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Random Musings - The US Housing Market & The Sovereign Debt Crisis

May 10, 2010 – Comments (15)

Random Musings- The US Housing Market & The Sovereign Debt Crisis

Yeah, here we go again, another blog centered more around random thoughts than a centralized theme. I actually take that back, if there were a central theme here it would be the continued degradation of the quantity of credit available and the quality of the credit offered to US and worldwide consumers.

We’ve often heard about the quality of credit hitting the market since 2007 being absolutely terrible, but that’s only half the story. The story involved giving loans to unqualified buyers since as early as 2003-2004, just two years out of one of the nastiest recessions in the past 15 years. Peddling loans to customers who most banks willingly knew would default on them were justified by FICO scores which were becoming more meaningless by the day. Thus gave birth to subprime lending, the practice of taking a dumb idea and expanding this dumb idea to the only class of Americans who might be worse with their money than banks at this time. Current facts suggest that in excess of 50% of subprime loans are currently in default and an additional 50% of those which are able to modified re-default within six months. Are we past the worst of the subprime debacle? Absolutely! But have we seen the last of the generation of poor loans to subprime credit…. Oh boy we haven’t!

The truly horrifying fact here is that we are ramping up over the next few months to introduce a new series of loans even more insidious than the subprime loans which plagued the markets for 18 months, namely the Alt-A and Option ARM loans. These loans were some of the shakiest loans ever to hit the streets. You had undocumented income loans, little to no credit needed, incredibly low teaser rates and banks willing to sell these loans and attempt to repackage them to a secondary market full of suckers. How banks were able to get away with things like this, I don’t know, but they very simply did and we are about to enter a period of increasingly high loan loss reserves and we’ve all but tapped out any benefits from the Obama stimulus packages.

Alt-A and Option ARM loans that are about to re-set combined total a higher net dollar figure than what we saw in the subprime fiasco. Very simply speaking, we have even more bad loans about to default than we had back when we didn’t expect the housing market to go bad and naturally the market had until this past week been rallying for 14 months straight into this disaster. Based on the current estimates I have read from various ratings agencies (which I feel have been far from useful over the last decade), Option ARMs will be showing a default rate close to 30%, Alt-A undocumented loans almost 40% and even prime loans could crest at a default rate over 5%. 30%-40% figures already sound rather unappealing, but taking into account that this is a greater dollar figure than the subprime re-sets and you can see my cause for concern. The market has almost been lulled into a false sense of security over the past year and two months as things have gone from subprime hell into a general malaise and that malaise has been enough to propel us higher. Eventually the fact that news is no longer getting worse but is still in general bad is going to catch up and we’re beginning to see that now.

Even scarier is the location of the majority of these Option ARM and Alt-A loans… California, Florida, Nevada and Arizona – four states that already have some of the shakiest economies and have the potential for an even larger crater in home prices. It would not shock me if California saw a default rate on Option ARMs in excess of 45% by mid to late 2012, potentially driving that state economy back to the brink of bankruptcy.

Who does this affect? Essentially every aspect of the economy to be honest but most predominantly the financial and homebuilding/construction sectors which I have been predominantly bearish on for some time now. Unless you are riding a financial horse in the US that has been fiscally prudent with their cash and has hedged as far as possible out of risky home loans, like US Bancorp for example, you don’t have any business holding larger banks in the near-term future. I mean think about it, there are two sides to every trade, so that means there are some larger banks out there and probably a very large quantity of regionals, holding some very shaky ARMs that are going to reset over the next 6-24 months and thoroughly destroy some balance sheets. We’ve seen nearly 70 banks failures so far this year. I think we will be talking about upwards of 240 bank failures before the end of 2012 from this point with regional carnage expected in the Pacific Northwest, Southwest, Southeast and Ohio River valley. I’m not recommending hardly any financials at the moment, but given what I’ve seen regarding housing prices and the quality of outstanding loans, Midwest regionals are at least moderately better off than those mentioned above.

So what could possibly be worse than giving out home loans to customers are who totally undeserving of those loans and will in all likelihood fail to pay them back? Well how about lending money to nations that are extended far beyond their capacity. Our housing market and lending structure might be a monumental disaster due to the creative (or should I say Mickey Mouse) business practices of professional bankers, but European lending practices have just been downright blind to economic and debt growth rates.

Almost every country in the European Union has actually done a good job in relegated their lending practices within their own borders. Countries like Spain have instituted considerably better lending practices than what we saw a decade ago by repackaging loans into a secondary market which forces the originator of these home loans to keep a portion of the loan on their books. This risk-sharing practice has led to a generally low default rate in Spain and in general the EU. Ironically only the UK has been particularly low on the scale in my opinion having generated a pretty significant amount of subprime loans, but even then they pale in comparison to what we saw in the United States. At worst you’re looking at a country-wide default rate on loans of probably 0.7% in the UK while you’re well in excess of 3% of all outstanding debt in default right now in the US.

