Mortgage Rates Do Not Matter

Yesterday the feds pumped $600 billion more into bailing out the economy. This time they manipulated mortgage interest rates by pledging to buy mortgage backed securities. The following includes a headline and excerpt from a Bloomberg story which sums up the action.

“Mortgage Rates Tumble on Fed Debt Purchasing Plan”

“Nov. 26 (Bloomberg) -- U.S. mortgage rates plunged by the most in at least seven years yesterday as a Federal Reserve pledge to buy $600 billion of debt succeeded where seven cuts in the central bank’s benchmark rate had failed.

The average rate for a 30-year fixed mortgage fell to about 5.5 percent last night after starting the day at 6.38 percent, according to an estimate from Bankrate Inc. It was the biggest one-day drop in at least seven years.”

Everyone from the policy makers to mortgage brokers to homeowners seem to be thrilled by the action and its immediate result. Optimism springs eternal that lower mortgage rates will prop up home values and bring buyers back into the market. Unfortunately this is not the case.

1. Mortgage Rates Do Not Matter When Housing Prices Are Declining

The role of expectations in this crisis continues to be overlooked and underappreciated. In a vacuum, lower rates would mean more buyers and higher prices. We are not in a vacuum.

When asset prices are falling and potential buyers expect them to continue to fall, people stay out of the market regardless of the cost of borrowing. While the mortgage payment on a house today is lower than it would have been last week, why would a prospective buyer purchase a house that is declining in value? Waiting a year (or three) allows a buyer to purchase the asset more cheaply. Buying a house today only exposes the new owner to leveraged equity losses.

This is the nature of deflation. Potential buyers don’t borrow money to purchase assets that are falling in price. Banks don’t lend money to purchase assets that are falling in price except under restrictive terms. The restrictive terms further restrain demand and reinforce falling prices.

2. Marginal Interest Rates Today Are Much Higher Than During the Housing Boom

The Bubble was fueled partly by extraordinarily low interest rates. While 30 year mortgage rates were widely reported during the boom, they were also largely irrelevant. Buyers and investors at the margin relied on ARMs and Option ARMs which provided, on a temporary basis, the ability to service mortgages for as little as 1% per year. It was these insanely low effective interest rates that supported unsustainably overvalued housing. Now that the market has wisely eliminated these economic time bombs from the mortgage market, marginal interest rates have risen dramatically.

Despite the headlines, mortgage rates have not dropped to 5.5% they have increased from the 1% to 2% range. Current housing valuations remain unsupportable at the current interest rate level. Prices will continue to fall.

3. One-Time Government Initiatives Are Ineffective

The expectation of future government purchases of mortgage backed securities dramatically reduced interest rates. But what happens as we approach the end of the $600 billion spending spree? The market will understand that the government arbitrarily manipulated demand for these securities and mortgage interest rates. Unless investors are suddenly willing to jump back into the breach and accept below market compensation, interest rates will rise again.

One time shocks, be they stimulus checks or government shopping sprees, don’t work. Savvy prospective home buyers will understand that this is a short term interest rate move. As rates rise again, demand will fall and price declines will continue. Lower monthly payments are great, but not if the value of your purchase is declining.

In fact, we might see rates start to climb in the near future. The market was charging interest rates above 6% based on perceived risk and the demand for mortgage securities. With interest rates now at 5.5% I would expect some of that capital to go away. If the market wasn’t able to attract sufficient capital at 6.5% why would investors stick around for arbitrarily lowered returns.

4. Non-Interest Rate Market Forces Will Continue to Determine Home Prices

Interest rates are a market force which impact housing values, but they are presently a minor one. Housing prices will continue to be determined by: The supply of unoccupied houses

• Housing inventories for sale
• Demand for home purchases
• Credit availability and terms
• Unemployment levels and trends
• Consumer confidence
• Perceived risk
• Expectations for the future
• Changing social and cultural values associated with homeownership
• Foreclosure volumes and trends

Every meaningful market force that influences price indicates that the housing market will continue to fall for the foreseeable future irrespective of mortgage rates.

Rate reductions make interesting headlines and are encouraging to optimists. They do assist individuals who have the ability to refinance their existing loans, but this beneficial economic impact is imperceptible given the laundry list of negative forces at work. Mortgage rates declines will have little meaningful impact on the housing market or the broader economy until prices approach a level where they are justifiable based on existing fundamentals and historical valuation norms.

Happy Thanksgiving

I am thankful that:

• Five years from now housing will once again be affordable
• For the first time in my professional career the United States is no longer in the midst of a Credit, Internet and/or Housing Bubble
• The future will belong to smart, dynamic, penurious, hardworking people rather than those focused on short-term, speculative gains or reliant on leverage for success
• The world’s assets will once again be valued based on fundamentals rather than momentum, perpetually increasing credit or the distortions of financial gimmickry
• Irrespective of how bad things get, the bottom of this downturn won’t resemble the human tragedy of the Great Depression

I am hopeful that:

• Americans will come to realize that the federal government is the source of our economic problems, not the solution
• The disastrous spending initiatives implemented by present and future administrations will be a lesson rather than a trigger for persistent economic decline
• The global depression won’t create the degree of geopolitical instability and conflict that occurred during the 1930s
• "Intelligence" may once again be attributable to intelligence and that merit reasserts itself as an American value

Brock, Rock and Sheila's Bailout Shock

Sheila Bair recently announced her intention to bail-out millions of homeowners facing foreclosure in direct defiance of the President and the US Treasury Secretary. Ms. Bair appears interested in “saving” America from foreclosures by using her influence over the FDIC. The people Ms. Bair is intent upon saving can not afford to make payments on the mortgages to which they willingly subscribed and own homes worth less than the balance of their loans.

Ms. Bair’s proposal is misguided, creates moral hazard, delays inevitable foreclosures, slows down the market clearing mechanism, will waste huge sums of taxpayer money, and will lengthen and potentially deepen an economic downturn which will not resolve itself until the housing market finds a sustainable bottom.

According to the FDIC’s web site Ms. Bair is a member of the Center for Responsible Lending. This is ironic in that Ms. Bair seems to be on the verge of the administering one of the least responsible lending efforts in the history of the United States. She is also a member of the Society of Children's Book Writers and Illustrators. This makes more sense as the idea of forestalling inevitable foreclosures with low-interest rate government loans is a proposal that could only work in a fairy tale.

As research for this article I read excerpts from Ms. Bair’s first book titled “Rock, Brock and the Savings Shock”. I realize that this is a children’s book and maybe I am not qualified to offer a review, but I offer two insights. Ms. Bair does not have a talent for rhyming, even at the second grade reading level. Secondly, Ms. Bair is intent on ignoring the advice she provides to children about the merits of personal responsibility and the benefit of saving one’s money.

Ms. Bair has recently made it her life’s work to reward irresponsible people who didn’t save enough money, borrowed too much money and bought too much house. Then again Ms. Bair ultimately rewards irresponsibility and promotes moral hazard in her children’s book as Brock “the responsible one” puts the money he saved into a joint account that he shares with his brother Rock “the squanderer”. The lesson of the book seems to be that it is a good idea to save money, but if you prefer not to someone who did will always bail you out.

I give the book one star but recognize that in a socialist educational curriculum it might easily merit three.

Maybe in the book’s sequel Brock, the responsible taxpayer, will have his savings confiscated from him by the government so that Rock, who bought a condo with an option ARM, can get bailed out by the FDIC.

Ms. Bair is obviously a smart and competent person. And it may be the case that she is in fact motivated by a genuine desire to assist people in need. It is possible that it just appears that she is pursuing politically expedient, self-promotional policies to the detriment of taxpayers and the economy.

Either way, Ms. Bair appears intent on becoming the face of "The Next Government Created Housing Disaster”. (see article of same name posted 11/5/08)

Ms. Bair is committed to:

• Exposing taxpayers to massive foreclosure related losses
• Delaying inevitable foreclosures
• Short-circuiting the market clearing and price finding function necessary to rationalize the housing industry
• Lengthening and deepening the housing and economic downturn
• Burning through the FDIC’s resources and necessitating a government bail-out of the banking insurance fund

It appears that Ms. Bair may have a future in politics. Unfortunately, what may prove to be expedient for her career will be a disaster for taxpayers and the economy. On the bright side, future generations of impressionable, young children may be spared the horrors of Ms. Bair's burgeoning career as an inspirational writer.

Our Government is Lost

A Lack of Understanding

Congress, the Executive Branch, the Federal Reserve and the US Treasury refuse to recognize that government actions directly caused the Credit Bubble, the Housing Bubble and the impending Economic Depression. By ignoring or failing to understand the cause of the problem, these policy makers are inappropriate to proactively navigate the economy through this financial crisis. Instead, the government continues to pursue policies such as stimulus checks, interest rate cuts, expanding monetary policy, government guarantees, loans, fiscal spending and bailouts which attempt to perpetuate or preserve the broken financial paradigm dependent upon expanding money supply and credit. These actions have little beneficial impact, but do create massive and inefficient economic distortions and have the possibility of lengthening and deepening the crisis.

