Friday, February 03, 2006

Our Worst Nightmare: Puncture of the Housing Bubble

Just read this superb Resource Investor article. It puts into perspective the potential ramifications of a housing bubble bust. The article is a rather long read, but well worth the time spent. I must warn you however, that it paints a downright scary picture for the future of our economy.

Here are a few snippets:

The key to holding up the entire speculative U.S. financial system with its current excessive levels of debt - federal (current account and trade), state, municipal, corporate and household - is maintaining the U.S. housing bubble. Anything less would result in America's worst nightmare and, in short order, the entire world. The housing market is dominated by Fannie Mae and Freddie Mac who hold 75% of all outstanding home mortgages (and the Federal Home Loan Bank Board to a much lesser extent). One too many additional increases in the Fed rate may well turn out to be the U.S. economy's Achilles' heel and lead to a major crisis at these two institutions generating an out-of-control systemic breakdown situation and disastrous financial implosion.

The Fed is between the proverbial 'rock and a hard place.' They engineered low interest rates in the first place, both to keep the financial markets going, and in large measure to keep the housing bubble afloat. They are now in the final stages of raising interest rates to prop up the collapsing U.S. dollar and to forestall rampant inflation. Were they to initiate one quarter percent increase too many it would destroy the interest rate environment that is essential to keeping the housing bubble alive; to keeping consumers spending at a high level thereby keeping the economy growing; to keeping corporate sales and profits high thereby keeping the stock market healthy. Have they gone too far already? The bubble seems to be loosing air slowly at this point but what will the impact be of the next increase? The impact of one too many rate increases on such a chronically debt-ridden and maladjusted economy must not be over estimated.

It is just a matter of time before further increases in mortgage rates will result in increases in monthly mortgage payments than some borrowers cannot handle. This will be particularly so for borrowers of sub-prime loans who were able to purchase their first homes with almost nothing in the way of a down payment and who, even now, have a delinquency rate at near record levels. In addition, as mortgage rates rise further, fewer first-time buyers will be able to afford to buy a home which will, in turn, slow down the sale of new and resale homes.

Indeed, the Fed are so concerned about this happening they are flooding the economy with almost limitless liquidity. There must be a crisis of historic proportions coming, and the Federal Reserve Bank of the United States is making sure that there is enough liquidity in place to protect our nation's fragile financial system. The amazing thing is that the Fed's actions mean they know what is about to happen.

That could be it?" Perhaps the Fed finally recognizes that the housing bubble has experienced a leak that could well escalate into major proportions soon. Perhaps the Fed has learned that one (or more) of the 3 American banks holding 95% of U.S. derivatives are experiencing some difficulties managing their risks. Perhaps Fannie and Freddie are encountering major derivative losses once again. Perhaps the Fed are concerned that the rising budget deficit and/or the ever increasing and already record-high current account (trade) deficits are very near the tipping point. Perhaps it is their fear that the recent and continuing interest rate hikes are going to have a very negative impact on the already overly indebted U.S. consumers (rising mortgage, lease and credit card rates), the stock market (lower corporate profits) and the bond market and lead to a recession. Perhaps the Fed sees their greatest fear of all - deflation - just around the corner.


Out at the peak said...

All eyes will be on the 10 year treasury. It has defied the federal rate influence completely during the rate hikes. This is because the USD was viewed stronger as the rate when up, thus attracting more money to buy the bonds and supressing the yield.

So the federal rate hike has done two things that I can see on the buyer's side: make ARMs as expensive as 30 year fixed and allowed banks to offer 4%-5% saving yields. The people who could only afford with a low ARM rate are now technically out of the picture, and are enticed to save money. If the yield curve corrects itself, a lot more will happen.

On the debt holder's/seller's side: Much earlier there was talk about how in 2006 the 2003 3/1 ARMs and the flood gates of resets started coming due. This magnifies in 2007, but the big year will be 2008 because the 2003 5/1 ARMs and the 2005 3/1 ARMs will be due. This should dwarf both 2006 and 2007, and the panic will already have a head start.

Bernanke will have a tough job of keeping the economy alive and defending USD status. I can't help but to think he'll cause hyperinflation as you have warned us.

Rob Dawg said...

Fannie Mae and Freddie Mac who hold 75% of all outstanding home mortgages (and the Federal Home Loan Bank Board to a much lesser extent)

I think that's 75% of the outstanding -conforming- mortgages. Something closer to a still scary 50% of all loans. Please correct me if I've got it wrong.

contrarian2day said...

Peak, I couldn't agree with you more. I think the Helicopter man will have his hands full with arms and interest only loans. When these things begin to reset, millions of homeowners will be in a nightmare of a pickle...

What will Ben Bernanke do? If he doesn't come to the rescue, our economy will be in big trouble and mortgage defaults will run rampant. If he does come to the rescue, the Dollar will be in big trouble, as foreign banks lose interest in our currency...

Let me explain further:

The Helicopter man will have two choices once he finds a stopping point with his current trend of increasing rates:

(1) He can begin to lower short-term rates again in an attempt to save the housing market, thus allowing people to refinance into new interest only loans--delaying the inevitable. But this would be devastating to the dollar, as foreign central banks would begin to lose interest in our currency and the value of their current (roughly $3 Trillion dollars) holdings would depreciate rapidly, possibly causing a massive dumping of the dollar. Note: This would also cause long-term rates to rise rapidly--due to lack of interest in, and in an attempt to attract investment in the dollar

Or the fed can (2) continue to raise short-term rates to keep foreign interest in the dollar (to finance our deficit and keep liquidity in the market), but this action would be absolutely devastating to the US housing market.

I personally think the Helicopter man will lower them again--to allow the consumer time to refinance (but the dollar will fall). The escape plan that I forsee is: The Fed will print trillions of dollars to purchase the dollars being dropped by central banks(one of the reasons for elimination of M3 publication) and voila, we enter HYPERINFLATION

Just a stab at trying to figure out the fed's master plan...