The long and winding road . . .

Previous postings focused on the 2008 economic meltdown. Here, I'll point to some trends in the housing sector that make me think that the end is not in sight for the current "Great Recession".

We've all heard about the rash of foreclosures from subprime loans. Sadly, foreclosures are not likely to end anytime soon. Figure 1 shows a graph from Credit Suisse (click on the figures to enlarge them) giving us a window into the near term:

1. The dark blue bars show subprime loans which dominated loan resets prior to spring, 2009. The chart shows how these loans are done resetting and relatively few will be at risk for foreclosure from now on. However, not satisfied with the damage from subprime loans, the Wall Street wizards created new and improved instruments of economic destruction.
   
   
2. The green bars show Alt A loans and the yellow bars depict Option ARM loans. These new toxic loans offered low "teaser rates" which reset after a period of time. Figure 1 shows that resets will peak in summer, 2010; then decline until March, 2011, only to peak again in the summer and fall of 2011. The number of resetting loans won't recede until September 2012. Since, it takes several months for homeowners to fall behind in their payments and several more months for their homes to foreclose, expect no end of foreclosures until spring, 2013.
   
   
3. The cumulative value of reset loans is about $1.8 trillion. While not all of these loans will foreclose, even a percentage (e.g. 30%, 40%, or more) of these loans foreclosing would represent an enormous loss of accumulated wealth.
   

Can't Congress do anything about this crisis?

Yes, they can . . . but don't bet on it happening anytime soon. The banking industry has successfully lobbied against any measures that might reduce foreclosures. For example, until 2005, bankruptcy law permitted courts to modify the terms of mortgages in bankruptcy proceedings. In 2005, Congress bowed to the demands of banks to pass legislation limiting the ability of courts to modify loan terms. Congress recently considered restoring this ability; but the bill did not move due to vigorous opposition from the financial sector. (Note that these banks used taxpayer bailout monies to "persuade" Congress of their position. Undoubtedly, some of the taxpayer dollars enriched a few campaign funds - a perfect example of a "green" recycling system!)

What does this mean for homeowners?

Housing prices have already declined substantially; in some areas, by more than 40%. If mortgages continue to reset as described in Figure 1, the market will be flooded with foreclosed homes and home prices will likely decline further. This deleveraging process will drive prices down far lower than might normally be the case in the collapse of a bubble. Ironically, the financial institutions that oppose efforts to prevent foreclosures would themselves suffer as they try to unload foreclosed properties in a glutted market. If this scenario comes to pass, we can expect the banks to come crawling to the taxpayers for . . . yes . . . yet more infusions of capital to keep afloat.

Commercial Loans: unfortunately, the practice of offering toxic loans also extended to the commercial sector. Figure 2 parallels Figure 1 by showing how commercial loans will reset in the next few years. Many of these are "toxic" loans which are likely to default, peaking in 2014 and subsiding in 2015. Their total exposure is about $1.5 trillion. If businesses start defaulting on these loans, many will shut down, leading to further job losses.

Figure 2. Leveraged Commercial Loan Resets


If left unchecked, these trends lower the prospects for economic recovery until 2015.


Federal Interventions

Stimulus Funding: during major recessions, government stimulus money can help prevent further decline. The social safety net of unemployment benefits, health coverage, etc. can play a critical role in stabilizing consumer spending and preventing a deflationary spiral such as happened in the 1930's. So, Congress passed the American Recovery and Reinvestment Act which directed funds to states to help stimulate the economy. ARRA should help stabilize the economy.

The downside, however, is that the substantial increase in public debt will be a burden for future taxpayers and, over time, could lead to a drop in the value of the dollar.

Money Supply: In addition to stimulus funding, the Fed has greatly expanded the supply of money. Figure 3 provides a historical perspective of the monetary supply, showing change in supply from the previous year. Over time, the change in supply tends to fluctuate between 0 and $100 billion. The last few months, however, have seen an unprecedented expansion to nearly $1 trillion. Flooding the market with money has been a key tool in keeping many banks afloat and has, perhaps, helped the country avoid a deflationary spiral.

On the other hand, such an enormous expansion in money supply greatly increases the risk of the dollar dropping in value and sparking an inflationary cycle. As the value of the dollar declines, imports and commodities become more expensive to American consumers. More alarming, however, is the impact on foreign investment. The U.S. is a "debtor" nation today, with much of our debt owned by foreign interests and especially China. A significant decline in the dollar could prompt these investors to sell their holdings to invest in more stable currencies. This would be akin to a slow-motion run on the American "bank". Should this occur, the U.S. economy would run the risk of higher inflation and a declining standard of living.

Figure 3. Change in Money Supply over Previous Year











Summing up: If the above indicators correctly capture key trends, we can expect:

1. Rolling waves of housing foreclosures, with continued decline in housing values. Homelessness and associated social ills may also increase.
   
   
2. Similar defaults in the commercial sector affecting small to medium businesses leading to renewed job losses and increased unemployment.
   
   
3. Despite the efforts of Treasury and the Fed to protect large financial institutions from losses, these trends - in the absence of Congressional intervention - will push more financial institutions toward bankruptcy. After investing trillions in taxpayer funds and more than doubling the supply of money, it will be difficult for the Federal government to do more if these institutions become unstable.
   
   
4. The above trends also put the country at risk for inflation and a decline in standard of living.