Housing Decline Will Put 10 Million Homeowners Upside Down, With More Mortgage Than House

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While inflation is making most of the headlines, there’s news from the deflation side too.

A headline tells us that homeowners are no longer remodeling as much as they used to. As expected, the people who hustle granite countertops are finally getting a rest.

Poor General Motors…GMAC says it’s closing offices in the United States and Canada following a $2.3 billion loss. First, the company takes it on the chin from mortgage losses. Now, it’s getting jabbed by losses from auto finance. Repossessions, like housing foreclosures, are rising. The repo lots are said to be bulging at the seams.

Jeremy Grantham says he thinks housing prices in the United States will go down 20% to 30% from their peak. That’s a potential loss to Americans’ implied wealth of as much as $6 trillion. This is part of what leads Financial Times columnist Martin Wolf to describe the coming slump in the United States as the “mother of all meltdowns .”

Wolf refers to the work of New York University economist Nouriel Roubini, who argues that the housing decline will put 10 million homeowners upside down, with more mortgage than house. It will lead to collapsing credit…defaults…and huge losses to lenders. It will also bring about a big cutback in consumer spending and unavoidably push the United States into a deep recession.

One of the wild cards of the doomsday scenario is the performance of the derivatives market. No one knows exactly what is in some of these instruments…and no one knows how they will hold up in a crisis.

One thing we do know here at The Daily Reckoning is that they will not hold up as expected. We know that because the assumptions behind them were, fundamentally, nonsense. The most sophisticated mathematical model in the world is not worth a campaign promise if the theory behind it is wrong. And the idea that you can model future prices on the basis of past prices with any predictive reliability is simply wrong. Speaking loosely, it is the problem noticed by Heisenberg when was trying to observe and measure atomic particles at the same time…or ethnologists when they are watching savages gootchy goo. The act of observation causes distortions. As soon as you notice “stocks outperform bonds over the long-term,” for example…you cause a distortion in the stock market. People buy stocks, expecting better performance. Buying drives up prices. Then, higher initial prices bring lower rates of return over the long run.

Using Black-Scholes pricing model…and other sophisticated tricks…the salesmen proved that they could produce higher yields with lower risk. The models, of course, depended on the future being like the past. But never before had investors been offered such opportunities to distort the price curve!

The derivative market exploded in the 2001-2006 period, with annual rates of growth (from memory) of nearly 100%. But then, subprime debt blew up…and buyers started asking questions. In 2007, the derivatives market fell apart. And so far this year, new derivative sales are off 93% from the year before. CDOs, SIVs, Monolines…they’ve all had big trouble.

“Many CDOs could be worth less than 5 cents on the dollar,” Strategic Short Report ‘s Dan Amoss tells us. “Final values won’t be clear until the loans supporting these securities go through the default and recovery process.

“Many Wall Street firms cannot simply confess their final losses, because delinquencies have just started picking up from generational lows. Also, these firms may soon discover that the insurance covering defaults of their CDO holdings is worthless.”

And now comes the Financial Times with more trouble. “CPDOs are at risk,” say the FT . What are CPDOs, we had to ask? They are Constant Proportion Debt Obligations…a kind of derivative on a derivative…a bet on the derivative index.

Not knowing anything about them ourselves, we turn to someone who does for an opinion:

“If these [structured products] do get unwound en masse, the effect on the market will be horrible,” said credit strategist Barnaby Martin at Merrill Lynch. “Between $1,000bn and $2,000bn of synthetic CDOs have been issued over the last four years. Any unwinding will likely be crammed into a much shorter time period.”

Bill Bonner
The Daily Reckoning Australia

Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
Bill Bonner

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