Treasury Secretary Henry Paulson delivered an upbeat
assessment of the slumping real estate market on Friday saying, �All the signs
I look at� show �the housing market is at or near the bottom.�
Paulson added that the meltdown in subprime mortgages was
not a �serious problem. I think it�s going to be largely contained.�
Paulson knows full well that the housing market is headed
for a crash and probably won�t bounce back for the next four or five years.
That�s why Congress is slapping together a bailout package that will keep
struggling homeowners out of foreclosure. If defaults keep skyrocketing at the
present rate, they are liable to bring the whole economy down in a heap.
Last week, the Senate convened the Joint Economic Committee,
chaired by Senator Charles Schumer. The committee�s job is to develop a
strategy to keep delinquent subprime mortgage holders in their homes. It may
look like the Congress is looking out for the little guy, but that�s not the
case. As Schumer noted, �The subprime mortgage meltdown has economic
consequences that will ripple through our communities unless we act.�
Schumer�s right. The repercussions of millions of homeowners
defaulting on their loans could be a major hit for Wall Street and the banking
sector. That�s what Schumer is worried about -- not the plight of
Every day now, another major lending institution unveils its
plan for bailing out the housing market. Citigroup and Bank of America have
joined forces to create the Neighborhood Assistance Corporation of America
which will provide $1 billion for the rescue of subprime loans. This will allow
homeowners to refinance their mortgages and keep them out of foreclosure. The
new �30-year loans will carry a fixed interest rate one point below the prime
rate, putting it currently at 5.5 percent. There are no fees, and the banks pay
all the closing costs.�
But why are the banks being so generous if, as Paulson says,
�the housing market is at or near the bottom.� This proves that the Treasury
Secretary is full of malarkey and that the problem is much bigger than he�s
Last week, Washington Mutual announced a $2 billion program
to slow foreclosures (Washington Mutual�s subprime segment lost $164 million in
the first quarter) while Freddie Mac committed a whopping $20 billion to the
same goal. In fact, Freddie Mac announced that it �would stretch the loan term
to a maximum of 40 years from the current 30-year limit.�
Forty years? How about a 60- or 80-year mortgage?
Can you sense the desperation? And yet, Paulson says he
doesn�t see the subprime meltdown as a �serious problem�!
Paulson�s comments have had no effect on the Federal
Reserve. The Fed has been frantically searching for a strategy that will deal
with the rising foreclosures. On Wednesday, The Washington Post reported that �Federal
bank regulators called on lenders to work with distressed borrowers unable to
meet payments on high-risk mortgages to help them keep their homes.�
When was the last time the feds ordered the privately-owned
banks to rewrite loans?
Never -- that�s when.
That gives us some idea of how bad things really are. The
details of the meltdown are being downplayed in the media to prevent panic
selling among the public. But the Fed knows what�s going on. They know that �U.S.
mortgage default rates hit an all-time high in the first quarter of 2007� and
that �the percentage of mortgages in default rose to a record 2.87 percent.�
In fact, the Federal Reserve and the five other federal
agencies that regulate banks issued this statement just last week: �Prudent
workout arrangements that are consistent with safe and sound lending practices
are generally in the long-term best interest of both the financial institution
and the borrower . . . Institutions will not face regulatory penalties if they
pursue reasonable workout arrangements with borrowers.�
Translation: �Rewrite the loans! Promise them anything! Just
make sure they remain shackled to their houses!�
Unfortunately, the problem won�t be �fixed� with a $30 or
$40 billion bailout scheme. The problem is much bigger than that. There is an
estimated $2.5 trillion in subprimes and Alt-A loans -- 20 percent of which are
expected enter foreclosure in the next few years. Any up-tick in interest rates
or unemployment will only aggravate the situation.
Kenneth Heebner, manager of CGM Realty Fund (Capital Growth
Management), provided a realistic forecast of what we can expect in the near
future as defaults increase.
Heebner: �The Greatest Price Decline in Housing since the
Great Depression� (Bloomberg News interview)
�The real wave of pain and foreclosures is just beginning. .
. . subprimes and Alt-A are both in trouble. A lot of these will go into
default. The reason is, that the people who took these out never really
intended to fully service the mortgage -- they were counting on rising home
prices so they could sign on the dotted line without showing what their income
was and then 2 years later flip into another junk mortgage and get a big profit
out of the house with putting anything down . . .
�There�s a $1.5 trillion in subprimes and $1 trillion in
Alt-A the catalyst will be declining house prices which is already underway.
But as we get a large amount of these $2.5 trillion mortgages go into default,
we�ll see foreclosed houses dumped on an already weak market where homebuilders
are already struggling to sell there houses. The price declines which have
started will continue and may even accelerate in some of the hotter markets. I
would expect that housing prices in �2007 will decline 20 percent in a lot of
�What you are going to see is the greatest price decline in
housing since the Great Depression. . . . .The one thing that people should not
do, is go near a CDO or a residential mortgage backed security rated Triple A
by Moody�s and S&P because these are going to get down-graded by the
hundreds of millions -- because they are secured by subprime and Alt-A
mortgages where there�ll be massive defaults.�
Question: Will the losses in the mortgage market exceed
those in the S&L crisis?
