Saturday, March 15, 2008

Bank mortgage losses - just beginning or almost over?


Interesting data in this link on recent trends in home ownership from the Census Bureau:

http://calculatedrisk.blogspot.com/2008/01/homeownership-rate-cliff-diving.html

Back in 2006 I found it interesting that the US home ownership rate had risen to about 5% over the 100 year average (69% vs 64%). Knowing that after bubbles burst, things tend to revert to the mean, I thought I might be able to estimate what the banks will lose post-bubble. A back of the envelope calculation yields about $1.5 Trillion in lender losses if the ownership rate returns to the 64% historical average. This is based on 20% loss on foreclosure assumption and the median home price of $235K - see the Census Bureau report in the above link for the number of housing units involved. The loss rate could be pretty optimistic - most banks are assuming their subprime CDO losses are between 50-100%, but this is due to trying to mark them to market in an illiquid market, not any real assessment of what home prices will do. The contrary opinion is here:

http://seekingalpha.com/article/68550-subprime-write-downs-more-than-50-done-write-ups-coming-next?source=feed

Given how wrong S&P has been about just about everything, I'm taking their opinion as evidence that someone paid them to paper over a really big hole. If the $1.5T is correct, it means only about 20% of the $1.5T has been written down so far, which means the failure of Bear Sterns is just one of many to come.

There is evidence that one cause of the higher home ownership rates is a permanent demographic shift towards people marrying later in life and thus there being a higher number of single-occupant homes. This would increase demand for housing absent that trend. However we also know that there were several other now reversed causes such as low interest rates, a blind rush to profit on rising home prices, and loose lending standards. In previous bubbles, ownership rates and prices of the asset in question reset to historical averages only after undershooting their historical averages, which could mean the 1.5T is too low.

Once the 10% of US homeowners that have zero or negative equity believe that the price of their largest asset is headed south for the long haul many will just bail. No lowering of interest rates will matter because they just won't want the albatross. The only thing that might have an impact is if lenders forgive the principle amount impacted by the price decline. Which puts us back into at least a trillion in losses for the banks. A loss like that would wipe out the market cap of a good fraction of Wall Street. Think tech stocks 2001-2003. Or Japan over the last 15 years.

The Fed's recent actions suggest that they will do just about anything to try to prevent it. We'll have to leave the efficacy and side effects of a mass bailout to another post.

What do you think? What do you trade?

[disclaimer: I am wicked short C, FNM, NTAP, QQQQ, DSL, BSCI but have bailed out of my builder shorts as of three months ago. ]

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