When Darth Vadar lured unsuspecting folks to the dark side, he was actually referring to the sinister and destructive nature of lax credit. For some reason, the business world and the mainstream media believed that this economy built on recycling credit was going to last forever. Even listening to the numerous housing shows, you would think that housing would always be the number one greatest investment on the face of the planet. Even today, as I was heading over to an appointment, I was listening to a prominent radio show on FM regarding real estate and the host is still in wonderland. One of the female co-host actually told a caller this:

“Right now is the perfect time to buy. Because even if real estate goes down, in 3 to 5 years you will have massive equity.”

I almost punched my stereo by this financially retarded advice. For one, the caller had no down payment. And another point, if real estate is going down and he comes in with little money, how is he going to have “massive equity” in the home? This was a case and point of so called real estate experts purporting short-term thinking and failing to look at the macro scope of this credit bubble. And then, I was watching a local television station this week discuss the record foreclosures here in California and they told the audience this nugget of wisdom:

“If you are having a hard time making your payment and have equity, refinance your house and get some money out. This will keep you afloat for a while longer. If this doesn’t do it, go ahead and cash advance on your credit cards to keep your mortgage payments.”

Am I really hearing and seeing this? Did I eat some kind of imported food tainted with hallucinogenic mushrooms? This “advice” is wrong on so many levels. For one, tapping out equity to keep a payment you clearly cannot afford is financial suicide. What you need to do is evaluate whether you need to sell your home or not. And tapping into credit cards as a short-term carryover loan to pay your mortgage is flat out stupid. You think these folks are going to pay the bank before they purchase food and keep their utilities on? The inflated sense of self for some of these experts makes you think that we are seeing miniature Napoleons running around.

In this article we will examine three major converging factors that bursted the housing bubble. First, we will examine the end of subprime lending. Second, we will look at the cancerous spread of horrible loans into the prime sector. Finally, as noted by last week’s tremendous drop in the stock market we will examine what will happen now that the bubble has fully burst and is spilling green toxic sewage credit all over the country.

Subprime Is Out to Lunch. Forever.

We witnessed weakness in the markets with many subprime lenders closing shop. We are now out over 100+ major players in the subprime market due to horrible loans and collapsing on their own weight. As the subprime market collapsed earlier this year, the market kept on chugging along because of the belief that this damage was contained to one sector. Clearly as the quarter progressed this was not the case. And how could it be any different? The housing market stalled and folks couldn’t play the musical chair game of refinancing. This was noted in the massive drop in mortgage equity withdrawals. Like a WWE wrestler, the market needed to tap out.

In addition, we realized that Wall Street had enough of subprime loans. Principally because hedge funds realized that the underlying assets may be a tiny bit overpriced. Oh really? I’m reminded of the story of some of the large hedge funds homes being inhabited by raccoons and roaming free range hogs. I wonder if the hogs went 2/28 on the property? The problem stemmed from long distant investors buying up properties sight unseen on inflated appraisals. Now that the market is scrutinizing what the collateral was, it does not like what it sees.

Later in the quarter, we have the end of the 2/28 teaser mortgages. A mainstay of the industry during boom times. No longer are folks able to squeeze into over priced places on these ridiculous loans. In Southern California we had a peak originating month in August of 2005. Perfect timing for next month where many loans will reset and folks are no longer able to refinance into additional loans. The problem is also happening where appraisers are now seeing homes drop in price. No longer will most banks give you a HELOC simply because you have a pulse and a home in an over inflated metro area. As in the last article, foreclosures are booming to the next level. Not only that, as highlighted in detail, people making $130,000 a year are also having problems covering their monthly nut.

It is clear that subprime is now down and out. But prime was protected right? Well this leads us into the end of Q2 and the infection of the prime sector.

