12 Percent Behind = Banking System is Toast

The US Mortgage Bankers Association reported a record 12 percent of the Nation's homeowners with mortgages are delinquent or in foreclosure. The article referenced does not give dollar amounts, but we will.

According to the Federal Reserve Bank, at year-end 2008, mortgages on 1-4 family units were 11 trillion dollars. Thus 12% times 11 trillion = 1 trillion, 320 billion.

Problem number one: delinquent mortgages aren't really worth any where near their nominal balances. A lot of them will go into foreclosure.

Problem number two: foreclosed houses aren't worth very much. Sometimes they become a liability to the bank.

Problem number three: there is a terrific glut of housing on the market right now. Throwing millions of foreclosed houses onto the market is like, well, putting gasoline on a fire. House prices will crash, and crash hard. Falling prices will create the bad sort of positive feedback in which more homeowners will 'walk away' before their financial position gets even worse.

Problem number four: commercial mortgages, credit cards, consumer loans, and business loans will be no help to banks. They are likely to perform as badly as home mortgages, or worse.

The real world is giving the US banking system a 'stress test' far worse than the coddlers in Washington could ever dream of. Most banks will fail, and resolving the failures through the FDIC will be a lot for that agency to digest. Even now, it is moving through the worst of the worst somewhat slowly as its resources permit. The sluggishness with which it is moving allows the financial rot to worsen and actually increases the ultimate cost to the taxpayer. (By the way, the slow pace of liquidations is a repeat of the lack of proper bank supervision which led up to the S&L fiasco some years back).

We expect the rot to get worse and worse until some sort of 'banking holiday' is declared to perform mass triage on the system. The sooner the reorganisation happens the better for everyone, but we expect that to be put off for a couple of years yet.

Las Vegas, NV: Bellweather of Doom

Our co-writer made a post a while back, laying out a brief case for the collapse of present valuations of American housing stock. He forecasted (and still forecasts) an estimated 87% drop in value for desirable, non-redundant living space, along with almost every mortgaged houseowner ending up 'under water.'

According to the basic number we've seen bandied about, approximately two-thirds of all houseowners have mortgages. We can surmise, without too much imagination required, that if house prices do indeed plummet 87% or so, almost all of these mortgaged houseowners will be 'under water,' and will likely default on their debt. This will of course create an enormous glut on the real estate market, and devastate the debt-addicted banking system of the United States, and indeed the world.

Our co-writer is now partly vindicated, by the original Icon of Sin: Las Vegas, Nevada. In a recent Wall Street Journal article, a study shows that 67.2% of all homes in Las Vegas have "negative equity;" or, in the common tongue, the owners owe more on their mortgage than the house is presently valued. We point out that 67.2% is right around two-thirds of all houses (and thus virtually every owner with a mortgage is 'under water'); Las Vegas is now the bellweather of the United States housing collapse.

It is difficult - if not impossible - to put a time-frame on this collapse, but we are confident that said collapse is both in progress, and cannot be halted in real terms. However, the Federal Reserve's attempts to rekindle inflation will likely succeed, and when that day comes some of these 'under water' houseowners will at least have the succor of having their nominal property values resume an upwards march. That will be a phyrric victory, but we suspect that realisation will take some time to dawn on the average American citizen.

Redistribution Worsens a Depression

A common theme of government attempts to 'turn this troubled economy around' is merely redistribution: taking money from taxpayers, and giving it to selected recipients; taking toxic assets, and replacing them with Treasury bills; taking private companies, and nationalising them (to some degree or other). In one way or the other, this process represents capital and income forcibly moved from one possessor to another.

For example: Ben Bernanke, Federal Reserve Chairman, recently announced that he is going to expand the Fed's balance sheet as much as necessary (scroll down to the speech's fifth paragraph from the bottom). He also said that the balance sheet would have to shrink in the future... but not to worry about such things now (same link, third paragraph from bottom).

This amounts to simply moving a problem hither and thither, rather than actually solving it. By definition, this is Lemon Socialism: taxpayer money reallocated by the government to support failed or failing enterprises. In essence, lemon socialism takes the bad decisions of a few, and forces the majority to pay for, and suffer the consequences of, those decisions.

As these enterprises have proven unsustainable, such 'zombie-ification' represents considerable misallocation of capital. This, in turn, means that incomes will be generally forced lower by the disruptive economic effects of the 'zombie' enterprises. Falling incomes are part and parcel of all depressions, and so such misguided government bailouts will only serve to worsen the 2007 Depression. Lemon socialism shenanigans are doomed to failure; however, Mr. Bernanke's Soviet-style speech makes clear he will try it anyway.

President-elect Barack Obama comes from a different bent. His economic recovery plan is redistributive from a populist perspective, meaning he will look to prop up the lifestyles of the broadest majority of people at the cost of a few. The simplest demonstration of this is by lowering taxes on 'the poor,' and simultaneously raising taxes on 'the rich;' one can throw in another tax rebate cheque or two for good measure. In a way, one can think of populist redistribution as the opposite of lemon socialism.

A more specific example, though, is the Hubbard-Mayer plan: if passed by Congress next year, this plan will make available to any house-buyer a 30-year mortgage of up to 95% of the house's value, all for a low, low 4.5% fixed interest rate. Estimates put the up front cost of this program at conservative $3 trillion.

