Many pundits have been downplaying the resetting of adjustable rate mortgages, saying that the worst is over. I don’t think so. There are $440 billion of adjustable mortgages resetting this year. That means that the majority of foreclosures will not occur until 2009. This means that the banks will still be writing off billions of mortgage debt in 2009. The reversion to the mean for housing prices and the continued avalanche of foreclosures is not a recipe for a banking recovery. Home prices have another 15% to go on the downside.
Fannie & Freddie Fiasco
President Bush signed the Housing Recovery bill this week. We are now on the hook for all of their bad decisions. We believe in capitalism when there are obscene profits, but we prefer socialism when it comes to losses. The CBO estimates that we will pay $25 billion for their mistakes, with a 5% chance that it reaches $100 billion.
The only problem is that they have been given an open ended guarantee. According to former Fed governor William Poole, Fannie Mae (FNM) is technically insolvent. Their shareholder equity was $35.8 billion at the end of 2007. It plunged by $23.6 billion to $12.2 billion as of March 31, 2008. Does anyone think that as of June 30, they have any equity left? We’ll know shortly. Fannie Mae has guaranteed $2.4 trillion of mortgages.
According to the Mortgage Bankers Association, as of June, 2.5% of U.S. mortgages were in foreclosure and 6.4% of mortgages are delinquent. Fannie and Freddie (FRE) are on the hook for $5.2 trillion in mortgages. It doesn’t take a rocket scientist to figure out that about 4% of the $5.2 trillion of guaranteed mortgages will default. This would be $208 billion in defaults. If they are able to recover 50% (current recovery rate) from foreclosure sales, their losses would be $108 billion.
Oh yeah, that would be our losses. This is assuming things don’t get worse.
Next Shoes to Drop – How High Will the Losses Go
Banks and security firms have reported $468 billion of losses thus far. Bridgewater Associates, a well respected analytical firm, thinks things will get much worse.
According to Bridgewater, the models used have grossly underestimated the actual losses. They doubt the financial institutions will be able to generate enough capital to cover the losses. According to the report,
Lenders would have to curtail loans by roughly 10-to-one to preserve their capital ratios. This would imply a further contraction of credit by up to $12 trillion worldwide unless banks could raise fresh capital.
Not all of these losses are in the sub-prime market. According to the report, more than 90% of the losses from sub-prime loans have already been written off. Unfortunately, the losses from the prime and Alt-A loans could be much larger than we have already seen. The sizes of these loan portfolios are much larger than the sub-prime portfolios. Further, Bridgewater expects about $500 billion in corporate losses that must be written off. This leads to the current estimate of more than $1 trillion in losses yet to be written off.
Bill Gross, the well respected manager of the world’s largest bond fund, expects financial firms to write down $1 trillion.
About 25 million U.S. homes are at risk of negative equity, which could lead to more foreclosures and a further drop in prices. The problem with writing off $1 trillion from the finance industry’s cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth.
Nouriel Roubini, economist at NYU, believes that losses could reach $2 trillion.
The other shoes have begun to drop. Last week Amex reported a 40% decline in earnings as their wealthy super-prime customers are not paying their bills. So, even the well off are struggling.
This week, CB Richard Ellis, the largest commercial real estate broker in the country reported an 88% decline in earnings. So, commercial real estate is imploding. Bennigans’s and Mervyn’s filed for bankruptcy this week. The consumer is being forced to cut back on eating out and shopping. The marginal players will fall by the wayside. Big box retailers, restaurants, mall developers, and commercial developers are about to find out that their massive expansion was built upon false assumptions, a foundation of sand, and driven by excessive debt.
The U.S. banking system is essentially insolvent. The Treasury, Federal Reserve, FASB, and Congress are colluding to keep the American public in the dark for as long as possible. They are trying to buy time and prop up these banks so they can convince enough fools to give them more capital. They will continue to write off debt for many quarters to come.
We are in danger of duplicating the mistakes of Japan in the 1990s by allowing them to pretend to be sound. We could have a zombie banking system for a decade. There is good reason for this gentleman to have a splitting headache.
My advice is:
- Absolutely do not have more than $100,000 on deposit with any single institution.
- Do not buy financial stocks. There are years of write-offs to go.
- When you see a bank CEO or a top government official tell you that everything is alright, run for the hills. They are lying. They didn’t see this coming and they have no idea how it will end.
- Educate yourself by reading the writings of Ron Paul, John Mauldin, Barry Ritholtz, Mike Shedlock, Bill Bonner, Paul Kasriel, John Hussman, and Jeremy Grantham. They will tell you the truth. Truth is in short supply today.
