By Mike Whitney ICH 4/24/07

Treasury Secretary Henry Paulson delivered an upbeat assessment of the slumping real estate market on Friday saying, “All the signs I look at” show “the housing market is at or near the bottom.”

Baloney.

Paulson added that the meltdown in subprime mortages was not a “serious problem. I think it’s going to be largely contained.”

Liar.

Paulson knows full well that the housing market is headed for a crash and probably won’t bounce back for the next 4 or 5 years. That’s why Congress is slapping together a bailout package that will keep struggling homeowners out of foreclosure. If defaults keep skyrocketing at the present rate they are liable to bring down the whole economy in a heap.

Last week, the Senate convened the Joint Economic Committee, chaired by Senator Charles Schumer. The committee’s job is to develop a strategy to keep delinquent subprime mortgage holders in their homes. It may look like the congress is looking out for the little guy, but that’s not the case. As Schumer noted, “The subprime mortgage meltdown has economic consequences that will ripple through our communities unless we act.”

Schumer’s right. The repercussions of millions of homeowners defaulting on their loans could be a major hit for Wall Street and the banking sector. That’s what Schumer is worried about—not the plight of over-leveraged homeowners.

Every day now, another major lending institution unveils its plan for bailing out the housing market. Citigroup and Bank of America have joined forces to create the Neighborhood Assistance Corporation of America which will provide $1 billion for the rescue of subprime loans. This will allow homeowners to refinance their mortgages and keep them out of foreclosure. The new “30- year loans will carry a fixed interest rate one point below the prime rate, putting it currently at 5.5 percent. There are no fees, and the banks pay all the closing costs.”

But why are the banks being so generous if, as Paulson says, “the housing market is at or near the bottom.” This proves that the Treasury Secretary is full of malarkey and that the problem is much bigger than he’s letting on.

Last week, Washington Mutual announced a $2 billion program to slow foreclosures (Washington Mutual’s subprime segment lost $164 million in the first quarter) while Freddie Mac committed a whopping $20 billion to the same cause. In fact, Freddie Mac announced that it “would stretch the loan term to a maximum of 40 years from the current 30-year limit.”

40 years!?! How about a 60 or 80 year mortgage?

Can you sense the desperation? And yet, Paulson says he doesn’t see the subprime meltdown as a “serious problem”?!?

Paulson’s comments have had no effect on the Federal Reserve. The Fed has been scrambling to deal with the slumping market and the rising foreclosures. On Wednesday, The Washington Post reported that “Federal bank regulators called on lenders to work with distressed borrowers unable to meet payments on high-risk mortgages to help them keep their homes”.

Huh?!?

When was the last time the feds ordered the privately-owned banks to rewrite loans?

Never–that’s when.

That gives us some idea of how bad things really are. The details of the meltdown are being downplayed in the media to prevent panic-selling among the public. But the Fed knows what’s going on. In fact, the Federal Reserve and the five other federal agencies that regulate banks issued this statement just last week:

“Prudent workout arrangements that are consistent with safe and sound lending practices are generally in the long-term best interest of both the financial institution and the borrower…Institutions will not face regulatory penalties if they pursue reasonable workout arrangements with borrowers.”

Translation: “Rewrite the loans! Promise them anything! Just make sure they stay shackled to their sinking houses!”

Unfortunately, the problem won’t be “fixed” with a $30 or $40 billion bail out scheme. The problem is much bigger than that. There is an estimated $2.5 trillion in subprimes and Alt-A loans—20% of which are expected enter foreclosure in the next few years. Any up-tick in interest rates or unemployment will only aggravate the situation.

Kenneth Heebner, manager of CGM Realty Fund (Capital Growth Management), provided a realistic forecast of what we can expect as the bubble loses air.

Heebner: “The Greatest Price Decline in Housing since the Great Depression” (Bloomberg News interview)

“The real wave of pain and foreclosures is just beginning….subprimes and Alt-A are both in trouble. A lot of these will go into default. The reason is, that the people who took these out never really intended to fully service the mortgage—they were counting on rising home prices so they could sign on the dotted line without showing what their income was and then 2 years later flip into another junk mortgage and get a big profit out of the house with putting anything down…

There’s a $1.5 trillion in subprimes and $1 trillion in Alt-A the catalyst will be declining house prices which is already underway. But as we get a large amount of these $2.5 trillion mortgages go into default, we’ll see foreclosed houses dumped on an already weak market where homebuilders are already struggling to sell there houses. The price declines which have started will continue and may even accelerate in some of the hotter markets. I would expect that housing prices in “2007 will decline 20% in a lot of markets.

