The Associated Press report the ebullient headline "Home sales rise from 1st quarter to 2nd", and go on to say, "U.S. home sales grew in the second quarter in 39 states, another sign that the ailing housing market is finally coming to life.
So it is all good, right?
Maybe not. Bloomberg reports the real danger: "Home Price Declines Accelerate in Second Quarter", and make the point that, while sales are rising, the price of housing continues to drop faster than ever!
The ongoing problem is laid out by a Deutsche Bank analysis. In the news on August 6th, Deutsche Bank analysts say that some 26% of US mortgages are currently underwater (the house is worth less than the mortgage owed), and that before prices stop falling, sometime in 2011, they expect this figure to rise to 48% of all mortgaged homes in the US, some 25 million mortgages.
Now look at the forecast pictures painted by US predictors, and there is an abyss of difference. First American Corelogic estimated that 11 million homeowners were underwater by the end of 2008. Zillow.com's estimate was that 20 million were already underwater in the first quarter of 2009. Moody’s Economy.com currently predicts a peak of 17.5 million in 2010, which sounds suspiciously rosy. But then, Moody's were the guys that gave junk mortgage securities an AAA rating, which fueled this mess!
So why are the estimates so far apart, and is it really important? I think it is, because I think we may be heading for another major bank catastrophe.
The problem is the way mortgage asset status is reported by the banks.
Let's take a mortgage that has a $2,500 payment per month, which has not been paid for 4 months. That is $10,000 that the bank has not received, but they have logged it as current income in their financial statements. There will be further charges for late fees. Until the property is foreclosed, and sold, the bank has no legal obligation to report the status of that mortgage as a filed asset, or the losses that may be expected from the foreclosure.
So until the bank forecloses on this mortgage, it can pretend that the mortgage is still in force and profitable, and keep adding the mortgage billings to their current income. Since over 80% of the $10,000 they are owed is likely to be interest, then they can add that to their current profits, whether they have received the cash or not. Likewise, they can add any further bank fees directly to their profit figures, even if they have not been paid, even when they have a fair idea that they never will be.
In the current mortgage climate, this inflates current profit figures, and understates the likely capital losses. It also means that, when the property eventually does go into foreclosure, the bank will not only have to write off the capital loss (how much less the house sells for than the mortgage owes), but they will also have to write off all that money that they have already declared as profit on the non-existent mortgage income and extra late fees, a real double-whammy.
So how much money are we talking about?
I know of one mortgage holder who mailed in the keys to his house on April 1st, 2009. His mortgage was paid up to date at that time, and he told the bank in writing that he was giving up the property. The mortgage was for $500,000, and the property is now worth around $220,000. By the time selling costs are paid, there is probably another $15,000 worth of costs, bringing bank losses close to $300,000.
Despite being notified in writing that the owner is walking away from this property, the bank continues to bill the mortgage each month as though nothing has happened, adding late charges with abandon. And there is nothing that obliges that bank here in California to declare this as a bad or doubtful debt in their reporting. All they need to do is to declare what percentage of their mortgages are late, not the quality of the loans themselves.
So why would banks behave in this manner?
I will advance a theory, and if I am right, there is a huge world of pain waiting for the banking sector, and also property owners.
I think the banks have been hoping against hope that the property market would stop falling, and begin to rise again, before they have to dump a whole lot more property into the market. Everything is timing. If all these foreclosable properties come to market at once, the market would disappear under a wash of red ink, and we would see a repeat of the bust of 1873.
And if property prices plummet further, even more people are incented to walk away from their mortgages, and this adds to the destruction of wealth the banks would experience.
So the reason for the banks "turning a blind eye" to non-payments, even when they know the mortgage is never going to be paid, has several benefits for them. First, they figure if they can cut back the supply of foreclosed properties, then the price drops that would accompany many more properties hitting the market won't happen, so they will get better recovery on their foreclosures. Secondly, they don't have to show their financial weakness, which may start further runs on the banks. Finally, keeping people in houses preserves the property value. Eviction means an empty house, which is preyed on by squatters and burglars at will, which further destroys the value of the house. So if the best option is letting the occupants stay in the house for the time being, so be it!
