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Generational Dynamics Web Log for 13-Feb-07
ABX Housing mortgage default loan index takes another big dive

Web Log - February, 2007

ABX Housing mortgage default loan index takes another big dive

Economists are debating how much "spillover" will occur, but "Contrary Investor" does it right.

The ABX index, that we discussed a few days ago, measures investor confidence that subprime mortgage borrowers will default.

On Monday of last week, the value of this index, known as "ABX-HE-BBB- 06-2," stood at 89.63. On Thursday, after the surprise negative earnings restatements at mortgage lenders HSBC and New Century, it fell to 86.00. On Friday it fell sharply to 82.68, and on Monday it fell again to 80.35.

Index price of ABX-HE-BBB- 06-2 from August to Monday, Feb. 12 <font face=Arial size=-2>(Source: Markit.com)</font>

Index price of ABX-HE-BBB- 06-2 from August to Monday, Feb. 12 (Source: Markit.com)

Subprime mortgages are those granted to home buyers with poor credit under the assumption that almost anything is safe when home prices are skyrocketing. But now that the housing bubble has been deflating for over a year, foreclosures are skyrocketing. Home sales haven't crashed as much as they might have, but prices are a lot lower, so homes are being sold at desperation prices.

(A web site reader wrote to me to say that I haven't justified the "desperation prices" claim. I guess it depends on how you look at it. If you have to sell your house for $50,000 less than you bought it for, because you can no longer afford your adjustable rate mortgage, you would consider yourself desperate, wouldn't you? Well, there are a lot of people in that situation right now.) (Added on 13-Feb)

There is little good news to be found anywhere, and a seemingly unlimited supply of bad news. Take a look each day at the housing bubble weblog. Each day, this site summarizes news stories from around the country on what's going on.

Here's a sample: Someone buys a home in 2005 for $800,000. He gets an "interest-only" adjustable-rate mortgage (ARM), so he only has to pay $1000 a month in mortgage payments. However, that payment schedule is for two years only, and it's expiring now. He now has to make both interest and principal payments on the mortgage loan, and the "adjustable rate" kicks in, since interest rates are higher now than in 2005.

The result: Their monthly mortgage payment goes from $1000 to $4000.

Furthermore, their home is no longer worth $800,000. It's now worth only $600,000.

These people are SCREWED, but at least they didn't commit fraud.

There are plenty of other people who lied on their mortgage applications, planning to keep the home for a few months, and then "flip" it by reselling at a higher price. Trouble is, the bubble has burst and it's not worth as much any more. Many people who closed these deals in 2006 didn't even make their first mortgage payment, and they're going to be charged with fraud.

Dear reader, have you ever heard the phrase "predatory lending"?

That's a new word in Washington these days. Congress is investigating whether mortgage loan companies are guilty of making it too easy to get mortgage loans. Get it? "Predatory lending." Ha, ha!

(A web site reader has written to ask me what the joke is in the preceding paragraph. The joke is that "predatory" usually means either preying on someone by plunder or pillage or by eating them, or else forcing them to do something against their will. So how can making it too easy to get a mortgage loan be predatory? Ha, ha.) (Added on 13-Feb)

The crap is really going to hit the fan before long. We're going to see home owners, loan officers, bank managers, investors, and hedge fund managers charged with unprofessional conduct, civil fraud, and criminal fraud.

Even mainstream economists are actually beginning to get alarmed, and they're debating about the spillover concept.

The question is: Will a collapse of the subprime mortgage market spill over into other sectors of the economy? Two economists on the Morgan Stanley web site argue both sides of the issue.

Richard Berner takes the optimistic argument, that "worries about a wider credit crunch are dramatically overblown." Strangely, Berner confines his spillover argument to the effect on the broader credit market, apparently believing that: as goes the credit market, so goes the economy:

"Soaring defaults signal that the long-awaited meltdown in subprime mortgage lending is now underway, and it likely has further to go. Fears are rising that this so-far idiosyncratic credit bust will morph into a broader, systemic credit crunch as foreclosures rise, lenders grow cautious, and Congressional efforts to rein in predatory lending further choke off supply. A credit crunch occurs when lenders deny even creditworthy borrowers access to borrowing. What are the risks of such a scenario? ...

But in my view and in the opinion of my colleagues Ken Posner and Suzanne Schiavelli, who cover the mortgage lenders, early payment defaults are symptomatic of and confined to aggressive lenders that stretched to maintain origination volume to cover a high fixed-cost business model. “Stretching” in this case means originating or buying so-called stated-income loans — those for which there is no documentation concerning the borrower’s ability to repay, only his or her statement. Fraudulent representation appears to account for much of the early payment defaults. In contrast, disciplined industry leaders have experienced almost no early payment defaults, in line with the modest deterioration in overall mortgage credit quality described above."

