Words have the power to both destroy and heal.
In thinking about where the economy, Fed, and markets will be going in 2008, I find my thoughts dominated by considerations of liquidity. Readers have heard me use the term "liquidity crisis" or "credit crunch" during 2007, but have rarely (if ever) seen me use "credit crisis" or "solvency crisis." This is purposeful.
Why do I avoid calling this a credit or solvency crisis? Surely I am not here to downplay the problems we're having in residential lending, or even consumer finance in general. I hardly need to enumerate the many problems in consumer lending. I think mortgage foreclosures will break all records in 2008, probably by a long shot. In addition, other types of consumer lending have and will suffer as well. Consumers have been using equity in their homes to help bail them out of other types of debt for many years, but in 2008, this option will be largely unavailable. The result will be weak performance in everything from auto loans to credit cards.
So are there large numbers of insolvent consumers? Sure. Is it going to create a pretty big problem for the economy generally. Yes. Recession? Maybe, just depends on what else goes right or wrong for the economy. Crisis?
I have a hard time with the word crisis here. Maybe I'm hung up on mere semantics. In my mind, a marriage in crisis is one where divorce is an imminent possibility. Not one where the couple just had a big ugly fight. A political crisis is one where the government might collapse. Not where an election is peacefully contested in the courts. To me, that word "crisis" suggests that action must be taken to avert some sort of disaster.
But what's the disaster right now? Consider these simple facts.
1) Most sub-prime ARM loans had a 2 or 3 year fixed-rate period. Therefore the only loans to reset during 2007 were made in 2005. Prime ARM's typically have a 3, 5, or 7 year fixed-rate period.
2) However, the sub-prime delinquencies in 2006 are the real problem. 2005 isn't showing a radically different pattern than past periods.
Notice the much steeper curve displayed in the 2006 vintage, which is like nothing else on the whole board.
3) In 2006, half of all sub-prime purchase mortgages were made with low or no documentation of income.
4) The Case-Shiller home price index is down 6.1% YOY. It registered its first negative reading in January 2007.
5) Conditions that normally precipitate higher delinquencies, namely unemployment, are not currently a problem.
So let's try to reconcile these three facts with how we'd expect a "normal" borrower (prime or sub-prime) under "normal" circumstances to behave. Normal people buy a house because they want to live there. Sure the fact that homes have historically been a positive investment plays a part, but for most people, their house is their home.
There will be some "normal" borrowers looking at negative equity, either now or in the near future. Of course, if that borrower never paid any attention to home prices around him/her, and just kept paying the mortgage bill every month, the negative equity would be of no moment. Remember if a "normal" borrower living in the house decided to walk away, they'd need to find someplace else to live. Given how badly defaulting on your home will mar your credit rating, the "normal" borrower would be loathe to just walk away, even if s/he is significantly underwater, as long as s/he can make the payments.
Plus, there aren't very many "normal" borrowers who would be underwater right now. Using Case-Shiller's data, only borrowers who put less than 6% down and bought their house late in 2006 would have negative equity currently. Perhaps borrowers in the "boom then bust" areas are more likely to be in a negative equity position. But still, we're talking about a relatively small number of "normal" borrowers.
So where are all these delinquencies coming from? And what does that say about what 2008 will hold?
First I think you have people who are delinquent for "normal" reasons. They've lost their job, they've gotten sick, they gambled away their starship, whatever. This caused them to rack up some credit card debt. In the past this borrower was able to tap home equity and get out of trouble. Unfortunately, the borrower isn't able to do this currently, both because lending conditions are very tight and because the borrower might not have adequate equity.
Like I said, this group probably isn't the lions share of the marginal delinquencies, because we aren't seeing macro events which would cause these events to happen on a large scale.
No, I think the bigger problem is investors. If you buy a property solely for investment purposes, then all the rules of a "normal" investor are out the window. I think many investors bought properties with little to no down payment. Investors were more likely to get involved in hot neighborhoods, where prices have probably been hit hardest lately.
Many investors just don't have the option of sitting on the property. If you bought an investment property but also had a house you are living in, you may not be able to afford two mortgages indefinitely. And you probably can't rent the place for the same amount as your mortgage payment. It might be that you can save your actual home by just walking away from your investment property. For the investor, the jingle mail option may just be the best of a bad situation.
So back to the "crisis" question. It is these speculators who are insolvent. So what we have are people who speculated in houses and lost. We have are banks who lent to the a fore mentioned speculators and have lost too. Bear in mind, these banks are the ones who agreed to limited documentation of income (perhaps so the speculator could claim this would be his/her primary residence?) or minimal down payments.
What we also have are brokerage firms who warehoused bonds backed by these speculation loans, assuming they'd be able to unload them into a CDO. They've lost too. We have banks buying AAA-rated CDO^2, who never asked why CDO^2 spreads were so much wider than other AAA product. Guess what? They've lost too. We have money markets buying securities they didn't understand. Losers. We have hedge funds who took already leveraged CDO and ABS product, and leveraged it some more! Loo--oo--oooooooser!
All this isn't a crisis. Its how the credit cycle works. When credit becomes too easy, bad loans get made. People get hurt. But that's the way of the world. You move on.
Where a crisis could develop is when the innocent are hurt just because capital becomes tight. Where a good borrower can't get a mortgage loan. Where a solid commercial real estate project can't roll over its bridge loan because banks are short on capital. That's where the real crisis can get going. Foreclosures happen that didn't need to happen, driving the price of assets lower. Lenders start taking losses on good loans, and suddenly are unwilling to lend to anyone. Investors struggle to value assets, not because of unknown losses, but because of unknown liquidity. Bids disappear.
That's a crisis.
Thursday, January 03, 2008
Words have the power to both destroy and heal.