[GJM] CITS CAPITAL & DEBT WATCH: "The Unraveling Continues"

[W. Curtiss Priest]

**                                                              **
		  W. Curtiss Priest, Ph.D.
	  Center for Information, Technology & Society
	      466 Pleasant Street Melrose, MA  02176
  E-mail: BMSLIB at MIT.EDU, Voice: 781-662-4044, FAX: 781-662-6882


			February 4, 2008

			Public Issue #132:

		    CITS CAPITAL & DEBT WATCH

		      "The Unraveling Continues"

	Commentary by Dr. W. Curtiss Priest, Director:

The recent infrequency of this newsletter is almost entirely
due to the obviousness of the problem.  And, when the cover
story of Business Week so clearly depicts the unraveling, the
inevitability of what all must suffer through is, as they say,
now, "front page news."

I take little glee in the unfolding, partly because close
family have first-hand knowledge that their homes can no longer
support debt-finances, 'obscene' spending habits.  Indeed, the
prudence within our own household was not mirrored in some of theirs,
and now our savings go to helping them.

And, the obscenity of it all only changes complexion.  One
who is dear to us lost telephone service as she lost the
service out of insolvency, declared bankruptcy, and, negleting
that using the phone without an assigned carrier creates obscene
levels of charges, running up $400 of phone debt in just two months.
She received this bill about the same day that her bankruptcy
was accepted by the court ... it is too bad that her bankruptcy
is not retroactive.  Another family already went through bankruptcy
once and now is probably about to do this a second time, plus,
financial spending differences between the spouses is likely
to add 'divorce' to the mix.  And, who knows what lurks in
other family households where we are not yet involved?

My neighbor, Jim runs a "boarding house" near us in this Boston
suburban middle class city, as both (?) daughters are recently
divorced.  I am sure he wishes he sold the house (mostly living
in New Hampshire in summer and Florida in winter), and some
smattering of information about his social security and pension
income suggests that he, too, must be walking on water.  Various
familys nearby are already housing their fully grown children, as
the combination of low-, or no-, income, added to the rapid rise
in housing costs in the Boston region, has made it impossible
for these children to live the American Dream -- homeownership
(or renting at market rates).  And this is all happening in "good
times."

Recently the WSJ's financial writer, David Wessel was interviewed
on PBS "Nighty News."  It was too painful to watch as he, and
every financial pundit, does not want "his/her words" on nightly
news to be THE trigger of a 2000 point sell-off, the next day.
So, a little hedge here, a little hedge there ... when directly
asked if there could be a problem, he, displaying no signs of
panic or dismay, simply said what some looming problems were, as
if he were recounting a situation that really didn't involve him.

Those of us who already experienced the emotions of panics and
crashes, as we read Kindleberger, Shiller, Jameson/Rees-Moog to
understand the never-changing nature of these events, found
ourselves shunned by friends and ignored by the media.  Meanwhile,
even Shiller is described as needing to bridle his tongue by
his lawyers about future house prices, as he is an advisor to the
S&P/Case-Shiller index.  Ohmi  Can we even count all the ways
in which people have been shushed?  And, what is one to think
when "e-Trade" advertises and brags that it has 1000 new "players"
EACH DAY.  Don't even bother going to Los Vegas to lose money;
we've brought the thrill and allure to your own PC!  And its
legal.

W. Curtiss Priest, Ph.D.
Editor

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Previous issues of the CITS DEBT WATCH:
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Cover Story January 31, 2008, 5:00PM EST

Housing Meltdown

Why home prices could drop 25% more on average before the market
finally hits bottom

by Peter Coy

As Washington policymakers struggle to keep the U.S. out of recession,
the swirling confusion over the housing market is making their job a
lot tougher. Will American consumers keep shopping or be forced to
pull back? Will banks lend freely or be hamstrung by mortgage
defaults? What are the best policy options right now? Those and other
important questions simply can't be answered without a good idea of
whether home prices will rise, flatten out, or keep dropping.

Some experts have begun to suggest that a bottom is in sight. Pali
Research analyst Stephen East wrote in a research note to his firm's
clients on Jan. 25 that "the sun is not shining very brightly, but at
least the worst of the storm has likely passed." With optimism
budding, Standard & Poor's beaten-down index of homebuilder stocks
soared 49% from Jan. 15 through Jan. 29.

But it's considerably more likely that the storm is still gathering
force. On Jan. 30 the government said annual economic growth slowed to
just 0.6% in the fourth quarter as home construction plunged at a 24%
annual rate. The Standard & Poor's/Case-Shiller 20-city home price
index fell 7.7% in November from the year before, the biggest decline
since the index was created in 2000.

And that could be just the start. Brace yourself: Home prices could
sink an additional 25% over the next two or three years, returning
values to their 2000 levels in inflation-adjusted terms. That's even
with the Federal Reserve's half-percentage-point rate cut on Jan. 30

While a 25% decline is unprecedented in modern times, some economists
are beginning to talk about it. "We now see potential for another 25%
to 30% downside over the next two years," says David A. Rosenberg,
North American economist for Merrill Lynch (MER), who until recently
had expected a much smaller slide.