The pessimistic side of the argument is taken by the Stephen Roach. Roach's spillover argument focuses mainly on the potential spillover to consumer spending, evidently believing that: as goes consumer spending, so goes the economy:

"One of today’s great paradoxes is the perceived lack of spillovers. Macro theory stresses interrelationships within economies, between markets, and across borders. Yet most financial market participants now believe in the theory of containment -- that disruptions in one sector, one market, or even one economy can, in effect, be walled off from the rest of the system. Whether it’s the bursting of the US housing bubble, carnage in sub-prime mortgage lending, or a slowing of Chinese investment, these events are quickly labeled as “idiosyncratic” -- unique one-off disturbances that are perceived to pose little or no threat to the larger whole. The longer a seemingly resilient world withstands such blows, the deeper the conviction that spillover risk has all but been banished from the scene. Therein lie the perils of a dangerous complacency. ...

Asset effects are also likely to keep putting pressure on American consumers. A personal saving rate that has now been in negative territory for two years in a row leaves little doubt of the asset-dependent support to US consumption. ...

Looking through the noise of energy-related gyrations to headline prices and inflation-adjusted household purchasing power, I remain highly skeptical of the consumer resilience call in a post-housing-bubble climate. And if the consumer finally fades, as I suspect, capital spending will be quick to go as well. I draw no comfort from ever-abundant coffers of corporate cash flow. If the demand outlook turns shaky due to spillover effects from housing to consumption, businesses will rethink expectations of future pressures on capacity utilization -- and cut back plans to expand capacity accordingly."

Unfortunately, both arguments are fundamentally wrong because they exhibit all that's wrong with current mainstream macroeconomics theory. They look at a few numbers from the past year or two and they draw conclusions from those.

I'll repeat an analogy I've used before. These two analyses are like the following weather forecast: "The outdoor temperature last week was in the 40s, this week it's in the 30s, therefore I predict that next week it will be in the 20s." This is obviously wrong, since if you look at long term trends then you know that the temperature's going to go up because summer's coming.

In the comprehensive analysis of macroeconomic theory that I wrote last year, "System Dynamics and the Failure of Macroeconomics Theory," I showed why the "static" view of macroeconomics that Berner and Roach are using cannot possibly work, and in fact hasn't worked -- it's called everything wrong for at least the last ten years, starting with the late 1990s stock market bubble. Macroeconomic theory has simply been wrong, time after time after time.

The world economy is driven by powerful generational patterns that pulse through the centuries. This really isn't so unreasonable even to someone who hasn't studied the subject; the length of a maximum human lifetime is around 80 years, so why should things like global finances resonate with that time frame? Any engineer will tell you that that makes perfect sense.

If you want to understand what's happening today, you have to look back farther than a couple of years. 1965 and 1975 are just as important as 2005 in understanding what's happening today. Trends that occurred over long periods can be even more relevant.

An astute web site reader has recently pointed out to me that the February, 2007, issue of the Contrary Investor newsletter does exactly that, at least back to 1945.

This newsletter says that "what we are seeing in these charts is an intergenerational change in attitudes toward leverage," and shows that the Boomer generation are going to be in serious financial trouble as they retire. (Gee, do you think they've seen my web site?)

Owner's equity as % of market value of real estate, 1945-present <font face=Arial size=-2>(Source: contraryinvestor.com)</font>

Owner's equity as % of market value of real estate, 1945-present (Source: contraryinvestor.com)

Take a look at the adjoining graph, which shows what percentage of their homes that people really owned (owner's equity versus real market value). You can see from this graph that in 1945, the average American homeowner owned 85% of his home, with the other 15% mortgaged out; today he owns only about 53% of his home.

This is the point that I've made frequently on this web site -- that the generations of people who lived through the 1929 crash and the horrors of the Great Depression were very cautious, risk-averse investors. As those people were replaced by Boomers and younger generations with no personal memory of the Depression, credit standards have become increasingly sloppy, so much so that the global economy has turned into a giant pyramid scheme.

The point of looking at economic figures back to 1945 is that things like public debt, balance of payments and other global imbalances have been growing exponentially since then, with no sign of leveling off (despite the fact that mainstream macroeconomic theory predicted that they should have leveled off and fell long ago). This is actually proof that we're headed for a crash, because it's mathematically impossible for these imbalances to continue as they have.

Generational Dynamics has been predicting since 2002 that we're entering a new 1930s style Great Depression, with a stock market crash most likely by the 2006-2007 time frame. A crash could come next week, next month or next year, but we can be sure that the "spillover" is going to be a lot worse than either Berner or Roach expect. (13-Feb-07) Permanent Link
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Generational Dynamics Web Log for 13-Feb-07 ABX Housing mortgage default loan index takes another big dive

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Generational Dynamics Web Log for 13-Feb-07
ABX Housing mortgage default loan index takes another big dive