Thank you, Jesse
Thanks, Jesse, again, for your comments. I will heighten your sense of anger at the level of civility in these web pages by noting that much of what you say about housing may indeed be true. And I will further infuriate your of civility by noting that people who are interested in the world of credit derivatives, to which you refer in your posting, should check out your article on said topic in the inaugural issue of Conde Nast Portfolio.
How about we agree to agree on the following: there has been a bubble in housing related credit, that the same sort of lunacy that infected investors and bankers during the 1990s infected investors and bankers, that there has been a collective, willful lowering of standards, that is likely to end badly for many of those involved, and that the unwinding of the bubble is sure to have some negative short-term effects on the economy.
Then I’ll stipulate that we can agree to disagree on the following: in the long-term, some of the innovations in housing finance that arose during the recent bubble may prove to be useful and beneficial to consumers, including some about which we are not aware.
Elsewhere on the site, I see that Maggie Mahar, author of the excellent bull market history Bull, has chimed in. She takes issue with my argument that “irrational exuberance . . . greed and risk-taking is embedded in the national character,” and cites Warren Buffett as a counter-example.
Well, Buffett surely is a counter-example, though he has taken plenty of risks in his career (they were just more calculated and turned out better than the risks the rest of us have taken). But I don’t find that a compelling argument. Buffett, after all, is something of a singular figure—the best investor of his era, a steady captain on a ship of fools. Thumb through Mahar’s Bull, and you’ll see plenty more Americans acting like Harold Hill of the Music Man than acting like the Sage of Omaha.
Dude, did this really need a brand new thread cluttering up the board?
Self absorb much?
Try not to be the Paris Hilton of the financial discussion set. It's not a worthy goal.
May 15, 2007 2:43 PM | Reply | Permalink
I haven't been paying much attention to this discussion, so I apologize if I'm repeating something already said. It seems to me that Daniel's thesis that bubbles are sometimes good for the economy may have some merit. When a new technology is created, no one knows exactly how to exploit it. There are many potential paths to explore, some of which will lead to profitable ends and some of which will lead to nothing. Exploring all those paths requires a lot of money--some of which will be lost. The bubble floods the market with capital, allowing abundant exploration and therefore increasing the odds that the successful paths will be found (and also increasing the odds that unsuccessful paths will be explored as well). If, however, the gains that come from finding the successful paths outweigh the losses that come from ending up on the wrong paths, then the bubble will have helped the economy.
When it comes to the bubble in financing alternatives for homes, however, I'm not sure I see any positive. The new mortgage alternatives simply allow people who really can't afford to buy homes to acquire homes and then lose them a few years later. I don't see any new technologies being developed or exploited. I just see money being extracted from the poor/middle class and going to the wealthy. Credit cards and mortgages seem to be great tools for getting average Americans to transfer their wealth to the captains of the financial industry.
May 16, 2007 4:04 AM | Reply | Permalink
could one of the "front pagers" explain to Mr. Gross that part of the purpose of TPMCafe is to engage the readers/commenters, and not just the other front pagers?
(I actually had something to say, but realized that I would be wasting my time)
May 16, 2007 6:35 AM | Reply | Permalink
There is a dominant narrative that says sub-prime is all about predatory lenders inducing wide-eyed borrowers to buy more house than they can afford thus leading to a cascade of foreclosures. There is a sub-narrative that says people are ruinously extracting all their equity in a mad drive to buy boats and 50" TVs. And another one that says housing is going over a cliff in a multi-year decline.
Yet all are lacking one key element. Data that actually demonstrates that any of those narratives actually dominate sub-prime lending, refinancing, or housing prices.
These are stories, compelling stories, but are they really true? What is pretty clear is that sometime before 2003 traditional underwriting standards came detached from risk/reward, money was sitting on the table and conventional financing wasn't allowing people to pick it up and the natural result was an end-run in the form of sub-prime. And a lot of people made a lot of money and a lot of people got into houses. It is also clear that this detachment between underwriting and risk/reward was the product of market appreciation that was unsustainable longterm. Benifitting from 20% appreciation is rational, banking on 20% appreciation is irrational and too many people were failing to keep that distinction in mind.
When the market stalled in 2005 end investors who were happy enough to snatch up those high returns in the good times got spooked, in turn funders got leery of funding and lenders who only make money when loans fund started dropping, first the small and then rather shockingly the large started dropping like flies. An industry that could only flourish if appreciation bailed out every loan failed when those loans had to carry themselves on the basis of actual income.
Well it is a wrenching outcome, particularly for the direct victims which is to say the employees of the lenders. But what about the poor borrowers? Well predatory lending is a reality, but it is not a new reality and it is very hard to distinguish between predation and the natural shakeout you have when any market turns south. So I would have to disagree to some degree on this:
"How about we agree to agree on the following: there has been a bubble in housing related credit, that the same sort of lunacy that infected investors and bankers during the 1990s infected investors and bankers, that there has been a collective, willful lowering of standards, that is likely to end badly for many of those involved, and that the unwinding of the bubble is sure to have some negative short-term effects on the economy."
