An Update on Housing Market Downside

The New York Times, in “Reports Suggest Broader Losses from Mortgages,” does a workmanlike job of providing an update on the losses likely to result from the housing slump.

Nevertheless, the piece feels woefully incomplete. It’s not the authors’ fault, but the bad news is coming in faster the experts can update their estimates. Today, we received word that sales of existing homes fell 8% in September. Annualized, that month’s sales are the lowest level since records were started in 1999. Bloomberg reported that Fed funds futures prices indicated that traders now put the odds of an October rate cut by the Federal Reserve at 100%. Similarly, the Wall Street Journal reported yesterday that option ARM loans are emerging as a new source of default worries. This is troubling for two reasons. First, they heretofore haven’t been viewed as a source of risk (hence existing estimates are likely to be too low). Second, because they weren’t regarded as risky, they weren’t given extra credit enhancement in structured finance deals. Thus, it will take a much lower level of defaults to lead to downgrade of securities that hold sizable amounts of option ARMs.

A completely different shortcoming is that this housing boom featured much greater leverage than past ones. We don’t mean simply no equity, stated income loans, although they are one manifestation. What we are instead concerned about is leverage on leverage, which we have not seen addressed anywhere. Admittedly, because almost all of this was done privately, it is well nigh impossible to come up with decent estimates, but even a crude stab at it would force some useful debate.

Let’s give some examples. Mortgage backed securities were resecuritized into collateralized debt obligations. Some of them used leverage in their structures, either through borrowings or the use of derivatives. Hedge funds would buy some of the tranches, and turn their not-so-jazzy returns into more interesting ones by borrowing against them. Hedge fund of funds invest in hedge funds, and many of them use leverage to boost their returns.

So while in the good old fashioned days, a house would have a mortgage on it, here that house may have a mortgage that has had more layers of leverage piled on top of it. A fall in the value of the asset will produce losses far greater than the mere amount of the mortgage write-down.

Gillian Tett, the Financial Times’ capital markets editor, provided a vivid illustration in January:

“Hi Gillian,” the message went. “I have been working in the leveraged credit and distressed debt sector for 20 years . . . and I have never seen anything quite like what is currently going on. Market participants have lost all memory of what risk is and are behaving as if the so-called wall of liquidity will last indefinitely and that volatility is a thing of the past.

“I don’t think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions . . . with very limited capacity to withstand adverse credit events and market downturns.

“I am not sure what is worse, talking to market players who generally believe that ‘this time it’s different’, or to more seasoned players who . . . privately acknowledge that there is a bubble waiting to burst but . . . hope problems will not arise until after the next bonus round.”

He then relates the case of a typical hedge fund, two times levered. That looks modest until you realise it is partly backed by fund of funds’ money (which is three times levered) and investing in deeply subordinated tranches of collateralised debt obligations, which are nine times levered. “Thus every €1m of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors’ capital – a 2% price decline in the CDO paper wipes out the capital supporting it.”

We are seeing some of that unraveling now. One can only hope that some of these players cut their leverage or sold assets before things got ugly.

One good thing about the New York Times story from an analytic standpoint, although it is far from good news, is that it is the first mainstream piece I have seen that acknowledges that this housing contraction could do more damage on an inflation-adjusted basis than the S&L crisis of the early 1990s.

From the New York Times:

Every time economists and Wall Street executives think they have acknowledged the full extent of the losses from the meltdown in real estate mortgages, more bad news turns up.

Merrill Lynch said yesterday that it would take a charge for mortgage-related securities on its books that is $3 billion more than the $5 billion it expected just two weeks ago. And a report from the National Association of Realtors showed that sales of existing homes in September fell twice as much as economists had expected, to their lowest level in nearly 10 years…

At this juncture, economists say the troubles in the mortgage market could, all told, cost financial firms and investors up to $400 billion.

That is far more than the roughly $240 billion cost, adjusted for inflation, of the savings and loan crisis of the early 1990s, according to estimates of the combined financial toll of that crisis on both the federal government and private sector. The loss in total real estate wealth is expected to range from $2 trillion to $4 trillion, depending on how far home prices fall, according to several economists.

That would be significantly less than the losses suffered by investors in the stock market collapse earlier this decade, which erased more than $7 trillion, or about 40 percent, of market value.

Experts caution that these estimates are preliminary and the total costs could get bigger still. They also note that the loss of real estate wealth could prove more damaging for the general public than falling stock values because more American families own homes than own stock.

