Friday, February 8, 2008

The Menace Of Mortgage Debts

Lessons From The Great Depression—
The Menace Of Mortgage Debts: Where Do We Go After The Housing Crash?

By Dr. Housing Bubble | 3 February 2008

As we approach Super Duper Tuesday, a day that is historical in magnitude, we need to reflect on how we got into the current housing mess. It would be easy to say that the mortgage problems simply arrived overnight— but they have been building up for a decade. This housing crisis is unprecedented; that is until we look at the mortgage mess from the Great Depression. On Saturday, I was digging through journals written during the Great Depression and found an article written by Arthur Holden for Harpers in 1932, four years into the Great Depression. This will be the fourth part in our Great Depression series:

"As the great depression advances into the fourth year it becomes increasingly apparent that the mortgage crisis involves something more than the "little fellow" struggling to keep his home. It is not only the function of "shelter" that is involved. The mortgage structure is a part of the whole economic scheme, into which is woven the intricate system of social inter-dependability which allows us to live and carry on. When the customary flow of credit is seriously interrupted at any one point many diverse processes are also interrupted upon which we depend for both the comforts and the necessities of life. Since the War [[WW I: normxxx]] the civilized world has experienced the greatest economic upheaval of which we possess a recorded history. The mortgage crisis is perhaps the final phase of this world-wide dislocation of our credit system."

You could take the above paragraph out of any business section of today’s business journals. We are suffering much like the credit problems of the 1930s. Housing even 76 years ago had a major impact on the overall health of the US economy. This housing mess is much beyond "subprime" since housing is such a staple of the American economy and we are seeing even prime loans coming under strain.

"To understand what has happened it is necessary to look at the problem in perspective. In the first place all facts are relative. We cannot understand the menace of the mortgage situation unless we consider the cost of carrying our present mortgage burden in relation to our changed national income. In 1929 the national income for the United States was 85 billions of dollars. By the year 1932 this figure had fallen to 36 billions. The most conservative figure for mortgages that I can find shows that in the year 1929 the combined total of urban and rural mortgages in the United States amounted to at least 46 billions of dollars. It is difficult to determine how much this figure has changed between 1929 and 1932. The first effect of the calling of outstanding loans was to increased the amount of money borrowed against real estate. It is safe to say, however, that any general increase in the total of mortgage loans has since been erased by the calling in of outstanding mortgages and the constant demand for the reduction of principal. I, therefore, assume that the total present mortgage indebtedness is about 43 billions of dollars."

We already know that wage growth has been stagnant throughout the past decade. However, during the Great Depression national income fell by an astounding figure while mortgage debt remained rather stable. What this did is multiply the overall burden of debt servicing, since it had to be done with less income. Sound familiar? We are already being given an idea of why it is important to quickly adjust mortgages to current market prices to alleviate some of the burden or we will quickly fall into a similar fate as then.

"The reduction of the national income has had a drastic effect upon the rents which it has been possible to pay. In other words, the yield of real property has suffered a sharp decline. The best estimates that I am able to gather indicate that this decline amounts to as much as 35 per cent. Yet the fixed mortgage charges have declined hardly at all."

We are already having predictions of this kind. Merrill Lynch went so far as predicting a 30 percent decline in national real estate. Of course to mention the Great Depression or any historical knowledge is blasphemy in today’s world of 24 hour pseudo-business cable stations. Yet we are already mentioning similar price declines in the magnitude of the 1930s. In fact, this bubble is much larger than any in history including that of the Great Depression.

"But the prosperity of the nation depends upon its ability to make economic use of what is capable of producing; that is, it must either consume what it produces or sell it abroad. If because of fixed contracts, real estate levies too large a tool on the national income, the amount of income available for the consumption of commodities contracts also. As a result we have industrial stagnation, followed eventually by hunger and suffering.

"Production cannot be generally resumed until credits are liberated to restore the purchasing power of the people. Credits cannot be liberated for the purchase of commodities, in appreciable quantity, so long as current funds are being drained off for the liquidation of capital obligations. Increased lending for refinancing purposes will only make matters worse, because on the one hand it draws off additional funds which might otherwise have gone into compensating producers, while at the same time it reestablishes debt burdens which we acknowledge we are unable to carry. "

This is a major rub for our current economy. At least during the Great Depression, we had a larger agricultural and industrial base. The amazing thing of today’s modern economy is that we essentially had an economy that was built on trading, building, financing, and flipping real estate. Our manufacturing base is nearly obsolete due to off-shoring. The center of our economic machine was trading houses to one another in the pyramid climb to larger and bigger homes. How we have continued on this long is simply amazing.

"Bankers are not free agents. They are frequently compelled by law to resort to foreclosure proceedings in the interest of the beneficiaries of trust funds in cases where it is apparent that foreclosure will not only cause further misadjustments but perhaps ultimately bring a burden instead of a benefit to the mortgagee. So long as they exercise a diligence in following the prescribed legal procedure, trustees are held harmless in the eyes of the law, quite irrespective of the social consequences their actions."

You can simply replace trustees here we hedge funds. With the Hope Now Alliance and all these ill advised "help plans" they haven’t done much since the problem isn’t just sub-prime borrowers but the "little fellow" who has good credit but is finding it ever more difficult to service their debt. Now with unemployment rising and so many people dependent on a perpetually increasing housing market, we are seeing our economy severely contract.

