The Mortgage Market Mess

The Daily Reckoning PRESENTS: This is not your father’s housing market, nor your grandfather’s, for that matter. For them, steadily rising – but basically stable – home values seemed (more or less) a given. Recent news suggests that that situation may be a thing of the past…

THE MORTGAGE MARKET MESS

The National Association of Realtors estimated optimistically (have you ever known a pessimistic realtor?) that housing prices will fall 16 percent in 2007 – their first overall decline in 40 years. Real estate investor Kenneth Heebner anticipates a 20 percent decline this year, due mostly to defaults in the “subprime” and “Alternative-A” mortgage markets. Needless to say, he is relatively more bearish on this year’s housing market.

To understand why, just do the math. In the United States today, there is approximately $10 trillion in outstanding mortgages, and of these, about one-quarter are subprime and Alt-A loans. (Subprime loans are made to borrowers with little or no credit, while Alt-A loans are made to borrowers with better credit but who are not considered prime.) Individuals who access such loans often pay a below-market interest rate, or an interest-only mortgage payment, for the first few years of the mortgage. But after that, mortgage payments are adjusted to reflect prevailing market rates. If 40 percent of the Alt-A market fails this year (as many estimate), financial markets will be looking at $1 trillion in defaults.

That’s a lot of defaults, especially when you consider that the 1980s S&L crisis cost, by comparison, $150 billion (about $240 billion in today’s dollars) and is partly blamed for the 1990–91 recession. Does today’s mortgage market promise a similar result today, on the eve of the baby boomers’ retirement?

If so, the sound that defines 2007 may not be that of Beyonce or Bell but of air seeping from the housing bubble. Though unpleasant, it is a sound much to be preferred, since it reflects a housing market returning to fundamental levels, as well as one that will offer buying opportunities to many who currently cannot afford housing. But still, $1 trillion dollars makes for a lot of failed loans that were issued over the last few years. Surely, this is a clear example of market failure. Right?

Well, no, because when hyper-regulated markets fail, you can’t blame market forces. In this case, rising real estate prices were forcing many low and middle class households out of the housing market well before the most recent recession. When that happened, home buyers had few options – either relocate to another part of the country and start over, or finance with a subprime or Alt-A loan and wait the bubble out. That’s what many did, and it quelled genuine political revolts in bubble-plagued markets in the early 2000s, especially in California and the Northeast.

The situation reminds us that bad things happen when pols manipulate markets to achieve their ends. In this case, there was a recession that resulted from an inflationary boom that they created. What do you do when housing market malinvestments, spurred by Alan Greenspan’s cheap-money policies of the 1990s, pushes housing prices out of reach to the middle class?

Option 1: Say mea culpa and cease policies that create bubbles in the first place (and pay a political price at the polls).

Option 2: Give those placed in such positions a short-term solution that allows them a way out, even if you are simply postponing the day of reckoning by a few years.

These two options reflect an important point made in Henry Hazlitt’s classic book, Economics in One Lesson. Economic policy options often have either positive short-term effects and negative long-term effects, or negative short-term effects and positive long-term effects. It’s obvious which option is favored in today’s mass democracy, since politicians are extremely short-term oriented – indeed, their focus is about as long as the next election.

What other lessons should be derived from the housing market mess?

Number One: Financial instruments have specific purposes. Using them for others can be disastrous. Consider financial derivatives, which are excellent tools that allow firms to manage risk. However, they are considerably riskier investments when used as basic stores of wealth or as vehicles for quick financial gain. Just ask the financial managers at Fannie Mae and Freddie Mac, Long-Term Capital Management, the cities of Cincinnati and San Diego, among others who incurred steep financial penalties for abusing derivatives markets.

Like many financial instruments, subprime and Alt-A loans serve a specific function in financial markets – in particular, they allow less-liquid, higher-risk borrowers access to credit when they can statistically prove that they will be more liquid in the near future. Many of the problems we see today in mortgage markets result from subprime loans that were made when politics trumped good economics.

Number Tw Public regulation of mortgage markets should be eliminated. If this were the case, they would not be subject to as much political manipulation (which was the goal of Fannie Mae and Freddie Mac from the beginning), while at the same time they would show the same level of stability and differentiation we associate with less-regulated markets. Private regulation would resurface. The problem is that much of today’s financial-institution regulation is based on the mistaken idea that that sector, and the banking industry in particular, caused the Great Depression. Such thinking justified the Glass Steagall Act and other regulatory interventions in the financial sector, and the result has been at least one significant financial crisis about every ten years. Until market controls are allowed to reassert themselves – controls that would eschew political considerations in the issuing of credit – we can expect continued volatility within financial institutions.

