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Global Financial Crisis Consequence of the Biggest Housing Bust in US History

Housing-Market / Global Financial System Dec 12, 2007 - 03:31 PM GMT

By: Mike_Whitney


Best Financial Markets Analysis ArticleThe wreckage in the housing market just keeps piling up. Sales of existing homes in October dipped 23.5% from last year. Prices on new homes dropped 13% year over year. Third quarter foreclosures skyrocketed to 635,000, a 94% increase over last October and an all-time high on the Misery-Meter. The real estate market is in free-fall and the real trouble hasn't even begun yet.

California, Nevada, Arizona and Florida are mired in a full-blown housing depression. Inventory is off-the-chart. Presently, there's a 10.8 month backlog and the numbers are steadily rising. If foreclosures continue at the current pace, by the end of 2008, there'll be a 14 month inventory. That means that every builder in the country could take off his tool-belt right now and stop working FOR MORE THAN A YEAR before the market would clear. Contractors would be filling out job-applications at Red Lobster or looking for an empty street-corner with a tin cup.

We're now entering the crisis phase of the biggest housing bust in US history; Greenspan's remake of Three Mile Island; only this time the whole country will be vaporised by a subprime-radioactive cloud.

As bad as the housing market is now; it's going to get a whole lot worse. Judith Levy sums it up in her article “ARM Resets to Hit Fan in 2008”:

“ In 2008 interest rates will be reset upward on $362 billion worth of adjustable-rate subprime mortgages [ARMs] ....The 'real crest of the reset wave' has yet to take place, which promises more pain for borrowers, lenders and Wall Street.... In addition to the $362 billion of subprime ARMs, $152 billion of other adjustable-rate loans are scheduled to reset in 2008, including jumbo mortgages and Alt-A loans. The Mortgage Bankers Association estimates that 1.35 million homes will enter foreclosure in 2007 and another 1.44 million in 2008, up from 705,000 in 2005.”

$514 billion in resets. 3.5 million foreclosures.

Did I say Three Mile Island? I meant Nagasaki.

California is bound to be the state that's hardest hit by the housing slump. Homeowners can expect to see price depreciation that could rival the Great Depression. As Broderick Perkins says,

“The California Association of Realtors reported the median price of an existing, single-family, detached home in California dropped 9.9 percent in October, compared to the same month a year ago. The decline was the largest year-to-year decline in CAR's history books....

We believe that a downturn is imminent, with sales volumes down 52 percent from the peak (in January 2005) and inventory (11.8 months) up 100 percent since last year. House price depreciation and credit deterioration go hand-in-hand. We anticipate residential mortgage credit deterioration to follow house price declines in California. Presently, credit quality (in absolute terms) is better in California versus the national average, but the rate of deterioration is much worse. For instance, in the second quarter of 2007 delinquency rates for prime ARMs and subprime ARMs rose 92 percent and 73 percent year-on-year respectively in California, versus 53 percent and 38 percent nationally," Goldman Sachs reported.”( Broderick Perkins, “Record Home Price Declines Portend Extended Downturn”, Seeking Alpha)

Wow. Home prices dropped 10% in a MONTH! Inventory is up 100%. Sales volumes are down 52%. Its the trifecta!

Its getting so hard to sell a house in California, that people are resorting to divine intervention. A number of websites have popped up on the Internet promoting transcendental or occult techniques for attracting potential buyers. recommends an old favorite; “burying a statue of Saint Joseph upside down in the yard”. The site even features its own “Real Estate Spell Kit” which includes:

1 Dressed and Blessed Saint Joseph Candle
1 Statuette of Saint Joseph
1 Bottle Saint Joseph Oil
1 Saint Joseph Chromo Print
1 Saint Joseph Holy Card Luckymojo even provides an optional prayer that can be recited during the ceremonial burying of St. Joseph:

Saint Joseph, I am going to place you
in a difficult position
with your head in darkness
and you will suffer as our Lord suffered,
until this [house/property] is sold.

Then, Saint Joseph, I swear
before the cross and God Almighty,
that I will redeem you
and you will receive my gratitude
and a place of honor in my home.

Following the prayer, the supplicant takes the statue of Saint Joseph and plugs him into the ground upside down and waits for the phone to start ringing. Who needs a realtor anyway? “If there's no yard, then dig a hole in a large potted plant.” St. Joe won't mind. All of this can be done without chanting, amulets, prostrations, or messy sacrificial animals.

It's worth a shot.

