THE DEBT CONUMDRUM PART I / SEEKING ALPHA ( RECOMMENDED READING )

The Debt Conundrum PART I

by: James Quinn

June 13, 2009

Dr. Frederick Frankenstein: [to Igor] Now that brain that you gave me. Was it Hans Delbruck's?
Igor: [pause, then] No.

Dr. Frederick Frankenstein: Ah! Very good. Would you mind telling me whose brain I DID put in?
Igor: Then you won't be angry?

Dr. Frederick Frankenstein: I will NOT be angry.

Igor: Abby Someone.

Dr. Frederick Frankenstein: [pause, then] Abby

Someone. Abby who?

Igor: Abby Normal.

Dr. Frederick Frankenstein: [pause, then] Abby Normal?

Igor: I'm almost sure that was the name.

Dr. Frederick Frankenstein: [chuckles, then] Are you saying that I put an abnormal brain into a seven and a half foot long, fifty-four inch wide GORILLA? [grabs Igor and starts throttling him]
--from

Young Frankenstein

The pundits on CNBC who appear every morning proclaim that things are returning to normal. It amazes me that such supposedly intelligent people have no idea what normal means. Since 80% of the people interviewed on CNBC manage other people’s money, I’m guessing they are just trying to stay in business by lying to the average investor. If they were honest, they would say they have no idea what the future holds. If they were outspokenly honest, they would say that a Frankenstein’s Monster is loose in the countryside and will wreak havoc on the American economy for years.

Definition of Normal: Being approximately average or within certain limits; typical

Definition of Abnormal: Not typical, usual, or regular; not normal; deviant

Which definition best represents our economic situation today?

I would contend that Dr. Bernanke (Curly), Dr. Geithner (Larry), and Dr. Obama (Moe) have placed an abnormal brain into the seven and a half foot, fifty-four inch wide GORILLA that is the American economy.

Only stooges would expect the same borrow and spend policies that ruined our economic system in the 1st place to fix the problem. The housing and debt crisis needs the attention of reality based,blunt, straight shooting doers. Not a 3 Stooges solution.

Housing Normality

As soon as we can stabilize housing, all of our troubles will be solved. This is the mantra we hear night after night on CNBC. The chart below unmistakably paints an abnormal picture of home prices. Karl Case, an economics professor at Wellesley College whose name adorns the S&P Case-Shiller home-price indexes, has studied U.S. house prices going back to the 1890s. Over the long run, he says, home prices tend to increase on average at an inflation-adjusted rate of 2.5% to 3% a year, about the same as per capita income.

The American population has steadily increased from 100 million to 300 million over the last 120 years. Home prices gained at an uneven rate from 1890 until 2000. Then the combination of bubble boy Alan Greenspan, Harvard MBA George Bush, delusional home buyers, criminal investment bankers, pizza delivery boys turned mortgage brokers, and blind regulators led to the greatest bubble in history. Prices doubled in many places in six years versus a 15% expected historical return.

Prices have now declined back within the range seen during the period from the 1970s through the 1990s. This is why the eternal optimists are proclaiming a housing bottom. These people don’t seem to understand the concept of averages. An average is created by prices being above average for a period of time and then below average for a period of time. The current downturn will over correct to the downside. The most respected housing expert on the planet, Robert Shiller, recently gave his opinion on the future of our housing market:

Residential investment and home improvement expenditures have averaged 1.07% of GDP over the last 50 years. This is the 4th time it has peaked above 1.2%.

After the three previous peaks it bottomed below 1%. Based on history, it will bottom out at .8% in the middle of the next decade. This would be a reduction of $70 billion in housing investment from the peak. Great news for Home Depot and Lowe's.

A housing rebound is a virtual impossibility based on any honest assessment of the facts. Homeowners currently have the least amount of equity in their homes on record. Real-estate Web site Zillow.com said that overall, the number of borrowers who are underwater climbed to 20.4 million at the end of the first quarter from 16.3 million at the end of the fourth quarter. The latest figure represents 21.9% of all homeowners, according to Zillow, up from 17.6% in the fourth quarter and 14.3% in the third quarter. There are 75 million homes in the United States. One third of homeowners have no mortgage, so that means that 41% of all homeowners with a mortgage are underwater. With prices destined for another 10% to 20% drop, the number of underwater borrowers will reach 25 million.

MORTGAGE DEBT

There are over 4 million homes for sale in the U.S. today. This is about one year’s worth of inventory at current sales levels. You can be sure that another one million people would love to sell their homes, but haven’t put their homes on the market. The shills touting their investments on CNBC every day fail to mention the approaching tsunami of Alt-A mortgage resets that will get under way in 2010 and not peak until 2013. These Alt-A mortgages are already defaulting at a 20% rate today.