Number Three: Home ownership was the American dream only to the extent that housing protected Americans from monetary inflation. Presidential candidates this year will wax ad nauseam that home ownership is the American Dream and that this dream is now too expensive for average Americans. What they won’t talk about is how government policies, and specifically monetary policies, help bring this situation about.

What is rarely asked is why home ownership ever became the American Dream. The dream was never so much to own a home for the sake of it. Rather, the real dream has always been to protect wealth from the evils of inflation, and the middle-class housing market generally served that purpose. Housing was the middle class’s best hedge against a growing government intent on expanding its scope and power by inflating the money supply.

Today, housing looks like a relatively weaker hedge, and if this trend continues, middle-class wage earners will have to find better assets in which to store the brunt of their wealth.

Regards,

Christopher Westley
for The Daily Reckoning
May 24, 2007

Editor’s Note: The tide on soaring real estate has ebbed… to some, it might even look like a chance to wander out and snap up property at new “low” prices… But don’t be fooled! Because the real wave of devastation – in property and on Wall Street – still looms on the horizon.

Christopher Westley teaches economics at Jacksonville State University. You can see his articles on the mises.org site here:

http://mises.org/articles.aspx?author=Westley

The Oracle of Greenspan has opined on the runaway Chinese stock market. Addressing a meeting in Madrid, the former chief of America’s central bank said the China boom was “clearly unsustainable…there’s going to be a dramatic correction at some point.”

Of course, we’ve been saying that not just about the Shanghai stock exchange, but about a lot of things. And so far, there’s been no correction of any sort. No yelling. No bawling. Not even a few poor souls jumping out of buildings.

But, for once, we’re in perfect harmony with the ex-Fed chief. A correction is coming. How dramatic will it be? When will it come?

Who can say? But never has the world seen a bubble that didn’t pop. Never has there been a boom without a correction. No sucker gets an even break.

So, we continue to hoist our “Crash Alert” flag…fully aware that it’s already been up for so long that people are beginning to snicker about it behind our backs. If we don’t get a crash, soon they’ll be chortling in our faces.

But hey…life has its difficulties for everyone.

“I don’t know,” began English financial columnist Simon Nixon over lunch yesterday. “There are a lot of threats facing this boom…as there always are. But I’m beginning to think a crash in China wouldn’t stop it. You saw what happened when there was that huge hedge fund blow-up a few months ago. No one cared. And when America’s property boom came to an end, it didn’t seem to make any difference either. I’m not sure anything can stop this boom.”

Simon was exaggerating to make his point. There is so much juice flooding into financial assets – from so many different directions…it’s hard to see what would stop it. Investors shrug off one calamity after another…confident that almost no matter what happens, asset prices will rise.

They are right, of course. Asset prices will rise as though they’re never going to fall – until they fall.

“M&A fuels record-breaking run for equities,” is today’s big headline in the Financial Times. The S&P 500 is at a record high. European stocks haven’t been so high in six and a half years. The Dow is trading in record territory. And Ron Baron, founder of the eponymous investment company, paid the highest price ever for a house – $103 million for a 40-acre parcel in East Hampton, New York, an area where many over-paid people in the financial industry have their homes.

And in China, the Shanghai Composite Index rose 1.5% to yet another record high.

“There appears to be no end in sight, for liquidity or for stock price appreciation,” says a strategist with Cantor Fitzgerald.

We pause to ask a question. When do really big corrections appear, dear reader? When people see them coming? Or when they don’t?

More news…

————–

Addison Wiggin, reporting from Baltimore:

“In China, trade talks with the United States ended…badly. Eh, not so much ‘badly’ as ‘totally useless’.

“The United States has asked that China let new securities firms enter the Chinese markets, and once there, to be able to do more joint ventures. They also want more Wall Street schmendricks to be able to throw their money around on Chinese trading floors.

“‘The Chinese are going to buy more ‘energy and environmental technology’ from the United States. And take ‘unspecified steps’ to fight piracy of DVDs and other goods. Yeah, right.”

