It's no longer possible for the bank executives who brought us this all-consuming financial crisis to plead "No one could have seen it coming!" Even the mainstream media are on to this falsity. They are publishing top ten lists of the perpetrators who caused the financial crash, and the now-celebrated few who predicted it, among them Nouriel Roubini, Robert Schiller, and Warren Buffett. But they tend to miss the blogs that, even more so than the professional economists, predicted quite well what would happen and how it would go down (literally). To help redress that omission, the blogs need to speak up. It is time, therefore, for one blog that got it right to lay out its case. It is time to do some serious bragging here at The Agonist!

There are some other reasons for speaking up now. Republicans and their "intellectual" noisemakers are perpetrating another round of historic revision, by suggesting that this crisis was brought to us by the Democrats and their love for Fannie Mae and Freddie Mac. These actors are said to have forced lenders to extend mortgages to poor people and minorities who are now defaulting in droves. While Fannie and Freddie kick-started the housing boom, the mortgages causing all of our woe were written from 2004-2007 when Fannie and Freddie were essentially out of business, nursing their accounting problems. It was Wall Street investment banks which took over the mortgage business in 2004 and abandoned all sensible credit standards. It is their loans and their securities which are the source of this problem, and it is not merely the historical record that is proof of their culpability; it is the fact that they themselves are now all bankrupt.

A second concern is that the knives are coming out for Nouriel Roubini, Robert Schiller, and others, arguing that they were perma-bears who just had to sit around and eventually be right when markets turned sour. Moreover, they were never very specific about what would happen. This is the standard gripe about those who are bearish, and the only way to counter it is to cite articles which were timely and deadly accurate in their predictions.

To correct these impressions and make the case for The Agonist, I am going to reprint here a September 15, 2005 post. Lest it appear that this is just an exercise in self-aggrandizement, let me say that my opinions on the housing bubble have been a distillation of the thinking of many others. Among professional economists and market analysts, besides Roubini and Schiller, others who have been prescient include Robert Prechter, Doug Noland and his colleagues at Prudent Bear, Jeremy Grantham, the editors of the contrary investor, and Bill Fleckenstein. It must be said that these commentators along with others, up until last year, were often ignored, ridiculed, or relegated to the lunatic fringe of the business world. It is very hard now to communicate to you what the environment was like up until 2007, when denial of the housing bubble was the mainstream thinking (by no less a figure than His Eminence Alan Greenspan), and the media rarely allowed dissenting opinions to appear. These people who spoke up about the mainstream insanity literally risked their professional reputations and their careers.

Because the media cheered on the housing bubble without question, you had to search for contrary thinking on the internet, and at a select few blogs like The Agonist (by now I think we have earned a capital T in "the"). This is not a place for polemics, or histrionic attacks on others. You have to present solid arguments to survive here, and thread commentary keeps all of us as writers constantly focusing and refining our arguments. Sean-Paul Kelley creates this environment, and if you think that is easy, think about all the other blogs where the ego of the owner dominates content and behavior. Besides the influence of Sean-Paul, my thinking has been developed and altered by so many here, among whom are Stirling Newberry, Ian Welsh, mauberly, Gandalf (in the old days), jwp, Brian Downing, Tina, Rick, Hannes, Michael Collins, bernardene, Escher Sketch, tjfxh, vonbahr, I Did Inhale Don, Tonsure Wimple, Synoia, canuck, dk, Phil, JustPlainDave, chicago dyke, adrena, Tony Wikrent, raja, Petronius, jonathryn, Chickadee, AMC, Buddhasixfour, jbaspen, brodix, justadood, barris j redux, nymole, creativelcro, steelhead, Sun Tzu, joaquin, nihil obstet, HongPong, caribdude, Doug Richardson, artappraiser, and others past and present who have kept us writers honest. If I missed you don't be shy! Send me a pm and I will be happy to edit the list.

The point is, a community of intelligent people have seen things developing that many, many others could not or would not. We have a right to celebrate! My own contribution consists of two things: I like to write English (as opposed to what passes for English by experts like Alan Greenspan), and as a trader I overlay a heavy dose of market experience when trying to predict what the financial markets will do. So in the following article, I tried to foresee what the trigger point would be that would burst the housing bubble, and two years later Bear Stearns was very happy to oblige. I am reprinting the article in full rather than linking to it, because it has long since exited the cache.