In recent years, the rise in real estate values has helped propel consumer spending, as homeowners refinanced mortgages and took out home equity loans.

“There weren’t a lot of people living off their capital gains from stocks,” said Jane Caron, chief economic strategist at Dwight Asset Management. “There were a lot people using their home as a piggy bank.”…

In a new report to be issued today, the Joint Economic Committee of Congress predicts about two million foreclosures by the end of next year on homes purchased with subprime mortgages. That estimate is far higher than the Bush administration’s prediction in September of 500,000 foreclosures, which in itself would be a tidal wave compared with recent years….

The Joint Economic Committee estimates that the lost of real estate wealth just from foreclosures on subprime loans will be about $71 billion. An additional $32 billion would be lost because foreclosed homes tend to drive down the prices of other houses in the neighborhood.

Those figures would cause a decline of $917 million in lost property tax revenue to state and local governments, which will also have to spend more on policing neighborhoods with vacant homes….

Still, subprime mortgages make up a relatively small share of the total housing market — about $1 trillion of the $10 trillion in outstanding mortgages.

The much bigger losses will be in declining real estate prices. Household real estate currently totals about $21 trillion, according to the Federal Reserve.

Global Insight, a research firm, predicts that the national average for housing prices will drop 5 percent over the next year and 10 percent before mid-2009, for a total of about $2 trillion. Economists at Goldman Sachs have predicted prices will drop by 15 percent, meaning an overall decline of more than $3 trillion; other forecasters have said the decline could be 20 percent or more.

House prices decline slowly, because many potential sellers simply stay in their current homes when they think prices are too low. But that becomes more difficult as people have to move either because of job changes or, increasingly, because their monthly payments are rising sharply. In the next 18 months, interest rates on more than two million homes loans will reset to higher adjustable rates.

Inventories of unsold existing homes rose last month to their highest level in almost 20 years.

Economists continue to update their predictions on how the loss of housing wealth might affect the overall economy. Nigel Gault, chief domestic economist at Global Insight, said he assumes that consumers reduce their spending by about 6 cents for every dollar of lost wealth.

If prices drop 5 percent next year, that would mean a decline of $60 billion in spending, all else being equal. That would be a noticeable slowdown, but not enough to cause a recession.

In the last several years, Americans have increased spending faster than their incomes by borrowing against the rising value of their homes. Economists estimate that such mortgage-equity withdrawals may have added one-quarter of a percentage point to consumer spending growth — a boost that could now disappear.

Thus far, spending has climbed more than 3 percent over the last year, and the most recent data on chain-store sales suggests sluggish growth but nothing near levels consistent with a recession.

The housing bust has also led to job losses. From the start of 2003 to March 2006, housing-related businesses like mortgage companies, home builders and contractors added 1.3 million jobs, or about 23 percent of all new jobs created in that period, according to an analysis by Mark Zandi, chief economist at Moody’s Economy.com.

Since then, the housing business has shed 383,000 jobs, while the rest of the economy has added nearly three million jobs.

Jan Hatzius, chief United States economist at Goldman Sachs, said the small decline in housing employment thus far is surprising and suggests more layoffs are ahead.

“You still have a million jobs that aren’t really needed anymore due to the downturn in housing,” he said.

D. Ritch Workman, president of the Florida Mortgage Brokers Association, believes he has an explanation. Many of the brokers and loan officers he knows are still working in the industry, even though they have taken on second jobs to make ends meet.

The home-loan company he owns with his brother in Melbourne, Fla., has seen revenue fall by half, to $500,000, and he has laid off two of its three salaried employees. But the firm has added several loan officers, who are paid on commission only, and it now has 18 people making loans.

“I am surprised they have hung in there,” Mr. Workman said. “But it’s a scary thing when that’s all you know. If for 15 years you have been a relatively successful broker and you have lived through the highs and lows, what are you going to do? Most of them are holding on for dear life and hoping things get better.”

On Wall Street, which fueled the housing boom by lending to mortgage companies and packaging and selling home loans, banks are writing off billions of dollars in bad loans and are setting aside billions more for the expected surge in defaults. Late yesterday afternoon, Bank of America said it would lay off 3,000 people across the company and has replaced the head of its investment banking division.

Update 10/25, 11:00 PM: Dean Baker points out that the New York Times’ estimates of $2 to $4 trillion in lost housing wealth is on the optimistic side, and some forecasters project as much as an $8 trillion decline.