Though the mortgage plan is certain to be broadly popular, it is a very, very bad idea: mortgage interest represents someone's income. It's not a fanciful thing, because the interest a bank charges does eventually become someone's means of living. By lowering the 30-year fixed rate mortgage from 6.1% (this year) to 4.5%, money is being pulled out of the economy, lowering income, and since falling income is the essence of a depression, this will exacerbate the 2007 Depression. The math: take 4.5% from 6.1%, and one gets a difference of 1.6%. Take 1.6% of $3 trillion, and one sees that this program alone will take away $48 billion of real income per year. Poof.

Avoiding Conceptual Traps

A depression is a confusing thing. Many things which were apparently normal one's whole life aren't happening any more. Economic growth and 'progress' seemed like orderly, lasting processes. Disorder and breakdown now abound. There is a tremendous temptation to renormalise observed events into patterns that just aren't there. Patterns create a sense of place and order; lack of them causes anxiety.

We would like to take a look at a few conceptual traps that will ensnare the unwary. These traps are created in one's mind in a desperate effort to carry on as usual in the face of circumstances that require a change of strategy. Change is difficult - the 'same old' is easy.

The Value Trap is claiming many victims even as we write. The Value Trap happens when the prices of an asset falls to a level which seems like a good deal. Buyers who may have sensibly avoided 'bubble' pricing, now buy what appear to be bargains. Unfortunately, prices keep falling. Buyers of houses with mortgages find themselves soon 'under water', with their downpayment wiped out. It is imperative to adjust one's frame of reference as to the value of a prospective investment, and if something seems like a good deal - beware.

Institutional Security is misplaced confidence in employers, pension funds, governments, and so forth. Many of these institutions are in really terrible shape financially, and will not be able to deliver on their promises (the State of California comes to mind). There, a lot of people have been banking on long-term employment, contracts, and pensions that will not last. Do not assume even that U. S. government, or any other national government, will fulfill its obligations. It is critical under the present circumstances to develop self-reliance. Could you support yourself if left to your own devices? If presently self-employed, do you have a broad base of customers and suppliers?

The Sound Dollar Trap results from putting one's faith in the U.S. Dollar (or any other currency). Dollars steadily lose purchasing power (for a discussion, see this article and pay special attention to Figure 1). Currencies are themselves institutions (in a broader sense) that are unquestioned, background 'realities'. Keeping some currency is a necessity for most transactions, but it is not a vehicle for any kind of long-term savings or investment. Just because it may have done less badly recently than other assets, does not make it in any way 'good'.

Bailout Rebound is our term for the notion that "happy days are here again" due to some new government program, or bailout. This manifests itself in investment markets as Bear Market Rallies - upward price movements on some 'good news' in spite of the pervasive trend downwards. One wants to believe that the 'bottom is in', that markets are recovering and it's time to invest, or buy that bigger house one has been wanting. One wants to latch on to any sign of an emerging trend towards recovery. In the 2007 Depression there will be many bailout rebounds, false dawns followed by greater darkness.

A variant of the 'rebound' is Dodging Bullets. This is a type of wishful thinking that results from surviving incremental adversity. Just because you survived the first round of layoffs doesn't mean you'll make it through the next. If a mortgage has been renegotiated, the borrower will still likely default (see this article). While maintaining a positive attitude is always beneficial, do not delude yourself with survival bias. Remember that we tend to hear stories of survival only because non-survivors are not able to tell their stories! Things look bad all around, and they are probably going to get worse. The 2007 Depression is going to mark a major shift in everyone's modus operandi. Vigilance and caution are the watchwords of the hour.

Finally, we would advise bewaring the possibility of a Crack-Up Boom. A crack-up boom happens when the people lose faith in their currency due to accelerating inflation. When severe inflation is universally acknowledged, people will buy things - anything - to get money out of their hands and into something that won't lose as much value as the money does. This repudiation of currency creates an enormous demand for goods, and the consequent increase in production looks like a return to prosperity. But don't be fooled if this event comes to pass. It would be but a phase of the 2007 Depression as it morphs into a hyperinflationary depression.

A Grim Prognosis for House Values

As you all know, the prices of houses has been falling in most of the "developed" world, but how much further are they going to fall? We are going to propose a simple model to estimate approximately what the prices will be at the end of the current Depression.

Let's say houses were twice times too expensive on an affordability basis (that is, the ratio of house prices to incomes was twice too high) at the peak of the mania, and let's say incomes will fall on average by half. So if housing then becomes appropriately priced based on affordability, the prices will fall by 75%.

Furthermore, if people decide they want to be more frugal, as they most likely will, they will probably opt to live in smaller quarters, or share larger houses with more people. Let's say the desire for space is reduced by half. Over a rather short period then, perhaps nearly half of the housing stock will become redundant. The prices on most of those units will likely fall to zero.

The price shock will likely cause the more attractive, non-redundant units to become "cheap" relative to income, and the 75% fall mentioned above is too little. Perhaps 87% would be a good guess. In summary a house that cost $400,000 in 2006 may end up going for between $0 and $52,000.

Given this extreme drop, just about everyone with any significant mortgage balance is going to end up 'under water,' and very tempted to 'walk away.' The implications of this are severe. The entire global banking system, including central banks such as the U.S. Federal Reserve System, will probably collapse - not that it is doing so hot at the moment.

Even if money is 'printed' with abandon, too many houses will loose too much value due to redundancy to save the value of mortgages, values upon which banks must rely to stay in business. Homeowners must be prepared for the possibility of a shocking decline in value, though if you live in a reasonably prosperous town where housing has been and continues to be affordable for most of the population, then you are probably safe from the worst.