All Subprime, All the Time

John Mauldin | Thoughts from the Frontline
March 23, 2007

At the risk of being all subprime, all the time, this week we look at what I think are the real risks for the economy as a result of the subprime debacle. How can one side say it is a contained risk (and in one sense it is) and not a problem for the economy while another side says it will drag the US into a recession and thus be a drag on the world economy? The answers will give us a handle on the whole issue, as we look at how the problem developed.

But first, let me correct an error. Last Monday in my Outside the Box, we used a brilliant piece of work from Dr. Woody Brock on why we need more derivatives and that the real problem in the derivatives market is not the size of the market. If you did not read it, you should. You can read it at www.2000wave.com/otb.asp?otbid=490. I forgot to mention Woody's website, which is www.SEDinc.com. There is a lot of useful thinking there as sample material. I serve on an advisory board for an investment firm in Europe with Woody and have gotten to know his work through them. His research is some of the more cutting-edge and thoughtful that I read, and I encourage my institutional and larger-firm readers to look at his work. I think you will be glad you did.

Woody will be just one of the speakers at my Strategic Investment Conference in La Jolla next month (April 19-21), and he is as entertaining as he is insightful. I am also very excited to announce that Paul McCulley of Pimco fame has said he can attend. Paul is simply one of the best speakers on the economy anywhere. That gives us what I think is one of the strongest line-ups of speakers at any conference in the country this year.

In addition to the above worthies, we have Louis-Vincent Gave, Rob Arnott, George Friedman, Dennis Gartman, Richard Russell and, of course, your humble analyst. Where else do you get to rub shoulders with such a powerhouse group, as well as listen to a select group of private fund managers from around the world? There will be plenty of time to meet them at breaks and dinners.

Sadly, because of securities regulations, we have to limit attendance to institutions and investors worth over $2,000,000. The conference is almost at capacity. My co-hosts, Altegris Investments, have done a great deal of work to insure that this is our best conference ever. To learn more, or to sign up, you can go to https://hedge-fund-conference.com/invitation.aspx. If you have any problems, let me know.

And now, let's look at where the risk is in the mortgage and housing markets.

All Subprime, All the Time

On Friday, we learned that existing home sales rose in February well above consensus expectations. Good news? Yes. The headlines in the financial press proclaimed (for the umpteenth time) that the worst of the housing slump is behind us. Home prices are down a mere 1.3% from a year ago, although the number of homes for sale rose slightly to a supply of 6.7 months, meaning homes are staying on the market longer, as sellers are still reluctant to sell at lower prices.

But the problems for new and existing home sales are in the future. Last year there were 400,000 foreclosures. Economy.com (Moody's) estimates that that number will double in 2007. That means that there will be an additional 800,000 homes added to the supply of existing homes this year, which is at a seasonally adjusted 6.69 million homes.

Doing the back-of-the-napkin math, that suggests there are about 3.6 million homes for sale on the market today. We could see that number grow by as much as 15-20% due to foreclosures alone over the coming months, as more homes go through foreclosure. Remember, the record foreclosures we are seeing today started as problems six months ago (or more in some states). As delinquency rates are rising sharply, the number of foreclosures six months from now is going to be even higher. It will take several years for this problem to work itself out.

800,000 Foreclosures in 2007

So, what do 800,000 foreclosures mean? It is like the old joke: when your neighbor loses his job it is a recession. When you lose yours, it is a depression. What it means depends on your position.

Let's make the math easy. Assume an average mortgage of $200,000. That would be $160 billion worth of foreclosures. But of course not all that $160 billion would be lost. The homes do have some value. Let's assume that the homes are only worth 80% of the foreclosed mortgages, an admittedly possibly bearish assumption.

That would mean lenders are going to have to lose $32 billion. Ouch. But even if it is $32 billion, in an $8 trillion dollar mortgage market and an almost $13 trillion US economy that is a rounding error, as long as you are not the lender.

