamentalism Zealotry
The sub-prime and overall mortgage carnage is now likely to lead to a financial crisis whose cleanup and bailout costs will make the S&L bailout bill look like spare change. We are only at the beginning of this fallout but, already, several proposals and bills in Congress have been submitted to help millions of sub-prime homeowners […]
The Ten Faulty Consensus Views about Sub-prime and Soft-Landing…and the Ten Ugly Truths about the Coming Economic and Financial Hard Landing
The sub-prime carnage is now front page news on every possible media; soon enough it may be even become cover story on People magazine as even Britney Spears will soon be asking about it. But many sophisticated observers and investors tell me they had not even heard once about this term until January. Too bad […]
Steve Pearlstein of WaPo on Liar Loans, Teaser Loans, Stretch Loans, NINJA Loans and Other Mortgage Monstrosities
Sometimes it takes a brilliant writer to express in concise and simple ways – that the common “human” can understand – what a few of us express in a much more technical language. This week I spoke at some length with Steve Pearlstein (the business columnist of the Washington Post) and discussed, among other issues, […]
Mainstream Monday Morning Quarterbacking on Subprime Mortgages..While Still Being Blind to the Spillovers and the Coming Credit Crunch
The subprime disaster is now in full swing with the second largest subprime lender (New Century Financial) effectively bankrupt and another one comatose today. Now that 30 plus more subprime lenders have gone out of business since December, even mainstream analysts are finally recognizing the subprime “carnage” and “meltdown” (to use words of the thoughtful, soft-landing mainstream and usually not-hyperbolic Richard Berner of Morgan Stanley).
However, the mainstream consensus is still arguing – with little evidence – that “this is only a subprime problem” , that “there is no risk of a credit crunch” and that this problem “will have no macro effects”. I disagree on this optimistic outlook as my last blog discussed in detail.
A minority of scholars and analysts – including Robert Shiller, David Rosenberg, the blogger Calculated Risk and a few others – already warned last summer about a severe housing recession (not the conventional consensus about a “housing correction”), about the risks and consequences of falling home prices (not the consensus about a “slower growth of rising home prices”), and about the risks of a fallout of this severe housing recession on mortgages, first subprime ones and then more broadly to the rest of the mortgage market.
I was not the first one to worry about housing and mortgages as a few others distinguished observers had already observed the incoming housing recession and its fallout. On my modest side last August, when I started to forecast a recession in the US in 2007 by Q2 that would be triggered by the housing bust, I also argued that this housing bust would soon also lead to serious risks and distress in the financial system. I pointed out that such stress and vulnerabilities would first be noticed in the subprime segment of the mortgage market as many (but not all of) of the excesses of the last few years in mortgage finance were concentrated in this market. I pointed out that the housing bubble and the credit bubble associated with it reckless lending practices and with regulator being asleep at the wheel while this unregulated gambling was taking place. I argued that the result would be financial distress and bankruptcy for many lenders and a systemic banking crisis similar to – or most likely worse than – the S&L crisis. As I put it last August:
“…not only we have had in the last few years a massive credit boom associated with the debt financing of the housing bubble; this lending boom has also been associated with an extreme loosening of credit standards that allowed the boom to continue and feed an ever more unsustainable housing bubble. Indeed, many mortgage lenders have gambled for redemption during the bubble years and engaged in extremely risky and reckless lending practices that may eventually lead to financial distress, or even their outright bankruptcy; we may be soon facing the same mess and systemic banking crisis that we had in the 1980s with the S&L crisis.
The lending practices of mortgage lenders became increasingly reckless in the last few years: indeed, in 2005 a good third of all new mortgages and home equity loans became interest rate only; over 40% of all first-time home buyer were putting no money down; at least 15% of buyers had negative equity; and an increasing fraction of mortgage came with negative amortization (i.e. debt service payments were not covering interest charges, so the shortfall was added to principal in a Ponzi game of accumulating debt). Finally, at least 10% of all home owners with mortgages currently have zero equity. This reckless lending scam was fed by ever loosening lending standards, the massive growth of sub-prime lending and over-inflated valuations of homes to justify new mortgages and refinancings (when significant equity extraction was occurring). It was a vast and growing lending scam where lenders’ behavior was distorted by serious moral hazard incentives driven by poorly priced deposit insurance, lax supervision of lending practices by regulatory and supervisory authorities, slipping capital adequacy ratios, too-big-to-fail distortions and the distortions created by the financing activities of the too-big-to-fail government sponsored enterprises (Fannie Mae and Freddie Mac). …
…the scariest thing is that the gambling-for-redemption behavior…are not the exception in the mortgage industry; they are instead the norm. There are good reasons to believe that this is indeed the norm as lending practices have become increasingly reckless in the go-go years of the housing bubble and credit boom. If this kind of behavior is – as likely – the norm, the coming housing bust may lead to a more severe financial and banking crisis than the S&L crisis of the 1980s. The recent increased financial problems of H&R Block and other sub-prime lending institutions may thus be the proverbial canary in the mine – or tip of the iceberg – and signal the more severe financial distress that many housing lenders will face when the current housing slump turns into a broader and uglier housing bust that will be associated with a broader economic recession. You can then have millions of households with falling wealth, reduced real incomes and lost jobs being unable to service their mortgages and defaulting on them; mortgage delinquencies and foreclosures sharply rising; the beginning of a credit crunch as lending standards are suddenly and sharply tightened with the increased probability of defaults; and finally mortgage lending institutions – with increased losses and saddled with foreclosed properties whose value is falling and that are worth much less than the initial mortgages – that increasingly experience financial distress and risk going bust.