Ignoring the Law of Unintended Consequences

Government refuses to recognize the Law of Unintended Consequences. Virtually every initiative undertaken since the crisis began has resulted in a string of distortions and encouraged unwise, inefficient and damaging behavior by individuals, companies and industries. TARP is just the latest example. A $700 billion bail-out intended to purchase toxic mortgage backed assets instead has been used for a laundry list of handouts. In recent days cities, states, the auto industry, homebuilding industry, consumer credit industry and insurance industry have all lined up to petition payouts. Investment banks, credit card companies and insurance companies have transformed themselves into banks to receive subsidies. The more committed the government is to performing bailouts, the more bailouts will be required. In the near future individuals will willingly choose to default on their mortgages, car loans and credit card balances in order to qualify for government assistance. No good deed initiated with taxpayer funds will go unpunished.

Unwillingness to Facilitate the Market Clearing Mechanism

Assets rose to unsustainable values, credit was too loose and leverage was out of control. The only solution to these problems is to allow the markets to work. Prices must fall, companies must go out of business and where excessive leverage was used, borrowers must be burned. No amount of government action can stop these excesses from reversing. The only logical, free market course of action is to facilitate the market clearing process. Encourage price discovery. Force companies to recognize bad investments. Instead, our government appears committed to perpetual attempts to prop up unsustainable markets rather than accept the inevitability of supply and demand, and the return of risk fearing rationality.

An Inability to do Nothing

If policy makers don’t have the intestinal fortitude to facilitate a recovery they should at least get out of the way and allow the free markets to operate. Left to their own devices these market will resolve the problems of overvalued housing, excessive credit and unsound businesses. The resolution process is painful and messy, but is preferable to perpetuating our problems through government mandates, price fixing and socialism.

Self-interested politicians have an inability to do nothing. It is not politically expedient. Inaction does not provide adequate political cover. Economic pain is inevitable, but policy makers fear that they will be perceived as culpable barring decisive action. When politicians act in the self-defined “best interests” of taxpayers, they can argue that policy makers did what they could and that things would have been worse had the government not acted. This fallacy perpetuated by self-preservation will produce a longer and deeper economic downturn to the detriment of all.

Is Bank of America in Trouble?

Origially posted on 11/7/08 at www.TheAffordableMortgageDepression.com

Bank of America is a monster. It is the largest bank in the US. This is a company that believes itself to be "too big to fail".

The market has already recognized that BAC's business faces a tough operating environment as the economy falters and interest rates fall. BofA's stock is down from $50 a share to $20 as of 11/5/08.

Bank of America has already subscribed to the government's $700 billion bail-out and has access to further Treasury funds should the need arise. Under normal circumstances the prospect of BofA failing would not be conceivable. But these are not normal times. Fannie Mae and Freddie Mac, with an implicit government backing, were thought to be unsinkable just a year ago.

Bank of America has created market concern through its own actions and missteps. Management foolishly invested in Countrywide at $18 a share and then acquired the mortgage broker for $6 a share mere months later. BofA could have picked through the worthless subprime broker during bankruptcy proceedings, but apparently executives preferred an acquisition.

BofA purchased Merrill Lynch in September 2008 for $50 billion. ML was willing to sell itself out of concern over its ability to survive. BofA executives were willing to pay a hefty premium to current market value for its wealth management and capital advisory services. Based on the residual values of Bear Stearns and Lehman Brothers, who had similar issues, Merrill may not end up being worth anywhere near the acquisition price.

Bank of America remains transfixed by the prospect of acquiring national, retail distribution networks. The Countrywide mortgage origination infrastructure and Merrill's army of retail brokers theoretically represent one-of-a-kind opportunities. This perspective ignores the reality of the challenges that these two companies face and the impact that the looming economic depression will have on their core operations. BofA would have been better served going on a buying spree towards the end of the downturn rather than before it began or by picking through the remains of bankrupt operations .

BofA also is one of the country's largest credit card companies. This industry is going to be pounded by the economic contraction, rising foreclosures, increasing unemployment, higher credit card rates, lower credit quality and declining demand for consumer debt within the securitization market. Credit card reserves and write-offs have already begun to climb and are unlikely to plateau until the housing market and broader economy stabilize.

Falling interest rates obviously have a negative impact on BofA's core retail banking operations. Contracting economic activity and the prospect of deflation degrade its lending activities.

At what point does the laundry list of BofA's woes impact its ability to finance itself or degrade its earnings to the point where investors start to pay attention? Ongoing charges associated with Merryll Lynch, Countrywide and credit card write-offs will be increasingly hard to ignore.

BofA is just pennies away from its 10 year stock price low. This is shocking given how dramatically the business has been transformed over the past decade. The federal government will ensure that BofA has access to capital and does not overtly fail, but that may not be of much consolation for BAC shareholders.

Analyzing Economic Distortions That Caused the Housing Bubble and Will Produce a Prolonged Depression

The following represents perceptions of the Housing Bubble and expectations for a Depression which were developed during 2005-2006 and have evolved with the financial crisis. It is the author’s opinion that this analysis reflects an accurate understanding of the underlying economic forces which created the current financial downturn and will continue to affect the economy through at minimum 2012. It is through an understanding of these forces that policy makers can craft suitable responses to the crisis, in defiance of political expediency, and act to ensure that similar self-inflicted injuries are not recreated.

An Inability to Recognize the Problems Created by the Housing Bubble

For the last three years economists, politicians and policy makers have been consistently surprised by declining housing values and resulting collateral damage to the economy.

As recently as 2005 these prognosticators perceived residential real estate to be a safe asset class that would not decline nationally. As problems within the housing market emerged and foreclosures began increasing, policy makers stated emphatically that disruptions would be restricted to subprime mortgages. The credit market dislocation of August 2007 was interpreted by these parties as a one-time and temporary event. Further disruptions to the global financial markets accompanying the Bear Stearns collapse, were supposedly averted by a government bailout. Politicians overtly used Fannie Mae and Freddie Mac in a misguided attempt to prop up the faltering housing market despite dangerous leverage and declining fundamentals. Government sponsored interest rate cuts, stimulus checks, liquidity injections and bailouts have been implemented with the intent to solve economic problems as they emerged and deepened.

In short, politicians and government policy enthusiasts have consistently failed to predict, correctly interpret or fully understand our evolving economic crisis. Oblivious to their lack of understanding, calls for further intervention, stimulus, bailouts and price manipulation continue to proliferate. Most of these efforts are unwise, unlikely to result in positive outcomes and have the potential to exacerbate current economic distress.

The Real Problem

Irrespective of government efforts to fight a growing laundry list of financial calamities, the real challenge facing our economy is that houses remain dramatically overpriced relative to the fundamentals that determine value. Unsustainable housing values are rarely credited as the source of recent economic volatility. More dramatic events including the collapse of the dollar, falling real estate prices, rising foreclosures, increased inflation, record oil prices, company failures, credit market disruptions, rising unemployment and the stock market collapse have tended to dominate the economic consciousness of the media and attracted the focus of policy makers.

These gyrations, although dramatic and painful, are not independent events nor or they the cause of our economic decent. Such events are the manifest symptoms of the fundamental problem of overvalued housing. The only realistic solution is for home prices to fall until they reach a sustainable equilibrium.

There is nothing inherently wrong with falling housing values. In fact, a lot of good comes from such asset price declines. Young people, individuals of limited means, those who have demonstrated fiscal responsibility, savers and future generations of potential homeowners all benefit from dropping housing prices. It is an interesting phenomenon that so little attention was paid to this group directly harmed by rising home prices and that a similar lack of interest is directed towards their benefit as prices fall.

The economic pain presently being experienced is the result of excessive debt that was attached to homes as prices rose nationally for a decade. These excessive debt levels were used as a means by which to purchase increasingly expensive housing, monetize paper equity gains and to leverage investment returns as property values rose steadily. Now that property values are falling, the leverage is having a sharply negative impact on the economy. Debt remains while the value of recently purchased houses has fallen and theoretical equity gains have evaporated. Leverage is especially painful when asset values decline as equity is destroyed at a rate that is magnified by the ratio of debt. This phenomenon is prevalent in an environment where little or no capital was necessary to buy houses in recent years. An increasingly large percentage of home owners now owe more money on their mortgages than the value of the underlying property. The level of homeowner equity relative to mortgage debt in the United States is at a record low and falling.

The decade of rising prices also materially distorted economic activity. Homeownership rates ranged between 65% and 70% during the boom. There has never been an asset class, much less an asset bubble, which directly impacted such a high percentage or large number of Americans. The direct and indirect wealth effects derived from rapidly rising equity values had a dramatic impact on the economy due to this high rate of ownership. Consumer spending and the national savings rate were dramatically distorted. Now that housing prices have stopped rising, the economy has been deprived of this sizeable, recurring and growing source of consumer spending.

The incremental consumption from rising home values, home equity loans and windfall gains on house sales is gone while the debt attributed to overvalued housing prices remains, must be serviced and repaid. The implications for consumer spending, unemployment and the economy are unavoidable.

Declining home prices impact the majority of our economy. Recent economic events are the painful symptoms of the resolution of this overvaluation problem. The more quickly prices can return to fundamentally sustainable levels the better. Regrettably, the slow moving housing market, compounded by the extraordinary amount of leverage which we have attached to overvalued houses, will inflict unavoidable economic pain that is unlikely to subside for years.

