Monday, February 04, 2008
John Bougearel
SuccssfulTradingTips.com

Can Overindebtedness in the Housing Industry Lead to a Debt-Deflation Spiral and Collapse of the US Economy?

"No emergency can justify the return to inflation." Ludwig Von Mises said eons ago. So what would Von Mises say in response to the current cycle of aggressive monetary easing by the Fed, I wonder?

As bad as the inflationary pressures are emanating from the energy and commodity sectors, there is a strong deflationary headwind playing out in the housing market and taking hold of the economy in a manner similar to the gripped the US economy during the Great Depression of the 1930's.

I mean, why else would the Fed so aggressively and so suddenly attempt to stimulate the economy with excessive monetary ease and advocate swift and decisive government intervention with fiscal stimulus? Do you think they don't know the moral hazards of what they are doing? And why did George Soros just last week go on record as saying that the US economy has reached the culmination point of a sixty year credit boom and that we were now entering an era of a prolonged and painful credit contraction?

It seems that what appears to be at stake here are the risks of another debt-deflation spiral like we had in the 1930's and therein lies the Feds' concerns. Even if they won't speak of the downside risks in more than an opaque sense, others are beginning to sound the alarms.

Consider this if you will: "In the fourth quarter of 2007, new foreclosures averaged 2,939 a day, double the pace of a year earlier. In the 1930s, lenders were seizing homes at an average rate of 3,000 a day, adjusted for today's housing stock size," according to RealtyTrac Inc.,

US mortgage foreclosures are set to top 1 million this year and home prices are falling at the fastest pace since the Great Depression. Bloomberg reported that the median home prices peaked in July 2006 at $230,000, and as of January 2008, the median home price has fallen 9.5% to $208,400 eighteen months later.

Merrill Lynch's economist David Rosenberg sees "potential for another 25% to 30% downside over the next two years" in home prices on top of the already 9% drop. A 35% drop from the peak median home price of $230,000 essentially reprices it to $151,000 in 2010. Many homeowners at risk have no money down in their home. To a degree then, the financial burden will not fall on the homeowners losing their homes, but back on the financial institutions and loan originators involved in this whole credit creation/lending process - as well as US taxpayers.

Financial institutions real debt burdens are beginning to soar amidst a current debt deflation crisis created by escalating foreclosures and falling home prices. To mitigate the burden of this growing crisis, there is anecdotal evidence banks are beginning to liquidate these unwanted assets at firesale prices. Deutsche Bank and other banks have been slashing prices on repossessed homes to get rid of them. In a recent transaction mentioned on Business Week's Hot Property blog, Deutsche Bank sold a house in Woodbridge, Va. in December for $150,000, less than half its last sale price of $315,000 in the spring of 2005.

If the median home price declines anywhere near 25%, this could spell T-R-O-U-B-L-E for the U.S. economy. "Keep in mind, says Merrill's Rosenberg, that the relatively puny price decline to date has already pushed home-loan delinquencies to their highest level in 20 years."

The Call for Intervention and Lots of it
Lehman Brothers Thomas Russo said "The direction we are heading isn't a good one. We need significant fiscal and monetary intervention. The measures being taken by the Hope Now program to freeze ARM resets being advocated by everyone from Treasury Secretary Henry Paulson, GS, JP Morgan, "just aren't enough" says Russo.

"The whole financial system has taken an amazing hit already and the bulk of the mortgage resets are still to come...declining home values will prompt people to snap their wallets shut [leading to underconsumption]. ...About $550 billion of subprime loans will reset before 2009 and most borrowers will have no option except to walk away because the drop in home prices and an increase in lending standards will prevent them from refinancing or selling."

Housing Crisis is Already Reaching Catastrophic Proportion
William McCarthy, a 62 yr old mortgage broker who declared bankruptcy in July 2007 when his 18 yr old mortgage business failed said he had "a client who called me sobbing because his wife committed suicide rather than face eviction."

McCarthy himself is facing eviction Feb 11 after his lender foreclosed on the interest only ARM he and his wife took out in 2005 for a ranch home without stairs that would benefit his wife's heart condition. Their plan was to sell their old residence before the ARM reset on the new mortgage, but the old home never sold. "Now, they are losing both properties" reports BN. His wife "goes to bed crying every night, and there is nothing I can do" says McCarthy. The banks won't even return my calls."