Shocking though it might seem, a decline of 25% from here would merely
reverse the market's spectacular appreciation during the boom. It
would put the national price level right back on its long-term growth
trend line, a surprisingly modest 0.4% a year after inflation. There's
a recent model for this kind of return to normalcy after the bursting
of a financial bubble. The stock market decline that began in 2000
erased most of the gains of the boom of the second half of the 1990s,
leaving investors with ordinary-sized returns.

Why might housing prices plunge violently from here? Remember the two
powerful forces that pushed them up: lax lending standards and the
conviction that housing is a fail-safe investment. Now both are
working in reverse, depressing demand for housing faster than
homebuilders can rein in supply. By reinstituting safeguards such as
down payments and proof of income, lenders have disqualified thousands
of potential buyers. And many people who do qualify have lost the
desire to buy. "A down market is getting baked into expectations,"
says Chris Flanagan, head of research in JPMorgan Chase's (JPM)
asset-backed securities group. "People say: I'm not buying until
prices are lower.'" He predicts prices will fall about 25%, bottoming
in 2010.

Nobody can be sure how far prices will decline. Still, if prices drop
that much, it could mean big trouble for the U.S. economy, which is
already on the brink of recession. It would blow a hole in the balance
sheets of banks and households, slicing more than $5 trillion off
household wealth. That's roughly the size of the drop in stock market
wealth from the peak in early 2000, a big reason for the recession of
2001. Yale economist Robert J. Shiller, a longtime housing bear,
points out that a housing decline that started in 1925 and ran until
1932 weakened banks and contributed to the Great Depression, which
started in the U.S. in 1929.

MACARONI AND CHEESE

It has become a cliché, but an accurate one, that Americans used their
homes as ATMs during the boom years. They lined up for cash-out refis
or home-equity loans to turn housing wealth into spending money. So
far, the amount of equity being withdrawn has remained surprisingly
strong?$700 billion at an annual rate in the third quarter. But it's
bound to dwindle if prices keep falling, giving the economy a further
downward push. According to an analysis conducted for BusinessWeek by
Zillow.com, the real estate Web site, a further 20% decline in prices
nationwide would mean that two-thirds of people who bought in the past
year would owe more than their homes would be worth, meaning they
couldn't take out cash if they wanted to.

Alesandra Sanchez, who works for the city of Las Vegas, and her
husband, Craig Mireles, a project manager for an architect, are living
that problem. Their house in Summerlin, Nev., has quickly gone from a
money geyser to a drain. The couple raised about $70,000 in cash in
2005 by refinancing less than a year after they bought their home.
They put the money toward student loans, medicine for Sanchez's
rheumatoid arthritis, and other things. Now the cash is gone and the
interest rate has ratcheted up to 11%. Alesandra says the new payment
of $4,200 a month "is doablebut it's like eating macaroni and cheese:
It doesn't leave room for anything else." No wonder that retail sales
fell 0.4% in December, and economists are projecting a sharp slowdown
in overall consumer spending this year.

The second shock to the economy from the housing bust will come from
the financial sector, which has been weakened by losses on mortgages
as well as mortgage-backed securities and more exotic derivatives.
Banks borrow so much money to fund their investments that if a loss on
some holding reduces their capital by $10, they have to reduce their
lending by $100 to avoid exceeding their self-chosen leverage targets,
calculates Goldman Sachs (GS) chief U.S. economist Jan Hatzius. He
estimates that banks and other financial institutions will suffer
about $200 billion in real estate losses and respond by cutting their
lending by $2 trillion, or about 5% of total lending. The cutback
could be even more extreme if they react to the turmoil by lowering
their leverage ratios, he says, rather than keeping them intact. Banks
have already begun tightening lending standards. In the third quarter,
mortgages were harder to get than at any time in the 17-year history
of the Federal Reserve's survey of senior loan officers.

Prices won't fall uniformly, of course. Once-booming cities such as
Las Vegas and Miami and weak economies like Detroit are likely to fare
worse than Seattle or Charlotte, N.C. The price decline will be
smaller if it's stretched out over longer than, say, two years,
because inflation will have more time to do some of the job of eroding
the real value of homes. Still, if the national average decline is
anywhere near 25%, the entire U.S. economy is in for trouble. Keep in
mind, says Merrill's Rosenberg, that the relatively puny price decline
to date has already pushed home-loan delinquencies to their highest
level in 20 years. The plunge in residential construction reduced the
economy's annual growth rate by a full percentage point in the third
quarter of 2007. A bigger decrease would wipe out even more
jobs?carpenters, real estate agents, mortgage brokers, furniture
salespeople.

For American consumers, meanwhile, huge losses would almost certainly
undermine the long-held premise that homeownership is the most
reliable way to build wealth and a middle-class life. "I know you're
not supposed to say I told you so,' but I'm at the age where I can do
it: Homeownership was oversold," says 67-year-old House Finance
Committee Chairman Barney Frank (D-Mass.).

