Mortgage Defaults May Trump the Fed

Good news everyone! The end of the world has been postponed indefinitely. You may now carry on as if another credit bubble is blowing (which it is, in China).

It was a truly bullish way to wrap up the week. China reported a 7.9% rise second in quarter GDP, driven mostly by a 15% surge in June consumption and a huge boom in bank lending and government stimulus. Aussie stocks felt the warm glow and rallied just below 4,000 on the ASX/200 Friday. Aussie stocks were up nearly 7% for the week.

But the even better news from the bullish camp is that perma-bear Nouriel Roubini has defected! Yes, Roubini told a conference that the “free fall” in financial losses is over and the U.S. may exit its recession by the end of the year. This was enough sweet talk to send the Dow up nearly one percent.

And then there was an upgrade to second half U.S. GDP forecasts from the U.S. Federal Reserve. In April, the Fed said second half U.S. GDP would shrink by 1.3% to 2.0%. The revised forecast released yesterday now says U.S. GDP will only shrink by 1.0% to 1.5%. A stunning upgrade!

The Fed’s revised projections also show that the U.S. economy will grow faster than it first thought in 2010, once the much-anticipated recovery takes hold. In April the Fed thought the U.S. would grow by 2.0% to 3%. But in the revised forecast now says the growth rate should soar from 2.1% to 3.3%. A stunning upgrade!

The only negative note in the Fed’s forecast is that it reckons U.S. unemployment will keep growing to over 10%. That, presumably, is a drag on the economy. But if credit conditions improve, maybe all the people who’ve lost jobs because the U.S. economy is not producing and not competitive can, you know, get a credit card and live off of that.

But putting on our serious face, and while we are giving valuable publishing space to the optimists, we should point out that some people think the worst case scenario for the U.S. Housing market is already priced in to financial stocks. This leaves said stocks all clear to lead the market higher, along with tech, resources, bonds, and cash!

For example, Jim Cramer reckons that if you assume a 50% total write-off rate on the 14 million mortgages written between 2005 and 2007 in the U.S., you are only talking US$1.4 trillion in losses (7 million homes X $200,000 per home. ) Cramer says the banks have already written off that amount and that the banks stocks are priced for a worst-case scenario that may not materialize.

And if it doesn’t, it would lead to a faster recovery in bank balance sheets, which in turn would lead to a recovery in bank lending, which would not lead to inflation because the Fed has a plan to remove liquidity from the system and everything thing will be fine!

And you thought Neverland was a ranch in California.

Whether Cramer is right depends on which vintage of mortgages have accounted for the losses in the financial sector so far and which are still going bad. The chart below from the Cleveland branch of the Federal Reserve suggests to us that there are more losses to come than have been accounted for. Why do we say that? First the chart…

What does the chart tell us? Well, it shows that in 2003 and 2004, Fannie Mae and Freddie Mac led the surge into subprime lending. This is the vintage of loans that went bad in the last year as interest rates moved up and house prices moved down, putting many new buyers and speculators underwater. This is where the first $1.4 trillion in losses came from.

But the real issue is the quality and quantity of mortgages that were packaged up and securitized from 2005 to 2007. As the GSE’s reduced their originations, banks stepped in—often having acquired non-traditional lenders for just this purpose—to keep feeding the boom. The banks wrote the loans and sold them to each other, purchasing default insurance on the securitized loans from AIG.

These loans are not subprime but supposedly higher credit quality Option ARM and Alt-A loans. And these are the loans the banks, we’d suggest, are carrying at elevated values. We’d also suggest the banks are not adequately capitalized to realize losses on these loans should the housing market get swamped again by another wave of defaults and foreclosures. This is where the second $1.4 trillion in losses will come from.

But of course it’s wacky to suggest all that. We might as well say that aliens crashed at Roswell and that the moon landing was faked (it probably was). There’s just no way it could get any worse than it did in 2007. Could it?

Dan Denning

July 21, 2009