U.S. Mortgage Lenders Will Need Federal Govt. Bail Out

Uh oh...here come the clowns.

"The impact of losing 2.2 million homes, I suspect, will be in a lot of areas of our cities and towns that are already pretty hard hit, so we clearly want to look at it."

What the chairman of the Senate banking committee wants to look at is the same thing that Wall Street was eyeing yesterday...the thing was so disagreeable it sent the Dow down 242 points...and, according to the English papers, upset stock markets all over the world.

And... "it's going to get uglier," said Angelo Mozilo on TV yesterday.

The whole U.S. mortgage industry – with over $10 trillion outstanding – is already not prepossessing sight. It faces a 'liquidity crisis,' the CEO of Countrywide Credit (NYSE: CFC), the nations' number one mortgage lender, told viewers. There are more than $1 trillion in 'subprime' mortgages outstanding. Many of these are turning out as anyone with half a brain might have expected – badly. And yet, the mathematical geniuses who package and trade these things seem to have been caught unaware.

Take a look at the ABX index, where subprime-collateralised debt is traded. The ABX, says the New York Times, "tracks how much it costs to insure a group of BBB-minus bonds based upon subprime mortgages. The Index is a derivative which falls in value when the cost of insurance rises, so it can be seen as a proxy for the value of the underlying bonds". With defaults in the mortgage business mounting, insurance costs have increased dramatically, sending the index into a spiral down. It has declined approximately 30% since January 1, 2007, and 7.4% literally overnight during the recent subprime crisis.

Yesterday was not exactly ugly...but nor was the picture as placid and pretty as it has been for the last few years. Mortgage payments are getting later...nearly 5% of them are delinquent. Among subprimes, the delinquency rate has jumped to 13.33%...with subprime ARMs (adjustable rate mortgages) at 14.44%.

Of the entire mortgage market, about a third is insured by the U.S. federal government – that is, about $360 billion worth. But according to Martin Hutchinson's calculations, if the US housing market goes down just 15% - a rather modest decline for such an immodest boom – the mortgage industry and its backers, lenders and investors would suffer a capital loss of about $1 trillion, with about a quarter of that amount in loans guaranteed by the federal government's bagholder – Freddie Mac.

Freddie Mac (NYSE: FRE), unfortunately, has only about $79 billion to draw on...which would leave it a little short. Seeing the handwriting on the wall and reading it without moving their lips, its executives announced that they would tighten standards. Henceforth, it would be harder to lay defective mortgage credits onto the feds. Thus Mozilo's comments. A 'liquidity crisis,' after all, doesn't arise in the desert. Where there is no credit, no one expects credit. Where there is a flood of it, on the other hand, people come to rely on it. And where there is excess credit, people come to rely on it excessively.

How quickly a market can go from excess to shortage! We now see what can happen to the entire 'flood of liquidity' that buoys up everything from the prices of Bombay apartments to the art auctions at Christie's. It can disappear in a trice. Then what happens to all those assets? Simple, they sink back to more reasonable prices...and then (because markets tend to over-react in both directions) to prices that are unreasonably low. So, you see, dear reader, there is much to look forward to.

But let us return to the US Senate, just to laugh at the clowns. The gap between what the feds' insurer has on hand...and the loss it is likely to be asked to cover...is approximately $150 billion. Small change, to be sure. But where will it get the money? And it is not as if the entire rest of the financial picture will remain as soggy as it is now – even as the mortgage industry dries out. We saw yesterday that the Dow is likely to follow the mortgage industry. And the economy, too, it likely to feel the dry breezes blowing off the mortgage financing badlands. Just as the consumer's water line is connected to the community reservoir, so is his individual consumer spending firmly attached to community house price trends. Come the parching winds and it is likely to curl up and blow away.

Still, the Daily Telegraph reports that "American politicians are considering an emergency bail-out of 2.2 million borrowers struggling with their mortgage payments."

Are these the same politicians that are already adding half a trillion to the US national debt in the next two years? But anything is possible. If the government – against all odds – can bring peace and prosperity to Iraq, surely it can stop a liquidity crisis...can't it?

Bill Bonner
The Daily Reckoning Australia

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