The Revolving Reset Door

For the last decade we’ve been obsessed with the housing market. With new underwriting software, mainstream media shows, and the ability to tap home equity we became a nation fueled by housing appreciation. Never have we had so much refinancing activity and mortgage equity withdrawals hitting the economy. The perception that your home is an ATM and a virtual American Express card is something new. Even in past housing bubbles, the money was made by flipping or assigning rights of the property to another person. This bubble is in another dimension because with cash-out refinances and buying 2^nd homes, home owners became on a microcosmic level mini banks. They had the potential to lend money to themselves. They assigned the ability to purchase 2^nd homes via the leverage of their first home and the perceived equity. Many folks are learning a hard lesson that the equity in your home isn’t yours until you sell and have the cashier check in your hand.

The slow decline is happening because there is a systematic time bomb of mortgage resets waiting in the wing. Like a jaguar stalking its prey, it is lingering in the corner ready to pounce. How much is really resetting? According to Credit Suisse, the biggest month of mortgage resets will be October 2007 where $50 billion loans will reset for the first time. In addition, we are already in the full reset mode with $30 billion in loans resetting each month from now until September 2008. You think it is bad now? The market is still thriving a bit because summer does bring out buyers and sellers that really have no idea of the credit bubble working behind the scenes. If anything, this is the absolute last leg of the housing market for a long time. See, the Ponzi game could only last for so long. With housing in major metro areas going up each year, it masked the financial naiveté of many buyers who got in trouble because they simply listed their home and actually made some money by selling in record time. Or they played the refinancing musical chair game and bought time by giving themselves a short-term carry over loan. However, this all ends when lending gets tighter and the lava like pace of the mortgage reset is creeping to you and there is nothing to do except watch. How does this wave look like? We’ve all seen this fantastic chart of mortgage rate resets from Credit Suisse (by the way, we are at number 7):

Overly Optimistic Scenarios

Optimism is good. In fact, it is better to be optimistic in your life. It is healthy for you. You may be thinking, “Dr. Housing Bubble is optimistic? What is the world coming to!” Indeed, you should be hopeful for the future but blind adherence to positive thinking will only lead you down a disastrous road. Prudence must be exercised especially in the credit bubble we are living in. However, in the last few years we’ve witnessed an entire syndicate of people hedging their entire lives and careers on the housing and credit industries. Even the insurance companies and lenders have overly optimistic scenarios because they used faulty models of housing appreciation. Let us run through an absurd model used by some subprime lenders. They factored in a percentage of defaults, yet with these defaults they assumed that they would be able to unload the properties at market rates and recoup their losses! Think about that for a second. Even though they had assumption models predicting certain losses they were also factoring in the sale of the home at an optimistic sales price. What if the home doesn’t sell? They became flippers without even knowing it. Somehow the belief of the new economy was built on managing and repackaging credit from now until the end of time. Of course debt is not wealth. But look around your immediate environment and you will see artifacts of the false gods of debt. Leased cars. Massive McMansions. Multiple vacations a year to exotic locations. All under the umbrealla of credit. Our society drank the Kool-Aid and bought the line that debt is wealth.

Well the game could only go on so long. With the massive consumerism of this culture being funded through foreign entities, there had to come a point where you reach a credit watershed event. We’re not there yet. I know many are calling the bottom but as you can see from the above chart, we are only shifting into the next stage. In order to purge the market unfortunately, there will be a prolonged shift on the credit markets and how people perceive debt. Foreclosures are rising but are not in crisis mode. All this bail out talk is absurd because it doesn’t address the underlying economic neurosis. I think I can best convey this point by giving a personal example.

A very successful friend who is a business owner decided during the technology bubble days to invest $300,000 in technology stocks. He got in one year before the bust. He saw his portfolio jump to $340,000 in one year and I thought he was a genius even though the companies he picked had no projected earnings. Well, the bubble burst and his portfolio dwindled to $60,000 in a matter of months. Turns out a few of the companies had accounting “irregularities”; funny how they use words as if it were a digestive problem. So what did he do? He decided to hold onto these losers until they came back again! “They’ll come back. These are great companies.” Indeed, the companies that survived were great but absurdly overpriced. They never came close to their peak prices even to this day. So you would think he learned his lesson. Fast forward a few years and now we are in the housing frenzy. He decides that he will purchase rental properties in California since housing is the new tech startup. Instead of venture capitalist and day traders we have mortgage brokers and warehouse lending operations fueling this fire. He started buying a few years ago and now has a few properties that are negative cash flowing but they’ll go “up like crazy” according to his market analysis. Many of his homes are now back down to 2005 and in some cases 2004 prices therefore giving him zero equity even with the ridiculous appreciation. His response? “It’ll come back again!”

Financially, his family is doing really well so it won’t impact him aside from taking a hit to the ego and a drop in his net worth. But the underlying psychology behind this has no merit in economics. Essentially, people jump from one bubble to another like folks that jump from one bad relationship to another. At a certain point, you start to realize that maybe the problem isn’t the other people but potentially it is the person looking back at you in the mirror. Unless the credit using public understands the nature of debt and how bubbles inflate and then bust, this endless cycle of bubbles will keep on occurring. And from all financial literacy surveys I have seen, Americans need a major financial makeover. The problem? The so called gurus are dependent on the system as well. From banks, home repair stores, electronic departments, credit card companies, and the housing syndicate these sectors rely on the continuance of the housing and credit bubble expanding. After all, if you bought items with money you did have, why would you need credit? Because of a FICO score? Who owns FICO? As you can see, the rabbit hole goes much deeper than most would like to admit.

Market Psychology

It is interesting to hear certain media outlets say that housing will not pick up until 2009. In fact, they stop short of saying housing will be a horrible investment for the next two years. Try telling that to the person that just had their home foreclosed. Or the person that just saw a 50 percent increase in their housing payment. Suddenly the eager lender who went stated income is hesitant to offer them a refinance or payment support. When you hear talk about bailout why don’t they chase lenders that committed fraud and create a restitution fund from their earnings or profits? Companies and banks that benefited the most with fraudulent loans should pay something back. This way, those that actually managed their finances wisely won’t be taxed and subsidize this credit bonanza. And even President Bush was questioned directly about the subprime debacle. The reporter asked if a crisis in the housing markets existed and the President replied that everything was okay and we don’t need to worry about the market. No bail out from his administration even though they got loads of money from housing Political Action Committees. Maybe he got advice from the NAR which on a monthly basis adjusts their housing figures down. It is now becoming a running joke that whatever the NAR states, subtract one from it.

To a certain extent, I think folks are catching on that simply because you can charge something doesn’t mean you should actually buy it. Just because I can “buy” a Ferrari tomorrow doesn’t mean I will. Just because you can swim with sharks with T-Bone steaks tied around your neck probably doesn’t mean you should. It is called using restraint and assessing your actual situation. All it takes is a simple budget and a realistic assessment of the market. Something that has been absent since 2000. Like the amazingly well written letter from a lawyer during the Great Depression, from crash to an actual daily impact in the society took about 3 years. I’m still in the camp that doesn’t think we’ve hit the “crash” point. I’m thinking October will hit us hard for a couple of reasons. First, the record month of rate resets will hit a psychological tipping point. And second, we will have Q2 numbers coming out and housing companies (those that aren’t in bankruptcy) will be reporting more disappointing numbers. This bubble went global and together, we will share in some of this pain.

What are your prediction for the remainder of the year?