Government efforts have been directed at muting the impact of these symptoms. Some proposals have even attempted to prop up the falling house prices. A closer analysis and better understanding of the forces which created the Housing Bubble illustrates why such intervention can not work. If government intervention has the effect, either intentionally or unintentionally, of artificially propping up housing prices, such action will cause the economic impact of the inevitable correction to be more damaging.

The Real Estate Bubble

For a decade housing prices rose nationally at unsustainable rates. There were many forces which contributed to this incredible rate of appreciation. The most visible participants fall loosely into three categories.

The continuum of entities which facilitated mortgage issuances was the most visible group as these were the larger, more recognizable participants. Investment banks, rating agencies, lenders and mortgage brokers were compensated through fees based on the number and dollar size of the mortgage volumes they facilitated. The individuals that facilitated home transactions at the local level were also active and vital cogs in the Housing Bubble machinery. Real estate appraisers and brokers execute home purchases but also exist, in theory, to bring rationality and experience to a transaction between parties without such expertise. Such, transactions and mortgage originations could not have transpired without complicit buyers and investors who willingly or naively engaged in leveraged momentum investing. Each of these parties suspended common sense in favor of an optimistic perspective of the future and the pursuit of short term profits.

None of these contributions to the Housing Bubble disaster should be minimized, especially when it comes to adopting restrictions on future activities designed to prevent such abuses from recurring or when it comes to punishing those criminally liable.

Another interesting contributor to the phenomenon was the Federal Reserve and Alan Greenspan. His decision to cut interest rates to historical lows created the conditions necessary to propel the Housing Bubble into a more frenzied state and made an economic collapse inevitable. The Federal Reserve’s initial interest rate cuts may have seemed reasonable given the Internet Bubble inspired economic downturn. Greenspan’s actions were understandably complicated by the tragedy of September 11th. Regardless of these factors, the severity of the interest rates cuts and their persistence exacerbated the Housing Bubble, diverted large sums of capital to house construction and home purchases, and directly contributed to the housing mania from 2002 through 2006.

The subprime securitization model further facilitated the home construction and mortgage boom. Investment bankers and credit rating agencies failed to appreciate the risks of subprime securitizations being sold to investors. Excessive amounts of capital were attracted to and invested in U.S. housing based on false assumptions and facilitated by the rosy mathematics of securitizations. The securitization model changed from the repackaging and sale of sound mortgages generated at the local level, to attracting large sources of capital that could be profitably deposited in home mortgages. Mortgages were no longer exclusively driving the need for securitizations. The ability of investment banks to attract capital was in some degree driving a demand for mortgage product regardless of quality. This dynamic distorted the risk profile of some mortgages.

There is plenty of blame to go around for causing the Housing Bubble. The forces listed above defined the mania of the latter years of the housing boom. In reality, though, the Housing Bubble had been percolating for years before any of these abuses rose to prominence or began distorting the market.

When did the Housing Bubble Begin?

While a detailed analysis of the predictable and inevitable excesses of capitalism during the latter years of the mania is interesting, an analysis of the root cause of the phenomenon is necessary to gain a real understanding of the Housing Bubble.

Any analysis of national housing appreciation rates or of most local markets which defined the Housing Bubble definitively demonstrates that the phenomenon began between 1996 and 1997. National and city-specific prices began to rise during this period after having stagnated for years. Price appreciation began to outpace inflation and accelerated uniformly until the Housing Bubble hit the wall in 2005 and 2006.

I have included S&P/Case Schiller Home Price charts for cumulative index value and annualized rate of appreciation. These charts reflect the performance of a specific pool of the largest cities in the United States, but are demonstrative of the national appreciation phenomenon. A city by city review of the same data reveals the abruptness with which prices accelerated nationally during this time frame.

What Caused the Bubble?

The primordial soup from which the Housing Bubble sprang to life may be directly traced to Congressional intervention in the housing market during the 1990s. Congress established the preconditions and distorted the personal economic incentives necessary to create, gestate and perpetuate the Housing Bubble. Without these government distortions, none of the excesses or abuses that followed would have been possible.

In 1992 congress began directing Fannie Mae and Freddie Mac to purchase huge sums of low income mortgages. By 1995 the GSEs were being given specific directives by HUD as to what percentages of their budgets were to be allocated towards purchasing subprime mortgages. The amount of government controlled money being directed to subprime grew annually, fulfilling congress’ overtly stated and well defined social agenda. The Community Reinvestment Act revision in 1995 furthered this process. Banks and lenders were directed to dramatically increase their subprime lending. Rules regarding the securitization of such debt were amended resulting in Bear Stearns completing the first such offering of subprime debt in 1998. This securitization mechanism facilitated the flow of massive amounts of capital into subprime mortgages.

Until the mid-1990s, lenders did not make loans to people with bad credit in large numbers because such borrowers were unlikely or unable to repay those loans. Why suddenly during the mid-90s did lenders begin to ramp up subprime mortgages in a large and growing capacity? The obvious answer is that Congress compelled lenders to engage in subprime activities. Legislation required that financial institutions lend to minorities, direct loans to inner-cities and give mortgages to people with bad credit. Fannie and Freddie, at the direction of legislators, exercised undue influence over lenders to further encourage subprime lending. Financial institutions were dependent upon these monopoly-like GSEs to facilitate their traditional mortgage businesses and treated such pressure as a cost of doing business. Fannie and Freddie were also directed to dedicate a large and growing portion of their resources to subprime activities. These expenditures represented an enticing opportunity for lenders.

As home prices began to rise during the mid-1990s, partially as the result of increased demand by the new pool of potential subprime borrowers, lenders observed an interesting phenomenon. In an environment of rising prices, subprime mortgages were actually profitable for the lender. If borrowers ran into trouble they could sell their properties for more than enough money to satisfy the requirement of the mortgage. Even better, the lenders could refinance such mortgages based on rising equity and generate a new source of profitable fees. Subprime lending, created by government edict and nurtured by Freddie and Fannie, transitioned from a cost of doing business for private lenders into a profitable, if unsustainable, business model.

At the same time Wall Street figured out a similar lesson. Investment bankers had already discovered how to make pools of assets functionally less risky and more valuable than the sum of their parts through the magic of securitizations. These financial rocket scientists observed that in a rising house price environment much of the value structure of the securitized subprime debt was of high credit quality.

The challenge was figuring out a way to lend to low income borrowers with poor credit and no assets. Such lending was required to meet government mandates and could be profitably mined while housing prices were rising. Capitalism when presented with an opportunity to generate profit is good at solving such problems and the innovation of affordability mortgages was created.

Given their extensive experience and resources, government officials and regulators should have recognized the dangers of low down payment asset purchases and introductory interest rates which distorted economic incentives. These mortgages encouraged the use of extreme leverage which was completely unsuitable for most home buyers. Teaser rates created an immediate but unsustainable economic incentive to buy houses. Both characteristics decoupled the prices of houses from the fundamentals of value. Combined with the expectation of rising prices, buyers were no longer sensitive to what price they paid for a house as they were not restrained by the need for a down payment or the necessity of cash flow to service traditional mortgage payments.

The Federal Government Is Complicit and Hypocritical

The federal government had been enjoying the “free lunch” of stable and rising housing prices
and high homeownership rates for decades. In fact Congress had actively engineered this phenomenon in part through the creation and manipulation of Fannie Mae, Freddie Mac, HUD and other federal organizations that distort the housing market. The deductibility of mortgage interest, the Community Housing Reinvestment Act of 1977 and its important revision in 1995, and the favorable capital gains treatment of primary residences are just a few more examples of government policies which distorted the supply, demand, credit availability, interest rates and tax treatment of housing.

In a fascinating and effective piece of political marketing government has consistently undertaken these efforts in an attempt to “make housing more affordable”. Yet in every case, with the exception of the recipients of direct welfare, each effort by the government to make housing more affordable through intervention has made housing less affordable.

For example, interest rates on mortgages are lower in the United States due to Fannie and Freddie’s abilities to borrow capital at preferential rates. The price of housing is partially dependent on interest rates. Lower mortgage rates mean higher prices. Buyers delude themselves into believing that they benefit from the lower, government sponsored mortgage rates but they in turn pay higher prices to purchase their homes.

The deductibility of mortgage interest is a popular tax break. Home buyers believe they are better able to afford houses because their effective cost of borrowing is lower. The lower cost of servicing a dollar of mortgage debt means that every buyer can afford to pay more for a house with the same level of cash flow. In reality the same pool of buyers are pursuing the same pool of houses but the buyers have a lower effective interest rate on their mortgages. Since house prices correlate to lower interest rates and higher effective incomes, house prices have risen accordingly.

Congress Pats Itself on the Back

The government’s initiatives designed to increase homeownership rates and provide mortgage access to subprime borrowers succeeded. As house prices rose steadily during the Housing Bubble to unsustainable levels, congress, policy makers and regulators cheered “financial innovation” for allowing subprime borrowers to access homeownership through affordability mortgages.

As Americans leveraged their houses to dangerous levels, congress, policy makers and regulators did nothing. In fact, they roundly applauded the benefit to homeownership rates of using such leverage.

When the wealth effects of rising home prices stoked unsustainable economic activity no government initiatives were proposed to limit the Housing Bubble’s impact or restrain rising prices. When Americans stopped saving and monetized their theoretical home equity gains the government did not cry foul, preach sanity or regulate this destructive behavior, they cheered and claimed credit for the roaring consumer based economy.