Get Your Brickbats Here!
Being a five part series on life after the housing bubble bursts
September 15, 2005

Here's a bit of trivia you can file under the category of "My How Times Have Changed." In 1980, U.S. homebuilders were so incensed at the anti-inflation policies of the Federal Reserve that as a protest they pasted postage stamps on bricks and sent them through the mail to Fed Chairman Paul Volker. Those contractors who couldn't afford the postage for a brick - and there were thousands facing bankruptcy at the time - instead mailed door keys representing all the homes not being built.

When Paul Volker was appointed Fed Chairman in August, 1979, the consumer price index was raging ahead at a rate of 11.3% p.a. He quickly put in a series of policies designed to eradicate excessive inflation, and the principal weapon he used was high interest rates. By October, 1981, the prime rate at major banks reached 18.5%, and mortgage rates were higher still. Housing starts in the U.S. collapsed and did not begin a recovery until 1983.

Here's a second bit of trivia you can file under "And You Say There is No Housing Bubble." In 1980, at the peak of the inflationary scare, housing prices were increasing at an annual rate of 15.6%. Twenty five years later the U.S. is once again experiencing similar inflation in housing values; for the month of June, 2005, U.S. housing prices increased at an average annual rate of 14.7% (in many markets on the coasts the increase was much higher).

You would think the Federal Reserve would be just as worried now about excessive rates of asset inflation as they were in 1980. But you would be wrong. This time around, the Federal Reserve is doing nothing about the inflation in housing markets, and homebuilders are quite content that nothing needs to be done. The arguments the Fed makes in support of this inaction are that it is not responsible for asset inflation; there is no leakage into the general price structure from housing inflation; there is no national housing bubble; and while there may be some future decline in house prices in some markets, it won't have significant impact on the national economy. In other words, this is a benign form of inflation best left to market forces to temper.

Why Home Prices Will Head Down

But is the inflation in housing values quite as benign as the Fed has claimed? Lately even Alan Greenspan has begun to suggest that investors and consumers are over-reliant on asset price gains to support their spending, and more than likely housing prices in some parts of the country will be heading down. It may be way too late for the Fed to do anything about it, but at long last the Fed is recognizing it has an asset inflation problem on its hands, one that is no different than the inflation faced by Paul Volker (who, by the way, has for some time been warning about this impending problem).

This also means that the Fed has now joined the "rubber band" crowd - those economists who believe housing values are stretched so far from their norm that they must eventually snap back. There are several ways to express this argument.

The first method is to rely on some basic numbers, which are eye-popping in most cases. For example, since 2002 the median price of a home in the U.S. has increased 40%. In the western states the median value has increased 50%, and in the northeast 56%. Someone owning a $200,000 home in California in 2002 now owns a $300,000 home. It's hard not to notice the paper profit of $100,000, and it is harder still not to extract and spend that profit with some of the creative financing techniques around that allow the homeowner to "remove some cash" from their property.

How is this happening when the economy is growing at best at a 4% annual rate? What is the likely trajectory of home values in the future? Is the $300,000 home in California going to continue to increase forever at a 15% - 20% annual rate? Will housing values somehow stabilize at these lofty levels? Or will values actually decline?

Anyone with some basic experience in the financial markets will tell you that only in hyperinflationary economies can you expect asset values to increase annually at double digit rates for long periods of time. Even then, the system ultimately crashes and values fall back to some median price existing before the hyperinflation took over.

Statisticians tend to say that in many markets prices are "mean-reverting" - prices revert to a long term average. The statistical argument regarding housing prices today is that the values being seen in the market are now two to three standard deviations away from their mean. This is another way of saying that a few years ago one would have predicted only a 1% -5% likelihood that we would see housing prices at today's levels. Those who study markets over long periods of time identify price variances of this magnitude as evidence of a financial bubble, and in every case known in the past, prices do eventually move back to their mean value.

In other words, whether you look at the housing market from an economic or statistical point of view, housing prices are stretched like a rubber band and will mostly likely snap back to some average level. It is not necessary to describe the housing market as a bubble to come to this conclusion.

If you accept this conclusion, the question then becomes, what happens to the California homeowners who have cashed in $100,000 of profit, and find themselves with a mortgage of $300,000 on a home worth only $200,000? What happens to the bank holding the mortgage? Is government going to step in to help with situations like this?

