And the Wheels Fell Off…

For the first time since the Federal Reserve began tracking home equity data in 1945 the amount of equity homeowners hold in their homes fell below 50% in the fourth quarter of 2007 according to the Federal Reserve. More interesting still is the finding by Moody’s that approximately 10% of homeowners now have zero or negative equity in their homes. This resulted from a 8.9% drop in U.S. home prices in the fourth quarter of 2007.

And analysts are predicting roughly an equal decline in home prices in the first quarter of 2008. That will put nearly 20% of homeowners at zero or negative equity.

What happens if homeowners are genuinely the rational actors of neoclassical economics? They default on their mortgages the moment they reach zero equity and wait for the up to two years it would take for their lender to force them out by foreclosure. That means large-scale bank failures even with a massive federal bailout. Can we say the magic words “conjunctural crisis of capital”?

More below…

The only way out of this crisis is for lenders to recognise that the paper they hold on these homes is only partially secured and that they must renegotiate lower rates of interest with borrowers.

The most advantageous way to do this and still protect lenders is to allow bankruptcy judges to set lower intetest rates on defaulted home loans, as legislation proposed by the Democrats in Congress would permit. But does the mortgage banking industry see the writing on the wall? Most definitely not. Their lobbyists are holding adamant against any modification of bankruptcy law which would not permit them to squeeze blood out of every rockbottom homeowner in America, and doing so with Republican support, despite Fed Chairman Ben Bernanke’s pleas to the mortgage industry to renegotiate these clock-cookooland mortgages. The latest propaganda of the mortgage banking lobbyists projects an immediate two percent rise in all interest rates if the legislation passes. This is errant nonsense, pure scaremongering when they should be terrified at the consequences of their own shortsightedness.

I don’t know what will happen. Part of me hopes that the mortgage banking industry wil continue its shortsighted advocacy of raw greed. It’s been a very long time in America since we’ve had a stark reminder that the ultimate defence of the working man against corporate rapacity is a mob with shotguns and torches, and mass foreclosures on the anticipated scale is likely to rouse such a mob. Perhaps that’s what it will take to get a reasonable regulatory regimen to prevent the sort of madness that engendered this housing bubble in the first place. It was the threat of such mobs which made New Deal regulation palatable to Wall Street in the 1930s. But capital markets have notoriously flat learning curves, particularly it involves foregoing short-term gain for long-term survival.


  1. Greg,

    Were the banks dealing with corporate customers facing a squeeze, they surely would negotiate new terms rather than face the chance of losing everything. In situations like this, however, the banks think they have their borrowers over a barrel, where the choice is between impossible mortgage and homelessness.

    Especially over the last 8 years, where the wealth transfer from lower and middle class to the upper class has been so pronounced, we see the disparity between how individuals of modest means are treated, compared to how rich persons and corporations are treated.

    In the last banking crisis, the savings and loan bailout, a wealth transfer from us (average joes) to them (banks, wealthy stakeholders) prevented a meltdown. People put up with it because it prevented the loss of entire savings accounts and banking infrastructure.

    This time, millions of people are at risk of being on the street. I don’t think that a “solution” of yet more wealth transfer to the wealthy is going to fly this time. It should be interesting, in any event.

    Here on Martha’s Vineyard, there are two home markets: regular person houses, and luxury vacation houses. The regular person housing market seems to have leveled off, with houses maintaining value but not losing. The megahouse market may be cooling off, but it’s hard to tell because it’s not that big a market and the sample sizes are small.

  2. There is a old RE observation — “You lock your profit in when you buy. Riding the inflation curve is just the gravy.” — Still holds true. I sit in a townhouse with 70% equity and am about ready to pay it off. I was frugal and prudent.

    That being said, a lot of people were playing stupid in the RE market since 2000. Why should I as a taxpayer who was wise enough and thrifty enough be having to pay for the stupidity of somebody buying into a interest only ARM with 5% down? You don’t hear people clamoring for taxpayer assistance for somebody making a leveraged investment in the stock market who then gets a margin call. Both are the same economic play, just two different financial instruments.

    Then there are the moral hazards factors —

    * Meddling in existing contract structure rewards bad behavior. As a consequence, you will get more of that behavior.

    * People will make the assessment that there is no risk and no consequences to a bad RE deal. Again more bad behavior.

    * Once the Govt’s nose if fully in the tent it gives them the leverage to do as they will with any homeowners contract with a lender. And don’t assume that they will always be in the homeowners favor. Politics and campaign fund raising being what it is.

    Lastly, there is never a free lunch. By discounting existing mortgages by fiat the costs of doing so will show up in future mortgage rates. The additional risk to the banks will be factored in with 2% additional increase in base level rates.

    Consider it.

  3. John,

    You say, “Why should I as a taxpayer who was wise enough and thrifty enough be having to pay for the stupidity of somebody buying into a interest only ARM with 5% down? You don’t hear people clamoring for taxpayer assistance for somebody making a leveraged investment in the stock market who then gets a margin call.”

    But you’re wrong about the latter. When the Savings banks were failing in the S&L crises of the Reagan years, here came the taxpayers to bail them out.

    When Long Term Capital Management couldn’t make its margin calls, here came the federal reserve to organize a bail out:
    _Capital_Management” rel=”nofollow”>…

    I’m not saying that the taxpayers should bail out people who bought mortgages they couldn’t afford. Especially since a lot of those people were speculators.

    What I am saying is that it’s a myth that the government doesn’t bail out investors who get in over their heads. It does. But it bails out rich investors, not poor shlubs about to lose their homes. It bails out the millionaires. That’s what I object to.

