Housing Market Meltdown
Bob Chapman
Moneylenders are growing cautious as the housing credit crunch descends upon the lending industry. The meltdown has begun as foreclosures rise and Congress figures ways to reign in predatory lending. We are moving back to mortgages where first time buyers will have to come up with a 20% deposit and have a 900 rating to buy a house.
The major investment bankers would have us believe that isn’t going to happen. After 22 subprime lenders either went out of business or were bought out in December and January there is a strong cause for concern. We are reassured that most lenders have strong balance sheets. We wonder how strong they will be when they get hit for $800 billion in bad debt. One third of those subprime borrowers and others with nothing down on their homes, with FICO scores of under 620 and with no equity, represent a black hole for lenders. Investment bankers would have us believe that subprime loans make up only about 11% of the $5.5 trillion mortgage market, or $605 billion. That is about one-third correct. 2006 subprime delinquency rates are close to 13% whereas the rate for fixed rate prime loans is 1%.
The recent jump in defaults, especially for loans originated in 2006 has accelerated concerns about the criteria in subprime lending. It is obvious lenders, brokers and builders have thrown caution to the wind to move inventory. Some buyers are totally unqualified or immediately after purchase the price of the house has fallen. That means loan originators are taking back bad paper with rates up, home prices declining in 7 of 20 markets and prepayment penalties affecting recent loans, many sub prime borrowers cannot refinance under any circumstances. One of the major default factors in 2006 was no document loans, wherein most of the borrowers overstated their income by 50%. A good part of early payment defaults was caused by fraud. Even disciplined lenders will see many defaults over the next few years due to falling home prices, inflation and a slowing economy.
Prime securitized paper is holding up well, but house prices are only off 10%. Higher rates and lower prices will affect these loans. The BBB or BBB- subprime ABS is already in a world of hurt. Again, so far there have been little indications that prime loans will suffer, but falling markets tend to hurt all sectors, no matter how stable they may be.
What is almost sure to happen is that lenders are going to be totally driven out of the subprime loan market. That means an end to no document loans. It means 20% down and a 900 rating. It means a further real estate slowdown, illiquidity and lower house prices. The subprime meltdown is showing all the classic symptoms of a bust accompanied by tighter credit rules. That means all those unqualified buyers over the past three years are going to have difficulty making new loans. The push from the bottom of the housing pyramid will end denying solvent owners the ability to move upward in the housing market. There will be few available to buy these homes so they can buy more expensive homes. Lenders have already tightened and there could be a congressional backlash to the defaults of lower income borrowers who are often seen as victims of predatory subprime lending practices. This backlash would drive lenders out of the subprime market.
We have already passed the tipping point and lending in this venue has entered systemic risk. We see the ABS market in a melt up, which is only just beginning. Just because there is trillions of dollars floating around does not mean there is resilience in the financial system. In fact, it is just the opposite. Easy credit has led institutions to assume risks they would never assume otherwise. Contrary to what the experts say funds for lending in the subprime area are going to dry up and eventually funds will dry up in broader capital markets as well.
We have very complacent markets. The theory nothing unusual or untoward can happen holds forth. In housing a 35% drop in new home sales, a 35% fall in new housing starts and a 16% decline in homebuilding activity over the past year has produced a loss of 110,000 jobs in the residential construction industry from its recent peak. We see some job absorption in commercial real estate construction, but that should end by the end of the year. We do not believe the economy can operate on a two-tier basis. Durables and high-ticket items have faltered and will continue to do so. There is a lack of savings and a preponderance of debt, as unemployment rises. Good paying jobs are disappearing into the free trade and globalization sinkhole to be replaced with $10 to $12 per hour service jobs. The drop in income alone will prohibit consumption expansion. The house cash outs and equity loans are dwindling as interest rates rise and home appraisals fall. We are told real spending growth is 4.4%, due to wage increases. That is based on official CPI figures, which are bogus and economists are well aware of that. Our estimate is a loss of 5%. Thus, there will be no thrust in consumption. Employment losses in construction have been about 14% or 113,000.
We see a 50% reduction over the next two years or an additional 400,000, so we have a long way to go. The lack of increased interest rates may slow the decent of the housing industry and the economy to 2-3/4% over the next two years, officially, but the dollar will soon test 80 on the dollar index and gold will test $850.00.
As a reminder of the chaos now taking place in the subprime mortgage market, the cost of insuring against default on subprime mortgages, via derivatives, has exploded amid a spate of downbeat news from the sector. Indeed, the implied spread on the riskiest, BBB- rated tranche (offering) of the ABX index, an instrument that protects investors against default risk on subprime mortgage backed securities, has doubled to about 1,000 basis points in just three weeks.
House price appreciation is over and the question now is how far will prices fall? That means consumers will have considerably less in the way of excess asset appreciation that can be used to support spending and saving. Net equity extraction from residential property has already fallen from 8.5% of disposable income in late 2005 to 6.5% in late 2006. This is a major problem with debt rates so high and income-based savings in negative territory for two years and at record lows.