What you are going to see is the greatest price decline in housing since the Great Depression…..The one thing that people should not do, is go near a CDO or a residential mortgage backed security rated Triple A by Moody’s and S&P because these are going to get down-graded by the hundreds of millions—because they are secured by subprime and Alt-A mortgages where there’ll be massive defaults.

Question–Will the losses in the mortgage market exceed those in the S&L crisis?

Heebner: “They’re going to dwarf those losses because the losses could easily approach $1 trillion—that dwarfs anything that has ever happened. Enron was $100 billion—this will be far greater than that…..The good news is that most of these loans are owned by Hedge Funds…You hedge funds buying these subprime and Alt-A loans and leveraging them at 10 to 1. They buy a pool of mortgages at 8% and they borrow against it in yen for 3% and then lever it at 10 to 1so you have a lucrative profit And the hedge fund you are running, the manager is going to get 20% of the gain—so even if it’s a year before you go broke; you get rich until the fund is shut down”.

Heebner added this revealing comment: “The brokerage firms created “securitization” they know the products are toxic. I don’t think they are going to suffer losses; they simply passed them on to everyone else. The only impact this will have is the profits that flow from it will get less….But it is less than 3% of revenues in even the most exposed brokerage firm so THEY’RE NOT GOING TO GET CAUGHT.”

Although Heebner believes the brokerage houses will do fine; the same is not true for the small investor who’ll be left holding the bag. Nearly 70% of subprimes have been securitized. That means that the vast number of shoddy “no down payment, no document, interest-only” loans that are headed for default have been transformed into securities and sold to hedge funds. As the housing market continues to falter, these funds will plummet at an inverse rate to the amount of leverage that has been applied. That may explain why, (according to Bloomberg Markets) the “wealthiest Americans have been bailing out” of hedge funds at an alarming rate. A report in last Thursday’s New York Times stated:

“Americans with a net worth of at least $25 million, excluding the value of their primary homes, reduced their exposure to hedge funds in 2006”– The amount of money held by wealthy investors in hedge funds has dropped dramatically– “The average balance, which was $2.8 million in 2005, was just $1.6 million last year, a 43 percent decline”.

So, what do America’s richest investors know that the rest of us don’t?

Could it be that the over-leveraged hedge funds industry is about to take a massive hit from the subprime implosion?

If so, it won’t be the brokerage houses or savvy insiders who get hurt. It’ll be the little guys and the pension funds that take a beating.

In Henry C K Liu’s “Why the Subprime Bust will Spread” (Asia Times) the author believes that the bursting housing bubble will trigger a major pension crisis. After all, who are the “institutional investors? They are mostly pension funds that manage the money the US working public depends on for retirement. In other words, the aggregate retirement assets of the working public are exposed to the risk of the same working public defaulting on their house mortgages”. (Liu)

The origins of the housing bubble are complex, but they are worth understanding if we want to predict how things may progress. The housing bubble is not merely the result of low interest rates and shabby lending standards. As Liu says, “the bubble was caused by creative housing finance made possible by the emergence of a deregulated global credit market through finance liberalization. The low cost of mortgages lifted all US house prices beyond levels sustainable by household income in otherwise disaggregated markets” The deregulated cross-border flow of funds (via the yen low interest “carry trade” or the $800 billion current account deficit) have played a major role in inflating the US real estate market.

Liu adds, “Since the money financing this housing bubble is sourced globally, a bursting of the US housing bubble will have dire consequences globally.”

This is clear, since nearly 50% of “securitized” mortgage debt is owned by foreign investors. The subprime meltdown is bound send tremors through the entire global financial system.

The housing decline is further complicated by Wall Street innovations in derivatives trading which has generated trillions of dollars in “virtual” wealth which is affecting the Feds ability to control inflation through interest rate manipulation. As Kenneth Heebner said, “You have hedge funds buying these subprime and Alt-A loans and leveraging them at 10 to 1. They buy a pool of mortgages at 8% and they borrow against it in yen for 3% and then lever it at 10 to 1so you have a lucrative profit.”

In her recent article “War Drags the Dollar Down”, Ann Berg refers to Wall Street’s “swirling galaxy of exotic finance” which has “worked magic for the government and the elite”, but has yet to weather a severe downturn in the economy.

How will the market’s deal with a storm in the hedge fund industry? Will the dodgy subprimes and shaky collateralized debt obligations (CDOs) trigger a crash or has the risk been wisely dispersed through derivatives?

No one really knows.

As Berg says, “Derivatives numbers are staggering. The Bank for International Settlements estimates that the notional amount of derivatives traded on regulated exchanges topped a quadrillion dollars last year and that the outstanding unregulated off-exchange (called over-the-counter — OTC) amount stood at $370 trillion in June 2006. Because the OTC market is composed of endless strings of bilateral transactions — the systemic risk is unknown.”