Who loses? Obviously, a lot of mortgage banks. On March 2 www.lenderimplode.com listed 28 subprime mortgage firms that were shut down or taken over. One week later it was at 34. The count is now 44. Nine of the top 25 subprime lenders are either bankrupt or no longer operating independently. Many have given earnings warnings, and have massively increased estimates for loan losses. The shareholders, whether public or private, of these companies lose.

For most shareholders of public companies, a mortgage company would be a small portion (perhaps through a mutual fund) of an individual's portfolio. Not a devastating loss to the system as a whole, and the pain is shared throughout a multi-ten-trillion-dollar stock market. Sad, but not anything that poses systemic risk.

As an example, H&R Block had its lending facility cut in half from $4 billion to $2 billion. H&R Block is trying to sell its subprime subsidiary Option One, but the buyers are not lining up. Moody's has threatened to downgrade the credit rating of the parent, so there is some urgency. But until you know what kind of problems you are dealing with, how do you make anything but a fire-sale offer? And the stock is down about 15% simply due to a relatively small subsidiary problem.

Now, let's say you are an institution, a pension fund or bond fund who bought a RMBA (Residential Mortgage Backed Asset) or CDO (Collateralized Debt Obligation) with bad mortgages in it from New Century, who was the third largest subprime lender last year. They are under criminal investigations, lawsuits, their lending has been halted, and their line of credit is disappearing. They are probably gone, as is the chance to get them to take back their bad loans. You are going to lose some money in that CDO. Since a RMBA or CDO would have the assets from many companies, you are not going to lose all that money in your investment, just a fraction of the total value.

And since that institution probably only has a small single-digit percentage (if even that!) of these CDOs, it does not affect the overall viability of your fund. A hassle and annoyance but, in the end, a small-percentage write-off for the fund, and one that will not impact profitability from a total fund perspective that much. The pain gets distributed throughout hundreds of institutions and large funds, many of them in Europe and Asia.

Now, a lot of major investment banks have sold credit-default insurance. They could lose a few billion here and there. Given their enormous profitability, not something which should threaten any of the larger banks. Yes, it could be a hit to earnings. Again, the pain gets shared.

A few hedge funds will lose some money (if it is not your fund, does anyone care?). My anecdotal conversations suggest a lot more hedge funds will make money on this, as they saw the problems early on and got on the right (short) side of the trade. Again, shared pain.

Even if the losses are twice as bad as our assumptions, it does not pose a systemic risk, as the losses are readily dispersed throughout the system. So, when an economist goes on CNBC and says the subprime losses pose no threat to the economy, in one sense he is right.

That's the positive spin. If that was all it was, the loss of a (relatively) few tens of billions of dollars distributed throughout the world economy, then I would have to conclude they are right. But there is a lot more to the story.

It's Not a Request, It's a Demand

Let's go to that bastion of responsibility, the US Senate. In hearings this week on the problem of loose lending practices, US regulators were put on the hot seat. Senator Chris Dodd excoriated the Fed and the FDIC.

Senator Dodd said that US regulators had relaxed guidelines on mortgage lending at precisely the point in 2004 and 2005 when the riskiest ARM loans - which impose initially light monthly payments that escalate quickly at a later date - were increasing most rapidly. That also coincided with the start of the Fed's consecutive 17-stage raising of rates.

"Despite those warning signals the leadership of the Federal Reserve seemed to encourage the development and use of ARMs that, today, are defaulting and going into foreclosure at record rates," Dodd said, presumably referring to former Federal Reserve Chairman Alan Greenspan's infamous approval of ARMs for small investors, just as he was getting ready to raise rates. As Bill King notes:

"The Fed's director of banking supervision & regulation, Roger Cole, told the Senate Banking Committee that the Fed could've done more to prevent the subprime lending crisis. 'Given what we know now, yes, we could have done more sooner.' This begs the question 'why didn't you know sooner' given the empirical evidence of record credit creation, bubbly markets and real estate mania? How can anyone with a modicum of sense miss it?

"Sandra Thompson, FDIC director of consumer protection told the committee that there are about $1.28 trillion of outstanding subprime loans and 1 million will reset interest rates higher this year, and 800k will do the same next year.