And there are no downsides for the banks. Nobody will go to prison for doing this, even though it breaks all the rules of good accounting.
I fear Deutsche Bank's analysis is probably conservative. The financial sector has been bailed out once, but their performance with regard to their customers on the loan modification rescue plans is not working out well, mainly because there are no performance mandates for the banks, or penalties for the banks that do not play well with their customers. Hey, the banks don't want to modify loans, because it will cost them money! So they are dragging their heels here, as well.
There are more and more exasperated homeowners. There are more and more properties coming available for monthly rent at prices substantially below the old mortgage rates that people are paying, incenting them to walk away from their mortgage into a rental. And there is less and less stigma of walking away from a mortgage. As time passes, and more people you know do it, once this ice is broken, people are more likely to fall through.
What is the time frame for the cracks to appear?
The end of summer, I reckon. The Fourth Quarter.
Companies have kept staff levels up through the summer, because this is when people across the country go shopping, and businesses know that they really have to make hay while the sun shines, because when winter comes, sales are going to drop dramatically.
Federal incentives like the Federal "cash for clunkers" program is giving a short-lived shot in the arm to auto manufacturing and dealers, but it is not going to get the auto industry back on it's feet. Currently, it is clearing an inventory backlog for the auto industry, not resulting in a boom of new car manufacturing, so it is of greatest benefit to the dealers and the auto companies, not the workers who build the cars. It is not going to help with employment.
So the end of summer will bring with it a large increase in unemployment. The areas of the country that will be the hardest hit will be the small towns that have been dependent on distant markets and companies for their jobs and factory incomes, such as sub-contracting manufacturers to the auto industry.
Many of these small towns have no expertise in emerging technologies or new business, and there are no incentive programs I see that are going to help people stay employed there. This kind of radical economic change has been the cause of 'ghost towns' in the past, and this may become a re-emerging phenomenon for towns that are very dependent on a single company or distant subcontracts.
Manufacturing industry, much of which has been hanging on by its fingernails for several years, will close up at an accelerating pace. My analysis, which shows manufacturing increasingly being offshored for the last 30 years, predicts that China, the Asian Tigers, and Europe will increasingly encroach on high-value jobs (aircraft manufacture, auto manufacture) as well as low-value jobs. These manufacturing-intense economies have been developing their manufacturing technology, and are probably now four generations ahead of their US counterparts, which guarantees that these jobs are not coming back without severe protectionist policies, which would also accept high product price inflation.
This is going to impact the property market further, as consumption falls.
In the boom years, it wasn't necessary to be able to show the ability to pay as part of a mortgage application, because credit was so plentiful and cheap, and property prices were going through the roof. Now, any new mortgage application is carefully scrutinized on the basis of 'ability to pay', and accordingly, mortgages are much harder to obtain. With falling manufacturing incomes, house prices will continue to fall.
Generally, consumer purchasing is likely drop steadily, because people can no longer use their house as a piggy bank to underwrite their current spending by getting another mortgage. Many people financed cars by taking out a loan secured on their home, because the interest on the loan is tax deductible. A benefit for these homeowners is, when they walk away from their homes, they get to keep the assets they bought with the money they borrowed. A great way to buy a new SUV, free and clear, had we all only known!
This reduction in retail spending will further decimate service jobs before the end of the year, which will compound the downward spiral. Retail sales can be expected to drop as we enter winter, whammied by falling employment, tighter credit from credit card companies, and seasonal changes. Many of the retailers who have held on through the summer may choose to close their doors in the fourth quarter of this year. Meanwhile, there is little hope that employment will increase for some 18 months, a further damper on consumer spending.
The banks are also facing uncertain downsides in both the credit card market, and the commercial property sector, which will add to their woes in the fourth quarter.
This is a very dynamic situation, and any predictions I make are made much more uncertain by the inadequacy of current reporting requirements of banks. But the likely outcome is that property prices will continue to deflate, and when banks acknowledge their losses, we are likely to see another huge need for Federal support, and bank refinancing.
So keep your job, thank God you have one, and don't panic. It may get worse before it gets a lot worse, but we will still have our friends and family, and this may even pull us all a lot closer together.