Prime USDA Mortgages

Countrywide announced that it has faced one of its worst quarters. Not only that, the CEO Mozilo stated that he didn’t see housing coming back until 2009. Talk about a vote of confidence. We also saw the problems at Bear Sterns with prime loans going bad in the so-called Alt-A tranches. That is, financially risky loans given out to credit worthy customers. But again, simply because you have a 750 FICO doesn’t mean you can make the payments on a $600,000 mortgage unless you have income to back up your score. The issue with the last few years is income didn’t even matter. As I discussed many months ago, a study conducted by the LA Times found that stated income borrowers over stated their income 60 percent of the time. Out of these, 50 percent overstated their income by 50 percent. This in conjunction with mortgage resets is showing who has been swimming in Huntington Beach without any trousers now that the tide is going out.

So the market got extremely spooked. That is why last week we saw almost a 5% retrenchment of the overall stock market. And not only here in the US did markets suffer, but markets in Europe as well since they decided to jump into the worldwide credit orgy. Alt-A is going to face some serious pain. At the peak in California, 73 percent of all originated loans were adjustable. Now that rates are resetting in the face of housing depreciation home owners are facing something they didn’t expect. Being stuck. Stuck like a stick in the mud. Yet you hear housing pundits sound off asinine quotes like the two mainstream folks above, and you wonder why this bubble is bursting? Somehow they feel that everyone is living in their world of perpetual credit expansion. Many of the prime banks, hedge funds, and Wall Street drank this Kool Aid for many years. But the party is now finished. Eventually the music stops and the piper needs to be paid. Last week the overall stock market, which keep in mind supposedly tracks the health of the overall US market, went down with a three hit combination. And this is in the face of good GDP numbers! But the numbers are a farce because many are realizing that the sustained growth was predicated on us buying consumption goods on credit therefore inflating the health of the economy. Doubt me? Go to Target, Wal-Mart, Trader Joes, Ralphs, or the mall and count how many folks actually pay in cash or check.

So Now what that Housing is Done?

If you don’t want to take my word for it, you can listen to Mozilo who is head honcho of the mortgage giant Countrywide. He doesn’t see this “ship” turning around until 2009. I get a kick out of housing pundits stating things like this from the same housing radio show:

“Okay. Enough of the housing bubble. The correction is over. This is a perfect time to find a good deal. You will have equity in your home. Housing always goes up. We may see a small correction but once it goes up, it will go up fast like the last few years!”

Correction? We’ve been in a decade long boom and they think two quarters is a correction? We are in for multiple years of housing being a horrible overall investment. This assumption that housing goes up massively in good times and only retracts baby steps in bad times is fundamentally wrong and is clouded by their own judgment. To quote Upton Sinclair, “It is difficult to get a man to understand something when his job depends on not understanding it.” Clearly they are seeing what they want to see because the implication would imply challenging times for them should the market go down. You can’t blame them for this faulty analysis. However, they are fundamentally wrong and demonstrate their lack of macroeconomic policy each time they open their mouths.

On Friday we were left with a taste of things to come. An announcement that Fannie Mae and Freddie Mac may face losses of $4.7 billion in the subprime market. These government sponsored entities are the white elephants in the room in our over mortgaged 3/2 stucco home. As we were too busy looking at subprime imploding and Alt-A tranches getting hammered, most mainstream folks failed to examine the cancerous growth of this credit bubble. Now it is reaching the absolute nucleus of the US housing market. These two behemoths should they face a problem have the potential of bringing down the entire market significantly. Last week we dropped almost 5 percent across all major markets because of Countrywide and a fear of credit being shut off. Just wait if issues at the two GSEs are as bad as many think.

The housing and credit bubble lasted too long. There is tremendous excess that needs to be washed out. The market is in for a long and prolonged downturn. What you need to look out for is snake oil salesmen trying to tell you that we’ve already had our correction and it is time to buy. It is comical to think that many months ago the former NAR chief David Lereah had called the bottom, multiple times. Maybe we have a differing view on what constitutes a bottom.

Do you think Fannie Mae and Freddie Mac are the next to show cracks due to this housing market?