Federal Reserve Chairman Ben Bernanke’s call Tuesday for Fannie Mae and Freddie Mac, the government sponsored enterprises dedicated to housing lending, to reduce their outstanding assets below the current $1.4 trillion is a classic political statement. It will have no effect in practice, except to insulate Bernanke somewhat from criticism once Freddie and Fannie are subject to a gigantic taxpayer bailout. However, as the mortgage financing business gets deeper and deeper into difficulties, one begins to wonder whether a mortgage finance disaster could spread economically far beyond housing?
Home mortgage debt was $10.7 trillion in 2006, of which Fannie and Freddie had guaranteed $3.4 trillion and owned directly an additional $400 billion. Since the value of U.S. housing is approximately $22 trillion, if housing debt was one gigantic home mortgage there would be no problem. Even though the gigantic borrower might lose his job to gigantic outsourcing from India or China, with a 50% loan-to-value ratio there would be plenty of room for price declines before the mega-loan was in real trouble.
Unfortunately, the quality of home mortgages varies enormously, and the amount of collateral available is also varied, with zero or 5% down-payments having become increasingly common in recent years. According to estimates by RGE Monitor, sub-prime mortgages represented 13% of the outstandings and mortgages with negative or no amortization represented another 27% of the $6 trillion of mortgages originated in 2005-06. Add the two together, and you have roughly $1.4 trillion of mortgages sub-prime and another $1.6 trillion of mortgages endangered if interest rates were to rise sharply.
The fate of these two pools will be sharply different. In “Bear’s Lair” last August I suggested that house prices were likely to decline by 15% nationwide, with declines averaging 30% on the two coats where the run-up had been most excessive. That looked excessively bearish when I wrote it, but is currently looking increasingly prescient, and probably about right.
In that case, loan losses on sub-prime mortgages will be very extensive. Some sub-prime loans are in fact second mortgages, others are on new property or property that is in other respects wildly overpriced (the sub-prime borrower is generally in a rapidly rising market, and highly optimistic about both market prospects and his own financial condition.) With a 15-30% price drop, worse than is predicted by other commentators, and no equity cover in the first place losses on second mortgages may well be total. Even losses on sub-prime first mortgages may easily run 30-40%, when repossession and sale costs are factored in, with an overall default rate on these sub-prime mortgages of perhaps 75%. Thus a loss rate of 60% of the sub-prime mortgage pool would appear reasonable, far worse than pundits are currently projecting, to give a capital loss of $840 billion. A study by CreditSight Friday suggested that 500,000 houses would be returned to the market through repossession. That figure would represent maybe $100-200 billion of mortgage debt and looks to me distinctly low.
Losses on negative amortization and zero-principal mortgages to non sub-prime borrowers, on the other hand, will not be so severe. Interest rates are far too low in real terms, and are thus bound to rise either in the short term (if Bernanke tightens monetary policy to fight inflation) or, more likely, in the long term (as Bernanke loosens to fight the tsunami of losses in the mortgage markets, and inflation goes through the roof.) However, the overall excess interest costs born by these borrowers is unlikely to exceed 3-4% per annum, unless inflation really takes off, in which case house prices will, after a lag, follow it. Thus not all these mortgages will default, maybe only 1/3, and of the defaulters the losses will be limited, maybe 25% of principal. That gives losses on this mortgage pool of 8.3% of loans outstanding, or $140 billion. Just under $1 trillion in losses between the two categories, not counting whatever defaults may occur on prime mortgages.
However there’s a snag here, and that’s Fannie and Freddie. With $3.8 trillion of the $10.7 trillion of home mortgages, they should suffer $350 billion of losses. Since they have an upper mortgage amount limit of $417,000, they will have fewer loans on the coasts than average, and fewer loans against grossly overpriced McMansions than average. They may also have fewer sub-prime loans than average, though they have been active in negative amortization rubbish. Thus their losses may be lower than average, perhaps only $250 billion.
However, there’s a snag here. Fannie and Freddie’s combined capital is only $79 billion. That means they are almost certain to default, and to require bailout by the long-suffering U.S. taxpayer. The one consolation will be that their losses on inappropriately hedged interest rate risk on their $1.4 trillion of directly owned mortgages, about which Bernanke was concerned, will be dwarfed by their simple credit losses on their guaranteed mortgages as a whole.
The more interesting question, except for those who have foolishly invested too much in mortgage bonds or the stock of Fannie and Freddie is what effect this will have on the U.S. economy. A wealth loss of $1 trillion on mortgage debt is far from a negligible amount, but it doesn’t represent a huge hit compared with the fluctuations of a stock market that is currently worth $18 trillion or so. Even adding in a $3.3 trillion value loss on a $22 trillion housing stock, that’s still only equivalent in itself to a 25% stock market downturn, painful but by no means cataclysmic. However, the housing decline will not be an isolated event.
One problem that may make the downturn worse is that housing supply during the bubble has been poorly matched to demand. 39% of properties were bought as investments or second homes in 2005. You can bet your bottom dollar that many of those purchasers don’t realize the ghastly cash flow reality of rental property ownership, and so will drown financially and default on their loans when the repair bills arrive and the credit-worthy tenants don’t.
New construction was heavily concentrated at the upper end of the market, where wealthy speculators used non-repeating bonuses to make down payments on more house than they needed. The real estate industry trumpets growing population as a rationale for house price spirals and heavy construction, but the reality is that the baby boomers are close to retirement and will soon begin scaling down, while the 12 million illegal immigrants can’t afford McMansions, except to the extent of mass squatting in empty, un-saleable ones. This is not a problem we have seen in past housing booms; market signals this time around were especially distorted by excessively loose money and the speculative atmosphere that prevailed in the housing market in 2003-05.
Finally, there’s the disruption effect. Fannie and Freddie may have only $79 billion in capital, but they have guaranteed $3.8 trillion in mortgage loans, nearly 30% of U.S. Gross Domestic Product. If they have to be bailed out, the uncertainty while Congress is adding Christmas tree ornaments to the bailout bill is likely to be seriously disruptive to the U.S. capital markets in general. Given the Ecuador finance minister’s new-found determination to be “very responsible” some mortgage backed securities holders may come to wish they had invested in the sound economy and fiscal policies of Ecuador rather than in the profligate U.S. housing sector!
Thus the housing malaise, in house prices, national wealth, loan losses and market disruption, is likely to be gigantic, and will inevitably spread into the rest of the economy. In particular it will itself cause sufficient despair in U.S. securities markets to accentuate a stock market downturn that is in any case inevitable, given the current overvaluation of the market and the rapidly deteriorating state of corporate balance sheets. Between the two, housing and stocks, the decline in U.S. net worth is likely to be both steeper and deeper than any we have seen since the 1930s, as the excesses in stock market valuations, housing, fiscal policy and money creation all have to be corrected more or less simultaneously.
Having run a printing-press money policy for the last decade the Fed will have no easy way to get the economy out of the mess. Indeed, it may be forced to deepen the mire. It’s one thing to tolerate inflation at the 8-10% level in the interests of sorting out an unexpected but major U.S. downturn, it’s quite another to run the risk of hyperinflation as the Fed will do if it attempts to reflate housing and stock market bubbles before the excesses in the economy have been worked out.
Still, unlike in 1929, the voting public will not be able to blame Wall Street much, although doubtless it will be tempted to do so. This will truly have been a Main Street Crash.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)