We'll look in turn at each of these three players - the consumer, the financial industry, and government, to see how each is likely to respond to a downturn in home prices.

The Consumer

For homeowners, the annual appreciation in the value of their home has usually corresponded very closely to the general price increase in the economy. This relationship held steady from the end of World War II until about 1996, when it began to decouple. Since then, housing prices have increased at rates noticeably faster than those of consumer price inflation, and the rate of increase has been steadily accelerating.

This decoupling has had a profound psychological effect on homeowners. Prior to 1996, homeowners could not expect housing price increases to compensate them for general inflation in the economy. This also meant that if homeowners wanted to build up equity in their home, they had to do it the hard way, by repaying the principal due on their mortgage.

Following 1996, a miracle began to occur - the market itself was providing an equity build-up through home value appreciation well in excess of the rate of inflation in the economy. The homeowner now had an ally in paying off their mortgage, and as the U.S. is now approaching ten years of accelerating home value appreciation, the behavioral changes have been profound.

Consumers have discovered they don't have to pay principal at all if they don't want to. They can merely let their house appreciate in value, and as interest rates fall they can refinance the mortgage to pay back some of the principal. In an ideal world filled with prudent investors, this is what many homeowners would have done.

But a combination of economic recession, persistently slow wage growth, a collapsing and then stagnant stock market, and mortgage banking ingenuity, have all conspired to induce many homeowners to do the opposite. Rather than paying down their mortgage, homeowners on average have been increasing their debt. Homeowners can "cash out" some of their equity by refinancing their mortgage, and the cash can be spent on vacations, new cars, college education - banks no longer ask questions about where the cash proceeds are going. Consumers can even use this profit to invest in a second or third property, thereby taking advantage of the appreciation in value sure to occur down the road.

The concept of paying down your mortgage now seems quaint to many homeowners. People talk glibly of moving from property to property without ever making a principal repayment, and being able to do so through the miracle of home value appreciation.

This way of thinking, incidentally, is another good argument why housing prices are likely to fall. What the market giveth, the market will taketh away. There is no such thing as a sure profit in a free market, and housing is no exception. When investors spend five to ten years operating on the basis of guaranteed profits in a particular market (and this bias is now so deeply ingrained in the housing market that homeowners have a hard time imagining any other sort of world), then the market is highly likely to extract five to ten years of penance from these same investors. This pain is almost certainly to come in the form of at least five years of housing price declines.

Who will this pain affect the most? Homeowners can be ranked according to their susceptibility to a fall in housing values, from most to least susceptible. The most susceptible are those who are likely to be underwater as housing prices fall - i.e., their mortgage exceeds the value of their property. Given the high ongoing costs of maintaining property (taxes and material upkeep), such homeowners are more likely to sell the property at a loss. At the very least they are stuck living in their homes as long as they can afford the monthly mortgage, because otherwise they will have to sell at a loss.

Here is a ranking of homeowners by susceptibility to price declines (from most to least susceptible):

* Investors who have bought a home in recent years purely as an investment and not to live in. These investors have no personal stake in keeping the home if they are underwater - they can merely turn the home back to the bank and take a tax deduction on their capital loss. Many such investors expect to be able to rent out their property to cover their costs, but this is an unlikely scenario for most of them. Rents are already at depressed levels, and they will be heading lower as more investors reduce their rental rates in order to cover at least some portion of their costs.

* Homeowners who have bought a home in recent years using interest only or negative amortization mortgages. These homeowners do not have the sophistication to understand that they purchased a mortgage with an option attached, the option being the right in the early years of the mortgage to pay less or no principal and interest. The bank demands a premium fee for this option, which is paid upfront by the consumer in the form of points. Ultimately, however, the consumer will have to pay the bank principal and interest as if they had purchased a standard thirty year fixed rate mortgage, and they will also have to pay interest on the deferred principal and interest. These compensatory payments may begin three, five, or ten years into the loan, but somehow the bank will get its compensation. If the consumer wishes to sell the property and close out the mortgage, the bank will demand all of the necessary compensation then and there for the deferred payments that have occurred. The consumer will discover they have a much greater capital loss on the property than they expected.