"Sen. Chris Dodd (D-CT) about the subprime lending abuses: 'I don't want this to go on any longer - this has got to stop. Regulators were supposed to be the cops on the beat, protecting hard-working Americans from unscrupulous financial actors. Yet they were spectators for far too long.'

"Dodd directed Cole to apply the lending standards directed by the Fed, FDIC and other US regulators on March 2. 'It's not a request, it's a demand in many ways.'

"Sen. Robert Menendez (D-NJ) to Cole: 'It just seems to me you all were asleep at the switch.' "

I would bring up to the senators that they are even more derelict in not fixing the dire problems in Social Security and Medicare that we will face in the middle of the next decade. Talk about waiting until there is a crisis to do something!! But that would not be charitable, and distracts us from our topic.

Regulators will soon tighten standards, but they will be too late, as the market is doing a very good job of tightening for them. Credit lines are evaporating for low-documentation, 100% loans. As I have detailed in previous letters, almost 80% of subprime loans were made on a 2/28 basis, meaning that the first two years had low introductory payments, with significant balloons the third year. A large majority of these borrowers only qualified for the loan at the reduced, teaser payment rate and would not qualify for a loan at the full payment level. The bet by both borrower and lender was that the homes would rise 20% or more in value and could be sold at a profit.

But according to an extremely well-documented and thought-provoking report released on March 12 by top-rated housing research analyst Ivy Zelman and her team at Credit Suisse, this is not going to be a good bet for borrower or lender, and is going to have real consequences for homebuilders and those who want to sell and or refinance homes.

If you think I have been bearish on the housing market, I suggest you read this report. It is sobering. I will summarize some of the main findings (portions in quotations marks are direct quotes). And for those of you who would like to see the report in its entirety, since their clients already have had access to the report and considering that links to it are all over then internet, I provide a link to the 67-page report: http://www.billcara.com/CS%20Mar%2012%202007%20Mortgage%20and%20Housing.pdf

All Alt-A, All the Time

As I have written for months, the problem is not just in the subprime loans, but extends to the level between prime and subprime, known as Alt-A loans. Alt-A loans were just 5% of the market back in 2002, yet were 20% last year. 81% of those loans were low- or no-documentation loans last year. 55% percent of the borrowers took out second mortgages at the time of the original purchase, and loan-to-value was only an average 88%. 22% of all Alt-A mortgages were by investors or second-home purchasers, and thus are not owner occupied.

Subprime loans were another 20% of the total mortgage loan market last year. "2006 subprime purchase originations posted an alarming 94% combined loan-to-value, on an average loan price of nearly $200,000. Roughly 50% of all subprime borrowers in the past two years have provided limited documentation regarding their incomes."

Remember the study I quoted last week from the Mortgage Asset Research Institute, which looked at low/no-documentation loans? 60% of the borrowers exaggerated their incomes by 50% or more! "In 2006, 2/28 ARMs represented roughly 78% of all subprime purchase originations according to data from Loan Performance. According to our contacts, homebuyers were primarily qualified at the introductory teaser rate rather than the fully amortizing rate, which for many buyers was the main reason they were even qualified in the first place."

It stands to reason, then, that many borrowers simply will not be able to make their payments when the reset comes due, thus the prediction that as many as 20% of the subprime mortgages written in the last two years will default.

A 20% Drop in the Number of Home Buyers

Now, here is where it gets rather ugly. Warning: remove sharp objects from your vicinity before reading further.

"With financing pulling back at the entry-level, we believe it is only a matter of time until the impact is felt in other price points. If 15-25% of entry-level buyers that would have used subprime financing can no longer obtain funding, does this mean that 15-25% of potential move-up buyers can no longer obtain a buyer for their home, and so on?

"In our base case, we assume that 50% of the subprime market is at risk, taking originations back to 2003 levels, which would impact total purchase volume by 10%. Similarly, we estimate that 25% of Alt-A and 10% of prime loans would not be approved under tighter restrictions for various combinations of investor purchases, piggybacks, low down payments and low documentation, and the impending ripple effect down the entire housing market food chain. In aggregate, the total fallout of incremental originations would be 21% over the next one-to-two years.