Well I don't know that it was a 'bubble' or 'lunacy'. People made money and continue to make money on these securities, it is just that for a variety of reasons they are less willing to invest going forwards and as a result an industry sub-sector is suffering major wounds. Certainly there was a collective, willful lowering of standards. But that was because traditional underwriting standards became detached from risk/reward during a particular period. Subsequently risk/reward started moving back to traditional standards and resulted in some shakeout. "Likely to end badly for many". We'll see. But frankly not particularly supported by anything more than anecdotes.
Because what we are not seeing is sober reporting breaking all of this out by market and really establishing the correlations between pricing bubble, sub-prime lending and foreclosures. A lot of dots are being connected as if the causation was established when in fact we are not even sure of the correlation. Moreover sub-prime is being dumped into a single categorical basket when in reality the different products were marketed to different segments. A 2/28 is not the same as a 100%LTV stated/stated. Lenders are not blind. It was never the case that some street person pushed his shopping cart into a mortgage company and walked out with a loan on a $650,000 house on stated income/stated assets, that loans were written with no documentation by no means meant they were written with no information. As a loan officer I know says "I never lie to my loan reps, only to the underwriters".
In short plenty of vultures are circling and have been for three years now. Yet it really hasn't been established that anything has died or that anything more fundamental than a market correction is occuring.
May 16, 2007 7:18 AM | Reply | Permalink
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aMike
May 16, 2007 9:57 AM | Reply | Permalink
Daniel and Bruce -- (Bruce, please scroll down)
Daniel--
Thank you for your kind words about Bull!--and good luck with your book.
But I have to disagree that Buffett is a "singular" figure in resisting bubbles. He is one of the best investors around,but he has made so much more money than virtually anyone else because he started so early--in the 1950s. There are very few investors around today who began compounding their gains more than fifty years ago.
Most people who were investing in the fifites pulled out of the stock market (or were driven out) during the long bear market of the seventies. By the end of the seventies, Business Week was running a cover story titled "The Death of Equities" explaining that only "old fogies" bought stocks.
But Buffett continued buying in the seventies because stocks were cheap. And, as I mentioned in my post, he had pulled out of the market earlier--in 1969--because he thought stocks were too expensive. (And he wasn't alone--many investors over the age of 40 realized that stocks were wildly over-priced in the sixtites. That's why they called it the "go-go market"-- the money managers and individuals investing in that market were young--in their 20s and 30s
In the 1990s, Buffett knew stocks were over-priced and, again, he wasn't alone. Onceagain, older investors, money managers and analysts knew that price-earnings ratios were way out of whack--and that eventually they would have to revert to a mean. During that period, I had many many sources who realized what was happpening. (Though I admit, at a certain point I stopped calling sources under a certain age. The "true believers" had come into the market in the late eightes or early nineties, and had never bothered to read much financial history--or thought it was "different this time.")
But the problem was that if you were a mutual fund manager or a money manager, you couldn't pull out of the stock market. If you did you would lose your job and your clients.
Buffett didn't worry much about losing customers--and there were many others like him:
Jean-Marie Eveillard, Gail Dudack, Steve Leuthold, Jeremy Grantham, Jeff Vinik (who was fired from Fidelity's Majellan fund because at a certain point he shifted into bonds and cash).
But the majority of folks on Wall Street didn't feel they could risk losing their jobs . . And no one knew when the bubble would burst, just that, eventually, it would.
Bruce--
There is actually a lot of data out about
sub-prime mortgages.
First, forget about the wide variety of sub-prime mortgages and just look at the percentage of NO-down-payment loans made in recent years: About 38% of the most common sub-prime mortgages this year were for the full value of the home, up from 31% in 2005 and 21 percent in 2004, according to Bear Stearns. 45.5% of the loans this year required "low documentation" of borrower income and net worth, up from 44.5% in 2005 and 40.1% in 2004. The data reflect "common methods of allowing first-time homebuyers to borrow more than they can afford," . (Bloomberg)
Putting even more pressure on sub-prime loans is the notice by Moody's and Fitch that they are considering downgrading certain sub-prime bonds. (More on the risk in reaching for yield below
Then there is the steep rise in foreclosures:
Economy.com (Moody's) estimates that that number will double in 2007. That means that there will be an additional 800,000 homes added to the supply of existing homes this year, which is at a seasonally adjusted 6.69 million homes.
This is John Mauldin's comment on the numbers: "Doing the back-of-the-napkin math, that suggests there are about 3.6 million homes for sale on the market today. We could see that number grow by as much as 15-20% due to foreclosures alone over the coming months, as more homes go through foreclosure. Remember, the record foreclosures we are seeing today started as problems six months ago (or more in some states). As delinquency rates are rising sharply, the number of foreclosures six months from now is going to be even higher. It will take several years for this problem to work itself out.
Putting even more pressure on sub-prime loans is the notice by Moody's and Fitch that they are considering downgrading certain sub-prime bonds.
Finally, this from John Mauldin:
". . according to an extremely well-documented and thought-provoking report released on March 12 by top-rated housing research analyst Ivy Zelman and her team at Credit Suisse, this is going to have real consequences for homebuilders and those who want to sell and or refinance homes.
