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The Growing Financial Risks of the Housing Bubble   (May 30, 2006)

This is not your father's housing market or indeed, his mortgage market. The imbalances, and thus the risks, of the housing bubble have spread into our entire financial system.

How so? Let's start--and end--with mortgages, leverage, derivatives and debt. First up is the chart showing that mortgages have grown to about 2/3 of banks' total credit portfolios. Note how this is up from less than 30% twenty years ago. This isn't just a measure of their mortgage exposure; it's also a measure of their exposure to risk in the credit market should a decline in the housing market trigger a rise in non-performing loans--i.e., people squeezed by ARM re-sets or rising debt loads to the point they are unable to keep current on their mortgage payments.

A very knowledgeable reader who prefers to remain anonymous recently encapsulated some of the other risks inherent in the current housing and lending markets. His first point: the extreme downside risk inherent in highly leveraged real estate:
Your recent posting about the significance of a 10% decline is certainly right on the mark. What's interesting is that people don't think about the fact that in the stock market 10% volatility is nothing, but that's because margin accounts limit leverage of retail investors to 50%. In the housing bubble, 10% volatility is HUGE because there are so many investors leveraged to 100% (or more). Even those without interest only or negative amortization loans who HELOC'd (home equity line of credit) are at huge risk, especially since home equity is such a large part of people's retirement plans.
This contributor noted the psychological impact of the tax policy which rewards people for flipping their primary residence every few years--and the rise of mortgage-backed securities and derivatives:
Another topic of interest I don't see get much press as a driver of the housing bubble relates to the tax free treatment of the first $250K or $500K in gains on a primary residence. Although there's much press on how our government spurred the housing bubble with a liquidity bail out based on money supply and cuts in interest rates, I think the effect of these tax credits are hugely underestimated in terms of a wholesale change in American "investment psychology". An additional driver I would suggest which also gets little press is the massive proliferation of derivatives by financial institutions to off load and disperse mortgage loan risk and the lax regulatory environment promoted by the prior and current Fed.
A bit of history is necessary here. In the good old days, local banks would actually retain the mortgages they underwrote, collecting the interest and principal as an integral part of their portfolio of assets and their income stream. This is now as quaint as buggy whips. Lenders quickly sell any mortages they underwrite to large banks which just as quickly aggregate hundreds of millions of dollars of mortgages into "mortgage backed securities"--in effect, turning mortgages into securities which can be traded like bonds. As the chart reveals, this practise exploded in 2000.

And like bonds, the securities can be tranched into various chunks of risk and hedged by various types of derivatives. The idea, of course, is to minimize risk by hedging with derivatives--but the explosion of derivatives has put risk management in uncharted waters. As my correspondent explains:
Regarding mortgage backed securities, just to be clear, there seem to be two related issues:

1) This practice allowed a huge proliferation in the number and kind of lenders which effectively increased the money supply and was inherently inflationary compared with prior historical periods where money supply was controlled via the Fed.

2) Competition among these lenders and the perception that risk could be shared or off-loaded completely via mortgage backed securities and other related derivatives lead to a progressive relaxation of lending standards which effectively further increased money supply. When the financial system is stressed, these products may not perform as expected, just as portfolio insurance of the late 80's failed to function properly during periods of illiquidity. There seems to be so little transparency few if any have insight into the magnitude of the problem or how poorly the system might function when stressed. We have created a true Frankenstein, yet the Fed repeatedly commends this approach and lauds it's virtues to add market efficiency and lower risk.

There seems to be a real potential that a faltering real estate market will be create tremendous hardship not only directly to homeowners but also to every American if it spurs a major recession (with the potential to spread internationally). Should that occur, I think history will show the root cause to be a bad combination of monetary and fiscal policy (ie, Fed's bail out mentality, insufficient monitoring and regulation of mortgage backed securities and related derivatives, and excessive tax breaks on real estate). The real shame is that I feel we did it to ourselves since monetary and fiscal policy was the music that was played which would have had no effect if we didn't dance obligingly via a change in homeowner/investment psychology ultimately rooted in a modicum of greed.
Well said, well said.

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