But Will Intervention Work?
However much Russo and others would like to see interventionist methods work, many government agency programs simply are not working as hoped for. President Bush proposed helping 1 million subprime borrowers avoid foreclosure with state tax exempt bonds, but "states down want the risk any more than private lenders do." States and state municipalities are in a boatload of fiscal trouble to begin with. Falling home prices mean falling property tax receipts. If anything, they will have to borrow money to stay afloat themselves!

But that is not even the issue - 'yet.' State housing agencies already offering refinancing options are finding that "more than 50% of subprime borrowers are being rejected by state programs because their homes have lost too much value or they have accumulated too much debt. Often the borrower just has too much debt and the home does not have the value to support the refinancing" said Geoffrey Cooper at MGIC. That is the beauty of how negative amortization and MEW works.

Dawn Larzelere, director of the Ohio Housing Finance Agency found many applicants to be ineligible because they'd missed a mortgage payment in the last year. "I don't think our lending standards are too high. I think people have gotten in too far over their head" she said.

It is for reasons like this that Alex Pollock, former president of the Federal Home Loan Bank of Chicago, is urging "the creation of a federal lending agency based on the Home Owners Loan Corp., or HOLC, created by Congress during the Great Depression."

An Eternal Hosing Boom is Out of the Question
General economic theories about 'overinvestment' and 'overindebtedness' suggest that once a boom ends and the contraction begins, the economic downturn is accompanied by deflation. That certainly seems consistent with where are current boom-bust cycle in the US housing market appears to be headed.

Wilhelm Ropke described the phenomena as follows, "the credit expansion setting the boom going proceeds by way of the interest rate being 'too low.' The too low rate invited a general increase in investment which then leads the mechanism of the boom drifting towards its ultimate debacle. ..Introducing a general overinvestment disrupts the equilibrium of the economic system.

It allows more to be invested than is saved and makes available the necessary increase in money capital from credits which do not originate from savings but are created out of nothing through the banking system...The demonstration that the credit expansion of the boom leads to overinvestment provides at the same time a proof that the capital formation induced by credit creation, and the extension of production that it sets going, leads to a painful reaction expressing itself in the crisis and depression. This reaction can indeed be postponed by a further increase of the credit supply but only at the price of a corresponding aggravation of the ultimate reaction. An eternal boom is therefore out of the question. - Crises and Cycles circa 1936

Laissez-Faire Economists of the 1930's
Elaborating on the solutions attempted by the government and Federal Reserve during the 1930's Freidrich Hayek observed that, "To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which bought it about - because we are suffering from a misdirection, we want to create further misdirection....We must not forget that for the last six to eight years monetary policy all over the world has followed the advise of the 'stabilisers.' It is high time that their influence which has already done enough harm should be overthrown." - Monetary Theory and the Trade Cycle circa 1933

A century before Von Mises, Ropke, and Hayek, there was John Stuart Mill, another laissez-faire proponent who held the opinion that "in all the more advanced communities, the majority of things are worse done by the intervention of government than the individuals most interested in the matter would do them, or cause them to be done, if left to themselves." - Principles of Political Economy, circa 1848

Modern Day Laissez-Faire
Echoing Wilhelm Ropke of yesteryear is Pimco's Mark Kiesel who has recently been quoted as saying that "rescuing borrowers will only worsen the economic misery for everyone. Keeping the market from correcting itself only prolongs the problem....The housing market will find its own bottom, without a government bailout." Kiesel, I think, is suggesting that market forces today are akin to the debt-deflationary spiral of the 1930's and that they are simply far more powerful than any interventionists measures can hope to achieve. Certainly, the evidence thus far suggests that intervention up to this point
is having very little impact on the evolving housing crisis to date.

Debt Obligations of Every Description Running Everywhere
Irving Fisher, another economist who lived through the roaring twenties and the Great Depression, believed the "great cause of overborrowing" was easy money. "The depression grew out of a boom, which started in a credit currency boom, which started from a debt boom...there were international debts of every description, long and short, public and private, the obligations running in every direction."

Debt Obligations of our Modern Day Shadow Banking System
What Fisher describes about obligations running in every direction back in the 1930's is eerily similar to the modern day runs on our Shadow Banking System (a term coined by Bill Gross and Paul McCauley and which I have written about in earlier reports), where subprime counterparty risks are unknown and unquantifiable, morphing into a thousand "Waldo's" popping up everywhere as the housing crisis deepens.

