The Binary Circumstance

From Yahoo News/Reuters:

NEW YORK (Reuters) – Nearly one in five U.S. mortgage borrowers owe more to lenders than their homes are worth, and the rate may soon approach one in four as housing prices fall and the economy weakens, a report on Friday shows.

About 7.63 million properties, or 18 percent, had negative equity in September, and another 2.1 million will follow if home prices fall another 5 percent, according to a report by First American CoreLogic.

The data, covering 43 states and Washington, D.C., includes borrowers nationwide, even those who took out mortgages before housing prices began to soar early this decade.

Seven hard-hit states — Arizona, California, Florida, Georgia, Michigan, Nevada and Ohio — had 64 percent of all “underwater” borrowers, but just 41 percent of U.S. mortgages.

This is a really big problem and you will see the government and banks moving more aggressively to adjust mortgages to keep people in their homes no matter who gets elected president.

Even a small decline in value from this point will put 25% of mortgages underwater.

The problem is that all the governement intervention in the market so far, which created the bubble in the first place, has distorted housing values to the point that nobody really knows what the real value of a particular home is. If you don’t know its value, it is very difficult to figure out a “safe” value for a new mortgage. If housing prices continue to fall after an adjustment, there’s nothing to keep the house from going underwater again.

In spite of today’s huge stock market rally, there are many, including myself, who think we have probably not hit bottom. CNBC has a useful article on how to identify capitulation. I’d suggest reading the entire article and also looking at the graph which identifies the stages.

The activity in the Dow Jones Industrial Average and other global markets shows an acceleration of downwards momentum. The massive increase in volume has not yet developed and this suggests the market bottom is not yet established. There is a high probability that markets will see a selling climax in the next 3 to 5 days.

But here is the important difference. The recovery rally after climax selling is temporary. It is part of a longer-term consolidation pattern that may last months, or even a year, and make more new lows before a new sustainable uptrend can develop. The potential shape of the recovery is shown in the chart. The bull market rebound rally follows a temporary selloff. A bear market rebound rally follows climax selling. It is a relief really, but it is not part of a sustainable trend change.

After a bear market, volumes remain low. When you lose trillions of dollars it takes a long time for spare change to start rattling around the economy again. Spare change drives the bull market because money is available for speculation.

Today the House approved the massive $700 billion bailout (I’m sure that’s just the beginning) that was approved by the Senate a couple of days ago.

The stock market as measured by the DJIA had been up over 300 points in anticipation of the positive vote in the House. But it dropped 470 points off it’s high for the day to close down 157 points for the day, and down over 800 points for the week.

In addition, the credit markets remained frozen after the bailout was approved.

My own personal view is that the market is trying to form a bottom and it would do that without the bailout. (See some of the evidence here.) The pressure to get the bailout passed was more about getting the taxpayers to pick up the bill for the bad decisions of banks. It would be much harder to sell that politically if the markets had already started to recover on their own.

Today’s purchase of Wachovia Bank by Well’s Fargo without any help from the government, along with Warren Buffet’s multi-billion dollar investments in Goldman Sachs and GE show that big investors are finding great long-term value in the stock market at these levels.

Continued efforts by the government to artificially prop up markets with bailouts and restrictions on short sales will only further erode confidence I believe. Artificially propping up housing prices didn’t work in recent years did it? That’s what got us into this mess. But at along as the public views government intervention in the markets are their salvation, we’ll get more of the same. I fear this could drag on for a long time.

Markets, in order to function properly must be free and honest. The government has a nasty habit frustrating those ideals making it impossible to know what the true value of anything is.

President Bush along with others in his administration have told us repeatedly as the housing bubble burst and the credit crisis swept around the globe that the American economy was sound. Now he’s singing a different tune and the name of that tune is “700 Billion Dollar Bailout.”

Now Bush says the U.S. is in the midst of a serious financial crisis.

In his speech last night he said very little about the causes of the current credit problems which are largely due to government monetary policy and their cozy relationship with Wall Street. Bush did mention Fannie Mae and Freddie Mac but made them sound as if they were the victims of the mortgage meltdown rather than one of the main causes.

Bush said:

See, in today’s mortgage industry, home loans are often packaged together, and converted into financial products called “mortgage-backed securities.” These securities were sold to investors around the world. Many investors assumed these securities were trustworthy, and asked few questions about their actual value. Two of the leading purchasers of mortgage-backed securities were Fannie Mae and Freddie Mac. Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk.

While he acknowledged that they helped fuel the market for questionable investments, he inaccurately described their role. They are the creators of mortgage-based securities, not the buyers. They buy loans and package them into securities that are sold all around the world and they guarantee the loans and the principle. When borrowers began to default, Fannie and Freddie had huge liabilities which is why the government took them over to keep them from failing.

The government takeover of both companies put the taxpayers on the hook for the loan guarantees.

Wikipedia describes their role:

Fannie Mae (and Freddie Mac) buy loans from mortgage originators, such as banks and non-bank mortgage firms. It repackages the loans, as mortgage backed securities, and sells them on the secondary mortgage market, with a guarantee that the interest and principal will be paid, whether or not the original borrower pays. Also, Fannie Mae may hold the purchased mortgages for its own portfolio. By purchasing the mortgages, Fannie Mae and Freddie Mac provide banks and other financial institutions with fresh money to make new loans. This gives the United States housing and credit markets flexibility and liquidity.[6]

If he doesn’t understand the cause of the problem, can Bush and Co. be trusted to fix it?

We must not forget how we got conned into the war in Iraq with a lot of fear-mongering. Remember how little it was supposed to cost and quickly that problem was supposed to be fixed?