Heebner: �They�re going to dwarf those losses because the
losses could easily approach $1 trillion -- that dwarfs anything that has ever
happened. Enron was $100 billion -- this will be far greater than that. . . . .The
good news is that most of these loans are owned by Hedge Funds . . . You hedge
funds buying these subprime and Alt-A loans and leveraging them at 10 to 1.
They buy a pool of mortgages at 8 percent and they borrow against it in yen for
3 percent and then lever it at 10 to 1so you have a lucrative profit And the
hedge fund you are running, the manager is going to get 20 percent of the gain
-- so even if it�s a year before you go broke; you get rich until the fund is
Heebner added this instructive comment: �The brokerage firms
created �securitization� they know the products are toxic. I don�t think they
are going to suffer losses; they simply passed them on to everyone else. The
only impact this will have is the profits that flow from it will get less. . .
. But it is less than 3 percent of revenues in even the most exposed brokerage
firm so THEY�RE NOT GOING TO GET CAUGHT.�
Although Heebner believes the brokerage houses will do fine;
the same is not true for the small investor. Nearly 70 percent of subprimes
have been securitized. That means that the vast number of shoddy �no down
payment, no document, interest-only� loans (that are headed for default) have
been transformed into securities and sold to hedge funds. As the housing market
continues to falter, these funds will plummet at an inverse rate to the amount
of leverage that has been applied. That may explain why, (according to
Bloomberg Markets) the �wealthiest Americans have been bailing out� of hedge
funds at an alarming rate.
A report in last Thursday�s New York Times stated, �Americans
with a net worth of at least $25 million, excluding the value of their primary
homes, reduced their exposure to hedge funds in 2006�
The amount of money held by wealthy investors in hedge funds
has dropped dramatically.
�The average balance, which was $2.8 million in 2005, was
just $1.6 million last year, a 43 percent decline.�
So, what do America�s richest investors know that the rest
of us don�t?
Could it be that the over-leveraged hedge funds industry is
about to get hammered by the subprime implosion?
If so, it won�t be the brokerage houses or savvy insiders
who get hurt. It�ll be the little guys and the pension funds that take a
In Henry C K Liu�s �Why the Subprime Bust will Spread� (Asia
Times), the author states that the bursting housing bubble will trigger a major
pension crisis. After all, who are the �institutional investors? They are
mostly pension funds that manage the money the US working public depends on for
retirement. In other words, the aggregate retirement assets of the working
public are exposed to the risk of the same working public defaulting on their
house mortgages.� (Liu)
The origins of the housing bubble are complex, but they are
worth understanding if we want to know how things will progress. The housing
bubble is not merely the result of low interest rates and shabby lending
practices. As Liu says, �the bubble was caused by creative housing finance made
possible by the emergence of a deregulated global credit market through finance
liberalization. The low cost of mortgages lifted all US house prices beyond
levels sustainable by household income in otherwise disaggregated markets.�
The deregulated cross-border flow of funds (via the yen low
interest �carry trade� or the $800 billion current account deficit) have played
a major role in inflating the US real estate market.
Liu adds, �Since the money financing this housing bubble is
sourced globally, a bursting of the US housing bubble will have dire
consequences globally.� Since nearly 50 percent of �securitized� mortgage debt
is owned by foreign investors; the subprime meltdown is bound to send tremors
through the entire global financial system.
The housing decline is further complicated by Wall Street
innovations in derivatives trading which has generated trillions of dollars in �virtual�
wealth and is affecting the Fed�s ability to control inflation through interest
rate manipulation. As Kenneth Heebner said, �You have hedge funds buying these
subprime and Alt-A loans and leveraging them at 10 to 1. They buy a pool of
mortgages at 8 percent and they borrow against it in yen for 3 percent and then
lever it at 10 to 1 so you have a lucrative profit.�
In other words, low interest foreign capital has flooded US
markets and contributed to distortions in housing prices.
In her recent article, �War Drags the Dollar Down,� Ann Berg
refers to Wall Street�s �swirling galaxy of exotic finance� which has �worked
magic for the government and the elite,� but has yet to weather a severe
downturn in the economy.
But how will the market deal with a sudden downturn in the
hedge fund industry? Will the dodgy subprimes and shaky collateralized debt
obligations (CDOs) trigger a crash or has the risk been wisely dispersed
through derivatives trading?
No one really knows.
As Berg says, �Derivatives numbers are staggering. The Bank
for International Settlements estimates that the notional amount of derivatives
traded on regulated exchanges topped a quadrillion dollars last year and that
the outstanding unregulated off-exchange (called over-the-counter -- OTC)
amount stood at $370 trillion in June 2006. Because the OTC market is composed
of endless strings of bilateral transactions -- the systemic risk is unknown.�
The comments of the president of the New York Fed, Timothy
Geithner, help to clarify the abstruse activities of the modern market: �Credit
market innovations have transformed the financial system from one in which most
credit risk is in the form of loans, held to maturity on the balance sheets of
banks, to a system in which most credit risk now takes an incredibly diverse
array of different forms, much of it held by nonbank financial institutions
that mark to market and can take on substantial leverage.�
Geither�s right. The markets now operate as unregulated
banks generating mountains of credit through massively leveraged debt
instruments -- a monster credit bubble larger than anything in the history of
So, where is all this headed?
