REARRANGING THE FURNITURE WHILE THE HOME IS FORECLOSED UPON (U.S. HOUSING COLLAPSE IS FINALLY HITTING HOME) - July 24, 2008

If you have not noticed yet, the whole financial industry neighborhood is crumbling under the weight of the US housing mortgage collapse. Financial stocks have dragged down global equity markets. Fannie Mae and Freddy Mac, the two premier US quasi-government backed mortgage lenders, (in combination owning or guaranteeing over half, $6 trillion of $12 trillion US home mortgages), have shed close to 90% of their stock price in less than a year, the most dramatic drops coming most recently in double digit percentage slices per day. (July 7-11, their stock price dropped by 75%). Commercial banks and investment banks, (US based and international), are responding by firing workers and freezing lending activity to glacier pace, pre global warming. Mortgage lenders and insurers are going under or are bouncing around rudderless. A far reaching proposal was launched this spring to rearrange and centralize US regulatory authority in the financial industry. Motivated by the unprecedented and continuing collapse within the housing and mortgage markets, nonetheless, this does little to salvage the home today, for those facing unprecedented drops in the value of their most valuable asset as well as those already facing foreclosure. (As of this week Congress has adopted new legislation that may be decisively helpful, and, in change of course, President Bush apparently is intending to sign soon).

WE TOLD YOU SO BEFORE: IT IS GOING TO BE WORSE THAN EXPECTED

There is always some satisfaction in saying one was right in their prediction, even when the result is mutually detrimental. Here I will only mention it as a point of reference rather than gloating.

In my two previous columns on the subject in the EuropeanCourier.org: January 27, 2008, “US Economy: Recession or Transition” and March 1, 2008, “US Economy: Phoenix Rising or Wounded Duck Flying?” we anticipated that not only the current housing market slump would be deeper and broader, but that the then immediate regulatory response would exasperate the crisis. The former assertion is self evident. The later may not be as clear. However, the initial so-termed tightening of mortgage lending standards at the encouragement of regulators has not only detrimentally impacted lending, but it has furthered the decline of housing values, and especially at a time when most other real asset values, including energy, metals and grains, have been rising in the opposite direction.

CONTINUING INCREASE IN MORTGAGE DELINQUENCY AND DEFAULTS TO UNPRECEDENTED LEVELS

The value of US housing has continued to decrease going well below the “water mark” on many conforming mortgages, (that is a drop of 20% or more equal to the standard equity investment of purchasers on US homes). It is estimated that almost 1 in 10 of US mortgages are in default or 90 day delinquency. Some regions and cities are doing considerably worse. (Approximately 2 of 3 US homeowners have a mortgage on their homes). The situation is only expected to get worse with:

- housing values dropping below 30% from highs;
- the “universe” of mortgage lenders sharply contracting; and
- defaults and delinquencies doubling from current levels as mortgagors are caught in squeeze due to

   dropping home prices and no or highly restrictive mortgage lending.

It had been argued by some that this housing market slide was nothing more than a bubble bursting, an inevitable correction due to speculation buying and irresponsible lending. Undoubtedly there was a bit of that, but these speculators have long been foreclosed upon and these lenders are in dissolution or inactive. The greater problem is the reverse now: that the US and probably the rest of the world will not have enough housing lenders. Fannie Mae and Freddie Mac are edging toward unprecedented waters of government bailout. Indymac Bank, the second largest mortgage lender in the US only a year ago, was taken over by the regulators over the weekend, (July 11, 2008), and is out of the market. Mortgage lending will be highly restrictive, both in terms of number of potential lenders and conditions.

MEDICINE EXASPERATES AILMENT

The initial reaction of government regulators was to purportedly tighten mortgage lending criteria. While such could have been advantageous before the crisis, it has only made it worse once in the grips of the crisis. As pointed out in our January 27, 2008 article, this would only exasperate the crisis by then pushing values in the opposite direction and catching many homeowners and lenders in liquidity squeezes or with no or little alternatives.

The “remedy” was not addressing the new, rapidly evolving crisis but rather old problems that had already mutated into new crisis. It was a rear view mirror methodology searching for culprits as much as for solutions. By focusing on the blame game, the legislative and executive authorities in the US have missed the urgency of the problem as well as the appropriate solutions. The proposed solutions missed the mark, and, instead, the homeowner was run over for the second time in this housing crisis cycle.

WILL IT GET WORSE BEFORE BETTER?

Yes!

REVERSING CURRENT VICIOUS CYCLE

The vicious cycle will be difficult to reverse, and it is definitely in motion now. The question is what other financial instruments, real assets as well as business enterprises may be swept up in the cycle?

Standard macroeconomic measures ha ve not been determinative in reversing the current cycle.

- Bailing out Fannie Mae and Freddie Mac has not altered the underlying US housing fundamentals. In the

   short term it may only confirm the worst fears and fuel the “short sellers” in housing and financial equities,

   even if long term the help for Fannie Mae and Freddie Mac is necessary and helpful.
- Lowering Fed rates may return positive spread earning opportunity for financial institutions; however

   spreads between Treasuries and mortgage rates remain undesirably high.
- Lower Fed rates may have fueled lending in other areas, including facilitating speculation in energy that

   has only made worse the plight of the consumer through higher prices in everything from gasoline to food.

WHAT TO DO TO SALVAGE HOUSING, AND FINANCIALS? (THERE IS NO EXCLUSIVELY FREE MARKET SOLUTION)

Reversing the current downward housing cycle requires helping the homeowner directly. Most current avenues of assistance have been voluntary to a lender community frequently not accustomed, inclined or perhaps legally empowered for such.