But sorcery won't work for everyone and the deteriorating housing market is sending tremors through the broader economy. In fact, the accelerating rate of foreclosures has put Washington in full panic-mode. Treasury Secretary Henry Paulson has been frantically trying to put together a bail-out package that will keep millions of homeowners from losing their homes. Here's Paulson's statement from earlier in the week:

“ As we are all aware, the housing and mortgage markets are working through a period of turmoil, as are other credit markets, as risk is being reassessed and re-priced. We expect that this turbulence will take some time to work through, and we expect some penalty on our short-term economic growth.

To speed up the modification process, Treasury is working through the “HOPE NOW” alliance with the American Securitization Forum to convene servicers and investors so they can develop categories of borrowers eligible for appropriate modifications and refinancings, and an industry-wide solution....I am confident they will finalize these standards soon. And I expect all servicers will implement them quickly, and create benchmarks to measure their progress along the way. As a result, what was a fragmented, cumbersome process can be a coordinated effort which more quickly helps able homeowners.”

Who does Paulson think he's kidding? He knows the plan is a non-starter. Why would homeowners opt to make outrageous monthly payments on homes that are quickly losing value, when they can just park the keys on the kitchen counter and vamoose. There's no incentive for them to be shackled to a home if prices are going down. They'd be better off loading up the U-Haul, grabbing the dog, and letting the bank worry about it. That's who Paulson is really worried about anyway. “Helping the homeowner” is is just a red herring.

There are a number of glitches to Paulson's scheme. For example, if he freezes monthly mortgage payments, then bondholders won't get what they bargained for and the market for mortgage-backed securities (MBS) will dry up. As Tom Deutsch, deputy executive director of the American Securitization Forum, said, ``If they no longer invest in mortgage-backed securities, you've cut off the credit available for refinancing, you cut off the lifeblood of being able to give better loans.” (Bloomberg)

That's right. If investors don't get the returns they were promised---or if the government arbitrarily changes the terms of the deal—bondholders will just take their money and put it somewhere else. It's as simple as that. That would trigger a run on the MBS market and put the kibosh on Paulson's plan.

One thing is certain, investors will not sit by quietly while their rights are trampled and their profits are slashed so that people can stay in their homes. That won't happen. Any viable bailout plan will have to be evenhanded, so that everyone shoulders part of the burden. Besides, these bonds are covered under contract law and the investors have rights. Paulson seems to thinks he can just make up the rules as he goes along. But he's wrong. If he tries to void or rewrite the contracts he'll be hit with class-action lawsuits that will stop him in his tracks.

The best summary of Paulson's plan appeared in the Wall Street Journal: “This whole scheme is an act of eminent domain, except the government isn't formally seizing property rights, but emboldening private parties to do so. Why is no one calling a spade a spade?”

It's ironic that the biggest boosters of free enterprise—like Paulson---are the first to do an about-face at the first whiff of grapeshot. Whatever happened to principles? Does Paulson really want to promote a scheme that forces the revision of contracts as well as repeals basic property rights? Needless to say, Paulson's metamorphosis into Leon Trotsky has not been warmly received on Wall Street where he has been lambasted by friend and foe alike.

The housing blowup is having dire effects on global financial markets. The credit crunch has spread throughout Europe where lending standards are tightening and industrial growth is threatened by the falling dollar. Consumer confidence has plummeted in Europe just like in the US. Last week, the Dow Jones slipped below its August low of 12,850 following the path of the Transports. The stock market continues to lurch back and forth furiously like an overloaded washing machine; soaring 100 points one day and then, plunging 200 the next. The volatility is just another indication that we are entering a primary bear market. Dow Theory suggests that the trajectory will continue downward into recession.

The subprime debacle has cast doubt on whether the “structured finance” model of securitizing debt will survive. On Monday, there were crucial new developments in this story that will have profound effects on the future of many the country's largest investment banks. E*Trade Financial has been forced to liquidate $3 billion of its mortgage-backed securities. Up to now, the banks, hedge funds an other holders of these toxic MBS and CDOs have been reluctant to sell, fearing that trillions of dollars in asset value would be immediately wiped out (for similar investments) once a firm “market price” is established.

Well, the Day of Reckoning arrived on Monday and the only thing missing was the funereal dirge and the wreath of fresh lilies.

According to Reuters: “ Financial analysts on Friday said E*Trade got anywhere from 11 cents to 27 cents on the dollar for its $3.1 billion portfolio of asset-backed securities. The portfolio sale was part of a $2.5 billion capital infusion from a group led by hedge fund Citadel investment Group.

