“You may require payment from a foreigner, but you must cancel any debt your brother owes you.”
Well it appears that Senator Dodd is taking a page right out of the bible. With the recent congressional hearings there is sudden talk about a bailout for many homeowners who over extended themselves. Every financial institution, news outlet, and citizen is wondering how bad will this housing bubble pop. Keep in mind that only a year ago there was serious doubt that a housing bubble even existed. Any housing bear was seen as wearing a tin-foil hat and running around proclaiming concentric circles appeared in the corn fields last night. But now that we are on the verge of having $1 trillion in mortgages reset this year, the only question that remains is how bad is this going to get? Are locusts clouds going to infest the 405 and 10 freeways? This biblical fire and brimstone talk is fun!
One Trillion is A Lot of Bling-Bling
Keep in mind that the subprime market used to represent a very small portion of the market until the last three years. We always hear pundits talking about “well subprime mortgages ALWAYS existed and housing was always fine.” Well yes, but that was before everyone on Wall Street went nutty for Collateralized Debt Obligations. In 2005 and 2006 $1.2 trillion in subprime mortgages were originated, over 21% of the entire mortgage market. Here is a rough breakdown of the share subprime used to comprise of the entire mortgage market:
1994-1998 – Approximately 2 to 4 percent of the total mortgage market
1998 – 2003 – Approximately 5 to 7 percent
2004 – Approximately 13%
2005 and 2006 – Approximately 21%
*source Inside Mortgage Finance
And what 21% means for two years is $1.2 trillion in risky mortgage debt. Now do you understand why the bloodbath has occurred in the subprime market? Not only that, but keep in mind that we have about 21 months where $20 to $30 billion of these notes will be resetting. We’ve just set this train on its tracks and no one is going to get in its way. So what options are available? Refinancing is out of the question because most of these folks couldn’t afford the place with conventional financing. Selling may not work either because many of these people have zero to negative equity and would need to short-sell the house. Holding out? How long can this last when many of these payments will reset and increase payments by 40 to 60 percent. Homeowners will get to choose their poison. Wall Street is like a cougar waiting to bounce on any sign of good news regarding housing because they have so much skin in the game; the Fed kept rates steady therefore Wall Street cheered. Today housing sales modestly went up (although median fell for another consecutive month) and the market cheered. Now looking at the above data, do you think a 3% jump in sales is going to stop this debacle?
More Bills Equals Less Discretionary Income
Now I know what you are saying, “Dr. Housing Bubble, you are such a neg-head permabear. Why are you trying to make me sad?” Yes, I’m the life of any party. Can you imagine spoiling the fun at a cocktail party talking about CDOs and massive resets with folks that made a mint flipping? No worries, I’m happy to collect my funds from shorting the herd and investing against the grain. Bulls make money, bears make money, and pigs get slaughtered.
But let us run a quick hypothetical. From the above analysis we know that many of these folks will try to pony up and make the new higher payments. So if John and Mary Debthead currently have a payment of $1,500 and there payment goes up to $2,000, where does that $500 go in the economy? Instead of John and Mary buying another disposable DVD player they are now facing a squeeze on their discretionary income. This is known as the reverse wealth effect. If you have a fixed payment such as housing eating up a larger portion of your monthly bill you must forgo something.
Now this leads us to the much touted fact that 70% of our economy depends on consumer spending. And considering that our savings rate is negative we do a damn good job spending every penny we got. So even a slight jump of $500 a month on a housing payment, the ramifications millions of times over is large. And we know many folks are facing resets of $1,000 to $2,000 a month.
A simplified equation can look like:
Rates reset = More Money to Home = Less Money on Consumer Goods = Contraction in the Economy
I loved it when Professors would explain stuff like this. It makes such perfect sense and all us in the bear camp saw this subprime “surprise” way in the past.
Bend it Like the Foreigners
Even though my above equation isn’t exactly E=mc squared there is a lot of truth in it. And there is another equation that we will be hearing a lot about:
We buy foreign goods = they buy our bonds = We get goods while they build a trade surplus
Simple right? So how does this look in our society? Just go to Wal-Mart and marvel at the amazing stuff we spend our discretionary money on. Now imagine what will happen to all this stuff when payments jump. You can’t buy something with money you don’t have. And considering the average American has close to $9,000 in credit card debt many are already financially strapped. Remember the market “crash” we had a few weeks ago? Why did this happen? Well one of the main reasons was talk of credit tightening. We’ve gotten to the point in the game were the only way to keep this going is by making money more abundant. But this creates inflation and ties the Feds hands because in order to keep housing going they need to drop rates. But the CPI and PPI, which are horrible indicators anyways, are still showing signs of inflation. Well of course it is! That is exactly what happens when you print too much money. And now we have a mortgage time bomb that will go off at a calculating pace while we head into a recession. Mark these words, there is nothing that will keep us from a recession. The plague is set in stone and the bush is burning, read these things for what they are.