I'm Not One to Worry but...

I have been writing for weeks about the inexplicability of the recent Treasury sell-off but the fact is that I am uncomfortable with both my explanations and with what is happening. Like the song said, "Something's happening here. What it is ain't exactly clear." But I am not giving up on figuring this out so here we go again.

So exactly what is happening? Here are what (I think) are the facts:

- economic growth is flat. By flat I do not mean GDP growth is zero I mean it is about 2%. I choose to call that flat.

- inflation simply is not happening. Well, it is happening but is benign. Somehow I fail to see that we are in trouble if core CPI is +2.5% but OK if it is +2.0%. Things are just not that fine. If anyone emails me about gasoline prices I will scream. Gas prices go up and down. They get headlines and tons of attention but so does Paris Hilton. Put it this way: both Paris Hilton and gasoline prices get much too much attention. And no cheap comments here suggesting that we combine the two problems by dousing Paris Hilton with gasoline.

- there is no emerging growth industry akin to the Internet of 15 years ago which is likely to create significant opportunities in capital markets.

- housing prices have been turning down slowly and steadily

- there was a ton of coverage about the B-paper mortgage problems but little understanding as to what the effects of that would be or could be on the rest of the economy.

So What?

I think that THE question which is going begging simply is this: what are housing values going to do over the next few (5-10) years?

Let's sidetrack for a moment to the mortgage business itself. I have made numerous observations in these newsletter that the recent state of affairs in the mortgage business was the result of the unmitigated greed of Wall Street firms who gained control of a significant portion of the mortgage securitization business and proceeded to make irresponsible loans (bad credit, high LTV, stated income) loans, securitize them and sell them to suckers. (Let me be clear. Wall Street did not do this alone they had the help of irresponsible, greedy parties in the mortgage business but finding irresponsible greedy people in the mortgage business is about as difficult as finding a dope dealer in San Quentin. The Wall Street firms had an obligation to the suckers who bought these securities and a wider implicit obligation to protect the economy and they abrogate that for short term money.)

The sucker nature of this is evidenced by the recent unwinding by Bear-Stearns of a large position held by a hedge fund. Herein lies the compounded risk. Not only were these bad loans but the folks who made them leveraged them multiplying the risks. In short losing your money in Las Vegas may be bad but if you have $100,000 of your own money and borrow another $1,000,000 and lose that in a poker game then, son, you have a bigger problem and what might be called an existential one. The extent to which hedge funds will be undermined by the B-paper collapse are not yet known and the further problem is that the leveraging of those funds may be leading to what we are seeing - the selling of U.S. Treasuries to an extent not explained by the economic fundamentals.

Unfortunately this doubles back to the mortgage business. We are faced with there being a lot of B-paper still out there in an environment not conducive to lower rates. Those loan offices who got the borrower a zany loan 2 or 3 years ago with the panache that they would find them a replacement ARM (of course bad credit and no doc) are going to have a bit of explaining to do.

Yes, it is sad that folks will lose those homes that they spent all of their life savings (which was $0) on a down payment and Congress can whip around loan officers making them look like 1,000 Dick Cheneys but the silliness aside there is a structural problem here. The more forced selling we have the further values will decline and the more values decline the less probable refiancings will be and more forced selling will take place.

So less building will take place and less selling of the stuff that goes with that building and consequent crappy GDP growth. As rates creep up and mortgage payments creep up on ARMs there will be less discretionary spending and GDP will suffer further.

Looked at from another perspective mortgage rates were low because there was little perceived risk because the value of the underlying assets (out homes) got so large that investors figured that there was no risk. With values declining there is risk

Bill Gross in a just published paper points out that the default rate on subprime in about 7% and that 7% default translates into 3-4% loss. For the players who leveraged that this translates into completely freaking broke. Gross also points out that thru the marvels of capital market arbitrage this could affect just about anything out there. By that I mean just what we have at present - if the leveraged suckers need to cash out it is not their worthless B-paper that folks will buy but US Treasuries or anything else that they may have. In short more forced selling and further declines in values of just about anything out there.

So What is Needed?

Well maybe in the short run some pain to discourage such activity in the future but the only real solution I see is a lowering of interest rates by the Fed. In an ethical sense this is real ugly. Hey please help us folks in the mortgage business make some more money on account of the problems that we created.

The silliness of the situation aside I genuinely think that we need lower Treasury targets to lower rates to alleviate the potentially very serious problem stemming from all of this.

Whether or not the concerns expressed here actualize will not be see for some time. There is little reporting of the condition of hedge funds. Pay attention to events like the Bear-Sterns thing. If this is something that grows to the size of several LTCMs then we have, quite possibly, a crisis.

If you have something to add to this discussion please post a comment on the blog.

Comments

[Heymull]

Home prices rose very high in some areas of the country in the last 10 years. Here on Long Island, prices have gone up 3 to 400 percent since the last pricing downturn in the 90s. We bought in 2001 so "only" gained 200 percent.

My mom's home price rose only about 100% in 25 years of home ownership in Fayetteville, NC. I know because I just sold her house in June. Nice solid growth, but paltry compared to Long Island.

The people and institutions that get hurt the most by the recent (rapid) downturn in home prices are the ones who speculated, hoping for high returns on short term investments. Idiots, all of them.

I would like to see laws passed (and enforced), getting us back to the days when you had to have several times earnings to earn the right to buy a mortgage. As "parental" as these laws where, they had their intended effect, largely keeping homeownership out of the hands of people who didn't earn enough to *buy* them. (I as going to say *own* but with zero or negative equity, what ownership ever existed?)

Putting off major mortgage business reform hurts every one. Lets get going.