When capital was directed to building homes that no one needed, the Federal Reserve and Treasury did not act. In fact, Government leaders marveled at their abilities to create millions of home construction related jobs.

Now that the Ponzi scheme has failed the government is acutely interested in market driven housing prices. Policy makers are concerned about the leverage of homeowners entering foreclosure. Politicians are surprised that consumer spending is dropping as home prices revert towards sustainable levels. The Treasury and Federal Reserve have sprung into action over lost jobs, bankruptcies and credit disruptions.

Government mandates and legislation created the problem of overvalued house prices by distorting lending practices and increasing both the supply of and demand for subprime mortgages. Legislators directly benefited from an electorate fat and happy on paper wealth gains, falling unemployment, a surging economy and increased tax receipts. Now, in the name of political expediency, government wants to take action that can only have the effect of lengthening and deepening the extraordinary economic downturn it created.

The Subprime and Affordable Mortgage Distortion

Affordable mortgage characteristics fundamentally altered the incentives of buyers and decoupled the relevance of house prices from fundamental value determinants.

On a macroeconomic scale the value of housing is determined by a large number of factors. Supply, demand, credit availability, mortgage terms, expectations for the future, perceived risk, cultural and social factors, tax treatment and recent performance trends to name a few.
At the individual level, the ability to purchase a home and the amount that a person can afford to pay for a home is restrained by access to credit, capital and cash flow. A potential buyer must have credit sufficient to be able to get a mortgage, must have sufficient capital to make a down payment and must have sufficient cash flow to service interest and capital repayment requirements.

Inappropriate government influence on GSEs and lenders artificially lowered the credit requirements necessary to access mortgages. Lenders were compelled to lend to individuals and in neighborhoods where they previously would not have operated. Once the Ponzi scheme developed self-sustaining momentum, no further government action was necessary as companies, eager to capitalize on this newly created profit opportunity, lowered the bar required to borrow money. When a reduced credit score ceased to be a competitive advantage in attracting borrowers, other mechanisms were adopted. Brokers ceased to verify the incomes of borrowers, issued mortgages that didn’t require such disclosure or in many cases committed fraud by overstating figures.

The larger pool of potential borrowers translated, as expected, into higher demand for houses. Increased demand started the steady acceleration of housing prices. Rising prices made subprime lending more profitable and lowered the perception of risk contributing to a further increase in the available supply of such loans.

Affordability Mortgages Were the Lynchpin of the Housing Bubble

Reduced credit requirements and access to mortgages were important to increasing demand, but the mortgage affordability characteristics which changed the capital and cash flow requirements necessary to buy a home were responsible for dramatically distorting economic incentives and home purchasing behavior.

House prices are restrained by the requirements of adequate credit, capital and cash flow.
The challenge facing private lenders was initially how to meet government mandates for subprime lending and, once a profitable subprime model was identified, how to structure mortgages so that they would be accessible to subprime borrowers with insufficient capital and cash flow. Thus were born affordability mortgages.

Down Payments

Low down payment mortgages reduced or eliminated the capital requirement of owning a home. Whereas a subprime borrower might have struggled to come up with a down payment to buy a modest home under traditional lending requirements, the same borrower could now “buy” a much more expensive home and put nothing down. Down payments are difficult to come by. They require a substantial effort to save. Accumulating such savings depends on deferred consumption. Once accumulated, there is a substantial opportunity cost involved with using the capital as a down payment to buy a house. The more expensive a house is, the higher the down payment must be. The higher the price of a house, the more savings, deferred spending and opportunity cost are required. When buyers invest their hard earned money to buy a house they are sensitive not only to price, but to value. As valuations increase relative to economic fundamentals, purchases become more risky and the potential for capital loss increases. Down payments regulate how high house prices can climb and correctly align the incentives and behavior of prospective buyers.

Low down payment and no down payment mortgages remove this fundamental impediment to rising prices. 100%-plus loan-to-value mortgages actually provided cash to people who bought houses, further distorting the incentives and behavior of buyers. These mechanisms incentivize buyers to purchase larger and more expensive homes. There is no marginal cost to the buyer in terms of capital required to buy a larger or more expensive house. In the case of 100%-plus mortgages there is a negative marginal cost. The buyer becomes disconnected to the fundamental value of the home. Price doesn’t matter as much when you can borrow all the money necessary to purchase an asset. For the first time in history, on a national basis buyers were not sensitive to the price or fundamental value of a home. Even stranger, rising house prices encouraged buyers instead of acting as a structural deterrent.

Transitioning from a down payment environment to a no-down payment environment will inevitably lead to increased demand, rising prices and decoupled valuations. This would be true for any asset class. Imagine if investors could put nothing down to buy stocks. What if private equity and hedge funds could buy companies with 100% borrowed funds. These 100% financing models effectively afford the buyer infinite leverage. In an environment of rising prices, optimistic expectations and low perceived risk, investors will access such leverage voraciously. Buyers no longer are sensitive to price or fundamental value. Based on expectation and perception, the elimination of down payments incentivized buyers to purchase as much house or as many houses as possible irrespective of price, thereby maximizing expected leveraged returns.

Introductory Adjustable Mortgage Rates

The other important characteristic that determines an individual’s ability to buy a house and regulates house prices is the cash flow requirement necessary to service a mortgage. Under the traditional mortgage model home buyers serviced market interest rates and typically repaid a percentage of borrowed capital. Buyers are restrained with respect to how much house they can purchase by their cash flow. It is for this reason that house values have typically had a steady relationship relative to income levels. The more house a person buys, the higher the cash flow required. Buying a more expensive house means allocating a higher percentage of one’s disposable income to servicing the purchase. Based on this model, overall housing prices are restrained by the income levels of individuals within a relevant market.

The innovation of adjustable rate mortgages reduced or functionally removed this important control on house prices. The marginal introductory rate of ARMs and Option ARMs dropped the effective interest rate to as low as 1%. For several years a buyer could service a mortgage for a small percentage of the traditional market rate. An important restraint on the price an individual could pay for a house was eliminated.

Beyond the ability to buy a high priced house, adjustable rates created another nefarious economic distortion. Renters were powerfully incentivized to buy houses irrespective of their financial circumstances. The security deposit necessary to rent an apartment represents a capital requirement that no longer existed when purchasing a home. Even more distorting was the reality that the cash flow requirements to service the introductory rates on adjustable mortgage were lower in many cases than the cost of renting an apartment. Many renters bought houses without regard to price because it made economic sense to do so for the duration of the introductory interest rate period.

Those buyers who considered that they would be financially worse off once the adjustable interest rates reset were assured that they would have the ability to refinance the mortgage based on rising equity or that the house could be sold at a higher price resulting from expected appreciation.

All things being equal, the lower the capital requirement necessary to buy an asset, the higher the asset’s price will appreciate. All things being equal, the lower the effective rate of interest on capital borrowed to buy an asset, the higher the asset’s price will appreciate. The only missing ingredients for such appreciation are confidence and greed.

Parallels with the 1920s and The Great Depression

Low down payments and interest rates were the conditions which precipitated the stock market bubble of the 1920s. Margin requirements to buy stocks were 10% and interest rates were as low as 1%. The ability of individuals to buy stocks in highly leveraged transactions with low maintenance cash flow requirements allowed for stocks to decouple from fundamentals and rise to unsustainable levels. Once these conditions existed, the only other ingredients necessary for an asset bubble were perception of risk and future expectations. A lack of material impediments to buying stocks at any price caused investors to become detached from their actual fundamental value. Speculators had the ability to leverage their capital dramatically, service the interest of this debt cheaply and had the expectation of receiving positive leveraged returns.

These conditions were duplicated by affordability mortgages and applied to the housing market to much greater effect. At the margin, the housing bubble was defined by 0% down payments and teaser rates as low as 1%. People with bad credit, could put nothing down and service a mortgage at a below market rate for years. It was these extraordinarily low effective interest rates and the absence of capital requirements that caused the Housing Bubble and sustained such lofty valuations.

Given the relatively larger size and greater rate of participation in the residential real estate market, the impact of these conditions was in many ways more widespread and pervasive than that experienced during the stock market bubble of the 1920s.

The Ponzi Scheme

Lenders and borrowers participated in the Ponzi scheme based on the assumption that prices would rise into perpetuity. As long as prices continued to appreciate both parties assumed that mortgages could always be refinanced and houses could always be sold for more than the value of the mortgage. Capital was assumed to be available and demand for houses was projected to continue. Competitive pressures and the pursuit of ever increasing profits sent this model to its logical extreme. Loans were extended to borrowers in amounts that could only be serviced at the teaser rates. Loans began to be made in excess of the value of the transaction. Option Arms were designed with the expectation that the value of the loan would continuously increase above the original transaction value. At the end of the bubble, defaults began to occur within months of loans being issued as borrowers were unable to service even the introductory rates.

Highly levered loans, on overvalued assets, serviced with introductory interest rates scheduled to reset much higher on a predetermined date are effectively economic time bombs. Neither lender nor buyer anticipated that these time bombs would explode. Both parties expected to be able to refinance the loan or sell the houses based on an assumption of continued price appreciation. And why not? Prices had been rising nationally for 60 years. Appreciation had been outpacing inflation since the mid-1990s. The federal government was using its resources and influence to expand access to mortgages, lower interest rates and manipulate homeownership higher.