What the European Union nations did a really piss poor job of was evaluating just how rapidly the governments of each of these nations were extending themselves. Currently you have Italy at debt levels which total 115% of the GDP. Greece is a close second with debt totaling 108% of GDP. Other nations which are seriously over-leveraged include Iceland at 101% of GDP, France at 79% of GDP and Germany at 77% ( I decided I would leave Japan out of the discussion, but at 190% of GDP they are spreading themselves so thin that I don’t think I will be recommending the Japanese stock market to investors in my lifetime.). What I found incredible about all of this is that Germany receives one of the lowest rates of default around because they are able to borrow easily due to record low bund rates while Greece is put into a stranglehold at 11%-15% borrowing rates.

Who is holding the majority of this outstanding debt? Why of course, the Germans and French! Are we really that surprised to see 2 of the five most indebted countries holding debentures to 2-3 of the other top most indebted countries? At least France and Germany can maintain those high levels of debt to GDP due to lower borrowing rates and higher net savings rates per household. What I want to know is what retarded monkey child thought it would be a great idea to lend money to Greece, a nation that has historically had VERY negative net savings rates per household and rising debt to GDP levels since January 2000. Another nation that shows this alarming problem is Denmark. They have had declining or should I say at least down-trending/erratic savings rates since 2002. Want another offender on this list with falling savings rates per household? Finland! Surprised much because I am certainly not! You can also tack on Norway, the United Kingdom and the Czech Republic as countries with significantly reduced or even negative net savings per household rates. (On a side note one I was shocked to find with erratic to falling personal savings rates was New Zealand).

These declining savings rates are REALLY concerning because overnight bank lending rates such as the LIBOR have been rising over the past two weeks indicating tightening credit markets again. I know a LIBOR rate of 0.43% doesn’t exactly inspire fear in the hearts of many, but when you’re used to a 0.23% lending rate just a few weeks ago and now are staring at an 80% jump in that rate there is considerable cause for concern. A great many European nations will not be able to survive another protracted credit contraction and I don’t think they will be readily able to rely on an injection of capital from the United States as I predict we will be mired in our own housing issues beginning in the next six months and lasting well through 2012. In a literal sense, the “spillover effect” you keep hearing about on financial networks has already occurred, it’s just a matter of containing it to a manageable level so credit quality remains acceptable, bond rates remain reasonable for borrowing and no one else gets to the brink of default like we’re seeing in Greece right now.

Unfortunately simply giving Greece money doesn’t make the issue go away! Back to what I was talking about before… the holders of Greek debt and for that matter any debt by these highly indebted to GDP nations. Almost every one of these countries, Germany included, maintains a large net liability position outside of their country. What that simply means is that the majority of holders of their debts reside outside their respective countries. Portuguese debt for example is almost 75% owned by people who do NOT live in Portugal meaning as the country is forced to go to market to find a buyer for their increasingly higher yielding bonds the country is growing poorer with each interest payment. This net negative effect can be seen on Portugal, Greece, Ireland, and to some extent Germany, Spain and France. Ironically I was staggered to find out that Italy has one of the lower net external debt positions and that might be the only reason their bond rates are so reasonable given a 115% debt to GDP ratio. What this also makes me realize is that the ratings agencies have significantly undervalued the probability of a problem with German debt in the future pricing the bund far below 3% now. Now don’t go taking from this the notion that Germany is going to default, that’s not what I’m saying, but I am saying that the quality of Germany’s debt and current debt holdings really isn’t as pristine as you’d think.

Historically speaking it doesn’t take a large foreign net debt position to create a poor economic event. Most of the nations in peril right now like Greece or to a lesser part Portugal have about 75% to 80% of their outstanding debts held in foreign hands. In the past it has taken on average a net exposure of around 55% given the right set of circumstances to cripple a nation, and there are plenty of nations in the European Union approaching those levels right now.

Long story short, this is a really dicey and complex situation in Europe that will not be solved by simply throwing money at it. These overly exposed countries are going to continue to grow poorer with every interest payment and debt levels at home in those countries will simply price them out of bringing paper to market and attempting to keep their debt within their own borders. Worst of all, this conflagration of events mentioned here, though not occurring all at once are likely to occur whilst the United States grapples with that second wave of adjustable rate mortgage resets discussed earlier.

Things really do not look good for the short-term future of the financial sector. Does that mean abandon all hope and put up an Alstry poster over your bed? No it certainly doesn’t because the market eats the perma-pessimist alive, but it definitely bodes a word of caution moving forward. I don’t think you will be changing your investment approach to companies in the technology of basic materials sectors because they are largely out of the general scope of the problem but could be dragged down with the overall markets just the same. What I do feel here and as I have been saying for quite some time is that there has been a lack of real forward thinking in the bond market which has unfortunately translated into some hypothetically great news for the US and world stock market. This pseudo-reality appears to finally be fading as the true quality of worldwide bonds is now being revealed and once again a poorly leveraged market of bonds and shady consumer loans looks ready to bring world markets back down to reasonable valuations. Considering another walloping is expected in the financial sector over the coming months or years but balancing that out with steady growth in technology, medical, mining and basic materials, I feel a reasonable fundamental level for the S&P 500 to be closer to 980. Now we all know that what is reasonable is rarely what the market will trade at, but given what I’ve rambled about here if you’ve even bothered to read this far, I think this makes sense to me…and really, isn’t that all that matters.

Ok, guess I’m done talking to myself for now….oh and yes I do realize the irony of writing all of this while the United States Federal Reserve opens up a line of credit to Europe.