  4. The problem with your assessment is that the Fed got involved because they were contractually obligated to assure the solvency of the FDIC. Ie. the $100k guarantee of Federal S&L’s to depositors. That was to cover the small guy’s money. As a consequence, the S&L bailout was an orchestrated event of one bank taking over another’s debt to protect the assets of Ma Frickert. The Fed relaxed the reserve rules on the buyer so that they could take on that debt and opened the discount window to facilitate it. The buyers had to do a write down on bad debt in the billions.

    But would not classify it as bailing out ‘rich friends’. The movers and shakers that fed at the S&L trough were wiped out as a result. Boone Pickins and others lost their shirt. Many went to jail for fraud. The poor ‘shrubs’ as you call it, were fully covered in the S&L mess. Which was the whole purpose.

    Nor is the comparison apt to the analogy I presented.

    In the current liquidity crisis, the Fed is already permitting quite a few hedge funds to go under as well as mortgage brokers (95 at last count).

  5. Hello John,

    The S&L bailout is complicated, with mainy parts to the story. Certainly there were Ma & Pa Frickerts who were protected by the S&L bailout. According to Wikipedia, which I believe to be accurate in this instance, causes 7, 8, & 9 or the crisis were:
    7. Fraud and insider transaction abuses were the principal cause for some 20% of savings and loan failures the past three years and a greater percentage of the dollar losses borne by the FSLIC.

    8. A new type and generation of opportunistic savings and loan executives and owners—some of whom operated in a fraudulent manner — whose takeover of many institutions was facilitated by a change in FSLIC rules reducing the minimum number of stockholders of an insured association from 400 to one.

    9.Dereliction of duty on the part of the board of directors of some savings associations. This permitted management to make uncontrolled use of some new operating authority, while directors failed to control expenses and prohibit obvious conflict of interest situations.”

    Plenty of these people got away scott free. There were plenty of instances of wealthy bank owners making loans to well to-do friends who then didn’t pay them back. That wasn’t the whole story, but it was a significant part of it. You and I paid the tab for that. It wasn’t cheap, neither.

    You didn’t comment on the Fed’s orchestrating a bailout of Long Term Capital Management.

    It appears, although it is not certain, that the Fed is propping up Citibank at this very minute. The incompetent executives at that outfit make more in a month than I’ve made in a lifetime, and yes, the taxpayers are paying for it, not just the stockholders.

    I’m all for preventing a financial collapse that would bring on a worldwide depression and all that. So let the Fed do what it needs to do. But don’t tell me the game isn’t rigged to support the support the high rollers. Its only logical that this is so, since they’re the people with the political clout. But it seems inconsistent if you don’t approve of the taxpayers bailing out homeowners who are going under but do approve of the taxpayers keeping afloat the biggest of the big fish. Yes, some hedge funds have gone under, but I’m not convinced that’s all there is to the story.

    But on a happy schadenfreude note, I saw where the Carlyse Group’s capital fund is in threat of ruin due to margin calls. Now, that would be amusing.

  6. Real irony for the Carlye Group is that they bought VZ Hawaiian Tel a few years back. They are still paying that off. If they fail, VZ might end up with Hawaiian Tel AGAIN as the carrier of last resort and largest debtor of record for the property.

    John I don’t approve of anyone getting bailed out period. Its back to my view of the ‘Moral Hazards’ aspects. You get the behavior someone is willing to pay for. I don’t want to sound like Jay Gould, but enough is enough. People need to shake out of this doldrum of a world without risk. The test in all this will come with the current AmBac problem in the muni bond market.

    Does the government bail out the muni holders or not? They ARE big fish based on holdings. But the backstory is quite a significant number of retirement funds are in the muni market. Eg California Teachers Union pension. Now one could argue that bailing out AmBac might be saving a ‘Big Fish’; but is it really if what you are doing is saving the pension fund position under it? Would it be rational for the State of CA to step in and save AmBac so as to save the pension? Some would argue yes and be right in their assessment.

    Way too many people thing that Wall Street is floating in money garnered from guys with big bellies. Quite the opposite is true. The largest source of funds today come from pension reserves and 401(k)’s. The very stuff that rank and file Americans have. Its millions of $100k positions that form the capital that Wall Street utilizes.

    But you wait, if the CA PF is threatened the Feds will step in. The Pension Guarantee Fund is barely solvent. Should the CA PF need to be covered the PGF would be in possible collapse. It could get very nasty.

  7. I know a thing or two about risk. When the business that my wife and I had failed in 1992, we used proceeds from the sale of our house to cover debts. It was another 17 years before we owned our own home again, and during those years we had lots of rough patches, including a short period of homelessness. On the idea of “no risk, no reward”: sometimes it’s “risk, no reward.” I get it.

    I think the government has an interest in doing what it can to protect the integrity of the system on behalf of people modest means. The idea of a social insurance to protect some kind of baseline quality of life seems natural and normal and right to me. I mean, we do have a fire department in my town, and a police department. I also live in a country that has armed forces– all instances of the government intervening in “the market” to spread risk and guarantee a baseline level of protection to all.

    One does see, of course, a consequence of the absence of Moral Hazard in the conduct of our imperial policy. Because the rich don’t serve in the military but benefit from its mercantile and imperial policies, they get the financial benefit without the risk of having their arms and legs, or the arms and legs of somebody they love, blown off in an IED attack. This situation makes me open to the arguments in favor of universal compulsory military service, or a random draft.

    I don’t like the situation where a teacher (or soldier!) is set to lose $50k hard-earned, while the hedge-fund manager walks away with his $20M bonus intact. There’s a big difference between playing with Monopoly money and investing your life’s savings in a pension, or in your home.

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