For the rest of this story, and for more insights into today’s markets, see The 5 Min. Forecast

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And more thoughts, views, and obiter dicta:

*** Oil climbed back above $70 today. The Iranians, apparently, rebooted their uranium enrichment program, sending jitters up the collective geopolitical spine.

“Iran is never going to give up their nuclear program,” Strategic Investment’s Dan Amoss tells us.

Iran’s Mahmoud Ahmadinejad keeps telling everyone that the program is strictly for the peaceful generation of electricity – and most think he’s lying through his teeth.

“That kind of thinking makes perfect sense,” continues Dan. “After all, if you’re sitting on some of the world’s biggest oil reserves, why do you need nuclear power? Therefore, the thinking goes, he must be trying to build nuclear weapons.”

“Whether he is or not one thing is certain: Iran does need nuclear energy to keep its economy going. Because Iran’s oil reserves are running out – fast.

“The dirty little secret Ahmadinejad is sitting on is that his country’s oil industry is struggling day after day after day to keep its oil production somewhere between 3-3.5 million barrels per day.

“So…we know that Ahmadinejad is being straight with the world when he says his country needs nuclear energy. That brings us to the question of whether he’s being straight when he says his country’s nuclear program is for only peaceful purposes – or whether at the same time he’s pursuing atomic weapons.

“I’m going to tell you right now – it doesn’t matter.”

*** “A weak dollar is the driving force behind global liquidity,” writes Alan Ruskin in the Financial Times. Ruskin’s point is the one we make every week or so. “The U.S. has a technology,” as Ben Bernanke put it, “called the printing press.” And lately, the United States has been cranking so hard the handles are falling off. The dollars come hot off the press…and even before they have cooled, they are on their way across the vast oceans to far Cathay…where they buy luxuries that the Homeland can’t produce. In today’s Financial Times, for example, one Chinese computer maker says it is making so much money it’s hardly knows what to do with it all. Lenovo – the PC maker bought from IBM (NYSE:IBM) two years ago – reported that profits ‘rocketed’ for the full year.

American emissions of paper money cause a kind of chain reaction of debasement. No country wants to see its own currency fall faster than the dollar – and especially not America’s major suppliers. (We used to refer to them as ‘trading partners,’ but the term seems sadly out of date, since the trade is almost only in one direction). The dollar-receiving countries rev up their own printing presses…layering various colors of ink onto sturdy pieces of paper so that they may use it to buy America’s currency.

Result #1: more paper money everywhere.
Result #2: lower interest rates
Result #3: huge liquidity boom.
Result #4: big run-up in asset prices…m&a activity…global bubbles some clown pays $71 million for a Warhol,
Surely there is a Result #5.

What? At the very least, it will be – as Mr. Greenspan suggests – a correction full of drama in the most affected markets. At the very worst, it will be something that mimics the four horsemen of the Apocalypse: worldwide depression, revolutions, wars and rumors of wars.

Stay tuned…in the meantime; why not hedge against a falling dollar using EverBank’s World Energy CD? With this FDIC-insured deposit account, you can automatically hedge any U.S. dollars you put in, simply by spreading them evenly the British pound, Norway’s krone, Australian dollar and the Canadian loonie…all of which have been soaring against the greenback lately.

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*** We walked back from our luncheon yesterday. London is a great city to walk. You can usually pass through a park or at least through a green square. And now, along the South Bank, you can walk for miles along the river. Our return took us from The Eye, across from Westminster, down to Blackfriar’s bridge.

Ambling along, we passed outdoor cafes, jugglers, fiddlers, classical guitarists. It was such a beautiful day – rare in London – it seemed as though everyone was outdoors. Couples relaxed on the benches overlooking the river. Others strolled arm-in-arm, under the plain trees. And down at the ITV headquarters, a couple of beautiful women stood on the sidewalk and prepared for a show, with camera men, technicians and flunkies hovering about.

We listened to conversations as we passed; they revealed the temper of our time.

“I told him he had better make a choice. I mean…why should I put up with this sort of twaddle?” said one young woman to her friend.

“Anne…yes…would you tell Freddie that we’re okay on that deal,” said a young businessman, sitting by himself and talking into the air. “The price is okay…but he’d better get that indemnity clause sorted out.”

“Who can afford to buy?” a mature woman, dressed in a business suit, said to a man with an open collar. “It is outrageous the prices they are charging in Croydon. I should have bought 10 years ago…when I got divorced. But then I didn’t have any money.”