Like all Ponzi schemes a collapse was inevitable. The supply of new construction far outstripped demand. Investors gobbled up theoretical condos, but once completed had no intention of closing on the purchases, much less living in them. At the end of the boom valuations had risen to heights that were straining even the mortgage affordability characteristics’ ability to support them. Defaults began to occur shortly after mortgages were issued. Homebuilders began to struggle to unload inventory. Price cuts began, initially in the form of material incentives such as free pools. Soon builders and home owners were slashing prices in the hope of eliminating the financial burden of continued ownership.

Once expectations of future appreciation vanished and the risk premium returned, the allure of infinite leverage attached to overvalued assets quickly evaporated. Without the rosy expectations of perpetual appreciation the whole scheme failed.

Price Reversion Driven by Dramatically Different Market Conditions

Now that the market has recognized the excesses of the real estate bubble, these affordability characteristics, which disguised dangerous leverage and distorted housing valuations, have disappeared. Homebuyers are faced with the prospect of putting capital at risk, committing to service a mortgage at higher interest rates in an environment where real estate values are high in historical terms and are faced with the prospect that those values may continue to decline. It is not difficult to see why prices are falling at record rates.

The structural market changes which drove price appreciation and homeownership gains have evaporated. Home prices are unsupportable given a reversion to the credit availability, capital requirements and effective interest rates of the pre-bubble environment.

Almost every fundamental determinant for the market value of houses today is less favorable than that which existed in the late 1990s, with the exception of population. The supply is higher as there are more vacant houses than at any time since the Census Bureau started keeping such data in 1960. The increase in housing stock has far outstripped the rate of population growth, more than offsetting any potential benefit from a larger pool of potential buyers. Demand is lower as a result of the decline in the availability of subprime and Alt-A mortgages. Credit is much tighter. The availability of highly leveraged and 100% loan-to-value mortgages, which had the effect of decoupling housing values from underlying fundamentals, are less prominent. Marginal effective interest rates are much higher. Houses are no longer perceived to be safe investments. Potential buyers no longer expect houses to appreciate rapidly and are increasingly worried that prices may continue to fall. Changing expectations have eliminated the home’s value as a leveraged investment opportunity. Cultural and social values attached to homeownership are being eroded.

One can reasonably expect homeownership rates to return to the 65% level which the U.S. economy structurally supported for 30 years prior to 1995. But the economic environment hasn’t simply reset to that of the mid-1990s. The terms and availability of mortgages have reverted, but credit is far tighter, the perception of real estate’s risk is different, the expectation of future performance has changed and the cultural value of homeownership has dramatically changed.

There are two discreet components to the value of a house which affect price. These include the value of a house as shelter and as an investment. The investment value is the component of housing prices which skyrocketed during the boom and is evaporating during the bust. The value of shelter is relatively static and related to income and relative rents. The investment value will continue to fall year after year until foreclosures are no longer happening in material numbers, credit isn’t restricted, buyers don’t expect real estate to continue to fall and inventories of houses for sale aren’t above historical norms. As long as expectations are negative and risk is high relative to fundamental value, prices are unlikely to stabilize until they approach the value of homes as shelter.

Economic Distortions Caused by the Housing Bubble

For a decade the Housing Bubble dramatically distorted economic activity. These distortions and their impact on the economy as they unwind have important implications for the length and severity of the downturn.

A Dramatic Increase in Leverage Underwritten By Unsustainable Asset Values

During the Housing Bubble the amount of debt attributable to houses increased in real and relative terms by a degree never before seen in history. The value of the housing stock in the U.S. more than doubled as it expanded by in excess of $9 trillion. Under normal circumstances such an increase would have contributed to a substantial expansion of home equity for existing owners. Instead, during this period of real estate appreciation, the ratio of debt relative to the value of housing increased dramatically.

As property values rose potential buyers would normally have been prevented from or have found it increasingly difficult to purchase houses. Homes become less affordable relative to income, capital available for down payments and cash flow necessary to service mortgage debt. Buyers relied on increasing percentages of debt to purchase higher priced houses. This capital was available for a myriad of reasons including government intervention, the Federal Reserve’s decision to lower interest rates, yield hungry foreign capital seeking risk-adjusted returns, the influence of securitizations, and a full continuum of companies working to facilitate the creation of mortgages. In many cases people borrowed 100% or more of the perceived value of the property to finance purchases. Others took out Option ARMs which resulted in debt levels far in excess of the transaction value of the home.

Another “financial innovation”, the ability to monetize theoretical equity gains through home equity loans, further exacerbated the leverage problem. Owners with rising equity and expectations of further increases cashed out their paper gains in favor of current consumption. As such, theoretical equity gains from rising prices were diminished or erased. This is the equivalent of Internet investors in 1999 borrowing money secured by unsustainable stock values in order to finance the consumption of motorcycles, boats, vacations and flat screen TVs.
As prices have fallen the equity gains are evaporating but the debt which was incurred remains. As leveraged as the asset class was at the height of the Housing Bubble, every day it becomes more leveraged as prices fall and equity disappears even more rapidly. One in six mortgages in America has a balance in excess of the underlying home’s value. Homeowner equity is at the lowest level as a percentage of total home value in U.S. history.

This extraordinary level of debt has dramatic implications for the economy as home prices continue to fall. Consumption is effected and consumer confidence is eroded. Consumer focused businesses suffer and unemployment rises. The debt must be serviced and repaid. When it can not be serviced or if owners decide it is not in their best interests to do so, foreclosures result which further erode home prices and destroy the capital base of our lending institutions.

The Wealth Effect of Rising Home Prices

Consistent and rapidly rising home prices distorted the economic decisions of home owners. As home values rapidly appreciated, leveraged equity returns contributed to a dramatic wealth effect. When people gain wealth they choose to consume more goods and services. As 75 million U.S. households experienced rising house values the impact of the bubble affected the entire economy. These people spent more money.

Rising values also dramatically distorted the U.S. savings rate. Americans consistently lowered their rate of savings as the Housing Bubble persisted. The savings rate dropped to zero and then went into negative territory during the worst of the mania. Such decisions seemingly made sense to homeowners as their wealth rose regardless of individual savings rates. Why save a small percentage of your paycheck when the consistent appreciation of your home increases your net worth by many times that which you could have saved?

Home equity loans facilitated this distortion as individuals could monetize their increasing equity for current consumption. The government’s tax policies further incentivized this activity. For anyone with a credit card balance, the prospect of accessing a home equity loan was an obvious benefit. Instead of paying recurring fees and high interest rates, a home owner could borrow money via an equity loan and deduct the interest for tax purposes. With the expectation of future gains, most borrowers anticipated that rising home values would effectively pay off the loans.

Home equity loans constituted approximately 3% on consumer spending from 2002 through 2005. This source of consumer spending has been removed from the economy. Record low savings rates further fueled the Housing Bubble driven consumer boom. Not only is the incremental consumption gone, but Americans will have to increase the rate of savings to pay back debt, make up for years of missed savings and restore equity in their houses. Such activities will further damage consumer spending. Even conservative people who didn’t over borrow or access home equity loans may reduce spending due to negative wealth effects from falling home prices, stock market losses, rising unemployment or impaired consumer confidence.

The Direct and Indirect Economic Impact of the Housing Bubble

The impact of the housing boom on the industries that constructed new housing, facilitated mortgages and executed home transactions was profound. While these segments are small relative to the total economy, their impact was dramatic, extended far beyond those specific sectors and dominated economic gains at the margin.

Home construction, mortgage facilitation and sales functions created millions of jobs. The impact of these incremental jobs was material. Employees produced goods and services, shopped in malls, ate at restaurants, bought houses and paid taxes. Employers that serviced homebuilders including carpenters, painters, furniture manufactures, roofers, landscapers, electricians, plumbers, wallboard manufacturers, sales people and marketers directly benefited from these activities. Real estate brokers, appraisers, mortgage brokers, investment bankers, ratings agencies and title companies were enriched by increased transaction levels. Many other businesses were affected by the increased employment, higher expenditures and the non-direct, iterative impact of prosperity.

Unfortunately this homebuilding episode was an economic distortion. The demand for incremental housing supply was driven by ill-advised government agendas, dangerous, inappropriate and highly leveraged mortgages, speculative investors, optimistic buyers and a massive availability of cheap capital. Today we have the largest inventory of empty housing units in our country’s history.

There is no reason to believe that any of these economic benefits will persist. We have already seen massive layoffs and contracting economic activity in the most affected geographies and industries. The employment benefits from the Housing Bubble will vanish as economic activity returns to levels last seen in the 1990s.

Impact of These Distortions

A decade of unsustainable housing appreciation dramatically distorted economic activity. The Housing Bubble created a legacy of extreme home leverage, deflating housing prices, negative wealth effects, declining economic activity and rising unemployment. The implications as these distortions unwind make it unlikely that the U.S. economy will avoid a prolonged depression.