* Homeowners who have increased their mortgage in order to take cash out of their property. These homeowners have fallen prey to an illusion fostered by the mortgage industry - that property price appreciation is something the homeowner has earned. The mortgage industry likes to talk about taking cash out of a property that has appreciated in value, but the industry never mentions that the only way ever to realize the value in a home is to sell the property and either rent or move to a smaller home . Taking on a higher mortgage for the purpose of spending is really doing two things: exchanging debt for cash, and gambling that the appreciation in home value will be permanently there until such time the homeowner actually does sell the property.

* Homeowners who have refinanced without increasing the size of their mortgage, and who have taken out some cash from their property. These homeowners have not added to their debt, but they are still gambling that their property value will stabilize or go higher over the life of the mortgage. If at some point property values fall, the homeowner could wind up underwater, because by taking cash out they have reduced the cushion between current property values and their mortgage balance.

* Homeowners who have refinanced without either increasing the size of their mortgage or taking cash from their property. These homeowners have lowered their monthly payments by refinancing, and have maintained the maximum cushion available between their property value and their mortgage balance. They are therefore less likely to find themselves underwater than other homeowners, but if the local decline in property values is significant - on the order, say of 50% decline over five years - even many of these prudent homeowners will be swept up into the list of those with underwater mortgages.

* Homeowners who have not refinanced and who have been paying down their mortgages regularly. These homeowners are less likely still to be affected by home value declines, depending on what portion of their principal they have retired through repayments.

* Homeowners who own their home outright and have paid off their mortgage. These people are becoming rare - they are usually a refugee of Great Depression thinking, or someone so wealthy they can afford to pay cash for their home. Even they are not immune to a decline in housing values. They will at least need to replan their retirement to the extent a sale of their home at a high price was part of their retirement objective. They may also wind up paying higher property taxes as the pool of property owners shrinks.

Notice as you go down this list that those most susceptible to a decline in housing values are those who are most dependent on property value appreciation in the future to get them out of their mortgages. The extent of their dependency will determine which of them will sell their property at a loss. But for all such homeowners, a general decline in property values will cause a sudden freeze in their expectations of moving to another property in the next few years - rather like a game of musical chairs when the music stops.

The great majority of homeowners will be stuck in their property for far longer than they anticipated; being underwater in a mortgage determines, for example, whether someone will want to take a new job in another city. The new job would have to compensate for the capital loss on the sale of their house.

There will be millions of homeowners who eventually will be forced to sell their home at a loss. The sequence of those who will be obliged to sell will pretty much follow the list above; the most susceptible to a decline in home values will be the first "out the door", so to speak. Each successive sale will put pressure on the remaining homeowners and on home prices, and as the price median ratchets downwards in one community after another, a "death spiral" of selling infects the market. This is the reverse process of the virtuous cycle of buying and price increases which have brought the market to its present over-valued state.

There will be other factors accelerating the death spiral set to afflict home values. As will be discussed later, the decline in home values will reverse all the positive affects the housing boom has had on the economy. This will lead to recession, which will lead to layoffs and eventual salary cutbacks for millions of employed workers. A general deflation will set in, wherein price levels across many products and services (with the possible exception of health care) fall in nominal terms. Workers will not be tempted by a succession of price declines, because they will not have the cash to make any but the most essential purchases; they will not have their homes to use as piggy banks; the stock market will be moving down in tandem with the economy; and for millions of baby boomers retirement will be approaching just when their retirement kitties are being depleted by market forces.

We can postulate a number of other economic and social developments connected to a decline in housing values. McMansions or any property with high maintenance costs will fall out of fashion. Frugality will become a new virtue, and extravagance in home furnishing and amenities will be considered poor taste. Families will double up in a home in order to share costs and prevent a forced sale of the property. All consumers, but baby boomers in particular, will return to the hard work of saving out of income rather than expecting the market to do it for them. Having been disappointed first in the stock market, and now in real estate, consumers will be distrustful of just about any savings vehicle other than cash. This will have serious impact on consumer spending and the health of the economy (as we shall discuss later). Finally, consumers will be hesitant to blame themselves for their problems. Instead they will blame the banks who led them into imprudent borrowing, and this will be a strident criticism from consumers because they will be waking up for the first time to the amount of debt they owe. A new fashion will rise among consumers - they will want to be debt free. The Suze Orman's of the world are already preaching this gospel, but it will become a universal theme taken up even by religious preachers sermonizing on how to lead a good life. Rest assured that the brickbats will be flying as well at the politicians, who will be accused of failing to regulate the housing market.

