Saturday, November 17, 2012

The Government Home Mortgage Bubble Is Beginning To Implode

The mainstream financial world was shocked this week the Wall Street Journal released an article titled "FHA Nears Need For Taxpayer Funds."

I have been discussing this coming bailout and disaster for years now. In 2009 I wrote an article called The Four Headed Monster, in which I described the new role taken on by the FHA in the mortgage market and how it would ultimately lead to that headline.

While long time readers have known this was coming, we can review briefly where we stand today.

The following chart shows the breakdown of mortgage originations (the entity that provided the loan) going back to 2005. It shows that over 50% of loans created came from the private sector (non-government) during 2005 - 2006. At this point the government's share of the market was already extremely unhealthy (they provided the other 50%). Before 1997 the role of the government in the mortgage market was far less.

You can see that beginning in 2008, things went from very unhealthy to a complete communist take over. The private portion of the mortgage market (the orange section) essentially has disappeared. The government now controls everything. VA are veteran loans (red), GSE's represent Fannie/Freddie (blue), GN is Ginnie Mae (green), and FHA is the Federal Housing Authority (green). All are government programs. Click for larger image.


Fannie and Freddie, which should have disappeared completely or been drastically reduced in size during the summer of 2008 have stepped up and begun purchasing and insuring even more mortgages than they were at the peak of the crisis. However, they needed a third entity to step in and help carry the load.

Enter the FHA.

The FHA has become the new de-facto subprime lender for the government. They kept their down payment program at only 3.5% as home prices were plunging, understanding that these loans would instantly move underwater. This allowed less financially intelligent buyers to step in front of a moving freight train and be decimated by the housing collapse. The tax payers were responsible for any clean up needed.

Now we are there. The next chart shows the loans insured by the FHA that are 90 days past due. They stepped in beginning in late 2008 to take over the subprime market and now those loans are beginning to default in mass. In September the number of serious delinquent loans rose to 738,991, which was 10% of their total $1.08 trillion in loans guaranteed. This only represents those are are 90 days past due. 17.3% of their total loans are delinquent.


AEI estimates the current capital shortfall at $48 billion, a number that is rising fast.

What will happen? Money will continue to be sent from the federal government (tax payer) to pay for these losses. The federal government will issue treasury bonds, raising the deficit, in order to send these funds. The Federal Reserve will continue to fund this deficit with a printing press through QE programs.

This is the exact process I laid out in 2009 in The Four Headed Monster. Now we are seeing it live.

As a brief refresher, let's discuss for a moment what would happen if they government stepped away from the mortgage market (or only became 50% of the market again instead of 100%), something every mainstream analyst says would bring "the end of the world."

Home prices would collapse. Banks holding the loans would take huge losses. The government would take huge losses on their nationalized mortgages.

The cost of living for every person in the country would fall significantly. Instead of going into debt and making mortgage payments on a $300,000 home, a homeowner could rent until they had a large enough down payment to purchase that same home that now costs $50,000 to $75,000. Their 20% down payment would be reduced from $60,000 to only $10,000. Their monthly mortgage payments would be 3 to 6 times less than they are now and they could have the same home paid off well before retirement.

Instead of being a debt slave to the government or a bank for the next 30 years (or probably much longer) they could own their home free and clear and use their money to purchase other goods - stimulating the economy in a healthy manner.

Would this ever happen? Of course not, but I just wanted to show you how terrible the "end of the world" would be. Change only comes when we reach a crisis. Until then, enjoy the temporary home price bounce. I really hope the Fed can bring mortgage rates down to 0% and the banks can hold the shadow inventory off the market forever. It will sucker as many people into the market as possible back in before we reach the real price correction that is coming.

For a thorough discussion on how the real estate market will look over the next few years I recommend reading through:

The Complete 2012 Residential Real Estate Outlook.

*This will be updated as we moved closer to January 1 as part of the 2013 outlook.*

4 comments:

  1. I want to thank you for this brief analysis of the housing situation.
    One thing I would like or you to consider is an alternate scenario - one where the government does not step away from the mortgage market in the case of an unfolding crisis but instead issues a sort of debt foregiveness for all outstanding mortgages. If that were the case then having debt/mortgage prior to this would be beneficial as you will own the property free and clear.
    I will give you one example - in Soviet Union prior to collapse the government was the sole owner of all property. During the collapse a decree was issued where people residing in a house/apartment were now the owners of those properties.
    This was followed by a switch to a new currency with people holding cash being wiped out.
    My question to you is - will it be possible for this scenarion to take place here instead of letting property prices collapse and standard of living costs to go down?
    This scenario will be much more beneficial to the banking establishment as they can start a new debt cycle from scratch - having sold all of their mortgage bonds to the government prioir to this.

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  2. NYC is asking why a government that monetizes its own debt doesn't do us a favor and monetize everyone's debt. Because if you freed the "debt slaves" without pain, they'd rush back to the bank and borrow trillions of dollars to buy second homes, new cars, fine art, gold bars, or whatever. The government would be forced to monetize again and again until the dollar lost all value.

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  3. Dave, each cycle of government monetization can last 20-40 years and that will solve the immediate problems. Also consider a scenario where the new currency is backed by gold that way the new dollar will be the undisputed world reserve currency for a long time.
    Political environment has to be considered along with economic logic. Logic tells us that the rates have to go up and prices will decline on real estate among other things. Politically this will be impossible as everyone will stop paying mortgage en masse and the government will be faced with interest payments that will be increasing dramatically. Unemployment will skyrocket and even unrest might take place. Question that you should ask yourself is why would the government willingly let a situation like that to take place? They will not. The plebes will need to be placated and show will go on.

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    1. I think such a move, debt forgiveness, even if it is only a portion of the mortgages is certainly possible. With the government as the mortgage market it will be far easier to handle such a task, or even modify loans, moving forward. The same type of argument will be put forth with student loans as that disaster unfolds. The comparison to the Soviet Union is fantastic.

      The question is then whether or not it would be beneficial to purchase a home today with as close to 100% financing as possible in hopes of this outcome occurring. The same argument is raised for buying real estate in anticipation of hyper-inflation; where the debt would be wiped away through currency devaluation.

      The problem is that if we do not reach one of these extreme events, and I still consider both as outliers at this point, it is much more likely that a higher interest rate environment (the one that I describe on this site) is what we will experience. I am a poker player, so I look at the odds I believe events will occur and then make investment decisions based on that - understanding that the outliers are certainly possible.

      In other words; I would rather buy gold and wait and see how the chips fall with real estate in the short term (preparing myself for a major investment into real estate if events unfold the way the I personally see them most likely to occur).

      Thank you for the insightful thoughts on the subject.

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