There are $2.4 trillion Alt-A loans outstanding. Alt-A mortgages are characterized by borrowers with less than full documentation, lower credit scores, higher loan-to-values, and more investment properties.

There are more than 2 million Alt-A loans in the U.S. 28 percent of these loans are held by investors who don’t live in the properties they own. That includes interest-only home loans and pay-option adjustable rate mortgages. Option ARMs allow borrowers to pay less than they owe, with the rest added to the principal of the loan. When the debt exceeds a pre-set amount, or after a pre-determined time period has passed, the loan requires a bigger monthly payment.

How can housing return to “normality” with this amount of still toxic debt in the system? It can’t and it won’t.

ALT-A MORTGAGE RESETS

Mortgage delinquencies as a percentage of loans stayed between 2% and 3% from 1979 through 2007. I would categorize this as normal.

The Mortgage Bankers Association just reported a delinquency rate of 9.12% on all mortgage loans, the highest since the MBA started keeping records in 1972. Also, the delinquency rate only includes late loans (30-days or more), but not loans in foreclosure. In the first quarter, the percentage of loans in foreclosure was 3.85%, an increase of 55 basis points from the prior quarter and 138 basis points from a year ago.

Both the overall percentage and the quarter-to-quarter increase are records. The combined percentage of loans in foreclosure and at least one payment late is 12.07%, another record.

Delinquencies on subprime mortgage loans rose to 24.95% from 21.88% in the fourth quarter of 2008. Prime loan delinquencies rose to 6.06% from 5.06% one quarter ago, a significant and disturbing increase from a group of borrowers that aren’t expected to default.

With the 30-year mortgage rate approaching 5.7%, mortgage refinancing activity has plunged about 60% in the last two months. Mortgage applications for new home purchases collapsed at a 20% annual rate in May too. Normality in the mortgage market appears to be a few years away.

MORTGAGE DELINQUENCIES AS A % of LOANS

Household Normality

“You can't drink yourself sober and you can't leverage your way out of excess leverage." - Barry Ritholtz

Barry is right, but it isn’t stopping the Obama administration from trying to solve our hangover with a lot more of the dog that bit ya. The current policy of borrowing in order to stimulate the economy is warped. Providing more easy credit so poor people can buy Mercedes SUVs will not solve our problems. The brilliant Doug Casey clearly understands the policy that should be in effect:

“The way a society, like an individual, becomes wealthy is by producing more than it consumes. In other words, by saving, not borrowing. But you don’t become wealthy by spending and consuming; you become wealthy by producing and saving. Inflation encourages people to borrow, because they expect to pay the debt off with cheaper dollars. It encourages people to mortgage their future. The basic economic fallacy in this is that a high level of consumption is good. Well, consumption is neither good nor bad. The problem is the emphasis on consumption financed by debt -- which leads to the national bankruptcy we’re facing. It’s much healthier to have an emphasis on production, financed by savings.”

Household credit market debt currently stands at $13.8 trillion, an all-time high. It has not fallen. From 1965 through 2000, it ranged from 14% to 17% of Household net worth. It currently stands at 27% of Household net worth, an all-time high. Is this normal or abnormal? At the end of 2008, household net worth totaled $51.5 trillion, down $11.2 trillion in one year. In order to get household debt as a percentage of net worth to a “normal” level of 16%, will require households to either reduce debt or increase savings by $5.6 trillion. I don’t think this will be done by next Wednesday. It will take a decade or more.

Source: Haver Analytics, Gluskin Sheff

Famed investor Robert Rodriguez places the blame for our current debt induced collapse squarely at the feet of our government.

“The regulatory agencies and the federal government were complicit in laying the groundwork that allowed many of these credit excesses to develop prior to this economic crisis. Had they done their job effectively, the economy would not have been pushed to the brink of collapse. I fundamentally disagree with these “rescue” programs since we believe our impaired financial system is being distorted by protecting inefficient and questionable business enterprises. Misguided measures to re-stimulate consumer borrowing, beyond just getting the system functioning, are highly questionable.

This net worth destruction is the most severe since the Great Depression. We have a news flash for the government, creating new credit programs for a consumer who was spending almost $1.1 trillion more than they were earning in spendable income, according to MacroMaven’s estimate, will be a non-starter. More leverage is not what they need. Encouraging the consumer to take on more debt is like trying to help a recovering heroin addict lessen his pain by providing him with more heroin.”