The Housing Bust and Lending: The Worst Is Yet to Come   (May 14, 2008)

It's worth recalling how few people buy houses for cash. The entire edifice of home ownership rests on debt--buyers being able to borrow large amounts of money for a reasonable rate of interest.

The entire housing bubble was essentially a debt bubble, driven by lending standards which sank to near-zero (anyone with a pulse willing to lie was suddenly qualified to borrow hundreds of thousands of dollars), non-U.S. buyers snapping up trillions in mortgage-backed securities (MBS) and derivatives, and lax lending regulations enabling banks to lower their reserves to 1% and spin the mortgages off their balance sheets.

This has all reversed, as this chart illustrates:

All these trends reinforced each other on the way up, and now they're reinforcing each other on the way down.

1. Lax regulations enabled "financial innovations" like no-down payment, interest-only, no-doc liar-loans to proliferate.

2. Global hunger for higher returns in a low-interest era fueled insatiable demand for supposedly "low-risk" mortgage-backed securities rated AAA by U.S. ratings agencies.

3. With the barriers to home ownership essentially flattened, home ownership rose as previously unqualified buyers flooded into the market.

4. As the debt bubble fed demand, prices and equity rose, enabling even more borrowing.

5. Skyrocketing values attracted speculators who ended up buying 40% of all homes sold in the peak years.

6. Fat profits in originating, underwriting and packaging trillions in new real estate loans attracted new "players" who lowered already low underwriting standards to zero, generating even more profits.

The only trend which hasn't reversed is systemic risk, which is still rising fast. Nobody seemed to care about the unsavory flim-flammery of bogus appraisals, "junk mortgages" bogusly rated "low risk" (AAA-rated) by ratings agencies, or the obvious conflicts of interest in the entire lending industry which encouraged every player to turn a blind eye on the other players' fudging/lies/omissions/wink-wink-nudge-nudge "collaboration" ( a.k.a. collusion).

For more on how collusion, omission, etc. inflated the bubble, please read Greed, Fraud & Ignorance: A Subprime Insider's Look at the Mortgage Collapse by Richard Bitner.

As the reinforcing fires of falling values, tighter standards and fear spreads, the risk of lenders failing is rising fast. If we think through the consequences of the debt bust--fewer fools (oops I mean investors) willing to buy depreciating mortgage-backed paper, fewer buyers willing to gamble that "the bottom is in," fewer buyers with actual down payments, i.e. qualified buyers, fewer speculators rushing to maximize their leverage, and less money to lend since lenders might actually have to keep some mortgages on their books--what does that mean for lenders who are reporting massive losses and impaired capital?

As frequent contributor J.F.B. has pointed out: how can lenders make enough money to rebuild their capital when they're writing far fewer loans, and their losses from mortgages, auto loans, credit cards, etc. are rising?

The short answer is painfully obviously to all: they can't. Will the fabulously wealthy sovereign wealth funds from the oil-exporting states rush in to "save the day" by pumping tens of billions into faltering, loss-wracked U.S. lenders? With six reinforcing trends all heading down with gathering momentum, why would they sink even one (depreciated) dollar into such a losing proposition?

Onky the U.S. taxpayers, via their representatives in Congress, are dumb enough to pour billions into "salvaging" the unsalvageable.

Put together sinking equity, rising defaults, tighter lending, risk-averse investors, a shrinking pool of qualified/willing buyers and sinking lenders, and the only conclusion which can be drawn is: the worst is yet to come.

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