Let's start with a few premises that you keep hearing on the nooz (and when its Kudlow speaking, it really is snooz!)
- This is all contained to subprime and won't effect the economy.
- Its a small part of the total mortgage load in the housing market that is affected.
- Housing will recover; it doesn't go down in price, it goes up over time. They aren't making any more land.
- The economy is doing great. Employment is up, unemployment is down.
- Growth rates are slowing but its a normal mid-cycle dip - this is still an expanding economy.
Ok, let's go after this in no particular order:
- The real story here is not subprime. Subprime loans are, for the most part, a sucker play and really are only a small percentage of the market. Let's face it - we're talking about people with 550 FICOs, some who have had a car repo'd or even filed bankruptcy. This isn't the majority or even a significant minority of homeowners (at least not yet - keep reading!)
- The real story here is in what is called the "ALT-A" space. This is where the real reaming is going to come back at lenders - borrowers - and the economy. "ALT-A" is what the industry calls "good" borrowers (700+ FICO scores, typically) who for whatever reason don't conform with the lending guidelines that have been established for more than 100 years. (Read the treatise on conventional lending if you've forgotten.)
So let's lay this all out in a way that is simple and easy to understand.
- Housing accounts for approximately 15% of GDP. Of that, 6% is new residential construction. The builders have all told us that their cancellation rates are running close to 50% either in cancelled jobs or specs they are not going to build over 2006 levels. In essence, half of residential construction has disappeared. That is 3% of GDP.
- Apply whatever discount in resales and ancillary items you wish. Charitably, call it 25% for existing home sales, furniture, moving expenses, etc. We have 9% left (15 - 6) so a quarter of that is roughly 2 and change. Call it 2% to be conservative. This gives you 5% of GDP that evaporates.
- GDP growth last year was 3.3%. Subtract 5% from 3.3% and you get.... what?
Now what is the definition of "Recession"?
A recession is two or more consecutive quarters of negative GDP growth.
Hmmmm..... only in a government school can you subtract 5 from 3.3 and not get a negative number.
Now this may be too pessimistic for housing. So let's say that it is. What else looks bad?
Well, you could go back to my posting on this just a little while ago, for example. There you would find four out of four leading indicators all pointing downward.
Fact is, ALT-A paper is dead weight. Lenders are going to have to go back to traditional underwriting values. This, unfortunately, means that those who are in non-traditional mortgages and can't pay won't be able to refinance out (since payments will actually go UP under a conventional mortgage) and those who can't qualify won't be able to buy. This is going to result in a huge number of short sales and defaults - but there really is no other way out of the box. Asset prices - in this case - house prices - must come down on average of 30% over the next five years.
This will create a recession as it will remove half - or more - of the buyers for new construction from the market immediately and essentially halt many resales until prices adjust. In fact, we are likely about to enter a recession right now, if we haven't already entered one. (a recession can only be called in retrospect, as the definition above should make clear.)
By the way, banks who are currently holding the bag have yet to catch on. 85% of foreclosure sales - which one can assume are being put on the market for their outstanding mortgage value - are receiving no bids. Gee, do you think that means the mortgage is for more than the market believes the property is worth?
Can we avoid an economic (and market) crunch? Sure. Santa Claus could appear tomorrow, wave his magic wand, and instantly inflate everyone's salary by 40% without creating more money or disturbing anything else in the economy. Or he could appear and pay off 30% of everyone's mortgage - with magic cash. I suppose that if I want to engage in magical thinking, I can come up with all sorts of ways in which this bubble does not explode and screw millions of people.
But - I live in the real world. I invest in the real world. And I am forced to use basic mathematics that I was taught in that real world, not "new math" where 2+2 = 5. No, I am not Arthur Anderson.
Now here's two other things to consider, before I leave you to ponder all this:
- The Fed uses inflation numbers that exclude food and energy. We, of course, must buy both to survive. Our government has done us the wonderful favor of driving corn prices through the roof to support our insane "ethanol" garbage, instead of drilling for oil we know we have both on land and in the Gulf. Well, corn is feedstock for chicken and also goes into a huge percentage of of our food products. Have you noticed that a 12 pack of Coke is up $1 in price in the last year? That, by the way, is a 30% increase. Just wait until you see the price of chicken in three to six months. Inflation is 3% eh? Not in your grocery basket its not.
- To those who claim that we'll grow our way out of this. Exactly how are you going to justify 5:1 house price to income ratios? How can anyone make the payments given these realities? It cannot be done on the fully indexed rates for people with ordinary, middle-class jobs, and you cannot write "Option ARM" loans on stable or depreciating asset values without having 20% of them default when they go to reset or recast.
Show me the way around what's coming, and I'm all ears. But show me with math - not fanciful thinking that violates even the basic premise embodied in 4th grade mathematics.
Oh, and while you're at it?
Explain this - the same toxic loans that caused this mess are being offered - right now.