One cannot even exclude systemic risk consequences if the housing bust combined with a recession leads to a bust of the mortgage backed securities (MBS) market and triggers severe losses for the two huge GSEs, Fannie Mae and Freddie Mac. Then, the ugly scenario that Greenspan worried about may come true: the implicit moral hazard coming from the activities of GSEs – that are formally private but that act as if they were large too-big-to-fail public institutions given the market perception that the US Treasury would bail them out in case of a systemic housing and financial distress – becomes explicit. Then, the implicit liabilities from implicit GSEs bailout-expectations lead to a financial and fiscal crisis. If this systemic risk scenario were to occur, the $200 billion fiscal cost to the US tax-payer of bailing-out and cleaning-up the S&Ls may look like spare change compared to the trillions of dollars of implicit liabilities that a more severe home lending industry financial crisis and a GSEs crisis would lead to.”
It took less than four months after these warnings for the financial distress among subprime mortgage lenders to fully come to the surface leading to severe distress in this industry – both among the borrowers and the lenders – and creating serious stress in the ABX, RMBS and CDO markets.
By mid-December the subprime meltdown and carnage was clear, the ABX indices started to plunge and the first signs of disruption of the CDO and RMBS markets started to appear.
Then many more started to follow this unfolding disaster, including myself as I analyzed in this blog this developing carnage and its financial fallout almost daily throughout the fall and the winter.
This rising mess – from a housing recession to the severe financial fallout of it – started to be seriously considered by conventional consensus in late January when it became front page in some financia
l press and when even mainstream soft-landing analysts started to talk about the subprime “disaster”, “meltdown” and “carnage”.
Now that the subprime carnage is so evident that even a visually-challenged person would notice it, the new conventional wisdom is that this is only a sumprime problem, that the credit crunch in subprime will not become a generalized credit crunch, that there is no disruption of the CDO and RMBS market, and that this disaster will have no macro effect. As I discussed in detail in my last blog this new conventional wisdom has little basis for its argument. First, this is not just a subprime problem as up to 50% of originations in the last two years are seriously problematic (narrow subprime, Alt-A, other near prime and part of the prime mortgages that had the same reckless features of subprime). Luckily this week a minority of Wall Street analysts (including Ivy Zelman of Credit Swiss) are starting to recognize the extent of the overall coming mortgage distress, not just the “now-obvious-to-the-blind” subprime distress; see the details of these excellent analyses below. Second, the severe credit crunch in subprime is now spreading to the other risky mortgages. Third, there are sign of the beginning of a disruption in the CDO market affecting the RMBS markets (see for example the articles in the WSJ and Bloomberg today).
Fourth, all the growth forecasts for the US economy by the consensus analysts were made before the fallout from subprime started. So how come almost none of those forecasts has been revised to incorporate any – even small – effect of the subprime and mortgage fallout on the macro outlook? Even Goldman Sachs – that has been much more pessimistic than the consensus about 2007 growth – says that the subprime credit crunch will reduce new home sales by another 200K relative to the already currently highly depressed level of 933K (that is already down a whopping 32% from its peak). So, 200K less new home sales in 2007 – let alone the fallout to other mortgages and to other housing related sectors of the economy- will have no macro growth effect according to most – but not all – macro forecasters. But what is the analysis of most macro analysts that leads them to argue that all this will have close to zero macro effects? Not even an epsilon reduction in their 2007 growth forecasts, not even a meagre 0.1% change, when their forecasts were made before the subprime fallout even started. Shouldn’t they at least reconsider and revise such forecasts? Greenspan says that there is now a 30% probability of a recession; while the Fed model – based on the yield curve – says the recession probability is at least 53%. But the Blue Chip panel forecasted yesterday a growth of 2.5% for H1 and rising to 3% by H2 of 2007.
But now the subprime and mortgage and credit crunch genie is out of the bottle and no amount of self-serving spin will be able to lock it back in the bottle. So kudos to Shiller, Rosenberg, Calculated Risk, Zelman and a few others who braved early on to say that the housing and mortgage emperor had no clothes.
Indeed, both the mainstream press and some serious analysts are now recognizing the full extent of the coming financial train wreck. Lets see now some details of this…