"The portfolio sale, one of the few observable trades of such assets, has very clear, generally negative, implications for the valuation of like assets on brokers' balance sheets," Credit Suisse analyst Susan Roth Katzke said.”

$.27 on the dollar! Yikes. No doubt they'll be pulling a few weepy bankers off the ledge before the week is out.

What is particularly distressing about the E*Trade sale is that over 60% of the $3 billion portfolio “WERE RATED DOUBLE-A OR HIGHER”. That means that even the best of these mortgage-backed bonds are pure, unalloyed garbage. This is really the worst possible news for Wall Street. It means that trillions of dollars of bonds which are currently held by banks, insurance companies, retirement funds, foreign banks and hedge funds will be slashed to $.27 on the dollar OR LOWER. Banks will have to hoard reserves to meet the new capital requirements on the falling value of their assets, which means that they'll have less money to loan to businesses and consumers. In fact, this is already taking place. (which is the real reason the Fed keeps injecting money into the banking system) The E*Trade “firesale” confirms that the country--and perhaps the world---is now headed into a downward deflationary spiral. The Fed will HAVE to cut interest rates 50 basis points on December 11, just to keep the financial system from freezing up entirely. That will, of course, further emasculate the dollar and send food and energy prices through the roof.

There's really no way to overstate the importance of the E*Trade sell-off. It is the equivalent of a neutron bomb detonating in the heart of the financial district. Yes, everyone is still milling around with their caramel Macchiatos clutching their Blackberries just like before. But the game is over. Trillions of dollars of market capitalization will be lost and some of the biggest names in banking will be carted off to the boneyard. It will be a miracle if the Fed's interest rate cuts are enough to keep the economy sputtering along while the losses are written-down and the country recovers its footing.

$.27 on the dollar should be inscribed on the headstone of every Wall Street fraudster and every chiseling “financial innovator” who transformed the world's most powerful and resilient markets into a carnival sideshow. It should include every subprime “no doc--no down” homeowner who lied on his loan application to goose the system and get another 50 grand for a jet-ski and 42” liquid TV; every cheesy realtor who fudged the paperwork to put unemployed busboys with bad credit in $550 McMasions in Loma Verde; every ratings agency stooge who got carpal-tunnel from stamping each shaky subprime loan with with AAA seal of approval; every lacquer-hair banker in a two-toned shirt who bundled up garbage loans and dumped them on Wall Street; every shabby hedge fund manager who used the subprime loans to beef-up his own personal administrative fees by leveraging the MBSs and CDOs at rates of 10 to 1; every regulator who serenely looked the other way while the market was dousing itself in jet-fuel and reaching for the matches; and, of course--above all--the Federal Reserve, who initiated this whole boondoggle by producing trillions of dollars of low interest credit which flooded the system creating the greatest speculative frenzy in the world history. Alan Greenspan—the Ponzi Ringleader-- deserves a place of honor at the head of the chain-gang as they are frog-marched to some remote black site where they can pay for their transgressions.

The rest of us will have to stay put and endure the fallout from a “completely avoidable” Great Depression. We're dead ducks.

Managing Director of Pimco Managed Funds, Bill Gross, summarized our present conundrum in a recent article:

“ What we are witnessing is essentially the BREAKDOWN OF OUR MODERN DAY BANKING SYSTEM, a complex of levered lending so hard to understand that Fed Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August. My PIMCO colleague, Paul McCulley, has labeled it the "SHADOW BANKING SYSTEM" because it has lain hidden for years—untouched by regulation—yet free to magically and mystically create and then package subprime mortgages into a host of three-letter conduits that only Wall Street wizards could explain.” (Bill Gross, “The Shadow Knows”, Pimco Funds)

A few months ago, Gross's observations would have been dismissed as the ravings of a doomsday alarmist. Now they are part of mainstream analysis. Gross is a realist. The financial markets are broken; it's time to strap the patient to the gurney and wheel it in to I.C.U. No more band aids, thank you. 

Closing Thoughts

The President of the St. Louis Fed, William Poole, discussed many of these issues in a speech last week. Poole insisted that it is not the Fed's intention to “pump up the stock market” or to protect investors from losses by lowering the Fed's Fund Rate. Rather, the rate cuts are supposed “to restore normal market processes. He said, “ An active financial market is central to the process of economic growth and it is that growth, not prices in financial markets per se, that the Fed cares about.”

Fair enough.