The Influence of Foreclosures on Housing Market Prices

When foreclosures are present in material numbers they determine the market for houses and place continuous downward pressure on prices. Much has been made of recent increases in existing home sale volumes. The media and uniformed analysts have interpreted these rising transaction volumes as evidence of stabilization, a market bottom or a recovery. Of course each of these announcements accompanies the news that prices have fallen dramatically. Anyone with a basic understanding of economics realizes that when prices fall, transaction volumes increase. Rising volumes aren’t positive from the perspective of the market stabilizing, although they are a signal that the markets are clearing. It is the presence of a material and growing number of foreclosures in the market which is driving volume increases and price declines in the existing home market.

Banks and lenders are not in the business of owning and administering homes. Lenders incur substantial costs associated with ownership including taxes, insurance and maintenance. Furthermore, lenders are compelled by regulators to divest themselves of such properties quickly. Lenders price foreclosed properties to sell. Unlike owners, banks do not have a reserve price, a mortgage balance to pay off, a misperception of the home’s value or price maximization as their goal. Lenders want to be rid of properties in a timely fashion.

To achieve the goal of divestment, lenders price homes at substantial discounts to current market prices. This discount varies by market but may be 10% to 30% relative to trailing, comparable transactions. In the presence of foreclosures, buyers generally don’t pay the existing market price. Potential buyers have the opportunity to purchase discounted foreclosed properties. Even in the instance where a buyer transacts with a non-distressed seller, the buyer has the ability to set the price at discounted levels due to the presence of foreclosed properties in the market. The seller must make concessions to compete with foreclosures.

The effect of foreclosures is to perpetually force the “market price” of houses lower as long as there is a steady and material supply of distressed, bank-owned properties. There is no reason why prices would stabilize in such an environment until values return to levels supportable by incomes and competitive with rents. If house prices get cheap enough, buyers will return regardless of price trends, future expectations or the presence of foreclosures. Unfortunately, these price levels will not be realized in the near future given the extraordinary appreciation experienced since 1996.

The Nefarious and Inevitable Impact of Affordable Mortgages

As we have examined market forces which determine home prices will continue to place downward pressure on transaction values. The impact of Housing Bubble created distortions will dramatically impact the economy, further reinforcing current house price trends. But the most nefarious force influencing home prices going forward will be the structural remnants of the Affordable Mortgages which were the very cause of unsustainable housing prices.
Economic Time Bombs

Mortgages with adjustable rates enticed buyers to purchase houses with temporarily low payments. Each of these mortgages was an economic time bomb due to explode when the interest rate adjusted. Lenders and buyers never anticipated that those time bombs would explode based on the availability of refinancing options, a robust demand for houses and the expectation of rising home prices. When the housing market crashed equity evaporated, refinancing options disappeared and the demand for homes dried up.

As rates have reset, the economic time bombs have started to explode. Thousands of mortgages will reset every day for years to come. At minimum, the higher interest rates stress the homeowner and reduce after-mortgage disposable income, detracting from consumer spending. In many cases though, interest rate resets trigger foreclosures.

Adjustable rate mortgages provide us with a steady, visible and quantifiable source of foreclosures through 2012. These are the structural remnants of the affordable mortgage generated Housing Bubble.

Of even more concern, what will inevitably be the worst performing mortgage classes and products in history, have yet to begin to reset in large numbers. Fitch estimates that Option ARMs which won’t begin to reset in large numbers until 2009 may default at a rate close to 50%. It would be no surprise if foreclosure rates exceeded this level based on an understanding of how these mortgage products work, and in what markets they are concentrated. Option ARMs, issued at the zenith of the valuation bubble, have allowed mortgage balances to increase while the value of the home backing the loan has declined rapidly.

What makes affordability mortgages truly nefarious is that their existence represents a persistent, structural impediment to the stabilization of the housing market. Many underwater mortgages will inevitably result in foreclosure, yet these mortgages are serviceable under the introductory or optional payment interest rates. When an adjustable mortgage hits the reset date or when the Option ARM loan balance triggers a reset, the foreclosure results. There are millions of these foreclosures looming over the next four years. We know they will occur, we know the time period during which they will be triggered, but there is little or nothing that can be done to defuse these time bombs. Many home owners understand that foreclosure is a certainty, but are incentivized to stay in their homes until the reset occurs because the introductory interest rate still represents a low cost source of housing.

No one can accurately predict when housing prices will find a bottom given the large number of forces which will dynamically affect the market for the next several years. But anyone who understands the mechanism that determines the price of houses at the margin and who grasps the volume of impending foreclosures through 2012, can conclude that the housing market is years away from finding a stable bottom.

The residential real estate market has little chance of meaningful recovery until 2013, and there is a material likelihood that prices will fall in real terms beyond that date.
Other Sources of Foreclosures

While less easy to quantify there are other sources of foreclosures which will represent a material source of such transactions going forward. In fact, the primary source of foreclosures has historically been normal business cycle friction. Foreclosures will proliferate as the economic downturn continues irrespective of the structural supply created by affordable mortgages.
Job Losses

The business cycle contribution to foreclosures is just beginning. Considering that past foreclosure cycles have been driven primarily by lost jobs, there will be considerable volumes resulting from the economic slowdown. Unemployment has begun to rise but is likely to worsen materially as credit tightens, consumer spending declines and negative wealth effects impact the economy.

Voluntary Foreclosures

A new source of foreclosures has begun to develop and may grow into a material source of home losses.

It may be in the best interest of homeowners to willingly default on mortgages, even if they have the ability to continue to service them. These people may have jobs and sufficient income to service their mortgages, but doing so would make no logical sense. How far underwater must an individual be to walk away from their mortgage? In California, where median housing prices have declined by more than 30% and some markets are down by 60% we may begin to find out.
The costs are known to the home owner. The borrower would see his or her credit damaged for a period of years. The benefits depend on individual circumstance but can be imagined. A buyer can rent an equivalent abode for less money per month than it takes to service the market mortgage rates. Additionally, the owner would eliminate a large sum of debt for which he or she is responsible. Why would an owner pay a high monthly payment to keep a house worth much less than the value of the loan into perpetuity. The savings requirement necessary to buy one’s way out of the underwater mortgage may make it untenable.

I am not advocating this strategy, simply observing the individual economic incentives which will inevitably lead to such behavior. While these borrowers will have defaulted on their individual responsibilities, the lenders should never have lent money to purchase dramatically overvalued properties with terms that might result in or encourage such behavior. Both parties are culpable.

The Case for a Depression

The consensus is that we will avoid a depression. In fact, the vast majority of prognosticators believe we will avoid a prolonged or deep recession. Some sense of stoicism has begun to leech into expectations as the credit and stock markets have driven home the seriousness of our situation in a quantifiable and obvious fashion.

There are numerous reasons sited as to why we will avoid a depression. These conclusions rely on static applications of historical rules while ignoring the dynamic conditions we are facing. These arguments resemble recent observations that “real estate is local”, “house prices don’t fall nationally”, “foreclosure problems are restricted to subprime”, “the credit crisis is contained”, “we will avoid a recession”, “Fannie and Freddie are solvent” or that “Lehman will survive”.

The logic behind these past and current observations is flawed. The lessons of the 1930s won’t allow us to avoid a depression because the forces at work are fundamentally different.

The politicians and policy-makers predicting that we will avoid depression in many cases were responsible for the Housing Bubble, missed the dangers of recent economic excess, consistently underestimated the impact of falling home prices, disregarded the deteriorating credit environment and were surprised by the recent stock market collapse. For two years Bernanke and Paulson testified under oath to congress that the economy was fine, risks were low and the housing industry related damage was contained. Why would anyone attach material confidence to their expectations now?

Miscellaneous Observations

The following represents a cursory review of the arguments against a depression and of the government’s response to the economic downturn to date. A complete analysis of these factors falls outside of the scope of this document.

Size of Government

The relative size of the federal, state and local governments compared to the 1930s is perceived to be a steadying force on the economy. In 1929 the federal government constituted 3% of GDP compared to approximately 20% today.

On the surface this argument makes sense until one considers that each government entity will be negatively impacted by declining real estate values, a decline in real estate transactions, declining consumer spending, declining business activity, declining tax receipts and rising unemployment. Many state and local government entities will be required to cut back spending precipitously. We have already begun to see states and municipalities run into budget or financing difficulties.

Federal Spending

At the federal level the government has already committed more that $1 trillion in the form to the $700 billion bail-out plan, individual bailouts of Fannie Mae, Freddie Mac, AIG and Bear Stearns, foreclosure aid and stimulus checks.

The federal government has more than $10 trillion in debt, is on the hook for Fannie and Freddie’s bad portfolio of mortgages, is running a federal deficit of close to $1 trillion and will see its tax receipts decline rapidly with a contracting economy and rising unemployment. The US debt is at its largest level relative to GDP since immediately following World War II and the worst of the economic downturn has yet to arrive.

How much money the federal government will be able to borrow and spend is a matter of debate. In order to provide incremental stimulus to the economy, the federal government must first overcome the numerous state and local spending cutbacks. Even if the federal government could meaningfully impact the economy with stimulus projects, I note that similar projects during the 1930s had no meaningful impact on extricating the economy from the Great Depression.

Aggressive Governmental Response to the Crisis

A lesson from the 1930s was that government did not respond aggressively enough to the crisis. Actions that were taken, including raising interest rates and tightening the money supply, were in fact harmful to the economy. As a result, our response to the Housing Crisis has been aggressive and has included interest rate cuts and liquidity initiatives.

