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Best of Kass: Subprime Bracketology
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Many, like Cramer, Larry Kudlow and others, readily dismiss the potential spending consequences of substantially less capacity in the subprime mortgage-lending market and the emerging trend by mainstream originators and lenders to reduce lending in the primary mortgage market and for refinancing cashouts.
Indeed, Jim takes the subprime issue one step further, noting that the mortgage house of pain will have a salutary market and economic result, as it will hasten the Federal Reserve's path toward monetary ease. Shockingly (at least to me), many others can't comprehend the link between mortgage availability and consumer spending, claiming that the correlation between the two variables is unclear.
I have not touched on the outlook for considerably higher credit losses at the financial intermediaries that address the housing market, which I will reserve for a future time. However, I will underscore the perfunctory conference calls and the generally disingenuous role of Wall Street rating agencies, which continue to hide the damage for owners of collateralized product paper as it relates to the collapse of the subprime market. It seems that at the end of every cycle's excesses, the investment community rationalizes the indefensible, owing to the enormous profitability of the products that are being peddled. The higher a market surges, the easier the product is to sell, but the less straightforward the pitch becomes.
Time and time again -- whether it be junk bonds, tax shelters, technology stocks, high-priced IPOs, glowing research reports -- Wall Street (despite former New York Attorney General Spitzer's noble initiatives) continues to exist for the purpose of raising capital (i.e., selling stocks and bonds) and not for the purpose of producing objective research and making clients money.
The brokerages' ties (in packaging and trading mortgage products) and earnings exposure to the subprime collapse -- they have 60% of the market share of the mortgage financing market -- were covered in depth in yesterday's New York Times article by Gretchen Morgenson. (Editor's note: A subscription is necessary to access this link.)
Broadly Negative Multiplier Effect
From my perch, the collapse of the subprime markets -- delinquencies now stand at 12.6% for subprime and 4.7% for the overall mortgage market -- within the context of the $6.5 trillion mortgage securities market will have a broad and negative multiplier effect on mortgage activity (housing turnover) and retail spending. It will also serve to further grease the current slide in new residential construction activity and hasten the drop in home prices.
It is important to understand housing's disproportionate role in terms of buoying employment and industrial production from 2000-06 in order to appreciate how violent the reversal's effect might be on aggregate economic growth. As I wrote back in October 2006:
# The real estate industry has been responsible for 40% of the job growth since 2001.
# The rise in home prices has provided for 70% of the increase in household net worth since 2001.
# The increase in consumer spending and real estate construction spending has contributed to 90% of the growth in GDP since 2001.
Not only did new home construction embark on an era of unprecedented growth, but the broad rise in national home prices gave way to the concept of the "Home as an ATM" -- a source of cash, a substitute for savings and an enabler of the consumption binge (which was above and beyond the income means of the average consumer).
During the 1990s, mortgage equity withdrawals averaged between $20 billion to $80 billion per year, or only about 0.50% of GDP. By contrast, average yearly mortgage equity withdrawals climbed to about $230 billion, or 2% of GDP, over the last five years and peaked at nearly 3% of GDP in the second quarter of 2006 -- or at an annualized yearly rate of almost $400 billion!
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Several months ago, Freddie Mac (FRE - Cramer's Take - Stockpickr) forecast that mortgage equity withdrawals will drop by 20% this year and by another 30% in 2008. These projections were done before the subprime fungus spread, and I think its estimates are too high.
In 2006, subprime mortgage loans trebled (to 36%) as a percentage of all mortgages issued. "Liar loans," or non- and low-documented loans that relied on the candor of homebuyers (never an intelligent loan strategy!) doubled (to 40%) over the same time frame. Creative loans, characterized by teaser rates, negative amortization and interest-only, among others, became the New Big Thing in real estate and dominated the mortgages issued in 2006. Refinancing cashouts proliferated, and, according to BankAmerica Securities, the average loan to a subprime borrower rose from 48% of the property's value in 2000 to 82% last year.
While the media have been focused on the D.R. Horton (DHI - Cramer's Take - Stockpickr - Rating) CEO's bleak forecast, every quarterly conference call with leading homebuilders last quarter confirmed the mounting restrictions of credit by mortgage lender. Stated simply, it is growing harder and harder to get mortgages. In the interim interval, the subprime market's health has worsened and so has, on a daily basis, the availability of mortgage credit (the lifeblood of our economy's well being).
In light of the recent adverse loan experience and bad publicity, most originators are avoiding these loans like the plague. Today, no mortgage lending officer at any bank or thrift will dare stretch lending standards to home buyers, as the mandate of tightened loan-to-values and higher FICO scores are, increasingly, the directive from financial companies' management.
Moreover, the fixed income market has a diminished appetite for packaged subprime loans and a diminished appetite for any collateralized product that includes subprime loans. It is unlikely that the institutional investors will hunger for this product for some time to come and originators will be faced with the hard reality that subprime loans will face more limited demand in the primary and secondary markets.
With financial intermediaries turning off the mortgage loan spigot, first-time homebuyers and trade-up buyers -- who already are pressed by the lack of affordability (home prices divided by household incomes) -- will have markedly reduced access to the residential real estate markets. As a result, the cyclical decline in housing will be forced into another down leg, just at a time when inventories of unsold homes remain elevated and the volume of ARM resets peaks (in third-quarter 2007). As a consequence, the gradual decline in home prices seen over the last 12 months runs the risk of becoming a full-fledged waterfall slide.
The mortgage market's new reality will serve to immediately (and adversely) affect housing turnover and reduce the demand for expenditures on many products. Exacerbating the decline in personal consumption expenditures will be the virtual disappearance of mortgage equity withdrawals, which have been the straw that has stirred the drink of consumption since 2000.