The Financial Industry

The picture described above for the consumer is certainly grim, but it is typical of the economic pain associated with the bursting of bubbles (especially one affecting so many consumers). But worse pain will be felt by the financial industry - that amalgam of commercial banks, investment banks, mutual funds, hedge funds, pension plans, mortgage brokers, real estate agents, credit card issuers, and other intermediaries who have become dependent on real estate for their profitability.

Financial bubbles are always and everywhere created by misallocations of credit. In a normal business cycle creditors are prone to loosen their credit standards as economic growth continues. This has to do for the most part with competition; as one bank reduces prices or liberalizes credit terms to build up business, others must follow. It takes a brave bank to purposely go against these trends, because it might mean permanently losing valuable long term customers, and it certainly means watching your stock price suffer from an unforgiving equity market that worries only about next quarter's earnings. As the economic cycle progresses, most banks take on credit risks they were rejecting during the last recession, and ultimately banks find when recession hits that part of their portfolio is damaged, forcing the bank to increase their reserves for credit losses. Well-managed banks cannot escape this damage, but they will avoid excessive losses that would otherwise seriously damage the institution.

In a financial bubble the credit process becomes highly distorted because the banks develop the belief that they have successfully eliminated the credit risk associated with many of the loans they are making. Often the bubble occurs in a financial product that requires collateral, a commodity that is deemed essential, or with borrowers who are viewed as "too big to fail". The banks believe they themselves hold only a small amount of credit risk, and have eliminated all the rest with "risk mitigation" techniques.

What is little appreciated is how dependent banks have become on real estate loans. Prior to the 1990's, real estate lending was a secondary source of business for banks, behind the business of lending to corporations. By 1988 real estate loans had crept up to parity with commercial and industrial business loans - the banking industry in the U.S. had about $600 billion of assets in each category. Since then there has been a dramatic reversal; commercial and industrial loans have plodded along, and by the start of 2005 had grown from $600 billion to $1.0 trillion for the banking industry as a whole. Real estate loans in the same period grew from $600 billion to $2.7 trillion, dwarfing the traditional business of lending to corporations, and swallowing up well over 50% of bank balance sheets. Banks aren't exposed simply to rising defaults on these loans; their revenue stream is hurt if the real estate business simply slows down.

What the banks will tell you is that most of the real estate business they have done is no longer on their books, having been sold off as mortgage-backed securities (in the MBS market). Moreover, what is left on their books has for the most part been guaranteed by the two major Government Service Entities (GSEs) for the housing industry: Fannie Mae and Freddie Mac. In their thinking, banks have a triple safety net: the ability to sell off their real estate loans to the GSEs or into the vast MBS market, the guarantee from the "government" for most of the loans they do hold, and the collateral behind these loans on their books.

More than anything, the "put" to the federal government represented by Fannie Mae and Freddie Mac has fueled the real estate boom. It represents a massive form of what central bankers call "moral hazard risk", which is the trap lenders fall into when they believe they have a central bank or government ready to bail out borrowers who get into trouble. Moral hazard risk invariably leads to very loose credit standards and often to outright fraud in the credit process.

Fannie Mae and Freddie Mac hold about $1.5 trillion in mortgages on their balance sheet, against which they carry about $30 billion of capital. Their ratio of capital to loans is minuscule in comparison to what a commercial bank must maintain, but they have gotten away which such a small amount of capital for years because as institutions chartered by Congress, they act as if they have a guarantee from the U.S. government for all of their obligations. Recently Congress and the Federal Reserve have been trying to convince the market that there is no such guarantee, but it is way too late for that. If any significant portion of Fannie Mae's or Freddie Mac's mortgage portfolio were to go into default, Congress would have very little choice but to bail them out.

Congress needs to worry about much more than that, however. The GSEs have guaranteed trillions of dollars more in mortgage obligations that are packaged into mortgage-backed securities. Any meltdown in the mortgage market would no doubt throw hundreds of billions more of defaulted loans back on to the books of the GSEs, requiring an even greater capital injection from Congress.