The heavy debt burdens borne by subprime borrowers today are fast becoming heavier with falling home prices and ARM resets. The big fear today is that falling home prices amidst ARM resets they can ill afford will lead to distressed selling which will further depress already falling home prices - creating the very same debt deflation spiral that Irving Fisher gave witness to 70 years ago.

The Liquidation Stampede
Irving Fisher goes on to say that "if liquidation for some reason gets into a stampede, it wipes out credit currency, which lowers the price level and reduces profits, which forces business into further liquidation, which further lowers the price levels and reduces profits and so on and on - a tail spin into depression, ...We now come to the paradox that if the debt gets big enough, the very act of liquidation puts the world deeper into debt than ever.

Each dollar represented in the unpaid balance grows faster than the number of the dollars reduced by liquidation. Payments could not catch up with the 'real' indebtedness - the more we paid the more we owed...the peoples real debts heavier than in 1929, heavier than in 1932, heavier than ever before in all history. Their interest, rent, and taxes are also heavier, and at the same time, their real income and real wealth are less."

Props to Consumption are Disappearing Fast
According to calculations by Macroeconomic Advisers, the last time household real estate, stocks and real incomes all declined in a quarter was during the 1974 recession, reported Bloomberg on Jan 29. `Wealth had been rising because of strong home prices'' and stock gains, said Chris Varvares of Macroeconomic Advisers.

``Now, we are losing that prop to consumption, so it all comes down to growth in real income.'' As these three-legged props to consumption are all flattened out simultaneously, the downward risks to consumer spending and 'underconsumption,' as well as the economy begin to mushroom. The only viable prop left to the economy may just be a huge increase in gov't spending (see Gross' comments below).

We live in times with striking parallels to Ropke's and Fisher's 1930's style depression. We already have rising interest rates on falling home values (via ARM resets) and overindebtedness. Just how far are we from the brink of a 1930's style liquidation that "gets into a stampede?"

How badly this story plays out in the end, no one has a clue. Do the interventionists and 'stabilizers' save the day? Or will the boom-bust theories of Laissez-Faire economists Ropke and Kiesel come to fruition simply because market forces are just too powerful?

The D Word for Deflation and Depression
One thing is crystal, there is unanimous consensus, even if the D word has yet to be uttered, on both sides of the camp that the US economy is at risk of entering the mouth of a debt deflation spiral, one which could put us on the brink of economic collapse reminiscent of the Great Depression. I am not saying the scenario is a plausible one, but this worst case scenario is more real and more tangible than at any other time in my life.
Bill Gross in summarizing the main tenet of Paul Krugman's book "The Return of Depression Economics, 1998, argues that "the crucial task of future policy would be to bolster demand as was the case in the FDR-driven 1930's as opposed to encourage supply which has been the case since the Reagan revolution."

"Because', Gross goes on to say, ‘demand in the form of consumption has been artificially and fictitiously stimulated in recent years by financial engineering run amuck, there is a legitimate question as to whether its black hole imploding destructiveness can be totally countered with another dose of lower yields and deficit spending packages. The $150 billion "return to sender" deficit plan advanced by Bush and the Congress, for instance, amounts to just 1% of GDP and is of marginal benefit to long-term prosperity'...

'The U.S. needs a Krugman "demand-based" fiscal package alright, but a $300-$500 billion permanent one, because as the system of modern day levered shadow finance slows to a crawl or even contracts at the edges, its ability to systemically fertilize economic growth must be called into question. To provide a stable recovery path, government spending needs to fill the gap - not consumption. Public works programs, badly needed infrastructure repairs, as well as spending on research and development projects should form the heart of our path to recovery.'

"As Keynes theorized and then Krugman affirmed, when private demand falters, it becomes the responsibility of government to fill the breach. Because it likely will not do so effectively until after a new Administration is elected in late 2008, the U.S. economy and its somewhat coupled global companion will sleep walk for some time and a resumption of prosperity as we knew it will be dependent on reforms of monetary and fiscal policy resembling the 1930s more than our past decade." - Gross' emphasis not mine

Sources:

Business Week
Bloomberg News
Pimco.com
Marc Faber - Tomorrow's Gold