The President of the New York Fed, Timothy Geithner, offered these comments at the Credit Symposium: (which also shed some light on these opaque transactions)

“Credit market innovations have transformed the financial system from one in which most credit risk is in the form of loans, held to maturity on the balance sheets of banks, to a system in which most credit risk now takes an incredibly diverse array of different forms, much of it held by nonbank financial institutions that mark to market and can take on substantial leverage.

Geither’s right. The markets are now operating as unregulated banks generating mountains of credit through massively leveraged debt instruments. So, where is all this headed?

No one really knows. When the housing bubble crashes into Wall Street’s credit bubble we’ll be in uncharted waters. But it looks like America’s wealthiest investors are running for cover before the whole thing blows. (A number of investors have already cashed out and put there holdings into foreign funds and currencies)

One thing is certain, though—time is running out. With $1 trillion in subprimes and Alt-A loans headed for default the system is facing its greatest challenge. US- GDP has been revised to a measly 1.8%, foreign investment is down, and the dollar is losing ground to the euro on an almost weekly basis.

Falling home prices have already precipitated a number of other problems worth considering. For example, Gene Sperling reports in “Housing Bust Meets the Equity Blues” that “The Fed data showed an amazing expansion (in Mortgage-Equity Withdrawal). In 1995, active MEW had been $37 billion. By the fourth quarter of 2005, it soared to $532 billion annualized, a 14-fold expansion”. These equity withdrawals have translated into consumer spending which accounts for at least 1 full percentage point of GDP. Declining house prices means that extra boast for the economy will now disappear.

Foreclosures are soaring and expected to get worse for the next two years at least. In California foreclosure filings jumped 79% in March alone. Other “hot markets” are reporting similar figures.

The glut of new homes for sale on the market has slammed sales of the nation’s major builders; most are reporting profits are down by 40% or more.

The collapse of the subprime mortgage market is also pushing some big U.S. homebuilders toward Chapter 11. According to Bloomberg News, “Some builders are staying out of bankruptcy by relying on the profits they made when sales boomed” in 2004 and 2005. Starting next year they must begin to repay $3.6 billion in public debt in what will certainly be a falling market. The prospects don’t look good.

Also, Credit card debt is way up (nearly 7% in one year) and economists are predicting that the trajectory will continue now that home equity is vanishing. Americans savings rate is in negative numbers and the steep increase in credit card debt (with its high interest rates) only compounds the problem. The American consumer has now compiled more personal debt than anytime in history.

The Grim Reaper Meets the Housing Bubble

Those who follow developments in real estate have probably heard many of the wacky anecdotes related to the housing bubble. Stories abound of young people buying homes just to use the equity to pay off tens of thousands of dollars of collage loans —or low paid construction laborers securing 105% loans without any proof of income and a poor credit history. One of the stories that got national attention was about Alberto and Rosa Ramirez, who worked as strawberry pickers in the fields around Watsonville each earning about $300 a week. They (somehow?) qualified for a loan of $720,000 which paid for a “new” four-bedroom, two-bath house in Hollister.

Madness!

Obviously, those days are over. The speculative frenzy that was created by the Fed’s low interest rates, the banks lax lending standards, and the deregulated global credit market is drawing to a close. The fallout from the collapse in subprime-loans will roil the stock market, savage the hedge funds, and shrink GDP to the size of a walnut. But, as Heebner said, the investment banks and brokerage firms will probably escape without a bruise.

Where’s the justice?

Despite Hank Paulson’s cheery predictions, we are no where near the bottom. In fact, a recent survey showed that only 1 in 7 Americans believe that house prices will go down. Even now, very few people grasp the underlying issues or their potential for disaster. They are in for quite a surprise.

As housing prices tumble, more homeowners will be the victims of “negative equity”, that is, a home that is of less value than the current mortgage. This is the very definition of modern serfdom.

We’ll see the steady erosion of confidence in the market as more and more people walk from their homes rather than be shackled to an asset of declining value. This will transform a “housing correction” into a major financial crisis.

Many people have linked their future and retirement to the “anticipated” value of their homes. It is impossible to gauge how shocked they’ll be when prices retreat and equity shrivels. The housing flame-out could signal the onset of a national trauma–another violent jolt to the fragile American psyche.

We’re still in the first phase of a process that will probably play out for 10 years or more. None of the bailout plans are large enough to make any quantifiable difference. The numbers are just too big.

Housing prices are coming down and the real estate market will return to fundamentals. That much is certain. The law of gravity can only be ignored for so long. We should probably follow the example of America’s richest investors and “Get out now!”

Special thanks to http://patrick.net/housing/crash.html (Housing Crash News)

See entire Heebner interview at http://patrick.net/housing/contrib/future.html>/a> )