An adequate understanding of the causes of the economic crisis has yet to be articulately demonstrated by the majority of policy makers and politicians responsible for formulating the government’s response. The federal government appears to have learned the lesson that it should try as many strategies and throw as much money at the crisis as is possible. For all of this aggression, such actions to date have been largely ineffective, misdirected and potentially damaging.

Fighting the Wrong Battle

The Great Depression persisted largely due to a lack of liquidity and confidence. Congress, the Treasury and the Federal Reserve have enthusiastically gravitated towards policies designed to fight these two forces. These initiatives are largely misplaced as our current economic predicament is not a crisis of liquidity. Today the crisis is defined by solvency and credit quality issues which are compounded by falling asset prices and excessive debt.

Reducing Interest Rates Perceived as a Positive

The government’s response to the financial crisis has ignored the lack of impact that interest rate cuts actually have on the contracting housing market. Cutting government controlled interest rates has no material impact on home prices or the housing industry in an environment where prices are falling. Mortgage rates are not directly set by the Federal Reserve. In fact, even if the government could artificially lower mortgage interest rates such a move would be ineffective in an environment where prices are falling and expectations are negative. Rational people do not borrow money to buy assets that are perceived to be declining in value.

The United States is acutely dependent on foreign sources of capital to sustain our economy. We have a trade deficit, low savings rate, a budget deficit and the need to service $10 trillion of federal debt. We further benefit from cheap foreign capital which finances our home mortgages.

Cutting interest rates devalued the dollar and caused a short-term increase in inflation. Foreign investors, who already perceived increased risks involved in investing in the United States, were directly injured by a devalued dollar and rising inflation. The devalued dollar also caused oil prices to rise dramatically. High oil prices further weakened a decelerating economy and negatively effected consumer sentiment. Any short term interest rate gains to the non-housing related economy were offset by rising oil prices, a falling dollar, inflation and the potential to disrupt capital flows important to the United States.

Consumer Spending Economy

Our economy is driven primarily by consumer spending. The United States is more exposed to the potential for a depression as declining housing prices, rising unemployment, a falling stock market, a contracting credit environment and deflating prices impact consumer spending related economic activity so pervasively.

The Banking System

The structure of the banking system was a major cause of the Great Depression. Our modern system is less of a concern despite the leveraged state of many financial institutions as the FDIC has removed the likelihood of persistent or damaging bank runs.

While one destabilizing source of lost of confidence and contracting capital has been eliminated, we have created other mechanisms that functionally will have the same impact.

Foreclosures

Analysts underestimate the impact of foreclosures on the economy. Instead of a steady supply of banks failing, we have thousands of houses falling into foreclosure each day for years to come. Each foreclosure results in an asset write-off and decreases capital available for incremental loans. Each foreclosure pressures prices, highlights the risk of lending, results in impaired credit for the borrower, contributes to deteriorating confidence and potentially reduces consumption. No single foreclosure is significant, but thousands a day over several years will have a debilitating impact on the housing market, the banking industry, the credit markets, consumer sentiment and the broader economy.

Hedge Funds and Credit Default Swaps

Since hedge funds and credit default swaps are unregulated and hard to quantify it is unknown what impact they will have on the economy.

What is known is that hedge funds in general rely on leverage to augment returns. Funds also make bets on the direction of stocks, commodities, interest rates, currencies and other asset classes that are extraordinarily volatile at present. Leverage combined with volatility and broadly deflating asset values is a recipe for hundreds of hedge funds to go out of business. The unraveling of a material number of such funds, in an orderly or traumatic fashion, could be destabilizing.

Credit default swaps are similar to insurance policies but are unregulated. This means that many of the underwriters of such swaps may not hold sufficient capital to meet obligations if events trigger default. This issue is partly what took down AIG. As volatility continues and company failures inevitably occur, the credit default swap industry has the potential to dwarf the influence of bank failures in the 1930s.

Proposals Have Been Discussed to Attempt to Prop Up Home Prices

There is a disturbing chorus of otherwise reputable individuals calling for government intervention in housing prices. These arguments are based on mistaken conclusions about current home prices and ignore the consequences of such government intervention.

As damaging as falling housing values are to the economy, they are symptoms of the artificial price appreciation which occurred during the mania of the Housing Bubble. Price declines are inevitable and necessary to restore sustainable economic stability. Asset prices will be determined by fundamentals which affect value, not by proposed government initiatives designed to prop up prices at arbitrary levels.

As uncomfortable a reality as this may be, the economy will remain volatile irrespective of government action while housing prices correct. Government intervention could impede the market clearing mechanism and both lengthen and deepen the crisis. The Japanese have been criticized for adopting and perpetuating a banking system that did not allow markets to clear following their housing bubble, resulting in a lost decade and 15 consecutive years of falling real estate prices. Yet recent proposals advocate similar government interference which would have the effect of propping up prices at arbitrary levels.

No good has ever come from price fixing. Attempts to influence housing values by interfering with market forces have the potential for perpetuating or generating another national housing disaster. Home prices remain unsustainably high and will fall as we return to the credit environment of the early 1990s and the cultural perception of housing persistent in the 1930s. As painful and long lasting as this dramatic decline in housing values will be, we must allow the markets to work. Inappropriate intervention will only worsen the damage and lengthen the duration of our present calamity.

Deflation

Most economists believe it is unlikely that we will experience price deflation. The danger of deflation is that people defer making purchases and avoid borrowing money because it becomes more expensive to repay that debt and prices are anticipated to be cheaper in the future.

We are already experiencing sustained price depreciation within the housing market, one of our largest asset classes. Rational people are unwilling to borrow money to buy houses when those properties are overvalued, falling at record rates and expected to continue to decline in value.

There are also downward pressures on the prices of commodities due to declining global economic activity. Oil, inputs to construction like copper, steel, cement and other commodities directly involved in economic activity are under deflationary pressure.

Tightening credit and steadily increasing unemployment further contribute to deflation. The government can inject as much money as it wants into the economy, but it can’t make banks lend, consumers borrow, restrain market driven unemployment or easily offset the impact of falling consumer spending.

The Federal Reserve has come close to exhausting one of its primary tools as government controlled interest rates approach zero. The Federal Reserve can’t reduce interest rates much more and these low rates are having little effect on the components of our economy responsible for the current crisis.

Based on the actions and statements of the Treasury, Federal Reserve and the Federal Government, it is likely that policy makers will do anything necessary to avoid broad based price deflation. They are committed to inflating the money supply in an attempt to navigate through the economic malaise. To this end, the government has been injecting capital directly into the banking system, increasing the money supply and mailing out government stimulus checks versus dropping them from helicopters. Such actions can distort measured prices and artificially prevent nominal price deflation. But the government can not prevent real asset price deflation. We are likely to see such deflating asset prices for several years to devastating effect.

The Magnification Effect

Finally there is the difficult to quantify but conceptually compelling concept of the self-reinforcing interplay between all of these factors.

During the expansion millions of jobs were directly or indirectly created by increased homebuilding, home transaction and mortgage financing functions. Increased consumption driven by wealth effects of higher equity value, savings rates which were distorted lower and homeowners that directly monetized theoretical equity. That increased consumption results in more companies, faster growing companies and greater job gains. Federal, state and local governments experienced tax windfalls and increased expenditures accordingly.

The impact of the unwinding of the credit and housing bubbles will be substantially larger than during the expansion. The magnifying effect of tightening credit, job losses, company failures, declining tax revenues, foreclosures, dramatically lower consumption, begrudgingly higher savings rates combined with a highly leveraged society will translate into a persistent depression.

The Next Several Years

House Price Declines

House prices will fall, regardless of government intervention, as long as market forces are such that valuations remain too high. House prices will descend rapidly while there is a material source of foreclosures. Structurally this will persist through at least 2012. It is highly likely that prices will fall beyond this date, at minimum in real terms, given the totality of the issues affecting the housing market.

It appears that the government may act directly to head off foreclosures by providing low cost mortgages to distressed owners for some period of time speculated to be five years. Such a program would be disastrous. Prices will not stop falling due to an absence of foreclosures. They will descend less steeply but the length of the descent will increase.

If federal intervention delays foreclosures, housing will not recover as the market is not allowed to clear. Inevitable foreclosures will be pushed out by several years and potential buyers will refuse to accept the prospect of a housing bottom until the government sleight of hand is reversed. Furthermore, as prices drift lower and unemployment climbs more foreclosures will occur. The government will be pressured to perpetually bail out homeowners.

We risk socializing the ownership and lending function with respect to troubled homes and creating a Japanese type scenario where house prices can not recover because the market isn’t allowed to clear and subsidized housing represents a consistent overhang on the market.

It is highly unlikely that housing will be a good investment over the next five years.

Economic Pain Has Yet to Really Be Felt

The fourth quarter of 2008 and a disappointing Christmas season will likely be the events that trigger both real economic damage and a capitalization by many employers. Disappointing retail sales will trigger widespread layoffs in the first quarter, and a steady and growing number of bankruptcies throughout the year. Unemployment will increase dramatically during 2009.

The Stock Market

There is unlikely to be a persistent stock market recovery for the next 18 months. The forces that have yet to significantly impact the economy are powerful and interrelated. High leverage, contracting credit, falling money supply, increasing unemployment, declining consumer spending and asset deflation will damage the economy and inevitably impact the stock market.