The so-termed assistance to homeowners has been largely illusory, and without vision or courage. Right wing populists have tried to lay the blame on fraudulent and speculative actions. They have proposed allowing the free market to go through its cycle. According to them, the carcasses left on the road, will be that of the fraudsters and speculators. However, this is a misleading and I believe disingenuous argument.

There is no exclusively free market solution to this crisis. Housing is now being driven by something other than fundamentals: more panic and a liquidity crisis. The US Government, in this case the FHA, (Federal Housing Administration), must be prepared to facilitate mortgage financings for delinquent mortgages on “primary homes” at current valuations and as an alternative to foreclosure by lenders. This would be the optimum alternative for current lenders, the US and local governments as well as homeowners. Why? (The US Congress, now both houses, has just adopted comparable legislation to above, and in change of course perhaps reflecting the severity of the problem, President Bush has indicated that he will sign).

- Lenders will not necessarily be able to recognize the full amount of their mortgage, but will most efficiently

   realize the maximum potential of any other alternative including foreclosure, (since lenders are also

   practically limited in foreclosure recovery to resale under current home values);
- Lenders and all parties will avoid the high transaction costs of foreclosure as well as liquidation of

   properties at bottom fishing prices to financial scavengers and speculators;
- Local governments will minimize property tax revenues, and avoid disruptions in their neighborhoods,

   from poverty to crime;
- The Federal Government will ultimately have to commit less resources in rescuing a broad range of

   mortgage lenders, insurers, GSE’s even if it assumes higher obligations for now through FHA mortgage

   insurance lending programs. (Government as a whole would also minimize expense that otherwise would

   be sparked by economic, social and even political disruption);
- Liquidity, the most badly needed resource in financial and home lending markets, will steadily return;
- Homeowners will benefit by being able to refinance into mortgages reflecting both more consistent housing

   values and mortgage rates;
- Home prices will more quickly bottom out and stabilize and allow for steadiness to replace panic.
- This is actually the closest to a “free market” solution available under the current

   circumstances of panic and where more standard free market options are dramatically

   drying up.

The US Congress is now considering measures that may have some greater beneficial impact at the level of the US homeowner. The US Senate has already adopted, but it is yet not clear where the Busch Administration will stand once the legislation, presumably, has been adopted by the House of Representatives, with overwhelming Democratic and significant Republican support.

THE BUDDING PARADOX

There is an overbearing paradox yet to be reflected in the capital markets. While US housing prices drop, almost every other real asset value has been rapidly rising, from petroleum to grains. Is there a new bubble inflating? Clearly, this paradox is reaching unsustainable levels especially when considering the US and overall global economic health.

These other real assets will have to level off, if not burst and deflate. The contradiction is unsustainable, even if we take into consideration divergent economic trends at global levels. On the other hand, US real estate values, especially home prices will again rapidly reflate, once the housing mortgage situation troughs out.

WHAT APPEARS MORE SECURE, RELATIVELY?

With this paradox in mind, natural resources should be avoided as an investment. Undoubtedly most real assets, including energy, grains, metals and building materials will continue to experience steady demand. If you were at the beginning of this cycle, such investments would have been sound and by now proven by big returns. Even in our January 27, 2008 analysis, we thought that resource equities still had room to grow. Now, be cautious.

On the other hand, what is a sound option especially if the US and by extension the globe, is economically turning downward:
- Innovation and technology will be sustained despite potentially lower consumer demand. Simply put, there

   is an ever greater need for efficiency and communication delivered by such;
- Financial institutions have been swept downwards across the board. Financial institutions which do not

   have even housing exposure, nonetheless have been punished by association. Distinguishing between

   institutions still stuck in the malaise and those free of it, will provide a sound opportunity for selective

   investment in such;
- US export industries, manufacture to entertainment, still have to fully realize full benefit of depreciated US

   dollar;
- US commercial real estate cannot avoid some of the problems of single family housing. In particular,

   commercial real estate also suffers from the liquidity crunch. HOWEVER, selective investment in real

   estate can be most timely over the next 6-18 months. AVOID speculative commercial real estate. It is still

   subject to significant uncertainty, even if high potential. Focus opportunities on real estate that has long

   term lease commitments from credit quality tenants, and is part of the continuing health of logistics,

   export and technology enterprises. This will allow for solid returns with minimum risk for now while

   providing the opportunity for long term value growth when real estate, including housing recovers.

A GARAGE SALE OF US ASSETS?

The theory that there is a substantial transfer of wealth from the US to overseas has been advocated from when I was studying for my MBA at Columbia Business School in the early 1980’s. Undoubtedly petro and import dollars have flowed overseas. On the other hand, capital flows, particularly, in the form of investments have flowed back to the US. Expanding global wealth does not have to be at the expense of any country or region, but to the contrary. There is an adjustment, but it probably is more within borders, including the US, and among economic classes.

Sovereign funds and other international investors may be reacting to the relatively lower US Dollar. Some may have jumped in prematurely into certain financial stocks, perhaps overlooking the yet inadequate response at the homeowner level to the housing crisis. Yet, long term, the US economy is strong even if currently limping. Putting the US homeowner back on track, consistent with the US social compact and economic fundamentals, is a crucial priority. Still, in the current global expansion, economically the US may even be undervalued, especially in real estate and areas of innovative growth. While at times it may appear like a garage sale, it is a global adjustment. There is always the risk of buying someone else’s junk, but America has continuing, perhaps even unrivaled value in this environment. Regardless of an Obama or McCain election, the US is a country more likely to be in tune with global economic and political trends, perhaps recapturing much of the leadership role evaporated under the current Administration.
 

Muhamed Sacirbey

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Author of the article is a former Vice-President of Standard & Poors.

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