The Amazin’ Ragin’ Contagion

When I wrote more over at RealMoney, I commented on how falling real estate values would eventually affect prime lending.  Here’s an example:

David Merkel
Hear Cody on Housing
8/24/2007 1:25 PM EDT

Much, but not all of the upset in the lending markets (which, if you look at swap spreads, the current manifestation of the crisis seems to be passing — down 4 basis points today), is from deflating values in housing. My estimate for how much further real estate has to decline on average in the US is 10-20%. We need to find owners for about 4% of the US housing stock that is vacant. The pain that has been felt in subprime and Alt-A loans will get felt in prime loans, and possibly conforming loans as well. Fannie and Freddie won’t get killed, but they will take credit losses.

So, listen to Cody. Residential real estate markets do not clear as rapidly as a futures exchange. The illiquidity and variations in lending standards tends to lead to markets that adjust slowly, and autocorrelatedly. I.e., if it went up last period, odds are it will go up next period, and vice-versa.

It will take a while for the residential real estate market to clear. When the inventory gets down to 3% it will be time to start speculating on homebuilders and mortgage lenders again, but real estate prices won’t start rising in aggregate until the inventory of unsold homes gets below 1.5-2.0%.

Position: none

Well, the chickens are now coming home to roost.  Residential real estate values have fallen enough that it has eaten through much of the equity of prime borrowers, leading to distress on prime mortgage collateral.  If that is not bad enough, the banks are also staring down falling commercial property prices.  Even Fed Governor Kohn is telling us to expect more loan losses, which I expect will cause monetary policy to be confused amid rising inflation.

At present, the fall in housing prices may be self-reinforcing, as lower prices make more homeowners marginal, and with a negative life event (unemployment, divorce, disease, disaster, disability), they can no longer afford their property.  Prime mortgages are no exception here, particularly if bought near the peak of the recent real estate craze.

Just be aware that the fall in housing prices will take a while to work out.  It may cause larger financial institutions to fail.  But eventually, there will be a bottom that can be bought, perhaps in 2009-2010.  Until then real estate related financials will remain under pressure, and some with concentrated interests, like the mortgage insurers, will die.