"If you think I have been bearish on the housing market, I suggest you read this report. It is sobering. I will summarize some of the main findings (portions in quotations marks are direct quotes). And for those of you who would like to see the report in its entirety, since their clients already have had access to the report and considering that links to it are all over then internet, I provide a link to the 67-page report: http://www.billcara.com/CS%20Mar%2012%202007%20Mortgage%20and%20Housing.pdf
All Alt-A, All the Time
As I have written for months, the problem is not just in the subprime loans, but extends to the level between prime and subprime, known as Alt-A loans. Alt-A loans were just 5% of the market back in 2002, yet were 20% last year. 81% of those loans were low- or no-documentation loans last year. 55% percent of the borrowers took out second mortgages at the time of the original purchase, and loan-to-value was only an average 88%. 22% of all Alt-A mortgages were by investors or second-home purchasers, and thus are not owner occupied.
Subprime loans were another 20% of the total mortgage loan market last year. "2006 subprime purchase originations posted an alarming 94% combined loan-to-value, on an average loan price of nearly $200,000. Roughly 50% of all subprime borrowers in the past two years have provided limited documentation regarding their incomes."
Remember the study I quoted last week from the Mortgage Asset Research Institute, which looked at low/no-documentation loans? 60% of the borrowers exaggerated their incomes by 50% or more! "In 2006, 2/28 ARMs represented roughly 78% of all subprime purchase originations according to data from Loan Performance. According to our contacts, homebuyers were primarily qualified at the introductory teaser rate rather than the fully amortizing rate, which for many buyers was the main reason they were even qualified in the first place."
It stands to reason, then, that many borrowers simply will not be able to make their payments when the reset comes due, thus the prediction that as many as 20% of the subprime mortgages written in the last two years will default.
A 20% Drop in the Number of Home Buyers
Now, here is where it gets rather ugly. Warning: remove sharp objects from your vicinity before reading further.
"With financing pulling back at the entry-level, we believe it is only a matter of time until the impact is felt in other price points. If 15-25% of entry-level buyers that would have used subprime financing can no longer obtain funding, does this mean that 15-25% of potential move-up buyers can no longer obtain a buyer for their home, and so on?
"In our base case, we assume that 50% of the subprime market is at risk, taking originations back to 2003 levels, which would impact total purchase volume by 10%. Similarly, we estimate that 25% of Alt-A and 10% of prime loans would not be approved under tighter restrictions for various combinations of investor purchases, piggybacks, low down payments and low documentation, and the impending ripple effect down the entire housing market food chain. In aggregate, the total fallout of incremental originations would be 21% over the next one-to-two years.
"Related to speculation, investors' share of the market climbed to roughly 18% in 2005 and 2006 from an average of 7% from 1998-2001, implying that a return to the mean would remove 11% of housing demand.
"Combining the two yields a 25-35% reduction in peak housing production. This would likely be exacerbated by declining consumer confidence, investor demand falling below historical norms, the risk of a softening economy and supply pressures weighing on demand (all of which seem present today), suggesting at least a further 10% drop.
"Aggregating the various impacts would result in a 35-45% drop-off in new starts from the peak of 2.1 million homes to roughly 1.2-1.4 million, as compared to the 16% decrease thus far on a trailing twelve month basis. For comparison, starts during the last three downturns ending in 1991 (down 34%), 1982 (down 32%) and 1980 (down 37%) fell by an average of 34%."
A drop of 20% in the number of homebuyers that we have seen in the past two years, coupled with a dramatic increase in the number of foreclosures, is going to put serious pressure on housing prices, especially in markets where there was a lot of "froth." And combine that with increased down payments and tighter credit for even credit-worthy buyers, and there is real room for concern.
Consumer confidence numbers are going to start dropping in the coming quarters. I think it is wishful thinking to believe that we will see a bottom of the housing market this month or even next quarter. Housing-related construction employment is going to seriously plummet. Consumer spending is going to take a hit as cash-out Mortgage Equity Withdrawals are going to be increasingly hard to get. Such mortgages accounted for 2-3% of GDP growth per year for the past four years.
In short, I think the case for a recession can still be made. And of course, there are those who think it will get even worse. Take Professor Nouriel Roubini of the Stern School of Business, New York University:
"Indeed, the subprime meltdown is now spreading to other parts of the mortgage and credit markets: near prime and risky mortgages (option ARMS) are now in trouble and they accounted for over 50% of mortgage originations in 2005-2006; subprime auto loans and subprime credit cards are in trouble; bank loans to home builders are in trouble; and bank lending to non-residential construction will soon also show cracks as the CMBX - the indices showing the cost of insuring against commercial real estate default - has sharply fallen, signaling a much higher risk of default even in this market segment.
"Corporate risk spreads will be the next shoe to drop, as the most serious academic studies on the topic show that corporate defaults are one fifth of what they should be given firm and economic fundamentals as a bubble of liquidity have masked some serious leverage problems in the corporate sector. So, a generalized credit crunch is underway and its outcome will be a hard landing of the economy this year."
May 16, 2007 10:52 AM | Reply | Permalink