No one really knows. But when the housing bubble crashes
into Wall Street�s credit bubble, we can expect the �big bang.� That may
explain why America�s wealthiest investors are running for cover before the
whole thing blows. (A number of investors have already cashed out and put their
holdings into foreign funds and currencies)
One thing is certain, time is running out. With $1 trillion
in subprimes and Alt-A loans headed for default, the system is facing its
greatest challenge. US GDP has been revised to a measly 1.8 percent, foreign
investment is down, and the dollar is losing ground to the euro on an almost
Falling home prices have already precipitated a number of
other problems. For example, Gene Sperling reports in �Housing Bust Meets the
Equity Blues� that �The Fed data showed an amazing expansion (in
Mortgage-Equity Withdrawal). In 1995, active MEW had been $37 billion. By the
fourth quarter of 2005, it soared to $532 billion annualized, a 14-fold
expansion.� These equity withdrawals have translated into consumer spending
which accounts for at least 1 full percentage point of GDP. Declining house
prices means that extra boost for the economy will now disappear.
Foreclosures are soaring and expected to get worse for the
next two years at least. In California, foreclosure filings jumped 79 percent
in March alone. Other �hot markets� are reporting similar figures.
The glut of houses on the market has slowed sales for the
nation�s major homebuilders -- most are reporting that profits are down by 40
percent or more.
The collapse of the subprime mortgage market is also pushing
many of the bigger builders toward Chapter 11. According to Bloomberg News, �Some
builders are staying out of bankruptcy by relying on the profits they made when
sales boomed� in 2004 and 2005. Starting next year they must begin to repay
$3.6 billion in public debt in what will certainly be a falling market. The
prospects don�t look good.
But the biggest problem facing the industry is the steady
erosion in the market itself. This was made painfully clear earlier this week
when the National Association of Realtors issued its report of March sales.
According to the Associated Press: �Sales of existing homes plunged in March by
the largest amount in nearly two decades . . . The National Association of
Realtors reported that sales of existing homes fell by 8.4 percent in March . .
. the biggest one-month decline since a 12.6 percent plunge in January 1989 . .
. The steep sales decline was accompanied by an eighth straight fall in median
home prices, the longest such period of falling prices on record. ..The fall in
sales in March was bigger than had been expected and it dashed hopes that
housing was beginning to mount a recovery after last year�s big slump. (A.P. �Existing
Home Sales Plunge in March,� 4-24-07)
The Grim Reaper meets the housing bubble
Those who follow developments in real estate have heard many
of the wacky anecdotes related to the housing bubble. Stories abound of young
people buying homes just to pay off tens of thousands of dollars of collage
loans with their �presto�-equity -- or low paid construction laborers securing
105 percent loans without any proof of income and a poor credit history. One of
the stories that got national attention was about Alberto and Rosa Ramirez, who
worked as strawberry pickers in the fields around Watsonville, Calif., each
earning about $300 a week. They (somehow?) qualified for a loan of $720,000
which paid for a �new� four-bedroom, two-bath house in Hollister, Calif.
It�s sheer madness!
Obviously, those days are
over. The speculative frenzy that was generated by the Fed�s low interest
rates, the banks� lax lending standards, and the deregulated global credit
market is drawing to a close. The fallout from the collapse in subprime-loans
will roil the stock market and hedge funds, but, as Heebner says, the
investment banks and brokerage firms will escape without a bruise.
Where�s the justice?
Despite Hank Paulson�s cheery predictions, we are nowhere �near
the bottom.� In fact, a recent survey showed that only 1 in 7 Americans believe
that house prices will go down. Even now, very few people grasp the underlying
issues or the potential for disaster. We�re on a treadmill to oblivion and they
think it�s a merry-go-round.
As housing prices tumble, more homeowners will experience �negative
equity,� that is, when the current value of their home is less than the sum of
their mortgage. This is the very definition of modern serfdom.
We can expect to see an erosion of confidence in the market,
a rise in inventory, and a steady increase in defaults. More and more people
will walk away from their homes rather than be handcuffed to an asset that loses
value every day. This could transform a �housing correction� into a nationwide
Many people�s futures are linked directly to the �anticipated�
value of their homes. It is impossible to determine how shocked they�ll be when
prices retreat and equity shrivels. The housing flameout has all the makings of
a national trauma -- another violent jolt to the fragile American psyche.
So far, we�re still in the first phase of a process that
will probably play out for 10 years or more, judging by Japan�s decades-long
decline. None of the bailout plans are large enough to make any quantifiable
difference. The numbers are just too big.
Housing prices are coming down and the real estate market
will return to fundamentals. That much is certain. The law of gravity can only
be ignored for so long.
Just don�t count on a �soft landing.�
Special thanks to Housing Crash News.
Mike Whitney lives in Washington state. He can be reached at: email@example.com.