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Thursday, December 20, 2007


taking the measure of credit contraction

this deserves more attention than i have time at the moment, but one of the impressions i have with respect to the credit mess is that very few attempts at grasping the true scale of the problem have yet surfaced. we are simply too early on in the credit unwind for respectable analysts to risk reputations with what would seem today outrageous loss estimates.

however, though the landscape is also littered with disasters that never were, the history of financial crises demonstrates that initial loss estimates for public consumption -- such as the sophmoric dimwittery put forward by former game show host ben stein today -- eventually end up being minor fractions of the total damage with great regularity.

being aware of that, some outlier thinking is welcome -- and calculated risk offers it.

One of the greatest fears for lenders (and investors in mortgage backed securities) is that it will become socially acceptable for upside down middle class Americans to walk away from their homes.

If every upside down homeowner resorted to "jingle mail" (mailing the keys to the lender), the losses for the lenders could be staggering. Assuming a 15% total price decline, and a 50% average loss per mortgage, the losses for lenders and investors would be about $1 trillion. Assuming a 30% price decline, the losses would be over $2 trillion.

Not every upside down homeowner will use jingle mail, but if prices drop 30%, the losses for the lenders and investors might well be over $1 trillion (far in excess of the $70 to $80 billion in losses reported so far).

i'm personally convinced by the implications of price-to-relative-metrics that a 30% nationwide real correction in house prices is not only a possible but likely destination. indeed, given the incedible and widespread excesses of the boom, with long-lasting trouble in american and european banking likely in my opinion to bring durable credit contraction and deflation, the possibility of significant overshoot -- that is, a regression well beneath the mean before a rise back up to the mean is experienced -- is altogether possible. as i've said previously, it concerns me deeply the ease with which mainstream forecasts of 20-30% nominal price declines have been elicited from major research houses. the implication, as above, is that the true scale of the decline is likely to be significantly worse.

one has only to look as far as jan hatzius' calculus to understand the implications -- with something on the order of $1.5tn in losses, the credit contraction implied by the current velocity of money would be on the order of ~$15tn. that would be some 35% of all outstanding money supply (that is, m3 plus bank credit plus government debt). that is an evaporation of money supply at least on the order of the banking catastrophe of 1931-33, when m2 contracted by about 30% and broader inclusion of credit supply probably significantly more.

futhermore, one has to be aware that this is not really worst-case thinking. paul krugman notes that a 30% nominal price decline over the next few years would put some 40% of american mortgagees underwater on their home. with most americans living in non-recourse states -- where the lender cannot pursue the defaultee, and the borrower effectively has a moderately-priced option to own which is going well out of the money -- and about $21tn in mortgage debt outstanding, one can eyeball that $1.5tn in mortgage credit losses could clearly be significantly worsted.

this line of thinking quickly leads to staggering consequences, but the enormity of the problem is not to be ignored by the prudent. it is one thing to experience a bubble and bust in paper assets such as stocks fueled mostly by margin lending, which exists at the periphery of the financial system. it is quite another, however, to experience a true credit bubble that widely infects home mortgages, commerical real estate, zero-percent auto loans, massive unsecured credit card lending -- the pretenses of all being predicated on steady asset inflation, and the conditioning of the population to expect and indeed rely on inflation to make their profligacy if not sustainable then endurable.

with the onset of deflation, the pernicious stubbornness of credit -- which happily expands with rising collateral values but obstinately refuses to recede with asset declines -- may well reverse decades of fiscal and social conditioning and change the very way we think.

though the stage may well be set for its arrival, it remains to be seen if anything like a full-fledged debt-deflation will materialize. i for one think the great depression was truly 'great' and that the model for asset price deflation this time around is likely to be found among other, lesser examples (including perhaps 1990s japan, which i cursorily cited here). but a wise investor will at least consider the possible downside from here -- and should not be reticent to admit that, while not the end of the world, it is truly intimidating and more likely to materialize than at any previous point since at least the mid-1960s and perhaps since the late 1920s.

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Great post Gaius,
Fixed-rate mortgages are definitely the "loan of choice" by today’s homeowners seeking a refinance mortgage. About 85 percent of refinance mortgages in recent months have been fixed-rate loans. The attractions of a fixed rate mortgage are a principal and interest payment and an interest rate that remain the same for the entire length of the loan. That stable predictability is what entices so many people to choose it, and its safety and reliability will afford the homeowner peace of mind. :)


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