The worst housing slump since the 1930’s is gradually engulfing the US economy and pushing it into a recession of unknown depth and duration. In 2007, many – including the Fed and the Bush Administration – believed that the weakness in housing would be sharp as excesses unwound, but also limited in its overall economy effect and importantly, that 2008 would see a gradual recovery. Very few observers before August anticipated a full-blown downturn that would compromise both households and the financial institutions that have supported and benefitted from the enormous expansion of the past several years. Even fewer realized that the force behind the boom was almost entirely debt-driven which in turn had become the basis for the greatest securitization programme ever, and one through which even more leverage had been created through complex derivative structures – and subsequently placed across the world. Rated AAA by accredited agencies and based on “solid” real estate whose historical default rates were manageable as well as predictable, it seemed inconceivable that the boom would lead to bust, but bust it would be.

In just five years outstanding US mortgage debt had doubled to $10 trillion or 75% of GDP, homeowners’ ownership rates had approached an all-time 70% level and residential investment surged to contribute some 6% percent of GDP – also an alltime record. Just as critically, mortgage companies proliferated amidst an explosion of products while households found that their homes, whose value was rising every quarter, could also be an easy source of extra credit to finance spending, resulting in a new kind of ATM. Wall Street could then securitize the debt, build derivatives on top with enough diversification to garner a high rating, and then sell the whole thing onto a third party – perhaps in Europe or Asia. But the boom, like many before, spawned its own eccentricities and extremes through innovation and increasingly lax lending standards that eventually came to overshadow the market. As the underlying credit basis for the sector changed with the huge growth in the debt structure, so did its vulnerability to relatively small alterations in financing terms & availability. By early 2007, it became apparent to those who would but look that not only were subprime and Alt-A borrowers dominating the market but persistent interest rate increases, courtesy of the Fed, were catching up with low “teaser” adjustable mortgage rates – while the excess supply of homes was building relentlessly. For instance, the number of new homes for sale hit an all-time record of 573,000 units as early as July 2006 (double the levels of five years earlier) well ahead of the actual market downturn. It was also about this time that prices of resale homes ceased increasing. So when the typical ARM (adjustable rate mortgage) reset at much higher interest rates, problems immediately arose especially among the huge number of subprime borrowers whose ability to pay more to service heavy debt loads was very limited. Selling out initially seemed a better option, but since house prices were no longer rising – in contrast to the months’ supply or inventory of houses for sale, which instead was (new home sales had actually peaked in mid-2005) – this simply added to the pressures gradually overwhelming the market, exacerbated simultaneously by problems among mortgage providers as losses accumulated. Many of these were to go bankrupt with the entire mortgage debt structure and its derivative offshoots subsequently coming under threat as defaults and foreclosures started to increase sharply. For the homeowner, houses became unsellable even at a loss while financing options narrowed dramatically as those lenders that survived backed away. By early 2008, the crisis was full-blown and the rest – including the Administration’s belated attempts to address the issues – is, as they say, history.

But not quite; for with the Fed’s actions and the unprecedented wave of credit write-downs (right now $330b) among the world’s major financial institutions, write-downs that are in some way connected to the US mortgage debacle, it has now become fashionable to consider the worst to be “over” and that a long period of recovery lies ahead. It is true that the Fed’s moves to lower rates substantially have taken some of the sting out of the $460b in ARM resets due this year – though “some” is the operative word, since many ARM rates have so far refused to respond much to policy rate cuts. It is also true that the various Administration & Congressional actions to beef up the capital and lending abilities of Government Sponsored Agencies (like Fannie Mae, Freddie Mac & the FHA) have plugged a few holes in (re)financing options, while Mr. Paulson’s HOPE and related initiatives have had some success at the margin in preventing foreclosures. Alas home prices continue to decline, plunging at an annualized rate of almost 26% over the past three months amidst falling sales, and the inventory overhang (houses for sale) remains huge. Crucially, in the first quarter, there were no signs of even a modest stabilization in the market, with construction contracting massively and almost 650,000 homes in some stage of foreclosure in the period, or 1 in every 194 households, which is up 112% from a year ago (the worst states are Nevada, California, Arizona & Florida; 1 in every 54 homes in Nevada are facing foreclosure while the ratio in California is currently 1:78, Arizona 1:95 & Florida 1:97). More than that, a record 18.6 million homes (or 14% of total US homes) are now empty, bloated by foreclosures – up 5.7% from a year ago – while the official vacancy rate (the number of empty homes that are also for sale) has jumped to 2.9%, the highest ever in a series that goes back to 1956. If one adds the percent that are available for rent but empty – and thus possibly for sale at some point – that number more than doubles. And now a new danger looms, one which UK homeowners will be familiar with from their experience some 20 years ago: Negative Equity. Estimates regarding the number of subprime and Alt-A borrowers who will owe more than the remaining equity in their homes will likely exceed 50% by mid-year if prices continue to fall – putting another $800 billion of mortgage debt at risk if these householders “walk away” as many are already doing (the default rate for subprime mortgages underlying bonds jumped to 26.6% in February, according to private sources).