"For example, two friends purchased adjoining identical houses in 1926 for $30,000. A certain bank placed a $15,000 mortgage on each. In 1929 the first owner paid off $10,000 on his mortgage. The second owner, when asked to do likewise, requested a reappraisal of his property. When a value of $40,000 was placed upon it he was able to induce the bank to lend him an additional $2,000, which he explained he needed in his business. In 1932 when both mortgages again fell due the bank needed liquid capital and, therefore, asked for full payments. Neither owner was able to meet this call. A reappraisal indicated that the value of the houses had fallen to $16,000 each. On one, the bank held a mortgage for $5,000, on the other for $17,000. What did the bank do? It commenced foreclosure proceedings on the strong mortgage fro $5,000 and allowed the weaker to stand. Why? It could readily transform the smaller mortgage into an asset on its books, whereas the larger mortgage would inevitably show a loss if the property were taken over."

You mean people were doing cash out refinancing back in the 1930s? Many mortgage brokers thought they were at the vanguard of mortgage financing but that game has been done, and nothing is new under this housing sun. I think you know how that game ended and there is nothing to stop history from repeating itself.

"It is often forgotten that real estate is a capital asset, not a commodity. Loans which are secured by capital assets are very different in their nature from loans which are secured by commodities.

"Real estate for example is not consumed, it is used. Never in one year are the capital requirements of the nation bought and paid for. When a loan is made against capital the lender in a sense purchases an interest in the property, limited by the conditions of the contract.
In the case of real estate he
[effectively] purchases a share in the property secured by a mortgage."

How many times have we read on housing or economic blogs that housing is not a commodity? I’m surprised that somehow rules that applied seventy years ago were no longer applicable in the financial engineering models of today. A house still has four walls and a roof. Quickly we are realizing that these "outdated models" do have some fundamentals behind them.

"When dollars being to rise in value, that is to say when prices in general being to fall, fixed obligations such as bonds and mortgages and other forms of notes offer an opportunity for a quick profit. This is a phenomenon that has long been common knowledge among shrewd investors. If, however, the fall in prices continues to the point where general earning capacity is inadequate to meet fixed obligations, then these special advantages begin to break down."

Bernanke has all but abandoned this point and remember that he is a student of the Great Depression. In his mind’s eye he feels that the Fed didn’t do enough quick enough to stop the Great Depression. His 125 basis point cut shouldn’t come as a shock to those of you who have read his research. Expect more rate cuts as he is now able to put his hypothesis to the true test in reality. This is not a trial run. The article goes on to offer 3 suggestions for fixing the current mortgage mess:

"Three ways have been suggested to take us out of our dilemma. These are:

"1. Inflation of the currency in the hope of raising prices to such a basis that the nominal income in dollars will be adequate to meet fixed contract obligations, which at present seem insurmountable. There are grave technical complications which tend to offset what the uninformed consider easy advantages of inflation. For real estate these complications would be ruinous.

"2. The laissez-faire method: to let contract which cannot be executed go by default. To real estate this means widespread foreclosure with properties passing into the hands of the prior mortgagee, or, where unsatisfied tax liens exist, into the hands of local governmental units. As has already been pointed out, such as method produces chaotic uncertainties and dislocations.

"3. The third method offers the substitution of new machinery for the adjustment of contracts which cannot be carried out in their original terms. In brief, this means the establishment of legal [means] to permit the waiving of accepted foreclosure proceedings in the public interest, on condition that all parties to the contract enter into new agreements which are equitable in the light of changed conditions."

Number 1 is all but hopeless, since the Fed has already taken the dollar to the gallows. Number 2 isn’t happening either, since we have the prospect of higher caps, massive drops in rates, and government programs such as FHASecure and the Hope Now Alliance [[all hoping to salvage some semblance of the 'status quo': normxxx]]. And the intervention hasn’t stopped yet. The third method offered the best solution in the 1930s and offers the best solution today. The only difference being that today people are often intentionally inviting foreclosure and the pride of homeownership is hardly a ubiquitous phenomenon. This doesn’t change the fact that for those who still want to live in their home, laws should allow for cram-downs and mortgage restructuring. Good luck getting this passed with second lien holders standing to lose their entire principal. We are in for years of legal wrangling.

This was addressed in the 1930s as well:

"Although legally there is nothing between strict adherence to the contract and the pleasure of the mortgagee, our great insurance companies, finding that they cannot enforce either the letter of the contract or the letter of the law, have commenced the granting of mortgage moratoriums. The situation is developing so rapidly that it is impossible to tell how far adjustments will have gone by the time this paper appears. As I write, bills have been offered in several State Legislatures providing for moratoriums on mortgage indebtedness and even on local taxation. A bill has already passed the House of Representatives in the Congress which is designed to permit a debtor to apply to the courts for the appointment of a custodian looking to 'a composition or an extension of time to pay his debts.' After acceptance by a majority in number of creditors, including a majority in amount of secured claims, the court may confirm this composition.

"What the nation as a whole needs is
the recognition of the principle that debt claims cannot exact a higher rate of interest than the product of labor will yield. Our debt obligations, like our tax obligations, are consuming far too large a share of the nation income to-day."

What is unfolding today seems to be an end to a super-cycle. A once in a lifetime credit bubble that permeates the entire economy. What we have here ironically is at the helm of the Fed, someone who studied deeply the Great Depression and is facing a very similar circumstance to that of 80 years ago. His hypothesis is that monetary policy could have stopped or at least mitigated some of the pain of the Great Depression. We are now seeing that theory being put into practice. So far there are few signs of it working and, if anything, the law of unintended consequences is showing that banks and Wall Street are benefiting more than the 'little fellow' [[but, of course, this has always been the eventual resolution: normxxx]]. You have to wonder if he is thinking, "maybe my thesis is wrong" but knowing how unwillingly many people in power are to admit to their mistakes, don’t bet on it.



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