Construction is starting to reflect problems. Blue Linx, an Atlanta-based building products distributor, said it swung to a $5.9 million fourth quarter loss and saw revenue drop sharply as the housing market slowed. The loss was $0.19 a share versus a profit of $0.48 a share yoy. The company said it continued to experience a share drop in demand that began earlier in the year as housing starts continued their slowdown and prices for wood based structural products remained sharply below year-ago levels The fall off in demand was exacerbated by ongoing inventory reductions throughout the supply chain, and by the normal seasonal business showdown associated with the winter months. We are sure this is happening all over America, especially in the 30 former hot markets.
KB Homes, one of the nation’s biggest homebuilders, swung to a loss in their fiscal fourth quarter, as it continued to offer large price and sales incentives amid a housing slowdown. The loss was $0.48 a share versus a profit of $3.44 a share yoy. Results included charges related to inventory and joint venture impairments, as well as the abandonment of land option contracts totaled $34.3 million. Its construction business posted an operating loss of $96.4 million. In its quest to dump inventory deliveries totaled 12,553 versus 11,946 yoy. Inventory was 17,384 units down from 25,722 units yoy. Cancellations cut net orders 38% to 6.059 from 9,747 yoy. Cancellations for the quarter were 48% up from 31% yoy, but down 53% in the third quarter. We have recommended a long-term short on this company.
Another subprime lender bites the dust. Brea-based ResMae Mortgage Corp. filed for bankruptcy.
Separately, Santa Monica-based subprime lender Fremont General Corp. said it would no longer offer second mortgages to homebuyers who need to borrow their down payment.Last week Irvine-based New Century financial said it would re-state earnings for 2006 because of subprime defaults.
Credit Suisse is buying ResMae assets for $19 million. The company is the 20th to be sold or closed as delinquencies rise and the market for home loans to high-risk borrowers contracts.
ResMae said it had been devastated by a surge in defaults, which led to increased demand by investors that it buy back loans that have gone bad. Merrill Lynch triggered the collapse by demanding it buy back $308 million of loans under so-called early payment default provisions.
Ben Bernanke says things are just fine. To quote: Subprime delinquencies are up appreciably. There is an accumulation in labor compensation. He’s prepared to take action on inflation, which is truly a laugher and that the US could cope if China sold dollars. He said China’s cost to them would be greater than to us. He noted the Chinese holdings of US debt was less than 5% of the total, which while large, is not by itself enough to be a monopoly of some sort. Questioning by the Senate Committee was a disgrace.
The MBA mortgage applications index rose 1.5% this past week. The refinancing index increased 4.5% as the purchase index fell 24% on the 4-week average. The week fell 1%. Mortgage rates for the 30-year fixed were unchanged at 6.24% versus 6.23%. The ARMS share of apps fell to 21.2% down from 22.3%, as refis were unchanged at 46.1%. Housing starts climbed 4.5% in December the biggest decline in 15 years for all of 2006.
Atlanta is saturated with an 11.2-month supply of homes and condos for sale, up from 7.2-months inventory in December. Many homes are being sold by lenders, which they received from homeowners walking away from mortgages. Foreclosures are abundant. Atlanta is #3 in mortgage fraud.
The number of homes sold in Southern California fell 17% last month to the lowest level in January in nine years - a drop from 21,895 to 18,128 in both new and existing homes.
The median price paid for a home was $485,000 in January, down 1% from December and 5% yoy. The market has finally broken. Prices were actually up in all counties, but San Diego led the pack, down 5.6% along with Ventura, down 6.5%. LA County rose 6.1%.
The monthly mortgage payment on a median-priced home in Southern California was $2,263 last month, up from $2,242 in December and $2,130 a year earlier.
The wellspring of today’s credit boom, the Ponzi Finance Unit, known as the subprime mortgage market is collapsing. Early payment defaults have driven 22 mortgage lenders out of business in just two months as mortgages return to originators in droves. Standards are finally being tightened, as many won’t be able to reset loans. Those in the riskiest CDO and securitization tranches will suffer heavy losses. As house prices drop in the former hot areas the better quality mortgages will be hit as well. Fannie Mae and Freddie Mac will be hit hard as well as derivative writers. As this problem deepens other credit markets will react negatively. If the yen carry trade ends, massive liquidity will dry up creating a crisis. This is real systemic stress and it will test the confidence of the entire system.
The National Association of Realtors said in the last quarter of 2006 median home prices fell in 40 states. The former 30 hot areas got hurt the worst with Nevada off 36.1%; Florida down 30.8%; Arizona down 26.9% and California off 21.3%. This is all exactly as we predicted.
Sales fell 10% yoy and the national median home price fell to $219,300, down from 2.7% yoy.
Prices fell 4.2% in the Midwest, 3.7% in the South and 2.4% in the Northeast. The West saw a 0.4% appreciation in prices. There are real financial problems brewing. This is but a harbinger of what is soon to come.