All this suggests that the process to restoring balance in the housing market has a very long way to go with the main impact on the homeowner probably still ahead, as weaker economic activity and higher unemployment add to the negative wealth effects of lower home values (currently estimated at some $3 trillion just since last summer). This makes us especially concerned for the US economy’s overall prospects for the next 2-3 years. As Warren Buffett said in a CNBC interview a few days ago, the “bubble in housing was huge” and the recession in the US “will not be short and shallow”.

The story does not end here. For many other members of the G7 – not to mention China & India – may also be poised to experience a similar trauma, as the excesses in housing & real estate unwind in characteristic capitalist fashion. In this regard, the UK, Australia, Spain, Ireland and even France are at much risk, all countries which have experienced unusual booms that have elevated prices to unprecedented levels, financed by increasingly exotic instruments amidst a general deterioration in lending standards. In Europe, Spain is tottering and Irish home prices are already down big. But the next flash point may well be the UK, where house prices last year reached nearly 6 times incomes – an all time record that compares with 3.5 times only five years earlier. Speculation has been rife, especially in the buy-to-let market where some have borrowed just $300,000 to finance an empire of $10 million or more, based on rising house prices and buoyant rents. And London prices in particular have been in “cloud-cuckoo land” for some time, having benefitted from the financial district boom, itself partly due the explosion in innovative products that helped the US mortgage-related bubble prosper. With mortgage refinancing options and availability shrinking and excess supply in some areas increasing rapidly amidst all the classic signs of an impending economic slowdown-recession, the prospects look bleak indeed. It is just as well that several UK banks are now looking to tap the markets for capital as those rainy days hinted at by Bank of England officials only last week may well be right round the corner.

It should be remembered that although the housing slump which began in North America and has certainly spread to Europe and parts of Asia represented the beginning of these difficulties, we suspect that before it is all over, we will see some additional and sizeable problems emerge. Leading this off is the very concept accepted until a few months ago by so many that this is uniquely a U.S. or North American problem, there can be no doubt that at this time it is spreading and that some of the real estate bubbles, particularly in northern Asia, China would come to mind, have not been fully recognized. Perhaps this will change after the Olympics, but real estate prices in general in a large number of the developing nations, in which we would include India as well as parts of South America, are equally vulnerable to sharp price changes.

For the moment we believe we are in a pause. The first crisis period which began in early 2007 probably ended with the failure and collapse of Bear Stearns. The next crisis period will probably begin some time between now and year-end, perhaps by an as yet unknown event, such as a major bank failure (we suspect it will be in the developing world) or the realization that the commodity boom has ended. On this latter score, a scenario of rapidly declining grain prices, as well as declining base metal prices and energy prices would also fully change the perception currently embedded in many financial markets that these areas are still safe. Oil, now trading at $120, may find its way back toward $60 a barrel rather quickly. This will likely be taken as better news for North America, but it will be disruptive once again as the financial calculations of many will be put to test once again. In other words, a developing world that slows down materially will act to reinforce the already developing slowdown now seen in all G7 countries.

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