All the pressure that has been building on the GSEs to slow down their growth and instead build up their capital has had an affect: the GSEs have not been adding significantly to their balance sheets for almost two years now. With the "lender of last resort" no longer there to back up bank lending, you would think that banks would slow down their own issuance of mortgages. But this has hardly been the case, because the MBS market has stepped in to replace the GSEs as a lender of last resort.

The MBS market now amounts to about $6 trillion in mortgages outstanding, and it is largely an unregulated market. With the GSEs effectively out of the picture, what has kept the housing market churning along for the past two years has been the ability of the MBS market to package and sell ever-more risky pools of mortgages, such as interest only, negative amortization, and no income verification mortgages. These types of instruments in any event would not have been purchased by the GSEs, so what has really been occurring is a sharp downshift in credit standards for the market as a whole.

Who is buying these packages of risky mortgages? Pretty much any organization that wants to earn a higher return than the meager 2% - 3% interest rates offered by the Federal Reserve for short term money. This means first and foremost the hedge fund industry, followed by mutual funds, pension plans, university and charitable endowments, and even the banks themselves who find real estate risks creeping back onto their balance sheet through their securities portfolios. A secondary source of investment has been from overseas, since foreign investors find the dollar extremely cheap. Individual foreign investors are said to be a major source of condominium purchases in frenzied markets such as Miami. What is undeniable is that the average American owner of a mutual fund would probably be very surprised that any real estate is owned by their fund, since this is often not the primary investment aim of a mutual fund.

Financial firms will be further surprised at how mistaken they were in pricing exotic mortgages, and how much outright fraud there is in the business. Just as the average homebuyer cannot possibly determine the true cost of the option they are purchasing with an exotic mortgage, only a handful of very large commercial and investment banks have the technical expertise to determine how to price these options. And even then, these banks know they must be highly conservative in doing so, because the volatility assumptions necessary in pricing an option can only be guessed at (there are no hard statistics on how such mortgages would behave over thirty years). If these banks started out pricing exotic mortgages conservatively, the rest of the market did not follow suit, as competition from so many smaller banks and brokers with no requisite expertise in options has forced the pricing down to unrealistic levels, guaranteed to provide losses for the market when the consumer gives up on the mortgage and turns the property back over to the bank for liquidation.

As to fraud, the market has moved beyond just anecdotal hints of fraud. We are now receiving government warnings from the FBI that organized crime has infiltrated the mortgage market in a big way, and the FBI states that there are four times as many complaints of fraud as existed one year ago. Noted another observer: "We've never seen so many schemes and such complexity to the fraud," said Sarah Ludwig of the Neighborhood Economic Development Advocacy Project, which has helped lead investigations into predatory lending in New York. "Everyone works to defraud: the broker, the appraiser, the attorney and the inspector. Before a homeowner knows it, they are in way over their heads." When the entire team of mortgage experts is arrayed against the consumer, it is easy for someone to be duped into buying an over-valued property, or one with hidden problems. It is also easy to trick a homeowner into signing over the deed of their home when the lawyer hides the document in a thick pile of forms the homeowner is required to sign to refinance their mortgage.

By far the most pervasive fraud exists in the appraisal process. If you follow the complaints regularly aired in chat rooms set up by professional appraisers, you can see that many of them are under intense pressure to "make the numbers". The mortgage broker insists that the appraiser meet a minimum valuation in order to get the deal done for a borrower who would otherwise not qualify for the mortgage. Appraisers across the country state that in many major markets home valuations are overstated by at least ten percent. It is easy to see how appraisal fraud and other illegal schemes are artificially inflating the value of all residential property, and why property prices must decline once these frauds unravel.

Let us estimate how all these players will be affected by a decline in housing values.

Taking into account what we said earlier about how consumers will respond to declines in real estate prices, and in what order consumers will be affected, the first obvious affect on the banking industry will be an increase in properties being returned to their true owners: the banks. Consumers will simply walk away from their properties, especially those for whom the home is only an investment vehicle or vacation property. Even homeowners who live in their homes will begin to look for rental properties (which will be viewed as relatively cheap), or they will move into the homes of family members, leaving the bank holding a property that now heads for foreclosure. Like any public corporation, banks are fundamentally interested in their quarterly profits and stock price, and the pressure will grow on the banks to dispose of these properties quickly in order "to get the problem behind them." This means an accelerated pressure on housing prices, which will serve to exacerbate the downward pressure other homeowners themselves are placing on market valuations when they put their property up for sale. Bank stock prices will tank once the market understands the full extent of their losses from selling distressed properties.