The Dow is present above 9,100. Many professional sources are predicting that we have seen the bottom of the stock market slide. The market may easily rise from its present level but there is no reason to believe that such a rally would be sustainable. It is difficult to imagine that the stock market won’t set new lows for this bear market in 2009.

Contracting Economic Activity

Non-government economic activity will contract for the entirety of 2009 and likely through 2010.

Deflation

Depressions tend to be defined by sustained periods of declining economic output, contracting credit, rising unemployment and falling asset prices. This environment is already persistent and there is little reason to believe that any of these requirements is likely to reverse itself in a sustained fashion in the near future.

Some will argue that depressions require broad based price deflation. Price levels are subject to manipulation. The federal government can insure that prices across the entire economy do not deflate simply by printing money. Mr. Bernanke can drop dollars from his helicopter in such numbers that the prices of goods and services will rise nominally. But the real price of assets will fall irrespective.

This is similar to government distortions effecting how we define a recession. Purists define recessions based on historical data showing declining GDP. In the second quarter of 2008 we had positive GDP. But that was the direct result of stimulus checks which artificially distorted that data. If thing government doesn’t want to meet the definition of a recession it can mail stimulus checks out every quarter.

Housing prices are falling because assets are overvalued and potential buyers expect prices to continue to fall. No amount of government interference, stimulus, liquidity injections or printing of money will change this situation.

Over the Next Two Years

· Unemployment is likely to rise through 2010
· Hundreds of small banks will fail
· Hundreds of hedge funds will fail
· Hundreds of highly-levered, private-equity, portfolio companies will run into trouble
· Credit default swaps will trigger crises globally
· Commodities prices will continue to fall or be weak driven by the global economic slowdown
· Any incremental efforts to prop up housing prices may slow the rate of descent, but will fail to stabilize prices and ultimately lengthen the decline

What We Can Do To Prevent Self-Inflicted Bubbles

The Lesson of the Housing Bubble

Government should not overtly interfere in or manipulate private enterprise to achieve social agendas. Every time government attempts social engineering through market manipulation distortions are created, unintended behavior is encouraged and economic damage results. Such manipulation is particularly dangerous when it directly influences asset prices.

Government should restrict its influence on private enterprise to minimal regulation that is designed to prevent unacceptable abuses or restrain behavior that the free market can not regulate itself.

Greenspan’s Fatal Flaw

Greenspan believed that the Federal Reserve could reduce the economic pain and damage of the business cycle’s downside. He concluded that such manipulation was a good idea and, if successful, would produce positive results. The Greenspan Put was best illustrated by his response to the Internet Bubble.

The downside of the credit bubble is a vitally important component to capitalism. It is comparable to the risk of bankruptcy confronted by private companies and the risk of capital losses facing individual investors.

When markets steadily rise, positive returns are consistent or volatility is reduced for an extended period of time, the perception of the risk is discounted by investors, companies and governmental policy makers. When people convince themselves that investments are less risky or that the chance of capital loss is small, behavior becomes distorted.

The Internet Bubble and Housing Bubble from 1996 through 2001 was an example of such a distortion. Following the Internet collapse it is possible that a recession would have occurred, the credit expansion would have mitigated and house price appreciation would have normalized. In fact, immediately following September 11th house prices stopped appreciating. But the dramatic cut in interest rates implemented by the Federal Reserve distorted capital flows and the behavior of potential buyers and investors.

Government should take special care when manipulating business cycles. The impact of such intervention may cause more damage than benefit. Furthermore, capitalism requires the profit incentive associated with investment as well as the risk premium and potential for capital losses to ensure that investments are allocated efficiently. Influencing perceptions of these characteristics creates harmful distortions as assuredly as overt interference in private enterprise.

Regulating Leverage Ratios

A responsibility of government should be to regulate leverage ratios employed by financial institutions and utilized in asset purchases. This observation has been vetted by history, represents common sense and is necessary to avoid the catastrophic abuses of excessive leverage that are inevitable in a financial system defined by free markets and unfettered competition.

To the extent leverage is made available to individuals, companies, investment funds and governments it will inevitably be utilized to excess. Regulators should determine leverage ratios that are suitable and consistent with a vibrant, flexible and growing economy. These ratios should not be excessive or promote dangerous and unreasonably speculative behavior. The government has recognized the necessity of such restrictions on stock purchases as well as on banking and insurance companies. Despite these well founded lessons, government has recently promoted the use of destructive debt in housing through tax incentives, Government Sponsored Entities, legislative distortions and overt cheerleading efforts.

In this capacity our government has failed miserably. In no respect did excesses of capitalism cause our current predicament. There were inexcusable abuses which steadily intensified during the mania. But capitalism does not dependably restrain the use of debt and leverage to buy assets, capitalize certain companies and finance speculative investments. The allure of leveraged returns is too attractive, especially while markets are stable and rising. Even rational or conservative individuals and companies come under pressure as their competitors access excessive leverage. Most individuals could not afford to buy a house in 2005 with a 20% down payment because prices had risen to insane levels driven by people using infinite leverage. Companies see competitors growing faster, capturing superior equity returns and extending better terms to customers through the magic of excessive leverage. Rational individuals and companies have the option of sitting the mania out, which may not be possible in the case of a company, or to rely on prevailing leverage ratios to compete.

If excessive leverage is made available to individuals, companies, investment funds and governments, those entities will inevitably make use of it irrespective of the potential for and inevitability of catastrophic damage.

Examples

We learned the lesson of allowing individuals to access dangerous leverage to buy stocks in the 1920s. As a result, margin requirements have been at the 50% level for decades. Since this regulatory requirement was introduced we have not had a leverage induced stock market bubble. The stock market bubbles we have experienced have been less broad and damaging than if extreme leverage had been available.

We learned that commercial banks and insurance companies required regulatory limits on their leverage ratios to prevent insolvency. Excess leverage in these industries is a recipe for eventual trouble as business cycles inevitably occur.

The loose credit standards of recent years were a failure of regulation similar to the 1920s. Individuals should not be able to buy stocks by borrowing 90% of the value of the asset purchase. In the same way, individuals should not be allowed to borrow 100% or more of the value of a home. This equates to an infinite leverage ratio as no money down is required. The availability of such leverage will inevitably be accessed and abused.

Investment banks should never have had access to leverage ratios that were demonstrated by Lehman Brothers and Bear Stearns. Hedge funds should not have access to extreme leverage. Many of the hedge funds that have failed or will fail have leverage ratios of more than 10 to 1. Given the volatility of the asset classes in which many invest or the inevitability of business cycle volatility, such leverage is insane and ensures that large numbers of these funds will fail.

The credit default swap industry is at the center of current economic volatility and will have a material impact on the global economic system as companies continue to fail. This industry has largely been unregulated to date. I am sympathetic to those who argued for it to be left alone from government interference. The one area where government should have injected itself is in regulating leverage ratios and minimum capital requirements. The credit default swap industry effectively provides insurance for bonds. Government recognizes that insurance companies should maintain minimum levels of capital relative to policy liabilities, but we ignored the same sensible requirements for credit default swaps.

In what was one of the most disturbing activities of the Housing Bubble, Congress overtly marketed Fannie and Freddie as private companies, yet allowed GSEs to leverage themselves to a degree unheard of by private financial institutions. Congress, addicted to the market access and low interest rates enjoyed by the GSEs, used these institutions to create and perpetuate the Housing Bubble. Their unconscionable actions during March of 2008 approach the threshold of criminality. These companies with dramatically deteriorating fundamentals and leveraged to a degree which ensured failure should have been doing everything in their power to survive. Rationality required eliminating dividends, dramatically reducing operations and tightening credit standards. Instead Congress compelled these institutions to increase activities, raised the cap on mortgage purchases, reduced capital requirements and directed them to buy mortgages in areas where prices were collapsing. Congress used these pseudo private GSEs in a desperate attempt to prop up falling real estate prices.

Congress’ attempt to double down on Fannie and Freddie’s activities were inexcusable. Fannie and Freddie were already likely to fail given their government mandate to buy low credit quality mortgages attached to overvalued houses and their extraordinary leverage. Congress’ panicked directives accelerated the collapse which occurred mere months after this latest government intervention.

Regulate Maximum Leverage Ratios

Regulators should establish minimal capital requirements and maximum leverage ratios with regards to the use of debt. The stock market bubbles of the 1920s and the Housing Bubble would not have occurred without abusive leverage. Investment banks and hedge funds would not be destabilizing the global market had they not had access to extreme leverage.

I am not advocating specific regulatory requirements. I think the 50% margin requirement to buy stock has worked well, but I can’t say whether we would be better off if that requirement was set at 40% or 60%. What I do know is that congress should have no direct ability to set or manipulate these ratios. Regulators should be insulated from such intervention. The Housing Bubble has clearly demonstrated the damage caused when government has the ability to manipulate market forces to achieve social agendas.

Irrespective of what minimum down payment requirement for home purchases is adopted, some economically deficient politician with an agenda will attempt to manipulate that rate lower to realize a social goal or purchase reelection. Relevant regulations must be adopted with the long term, sustainable health of the economy in mind, not the short-term, expedient goals of politicians.