"Related to speculation, investors' share of the market climbed to roughly 18% in 2005 and 2006 from an average of 7% from 1998-2001, implying that a return to the mean would remove 11% of housing demand.

"Combining the two yields a 25-35% reduction in peak housing production. This would likely be exacerbated by declining consumer confidence, investor demand falling below historical norms, the risk of a softening economy and supply pressures weighing on demand (all of which seem present today), suggesting at least a further 10% drop.

"Aggregating the various impacts would result in a 35-45% drop-off in new starts from the peak of 2.1 million homes to roughly 1.2-1.4 million, as compared to the 16% decrease thus far on a trailing twelve month basis. For comparison, starts during the last three downturns ending in 1991 (down 34%), 1982 (down 32%) and 1980 (down 37%) fell by an average of 34%."

A drop of 20% in the number of homebuyers that we have seen in the past two years, coupled with a dramatic increase in the number of foreclosures, is going to put serious pressure on housing prices, especially in markets where there was a lot of "froth." And combine that with increased down payments and tighter credit for even credit-worthy buyers, and there is real room for concern.

Consumer confidence numbers are going to start dropping in the coming quarters. I think it is wishful thinking to believe that we will see a bottom of the housing market this month or even next quarter. Housing-related construction employment is going to seriously plummet. Consumer spending is going to take a hit as cash-out Mortgage Equity Withdrawals are going to be increasingly hard to get. Such mortgages accounted for 2-3% of GDP growth per year for the past four years.

In short, I think the case for a recession can still be made. And of course, there are those who think it will get even worse. Take Professor Nouriel Roubini of the Stern School of Business, New York University:

"Indeed, the subprime meltdown is now spreading to other parts of the mortgage and credit markets: near prime and risky mortgages (option ARMS) are now in trouble and they accounted for over 50% of mortgage originations in 2005-2006; subprime auto loans and subprime credit cards are in trouble; bank loans to home builders are in trouble; and bank lending to non-residential construction will soon also show cracks as the CMBX - the indices showing the cost of insuring against commercial real estate default - has sharply fallen, signaling a much higher risk of default even in this market segment.

"Corporate risk spreads will be the next shoe to drop, as the most serious academic studies on the topic show that corporate defaults are one fifth of what they should be given firm and economic fundamentals as a bubble of liquidity have masked some serious leverage problems in the corporate sector. So, a generalized credit crunch is underway and its outcome will be a hard landing of the economy this year."

We'll close with two anecdotal stories that are just too good not to use. In a man bites dog three-part story from the Nightly News on PBS, we find condominium developers suing people who had contracted to buy 18 months ago. The price of the condos has fallen by 20% and the potential buyers simply wanted to walk away from their deals, losing their deposits. The courts in Florida have sided with the developers, forcing buyers to close on the condos at the original price.

From the transcript at http://www.pbs.org/nbr/site/features/special/070316_three_cities/:

"YASTINE (reporter): Litigation between buyers and developers over condo-related disputes fills the newspapers in much of Florida. Real estate analysts like Jack McCabe say it's a sign of the post-boom times.

"JACK MCCABE, CEO, MCCABE RESEARCH & CONSULTING: Speculators is [sic] what's really has driving this market over the past five years and why prices have gotten so high. All those speculators have left the market now and we're left with truly the end-user buyer pool in normal conditions, which is only 50 percent or less of what the market has been in 2001 through 2005.

"YASTUNE: New statistics show the pain. Median home prices in some areas, like Orlando, remain steady. But prices have fallen sharply in areas that were hottest during the boom -- Miami, Fort Myers, Sarasota, and Melbourne. So what's next? McCabe has a dark outlook for the next several years.

"MCCABE: We haven't seen the effect that we're going to see later this year and into 2008, the mass foreclosures that we're expecting. And also where lenders are going to be taking back projects from developers and in many cases hedge funds and investment asset groups are going to step in to buy those assets at highly discounted prices."

If you can buy something at a discount of 50% and sell it for a 50% mark-up, that still means a drop of 25% from the original price. But since it will take time to work through the excesses in the most overbuilt markets, the time value of money suggests there will be places where a 50% discount to the original loan value may be more than the market is willing to pay to take the risk and tie up capital.

