Many people wonder what the fuss is all about in the mortgage and credit markets. After all, they have owned their home for many years, the mortgage is at a comfortable level and the payments are manageable, and all the disruption is taking place at the margins. That is a fine viewpoint as far as it goes.

The problem is that mortgages are highly leveraged instruments, and so problems at the margin can become far larger problems if they result in a 10% or 20% or greater decline in the value of the underlying asset, if the problem is widespread enough, if enough people are affected. A classic problem is that the loan to value ratio for a mortgage can become indeterminate. Another, greater problem is that entire markets can seize up, and that is one reason that credit default swaps have had such a terrible record in 2007, as the chart above shows.

The WSJ has an article today on the pending Treasury proposal to put together some sort of relief plan that includes a deferral of resets in certain mortgages’ interest rates. The newspaper quotes many experts who are pro and con the plan, and says this:

As much as $362 billion in U.S. subprime home mortgages with adjustable interest rates are due to reset at potentially higher rates in the coming year, according to Banc of America Securities, risking a wave of defaults by borrowers unable to afford the new monthly payments. That in turn could exacerbate a wave of write-offs by investors who now own those mortgages. Losses related to bad mortgages already have reached the tens of billions of dollars and have led to turmoil in the world’s financial markets.

Fears that the problems could accelerate have led the U.S. Treasury and the mortgage industry to develop a plan that would postpone the higher rates for some borrowers.

The success of the plan, details of which are still under discussion, may hang on the many investors in securities backed by mortgages. A coalition of lenders negotiating with the administration includes investor representatives, but the securities are held world-wide and it would be impossible to get everyone’s approval. A deal could also spark lawsuits from investors who believe they’re being cheated out of their money.

Unlike in years past, when just a bank and a borrower were involved in a mortgage, today’s loans have been bundled together, sliced into securities and sold to investors. That has created problems for officials trying to help borrowers, because so many parties are involved.

We are firmly in the camp that doing something is better than doing nothing, even though the Treasury plan currently looks like some crazy Rube Goldberg device. Extending the pain will not kill the patient. However, harrumphing about “moral hazard” and letting markets work and so forth just might do great harm in this instance. Because the truth is that nobody really knows how bad the problem could get — the downside of leverage is panic.

We want to offer a few numbers that might be surprising about how anomalous is the current housing bubble and just how much spending in the US has tracked the increase in home values for much of this decade. This is from a report by Hegemony Capital Management on analysis done by another firm, Hoisington Investment Management:

Over the past 5½ years, $1.1 trillion of equity has been extracted from American homes. This represents almost half (46%) of the increase in total consumer spending over the same period. In the first nine months of 2007, $219 billion was cashed out of U.S. homes according to Freddie Mac estimates, equivalent to 53% of the increase in personal consumption during that period.

Household mortgage debt stood at $10.143 trillion at the end of the second quarter of 2007 compared with $4.295 trillion in 1999, an increase of 136% over six years. Mortgage debt relative to disposable personal income (the money used to service that debt) increased from 64.7% to 100.2% during this period, a 35.5% rise that was greater than the total increase that occurred over the 43 years leading up to 1999.

The value of residential real estate also jumped during this period, but the disposable income number is the one that pays the mortgage. The presumption is that without the housing equity extraction, consumer spending growth would have been much more muted. Furthermore, consumers added to their variable cost debt burdens to finance their spending, placing themselves in a vulnerable position when rates on teaser loans increase.

Moreover, home prices remain near record highs and, as Hoisington puts it, “the unprecedented advance from 1999 through 2006 was directly tied to an equally unmatched growth in mortgage debt.” From the 2006 peak, housing prices, in inflation-adjusted terms, have declined 3.4% thus far in 2007 according to the Shiller Real Housing Price Index. Real house prices therefore remain 58% above the previous cyclical high reached in 1989 and almost 94% above the average real price from 1890 through 2007.

Adding to Hoisington’s worries are the fact that housing starts and building permits remain well above prior cyclical lows (even after the housing market index compiled by the National Association of Home Builders declined 72 percent from its cyclical peak in June 2005); there is record inventory of unsold homes on the market; and nearly $800 billion of adjustable rate mortgages are due to reset between October 2007 and December 2008.

“Real house prices therefore remain 58% above the previous cyclical high reached in 1989 and almost 94% above the average real price from 1890 through 2007.” That certainly would appear to be a bubble that one would want to see deflate gradually.

We do not want to appear alarmist, and of course the harrumphers could be absolutely correct in their judgment that doing nothing is the best course. However, the worthy gentlemen of the Clearing House banks in New York also thought they were doing no harm when they voted to let markets correct themselves and so let a small bank fail many years ago. We all know the end of that story.

When it comes to highly leveraged investments — particularly one involving as many as 75 million Americans and their families — one wants to be very careful indeed. Whether you are for or against government action, it is important to remember that, as of today, nobody really knows where the bottom is or how bad it could get.

This entry was posted on Saturday, December 1st, 2007 at 11:52 am and is filed under General, business. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.