He added, “One of the most reliable and predictable features of the Fed's monetary policy is action to PREVENT SYSTEMIC FINANCIAL COLLAPSE. If this regularity of policy is what is meant by the “Fed put,” then so be it, but the term seems to me to be extremely misleading. The Fed does not have the desire or tools to prevent widespread losses in a particular sector but should not sit by while a financial upset becomes a financial calamity affecting the entire economy.” The Federal Reserve is now actively trying to forestall “a systemic financial crisis”. (Poole's words) The trillions of dollars that were loaned to mortgage applicants--and which ignored traditional criteria for lending---have created the likelihood of a decades-long downturn in the housing industry as well as a meltdown in the broader financial markets. The bundling of dodgy subprime liabilities and selling them as valuable assets to unsuspecting investors; is a scam that any competent regulator should have spotted immediately. And stopped. It doesn't take genius to see that offloading sketchy MBSs and “marked to model” CDOs to gullible institutions is wrong and a danger to the entire system.

Financial innovation has created a dilemma for which there is no easy solution. The Genie cannot be put back in the lamp. Paulson's remedies have no chance of succeeding. Mortgage-backed securities have been so chopped up and spread throughout the system; it would be easier to to unravel a bowl of spaghetti , separate each strand, one by one, and lie them next to each other without touching. It can't be done. The bad debts will have to be written down, banks will have to fail, and government will have to investigate affordable housing alternatives for millions of defaulting homeowners. Deregulation has created a monster. The prevailing Reagan-era, “supply side”, free market doctrine has removed tariffs, subsidies and other state-created price-distortions, but it has also eliminated all oversight and accountability. Government agencies no longer play an active role in policing the markets and, as a result, US financial institutions have fallen into disrepute.   

This is, first of all, a credibility problem and it will require astute leaders with a strong moral foundation, not evasive bureaucrats who're looking for a painless way to “cut their losses” and and keep the wheels of industry clanking along. Asset-backed commercial paper--a $2 trillion business--“is hardly trading at all.” The securitization of credit card debt, mortgages and car loans has slowed to a crawl and is in danger of stopping altogether. Many of the main engines for generating revenue for the banks—the repackaging of debt and amplifying it through levered derivatives—has vanished overnight. The financial markets have never been under such stress.

There's so much mortgage-backed gunk in the plumbing, the system is grinding to a halt. This is no the time for “business as usual” “garbage in, garbage out”. We need people who really understand what is going on to step up to the plate and propose coherent “fiscal” policy options that will steer the global economy away from the reef.

Forget about Paulson's “quick fix” snake oil. It's utter bunkum. The credibility of the system is at at stake. It's time to get serious.

By Mike Whitney


Mike is a well respected freelance writer living in Washington state, interested in politics and economics from a libertarian perspective.

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Elie Elhadj
24 Dec 07, 07:28
Credit 101 to bankers

Credit 101 to bankers

In December 1863, H. McCulloch, U.S. Comptroller of the Currency and later Secretary of the Treasury, wrote to all national banks. Here are some of the paragraphs.

“Let no loans be made that are not secured beyond a reasonable contingency. Do nothing to encourage speculation. Give facilities only to legitimate and prudent transactions.

“Distribute your loans rather than concentrate them in a few hands. Large loans to a single individual or firm, although sometimes proper and necessary, are generally injudicious, and frequently unsafe. Large borrowers are apt to control the bank.

“If you doubt the propriety of discounting an offering, give the bank the benefit of the doubt and decline it. If you have reasons to distrust the integrity of a customer, close his account. Never deal with a rascal under the impression that you can prevent him from cheating you. “Pay your officers such salaries as will enable them to live comfortably and respectably without stealing; and require of them their entire services. If an officer lives beyond his income, dismiss him; even if his excess of expenditures can be explained consistently with his integrity, still dismiss him. Extravagance, if not a crime, very naturally leads to crime.

“The capital of a bank should be reality, not a fiction; and it should be owned by those who have money to lend, and not by borrowers.

“Pursue a straightforward, upright, legitimate banking business. ‘Splendid financing’ is not legitimate banking, and ‘splendid financiers’ in banking are generally either humbugs or rascals.”

The sub-prime mortgage debacle in the United States should serve as a reminder, yet again, that gamblers must not be allowed to manage society’s saving. Central banks need to institute qualifying psychological testing to bar bank leaders with gambling propensity from wheeling and dealing in customers’ deposits and shareholders equity.

Elie Elhadj; author: Experiments in Achieving Water and Food Self-Sufficiency in The Middle East


01 Mar 08, 08:20
Great Site!

Hello there.

Just found your site. Great job!

I like it very much.

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