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Credit Crunches, Foreclosures, and Mosquitoes
(August 9, 2007) Coming back from our week off, we find this month’s headlines dominated by real estate troubles - slow sales, falling prices, fewer building starts, and the largest housing inventory on market since 1992. Introducing the 'poverty effect.'
The troubles among the poor folks in the subprime sector of home financing are certainly not news – we have seen story after story in both financial and mainstream presses about the fragility of loans written, particularly in 2005 and 2006, that enabled perennial renters to magically become squires of their own estates. In order to accomplish this economic miracle, 100% financing was often employed, with adjustable mortgages bearing teaser rates so low that virtually anyone with a pulse could qualify.

Even something called “NINJA” loans (made to borrowers with No Income, No Job or Assets) became standard, a process by which a mortgage lender would essentially ask the applicant to just fill in an income on the application form, without the nuisance of ever having such data verified. And the beauty part was, this imputed income was used to place the applicant in the most house that he or she could afford, during the 2 or 3 year low-interest ‘teaser’ period.

The expectation was that, down the road, of course, the house or condo would inevitably be worth more, enough more so that the ostensible home “owner” would then be able to refinance at a fixed rate, and even be able to withdraw some new-found equity at the same time. Probably enough dough to redecorate, or maybe put in a pool.

Such were the assumptions of the housing bubble before it sprang a leak. Now, every month tens of billions of dollars worth of the 'intro' phases of these mortgages are coming to an end, and the reality of 'market rate' monthly payments is decimating the budgets of many sub-prime and borderline borrowers.

Today we have real estate prices stagnating and falling, particularly at the level of starter homes built on the fringes of metropolitan areas. “Foreclosures Soar on Outskirts, more people on Valley’s fringe losing homes” was the front-page headline of Sunday’s Arizona Republic newspaper. Catherine Reagor wrote,

“Home buyers have long flocked to metropolitan Phoenix’s farthest flung suburbs to get the most house for their buck. In the housing market, it’s known as ‘drive until you qualify’- the farther out you go, the less expensive the homes. But where affordability and steady appreciations once enticed many to the Valley’s edge, foreclosures are now forcing them out.”

Not only that, but the next day that newspaper pointed out that the housing slump has brought mosquitoes to our desert city. Here’s how it works: Real estate investors bought a large proportion of the houses sold here during the big run-up in prices 2003-2005, and turned them into rental property. And then the rise in prices came to a halt. Many of those unlucky enough to buy around 2005 and 2006, when prices peaked, simply stopped making payments when they realized they were upside-down with little hope of making good on their investment. Finally their tenants were evicted by the entity holding the unpaid mortgage. This left an empty, neglected house, often with a swimming pool in the backyard. The pool stagnates, turns green with algae, and becomes a breeding ground for mosquitoes, which are normally very rare in our dry desert climate.

Besides mosquitoes, the collapse of the residential real estate market is producing a myriad of other unforeseen consequences.

Remember the 'wealth effect' enjoyed by homeowners year after booming year during the rising real estate market? Today, those same people are starting to experience a 'poverty effect' from that same domicile. Psychologically, such a realization makes a person think twice about buying that big-ticket item such as a car, lavish vacation, or home improvement. And if you had dreams of re-financing your home and taking out some equity for that spending, as they say in Brooklyn, fuhgetaboutit.

And with the more affordable homes not selling, market weakness is inevitably going to drift up into the more upper-end markets as well. People contemplating a ‘trade-up’ are not going to be able to sell their current abode for what it was worth even a few months ago, and that will take them out of the market for a home in a pricier area.

Jobs in home construction are disappearing rapidly. Those jobs, at least here in the Southwest, are held to a large extent by migrant laborers. And as those workers pick up their toolboxes and head back to their home countries, they leave behind even more housing slots to add to a growing inventory.

In this decade, over half of the new private-sector jobs created in the US have something to do with housing – construction labor, sales agents, mortgage writers, realtors, and the like. Although the housing sector itself only makes up some 6% of our economy, it has been far and away the most robust engine of growth in GDP in this decade. And the peripheral jobs created by that housing boom, from Home Depot to your local mortgage brokerage, have flourished right alongside. Today we are seeing quite a bit of that job growth becoming undone.

But even those with no connection to the housing industry have been the beneficiaries, directly or indirectly, of the re-financing frenzy which had freed up substantial funds for the consumer over the past ten years or so. Many people over the past few years have been able to pull more cash out of their houses than they ever did from salary increases. The impact on the US economy of the loss of house-as-ATM money will run into the hundreds of billions of dollars.

Arguably, the housing market over the past few years produced the kind of investment mania, not to mention water-cooler talk, of an intensity we haven’t seen since the surging equities market of the late 1990s. From McMansions to vacation and second homes, money has poured into this sector like there was no tomorrow – and what makes it potentially even more precarious than the equities mania is the fact that it’s pretty much all been done with borrowed money.

Who loaned all that money? Well, for the most part, banks and mortgage companies originated the debts, but passed it on in the form of sliced and diced, derived credit instruments. And those who bought this funny paper were individual and institutional investors and various funds, none of whom could ever be exactly sure just what had been borrowed against.

Thus, today we have a major credit crunch, mortgage companies going under, over-exposed hedge funds imploding, and some previously very solid banks and institutions getting stuck with some very questionable derivative ‘securities.’ Speaking of the resulting credit crunch, Bear Sterns chief financial officer Samuel Molinaro was quoted by Barron’s Randall Forsyth as calling the current market conditions “as bad as I’ve seen in 22 years.”

So what is the Fed to do? Most likely the Federal Reserve will continue to jawbone against inflation, but their hearts can't really be in it, what with housing going down the tubes and strapped mortgage-holders starting to feel like chumps. And Ben Bernanke and crew have to suspect that at some point American consumers, feeling the ‘poverty effect’ of their biggest asset crumbling in value, will cease consuming so reliably as they have over the past few years.

Before this year is over, we will no doubt see the word “recession” or “deflation” in a Fed bulletin or speech. And our bet is that the Federal Reserve will take definite steps to avoid starving off the 800-pound gorilla known as the US housing market. Indeed, that market’s sole potential savior at this point is the boundless liquidity that only the Fed can provide.

In short, this may be more of a problem than just a few mosquitoes in the desert.


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