The bank safety net will be discovered to be full of holes. The MBS market will be put into a state of crisis as a growing series of mortgage pools are found to have foreclosed properties well beyond the number predicted by the models when the pools were first brought to market. Lawsuits will be filed in attempts to force the banks to take back these properties onto their own balance sheets; the banks will be accused of mispricing the mortgage security or deliberately leaving out key information for investors. The banks in turn will request the GSEs to honor their guarantees, though this will apply largely to the standard, qualifying mortgages booked before 2003. The exotic mortgages that have been the mainstay of the market since then have no such guarantee, and investors as well as banks will be left holding hundreds of billions of dollars of losses with these securities.

The GSEs will have to absorb hundreds of billions of dollars of mortgages back on to their own balance sheets, but in a real market meltdown there are trillions of dollars of mortgages that have the potential to be turned over to Fannie Mae and Freddie Mac. This "financial nuclear bomb" certainly falls into the doomsday category of potential disasters from a housing price collapse, because ultimately it will require Congress to make an extremely painful decision on how much of the mortgage market to bail out. Of course, since the federal budget is already heavily in deficit, adding a potential trillion or two more to the deficit will have horrific consequences on the government securities market. Mitigating this disaster to some degree will be the fact that the MBS market will be clamoring for ever larger amounts of Treasury securities to serve as top-up collateral for deteriorating MBS issues. In other words, the MBS market will be frantically seeking Treasury notes and bonds to post as additional collateral, at a time when the federal government will be issuing possibly trillions more in securities to cover housing market losses at the GSEs. The consequence of all this will be that Treasury securities on a net basis will be under some pressure, but the real pressure will be on the spread between Treasuries and MBS securities. The spread will widen tremendously, reflecting the deterioration in the creditworthiness of these mortgage pools.

Mortgage brokers will disappear by the thousands once the mortgage business comes to a standstill. Real estate brokers will also leave the industry in massive numbers, and the days of real estate brokers driving clients around in the broker's Bentley will be over.
Attorneys general everywhere will have their hands full uncovering the full amount of fraud that has taken place in the mortgage industry. This will extend not simply to the scam artists who are now rife in the mortgage business, but to appraisers who overstated valuations, lawyers who filed false documents, inspectors who issued reports having never visited the property, brokers who left out key risks about the mortgages they were selling, and even homeowners who lied about their income on no-income verification loan applications. Several high profile bankers will go to jail as examples.

Very serious public questions will be raised about the lack of government oversight of the mortgage industry. Congress will be able to act with sanctimonious righteousness about their desire to rein in the GSEs, but this will not address the fact that there is no regulation of the hedge funds, mutual funds, mortgage brokers, MBS market, real estate brokers, financial advisers, appraisers, inspectors, and lawyers who profited from the real estate boom. An entirely new agency will be set up in the federal government to provide much more extensive regulation of the mortgage market, and the Federal Reserve will probably be given expanded powers to oversee hedge funds, the MBS market, and possibly even mutual funds.

The effect of all these developments on the national economy will be disastrous. Since about 40% of the GDP growth since 2000 has been estimated to be a result of the housing boom, this stimulus will disappear overnight. The consumer will be left to rely on their salary increases to support spending, but wage growth has been relatively stagnant and certainly insufficient to allow for a continuation of the current spending boom. Not only will consumers no longer be spending, they will be attempting to pay down their debts. This is the reverse of what has been occurring during the past ten or more years, when consumers blithely increased debt without really understanding the implications of their actions.

A third financial imperative will come into focus for the baby boomers: not only will they cut spending and begin to pay down debt, they will also need to start building up their cash savings for retirement. No longer will the stock market or the housing market be seen as surefire roads to retirement security, which means the consumer facing retirement will have to revert to the traditional, difficult approach of setting aside some net income every month.

