the housing crash

last may, i cried “bubble" and was promptly ridiculed as housing continued to boom.

“just wait,” i would say, “until 2007.”

now, home prices are dropping and interest rates are rising, along with defaults. and yet, there remain steadfast believers in a swift recovery. some are self-delusional investors; others are the realtors and mortgage brokers whose livelihoods depend on public perception. most unfortunately, though, even many lenders and analysts cannot see the forest for the trees, each intensely studying a tiny piece of an enormous system without fully grasping that the entire mechanism is on the verge of collapse. a quote from AmeriCredit Corp. c.f.o. Chris Choate (in an a.p. article) sums it up: “Unless you can draw some correlation between those [defaults] and what is going to happen to the consumer's job, we really don't see that that would have a direct impact on our portfolio.” well, lurking below their radar is just such a correlation – an economic feedback loop that threatens to turn otherwise isolated incidents into a systemic shock. this phenomenon was explored by Yale economist Robert Schilling in his excellent book, “Irrational Exuberance” (whose title is a tongue-in-cheek homage to former Federal Reserve chief, Alan Greenspan).

to understand why the housing collapse will soon reverberate through our economy, we should start at the beginning. housing began its meteoric rise when the fed dropped interest rates to historic lows, cushioning the dot-com collapse. cheap credit and novel mortgages brought new buyers into the market, making low up-front payments and believing that they could afford higher future payments thanks to rising wages or – better yet – by simply refinancing when their home value rises, as appeared inevitable. some buyers took this to extreme, financing 100% to purchase multiple homes on speculation. and even those on the sidelines were cashing out with junior mortgages, liquefying half of all appreciation over the last five years.

the end result was over $10 trillion in outstanding mortgages (less the approximately 20% paid to financiers) -- not an alarming number, in and of itself. what should concern us is that more than $2 trillion are adjustable-rate mortgages that reset in 2006 and 2007.

the chips are down, and struggling homeowners are counting on rising wages or home prices to come through. but as in any bubble, speculative prices were mistaken for real demand, and the resultant oversupply is sending prices even lower. if prices fall far enough, even another round of rate cuts won’t make refinancing a winning proposition.

the other hope is that wages will increase, but our economy is dangerously dependent on consumer optimism, and we have no reason to keep spending! we’ve already bought everything we need for the next five years – homes, cars, appliances – all paid for not with more or higher wages, but thanks to (highly questionable) asset appreciation. in fact, last year, americans spent more than they made for the first time since the great depression! and to the extent that income has increased, most of it has been in real estate and the new “service economy.” naturally, as housing deflates, realtors and construction workers will be fired in droves. and the service economy is highly dependent on discretionary spending, but we can’t keep spending, even if we wanted to. with home prices falling, we’re losing access to consumer credit, which recently fell by the largest amount since 1992.

meanwhile, wall street seems little concerned, with markets rising on great expectations for consumer spending. and so, the last five years of investment in capital and labor have assumed that home price appreciation would translate into permanent wealth. there go our best-laid plans.

add all of this together, and you see the downward spiral we face. mortgages reset and, lacking the collateral to refinance, the least creditworthy enter default. this puts more houses on the market, further depressing prices. as credit falls and real estate suffers, expectations and consumer spending wither, hurting the economy and employment. at this point, the trend doubles back onto itself, sending more people into default and putting more houses on the market, ad (nigh) infinitum.

elsewhere, stocks will falter, but the brunt of this contraction will be felt by hedge funds that bought mortgage-backed securities without regard to risk.

but i still have my eye on the biggest hedge funds of all, Fannie Mae and Freddie Mac. they cannot legally diversify their investments, so they have leveraged mortgages into the trillion-dollar range using nothing but other mortgages to “hedge” their risk, if you can even call it a hedge. if homeowners refinance in the next year, the twins will be left unable to cover their liabilities.

the scariest thing i've ever heard was when a Freddie employee told me, last year, that "as long as real estate prices don't go down, we're fine."

all this, and we haven't even mentioned the dollar. throw in the fact that china may not need our purchasing power anymore, and their release of foreign reserves could force the dollar to unforeseeable lows, bringing the twin deficits home to roost.

i just hope we'll learn that we're no exception to the rule of command economies. they just don't work.

hold on to your hats.