August 15th, 2023 by MG
There are several camps on the concept of a real estate bubble. Much like a high school clique list, you have your hardcore doomers, your middleliners, your people in the business trying to forecast “mostly sunny with a chance of rain” to keep their business going, and then you have the consumers out there trying to make sense of everything and trying to find how this fits into their daily lives.
I think each has some good points, but if there’s one truth to be had, it’s that none of us truly know what’s going to happen. We can only watch the sky fall and see what damage results.
Nouriel Roubini writes on his blog that this housing bubble we’re currently experiencing will be “MUCH worse” than the 1998 Long Term Capital Management (LTCM) liquidity crisis. Remember the term “Too Big To Fail” because we’ll be hearing more about it. LTCM was a hedge fund that had amazing success with returns of over 40% in its first years, only to eventually lose $4.6 billion dollars in less than 4 months. It was considered “Too Big To Fail” because the effects on the US market would be disastrous if it did.
Now we’re starting to hear the same about some of the companies who hold pieces of your mortgage once your bank sells it on the secondary market and it gets repackaged into pieces of multiple investments.
But why is today’s bubble so much more dangerous than previous financial disasters?
- “You have hundreds of thousands of US households who are insolvent on their mortgages. And this is not just a subprime problem: the same reckless lending practices used in subprime….were used for near prime, Alt-A loans, hybrid prime ARMs, home equity loans, piggyback loans. More than 50% of all mortgage originations in 2005 and 2006 had this toxic waste characteristics. That is why you will have hundreds of thousands – perhaps over a million – of subprime, near prime and prime borrowers who will end up in delinquency, default and foreclosure. Lots of insolvent borrowers.”
Importance: This is important because most people in the business and those afraid of inciting panic keep mentioning “containment” and how this bubble only affects subprime. The problem is that the products used to finance the homeowners now unable to make payments were not solely subprime but often a mixture.
- “You also have lots of insolvent mortgage lenders – not just the 60 plus subprime ones who have gone out of business – but also plenty of near prime and prime ones.”
Importance: There is an upwards gravity in the marketplace and bubbles like ours tend to pop “up”. Imagine getting the corner of a napkin wet – notice how the water slowly creeps up the napkin? The same happens the longer the prime lenders remain exposed to that bubble.
- “You will also have – soon enough – plenty of insolvent home builders. Many small ones have gone out of business; now it is likely that some of the larger ones will follow in the next few months.”
Importance: Many people not only bought up to the max they could (not) afford, but also from small builders. When warranty claims start going unanswered, or building defects start to become apparent, as these builders go out of business – a lot of homeowners will be left holding broken homes to complement their broken mortgages.
- “We also have insolvent hedge funds and other funds exposed to subprime and other mortgages.”
Importance: Picture a daycare full of small children. Imagine one child getting sick with an infectious disease. Exposure to that child, even though nobody knows how serious the illness is, continues to slowly infect the other children. The subprime crisis has been an interesting “dye test” to see how far subprime reaches. We’re learning more and more every day that there was never any way to just keep subprime “contained”.
So Why Exactly Is This Housing Bubble Different?
As Roubini goes on to explain:
Why? Insolvency versus illiquidity.
A liquidity problem occurs when a household, firm, country, etc is still solvent, but faces a sudden crisis, where a creditor is unwilling to refinance their claims for example. An insolvent debtor does not only face a liquidity problem, but could not pay the claims upon them over time, even if there were no liquidity problem. One, broadly, suggests sound fundamentals; the other very much not so.
And just hours later, Reuters reported the following:
Countrywide, the US largest mortgage lender, announced that it faces “unprecedented disruptions” in the debt market and secondary market for mortgages that “could have an adverse impact on the company’s earnings and financial condition, particularly in the short-term.”
Same for WaMu. This is a serious and scary development.