This may work for those consumers who have net income, but because the economy will essentially freeze, with individuals no longer able to move to another home, and no longer able to spend, corporations will respond to this sudden loss of revenue by doing what lately they seem to do best: laying off employees. Unemployment rates will skyrocket, perhaps as high as 15% but potentially much higher if the amount of distressed mortgages hits the trillion dollar level. Many millions of consumers will be without income entirely in what will certainly feel like an economic depression for them, whether or not it is classified as such by economists.

Such widespread economic distress will feed into the stock market, which will begin its steady slide down will several days of sharp shocks that will probably be described in the press as a stock market crash. It is easy to see the DJ average, currently at 10,500, find its way down to 4,000 or lower before the excesses from the housing boom are worked off. This process may well take five years; housing booms usually deflate for around the same number of years it took to create the boom.

What Will Be the Kick-off Event?

Since housing markets are not like stock markets, it is unlikely there will be a sudden crash in housing values that will signal the beginning of the housing deflation. But there could be a defining event that historians will say marked the onset of the housing bust. These events tend to cause a psychological awakening in the minds of the borrower and lender about the true nature of the risks associated with the mortgage market. The press and politicians will begin talking about what went wrong and how such problems can be prevented.

Many observers suggest that higher interest rates will bring about the collapse of housing values. This is certainly a possibility, but only in the sense that spreads to Treasuries will widen substantially, making private debt much more expensive than government debt.

It is well to remember that financial bubbles are at their core misallocations of credit due to poor risk standards by lenders. This suggests that the defining event in turning a housing boom to a housing bust will not necessarily be a rise in interest rates, but a "credit event". Credit events are surprises to financiers - often they involve a suddenly-revealed weakness in the financial condition of a major player.

Interestingly, the housing market already is operating under such an event, since Fannie Mae's accounting has been shown to be faulty, especially in regards the derivatives it used to hedge its mortgage portfolio. Fannie Mae has recently said that it will not know the true value of its derivatives hedges until late in 2006, which will mean that for three years the market will have had no trustworthy information about the financial strength of the largest player in the mortgage market.

But remember, Fannie Mae and Freddie Mac have been replaced in recent years by the mortgage-backed securities market as lender of last resort. The MBS market, being unregulated, has allowed for the introduction of much worse credit standards than were ever accepted by the GSEs. So the most likely area where a credit event will occur will be in the MBS market, involving some portion of the trillions of dollars of securities that are now owned by unsuspecting investors throughout the world. The event may be a default by one of the main participants in this market, or an announcement about a set of securities that are no longer as safe as they seemed when they were sold. A sudden repricing of all mortgage-backed securities, to reflect the newly-perceived risk in owning them, will ripple throughout all global financial markets, and will quickly bring to a halt the easy money that has fueled the housing boom. This more than anything will start the process of home liquidations that will become a self-fueled spiral of home valuation declines.

How will you know we have reached the end of the adjustment process and are ready to begin an economic recovery?

We live in a world where bankers look at mortgages as nearly risk-free instruments because the bank holds a lien on the property being financed. This way of thinking permeates the financial industry in the U.S., just as it lulled Japanese bankers in the 1980s.

It is interesting to read banking history from the 1930s and 1940s to see what bankers thought about mortgages then. There is little, or often no reference to the house as collateral providing any support to the loan. Mortgages were predicated entirely on the earnings power of the borrower, and on their savings capabilities. The mortgage was expected to be repaid by the borrower from their income, and the last thing a banker wanted to do was to foreclose on a home. A foreclosure represented a massive failure in judgment by the bank about the creditworthiness of the borrower, and it exposed the bank to the added expense of the foreclosure process as well as the risk that the property when finally sold would not yield an amount equal to the outstanding mortgage.

When bankers in the U.S. start thinking and acting this way again - as they now do in Japan - then you will know that some degree of sanity has returned to the housing market. Housing values by that time will have snapped back to more reasonable levels, which in many markets will mean values that are 50% lower than where they are today.

You will know the bottom has been reached when bankers want nothing to do with home mortgages - the exactly reverse of today's market where bankers are shoveling mortgages out the door even to the financially crippled. That will be the time to buy a home, assuming you can get a mortgage. Only those who today are taking prophylactic action in preparation for the coming housing deflation, by paying off as much debt as possible and raising as much cash as possible, will be eligible for a mortgage when the housing debacle finally reaches bottom.

References

Most of the data cited are from recent Federal Reserve financial industry status reports.