Number 2 is playing a huge role right now because all lenders have now cut the LTV by 5% in any declining area that Freddie or Fannie recognizes. This alone shuts out nearly everyone who bought in California in the last 3 yrs who did 90% financing or more.Notice Los Angeles County is classified as "distressed" while Riverside & San Bernardino counties are "severely distressed".
“Over the past few months, we have become increasingly concerned that the U.S. housing and credit market downturn would trigger not just a growth slowdown and substantial Fed easing — our long-standing view — but also an outright recession. The latest data suggest that recession has now arrived, or will very shortly,” Goldman said in a research note. The bank also expects a decline in consumer spending, which didn’t happen during the 2001 recession, amid spillover from the housing market.
Lehmans Achilles Heel
The next shoe to drop may be at Lehman Brothers, reports CNBCs Charlie Gasparino.
Video
Morgan Stanley $93.1 Billion and Bear Stearns $86.5 Billion in CMBS
Here’s a snap from a Citi research note looking at the strained condition of all things financial. In a 70-page tome entitled “Testing Times,” the bank’s chief IB watcher in Europe, Jeremy Sigee, makes a convincing case for sector-wide capitulation.
Investment banking business models are, of course, being put to the test. While hedge funds and private equity are still attracting inflows, and emerging markets are still riding high, proprietary risk taking and product innovation are being scaled back. So, having already been bearish on fixed income revenues, which are forecast to fall back to 2004/5 levels this year, the Citi team now see revenues from equities and advisory work falling by 10 and 20 per cent, respectively.
But what’s really got Sigee questioning his very employment is the collapse of securitisation and structured credit.
Nouriel Roubini, January 7, 2008
Mood and Views at the American Economic Association Meetings: Recession Ahead:
This is a crisis of insolvency, not just illiquidity; it is a problem of unmeasurable uncertainty (on the size of the losses and who is holding the toxic waste) rather than priceable risk; and liquidity risk is now severe and not manageable as we have a shadow financial system where non-bank institutions (SIVs, conduits, money market funds, hedge funds, investment banks, etc.) borrow short/liquid and invest in long/illiquid assets; so they are subject to a severe liquidity/rollover risk but they don’t have access to the lender of last resort support of the central bank in the case of a liquidity run.
The Economist magazine points out in its September 22nd issue, [both banking & shadow banking] are built on a fundamental (and ever present) mismatch: they borrow short and lend longer and riskier. Recognizing this flaw, governments have for over a century mandated that banks have an ample percentage of reserves in order to bridge the liquidity and investment risks that periodically ensue. Like Jimmy Stewart in It’s a Wonderful Life, the critical job of a traditional banker was to have enough reserves or cash on hand to prevent a run. Stewart’s modern day counterpart must follow similar guidelines, although a 21st century banker now can always look skyward for a guardian angel in the form of the Fed, the ECB, or the Bank of England. Recent infusions of over a half a trillion dollars by this triumvirate point to the perennial need for reserve banking in either an earthly or a more heavenly sense.
But today’s banking system as pointed out in recent Investment Outlooks, has morphed into something entirely different and inherently more risky. Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever. Financial derivatives of all descriptions are involved but credit default swaps (CDS) are perhaps the most egregious offenders.
According to the Bank for International Settlements (BIS), CDS totaling $45 trillion were outstanding at year end 2007, more than half the size of the entire asset base of the global banking system. Total derivatives amount to over $500 trillion, many of them finding their way onto the balance sheets of SIVs, CDOs and other conduits of their ilk comprising the Frankensteinian levered body of shadow banks.
Originators and existing supporters of these securitized WMDs might also point out that their reserves come in the form of equity and subordinated tranches comprising 10 or 20% of the repackaged loans. They do. But as this equity/subordination shrinks due to underlying defaults, the pyramid begins to unravel. Rating servicer downgrades can and do lead to the immediate liquidation of certain CDOs. The inability to rollover asset-backed commercial paper does and has led to the liquidation of SIVs or, pray tell, a misguided attempt to restructure them as super SIVs. CDOs and even levered municipal bond conduits known as "Tender Option Bonds" have been and will be similarly vulnerable to "Jimmy Stewart-like" runs as the monoline insurers that theoretically stand behind them are themselves downgraded to less than Aaa status.
The withdrawal of deposits from our new age shadow banking system has frightening potential consequences because a thinly capitalized banking system is always at risk relative to its more conservative counterpart. Visualize, as does Chart 1, in crude yet understandable form, today’s shadow system versus that of two decades ago.
While the exact amount of reserves supporting the Bank of Shadows is undeterminable, let’s go back to the $45 trillion BIS estimate of outstanding CDS for more insight. If total investment grade and junk bond defaults approach historical norms of 1¼% in 2008 (Moody’s and S&P forecast something close) then $500 billion of these default contracts will be triggered resulting in losses of $250 billion or more to the "protection selling" party once recoveries are inserted into the equation.
The unfairly "Ben Stein pilloried" Jan Hatzius of Goldman Sachs estimates that mortgage related losses of $200-400 billion alone might lead to a pullback of $2 trillion of aggregate lending. Even if this occurs gradually, he writes, "The drag on economic activity could be substantial." Add to that my $250 billion loss estimate from CDS, as well as prospective losses in commercial real estate and credit cards in 2008 and you have a recipe for a contraction in credit leading to a recession.
The basic problem is that house price declines create large amounts of negative equity. Homeowners with negative equity lose their ability to respond to adverse financial events such as job loss or mortgage reset by refinancing or selling their home, and they therefore become much more likely to default. The importance of this problem is illustrated in Exhibit 16, which shows the distribution of home equity among US mortgage holders at the end of 2006 according to an analysis by First American CoreLogic, Inc. About 7% of US mortgage holders had negative equity at that point, and another 14% had equity of less than 15%. Thus, 21% of all mortgage holders—holding about $3 trillion in aggregate mortgage debt given the average mortgage debt held by the vulnerable borrowers—would be put into a negative-equity position if home prices fell by 15%. Source: Calculated Risk/Goldman Sachs/First American Core Logic
If real estate drops 30% the red sector will be upside down. If housing prices drop 50%, then include the yellow area in the total. Figure a worse case scenario of a 50 percent drop, one fourth of all housing has the potential to become "Jingle Mail."
People in the purple band have no equity to lose. Those foreclosures were the first to affect housing prices. Now the home owners in the red region are in trouble. Bank REO's are pricing into the yellow region right now. The red and yellow areas represent cash that was in the home owner's wallet. It's slowly disappearing. Figure about 25% of home owners in the United States have a good shot at losing their down payment and paid in equity. This will affect consumer spending for many years into the future. A drop like that could take the "hurry" aspect out of any future home purchase. Source
It's true: 55.5% of American households either rent their home or apartment (32%), or own a home with no mortgage (23.5%), see chart above. Then add in the 34.5% of homeowners with a prime mortgage, and the 4.2% of homeowners with a FHA or VA mortgage, and you've got more than 94% of American households who are NOT subprime borrowers, and fewer than 6% who are subprime borrowers. And the subprime fixed-rate mortgages are not really a problem, it's only the subprime adjustable mortgages that are having problems with delinquencies and foreclosures.
Then consider that according to the Mortgage Bankers Association, the percentage of loans in the foreclosure process was 1.69% of all loans outstanding at the end of the third quarter 2007 (both subprime and prime). But because only 44.4% of all homes have a mortgages, that means that only about .75% of all American household own a home in foreclosure.
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