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September 1, 2006
The two-month-long bond rally has hit bottom. It’s been fun: From a peak at 5.24%, the 10-year T-note made it to 4.73% yesterday, which has taken mortgages from just below 7% to just below 6.50%.
This morning’s news that August payrolls had grown by 128,000 jobs was the rally killer -- the economy is slowing, not crashing. Bonds are way ahead of a chance for Fed easing; in the presence of current inflation numbers it cannot ease unless it sees a real threat to economic growth.
We might get some inflation relief from a decline in oil prices. One hint: on Tuesday morning, when Ernesto’s forecast changed from Gulf to Atlantic impact, oil prices fell below $70 as soon as markets opened. To have so much money deployed in a weather wager is a reminder that as a betting parlor, the financial markets make Las Vegas look like a Christmas Club. There is an ocean of oil in storage, and the speculative owners may tire of hoarding.
Speaking of bad bets….
I have argued that the most likely outcome for superheated housing markets is the historically modest retreat from top prices followed by a long, long flat interval. The over-leveraged and imprudent will be exposed, both borrowers and lenders, but declines in excess of 10% from prices actually paid (not asked) will be unusual.
One event could make the Bubblers correct by accident: at the moment that a market going into distress needs credit the most, credit tends to disappear, turning distress into disaster. Coinciding with this five-year bull run for housing has been the easiest credit and lowest defaults ever. Soon, both default and credit will begin to swing back toward center-line, and -- feeding on each other -- may cross over.
The default model is easy: flat prices combined with high leverage beget foreclosures. If you haven’t got any equity, and you get in trouble, you can’t get out. Credit is tougher to evaluate: so long as the borrower makes the payments, it’s a good loan, right? Uh-uh. In this cycle, I’ll bet that trillions of dollars of bad loans have been made, but looked good because doubling prices protected the borrowers. If your home doubles in value, you really have to work at it to get into foreclosure.
The first-time-ever grease on these easiest-credit-ever wheels: a nouveau Wall Street product: credit derivatives. You’re worried about making 100%, interest-only, stated-income loans? Let us help: we’ll hack up the risk into little pieces and sell it all over the world. Many takers. Many, many, many takers on both sides of the trade: the purveyors of bad loans getting rich, financing people really not qualified to buy a home but who want to get into the party; and the buyers of the risk also making a fortune because prices are rising so fast that all credit bets pay off.
Trust me: when the Street discovers big demand for a new product, it will manufacture more. How much more? Junk mortgage lending, “sub-prime”, is in 2006 running about $700 billion per year. What happens to housing if this source of credit dries up?
I believe that mortgage credit mispricing is widespread, and not just for junk loans. 95% financing for A-rated borrowers has been a standard product for 35 years. Until 10 years ago, the feat was accomplished with mortgage insurance; now it’s done as an “80-15-5,” second-mortgage piggyback, because the monthly payment will be about 10% lower than with MI, despite the higher-rate second.
MI companies have known their default risk to three decimal places, like all insurance providers. If the piggyback lenders are so much cheaper, they either know something about default that MI providers haven’t discovered, or they are kidding themselves, abetted by Street operators and their default derivatives.
During market extremes, bet on self-deception. The credit pendulum will swing.
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