Now That's Cheap!

I can hear you say, "It can't happen, John. Who would sell a home for less than 50% of what it cost?"

So, let's go to the second story, courtesy of Dennis Gartman (see more on him below). Instead of my telling the story, since he's the far better storyteller, let's see what he has to say under a closing headline of "Now That's Cheap":

"Knowing when something has gotten cheap is an art reserved to either the very wisest among us, or the very lucky, or at times the very stupid. It is not an art we are given to, although clearly we have some acquaintance with the latter. But sometimes even we can know when something has gotten cheap.... even very so, and it would appear that housing in Detroit, Michigan has gotten very, very cheap. Allow us to explain.

"We were sent an article yesterday from Yahoo! News detailing the levels to which housing prices in Detroit have fallen, and they have fallen very far indeed. Apparently last week, a Texas auction firm was commissioned to sell off a number of homes there. The prices were unbelievably cheap, with 'house after house [selling] for less than the $29,000 that it costs to buy the average new car.' The auctioneer became so exercised that he enjoined the audience with the simple statement that 'Folks, the ground underneath the house goes with it. You do know that, right?' Several houses that went by the boards sold for less than $10,000... some even for less than $7,000. As one participant said, 'You cannot even buy a good used car for that!'

"He's right. One gentleman, who a year ago thought he was buying a series of 'bargains' when he paid $70,000 for a number of houses, only to watch as houses of the same relative value in the same neighborhood sold over the weekend for half that. The gentleman in question apparently was not prepared to average down.

"Sadly, these 'bargains' are not only in seedy, run-down depressed portion of the city. We read where a house in Bloomfield Hills, an area of the city we've been to several times in the past two years and is really very, very nice indeed, which had been listed for $525,000 sold for $130,000! Five years ago, at $525,000 the house was a bargain; at $130,000 it is even 'bargain-er.' However, when nice, tidy, small houses begin to sell for less than the price of a nice, tidy, used car, either cars are expensive or houses are inexpensive... or both. Now, how do we do the arb?"

Turning 30, Too Much Stuff and La Jolla

It's time to hit the send button. If you are still with me, you have suffered long enough. We ended with a quote from Dennis Gartman. Dennis is a good friend. We frequently find ourselves speaking at the same conferences. I probably quote him more than any other source. He writes a daily 4-5 page letter that gets into my mailbox by 5:30 or so very morning. He gets up at 2:30 or so Eastern time, wherever he is in the world, to write the letter. (His travel schedule makes mine look sedentary.) He goes over all the markets (currency, commodities, stocks, energy, etc.), gives behind-the-scenes political updates and so much more. He is one of the first things I read every morning, as I feel it lets me know what happened while I slept.

I highly recommend the letter. You can learn more and get a free trial by going to www.thegartmanletter.com. But be warned. The letter is not cheap and it is highly addictive. And come meet Dennis live at my conference, as I mentioned at the beginning. Content aside, it is going to be a real contest to see who is the more entertaining of the speakers at the conference.

My oldest daughter Tiffani turned 30 last week, but the clan is gathering tomorrow night for the family celebration, and some of the kids are already at home, so I am going to try and get out of here in order to see them. Tiffani has worked for me for almost ten years, and now runs everything, it seems, but the research and writing at Millennium Wave Investments. I haven't been able to figure out how to delegate that to her, but I am working on it. I derive a great deal of pleasure from working with her, and those of you who work with us know how important she is to the business. Thanks, Tiffani.

I am moving in a month to a high rise in what is known as Uptown in Dallas. While the place is large as these things go (I have to have room for all the kids to drop in, of course), it is still requiring me to shed a lot of "stuff." It is amazing what we accumulate over the years. I have moved twice in the last six years, and thought I had shed a lot of "stuff," but now find the need to shed even more, as I don't get a garage to stuff full. I am going to have to cut way back on my tools. And look at boxes that have been unopened for years. I have no idea what is in them. Oh, well.

Have a great week.

Your looking forward to moving but not forward to packing analyst,

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