One look at the long-term home price chart tells you all you need to
know: Starting in 2000, prices crossed above their trend line and just
kept going up. The spike had never happened in modern U.S. history,
according to data dating back to 1890 that Shiller painstakingly
compiled for the second edition of his book Irrational Exuberance in
2005. Back then he predicted a sharp drop in house prices. Now he says
lawyers won't let him publicly forecast home prices because he's
involved in preparing the market-sensitive Standard &
Poor's/Case-Shiller home price indexes. All he'll say is: "This is a
historic turning point."

Optimists point out that the Fed, Congress, and the White House are
all committed to keeping housing aloft so it doesn't kill the economy.
The Fed reduced the federal funds rate by three quarters of a
percentage point on Jan. 22 and followed with a half-point cut on Jan.
30?an extremely rapid move for a major central bank. Homebuilders also
are doing their bit to support prices: They've cut production so
drastically that even though home sales fell more than expected in
December, the backlog of unsold new homes shrank slightly. Douglas
Duncan, chief economist of the Mortgage Bankers Assn., predicts
existing home prices will slip less than 2% this year before beginning
to rebound in 2009.

Pessimists aren't impressed. One of the first high-profile bears on
housing, Ian Shepherdson of consulting firm High Frequency Economics,
is looking for a 20% decline in prices from their peak but says 40%
wouldn't shock him. "We've never been here before, so there's no road
map," he says.

There's even uncertainty about where prices are right now, since many
would-be sellers are refusing to cut them enough to make a sale. A
Harris Interactive (HPOL) survey for Zillow.com in December found that
36% of homeowners thought their homes had increased in value over the
past year, vs. 23% who thought they had decreased. That willful
optimism translates directly into the record overhang of unsold
existing homes: more than 4 million.

For a truer picture of the market, look at sales by banks and
builders, which don't have the luxury to wait things out because they
have to worry about cash flow. Deutsche Bank (DB), among other banks,
has been slashing prices on repossessed homes to get rid of them. In a
recent transaction mentioned on BusinessWeek's Hot Property blog,
Deutsche Bank sold a house in Woodbridge, Va., in December for
$150,000, less than half its last sale price of $315,000 in the spring
of 2005. In November, Lennar (LEN), the big builder, sold 11,000 home
sites to a joint venture it formed with Morgan Stanley Real Estate for
$525 million, 60% below what they were valued on Lennar's books.
That's capitulation, and it's likely to occur more often as sellers
get the idea that waiting won't solve their problems.

MORTGAGE HURDLES

Plenty of other evidence supports the notion that home prices have
further to fall. There's a crisis of confidence in the securitization
of mortgages, which pumped up housing demand by giving buyers access
to nationwide and even global pools of capital. The loose links in the
securitization chain allowed risky loans to be made at low rates.
Trust in that system is broken and will not be mended quickly.

Almost the only mortgages being securitized successfully are the ones
bought by Fannie Mae (FNM) and Freddie Mac (FRE), the private
companies with implicit government backing. They accounted for about
87% of mortgage securitizations in December, vs. fewer than half in
2005 and 2006, according to the publication Inside MBS & ABS and the
investment bank UBS (UBS). Subprime lending is nearly shut down,
home-equity loans and lines of credit are scarce, and jumbo mortgages
(too big for Fannie and Freddie to purchase) command premium rates. A
survey of real estate agents found that a third of planned home sales
were canceled or delayed last fall because of loan problems.

Even Fannie and Freddie, which style themselves as the last resort of
the home buyer, have tightened standards and raised fees. And they
remain reluctant to raise funds to buy mortgages if it means lowering
returns to shareholders. Fannie Mae Chief Executive Daniel H. Mudd
joked to Wall Street analysts in December that the process of cutting
the dividend and selling preferred shares to raise money pained him so
much that "I wanted to cut off both my arms and both my legs, and my
head, and my kidney."

Cheaper mortgages won't necessarily ride to the rescue, either.
Thirty-year conventional fixed-rate mortgages failed to fall after the
Fed's two January rate cuts, averaging 5.5% on Jan. 30. Financing
remains cut off for subprime borrowers (BusinessWeek, 12/11/07) and
for owners whose home equity has dipped too low to qualify for a new
loan. Fed rate cuts will ease, but not eliminate, the pain from resets
on adjustable-rate loans.

For another bearish view, there's what economists refer to as the
Mankiw paper. In 1989, long before working in the White House as chief
economic adviser or writing his best-selling textbook, Principles of
Economics, Harvard University economist N. Gregory Mankiw co-wrote a
paper that was startlingly negative on housing. He and David N. Weil
predicted that home prices would decline by 47% after inflation over
the next 20 years, based on a shrinking pool of potential first-time
buyers and an expectation that baby boomers as a group would spend
less on housing as they grew older.

It could be that Mankiw and Weil were not so much wrong as premature.
Although boomers have thwarted expectations by adding on rooms and
second homes as they age, they won't thwart nature. "At some point,
death or illness will cause baby boomers' houses to come onto the
market," observed John Krainer, a senior economist at the Federal
Reserve Bank of San Francisco, in an in-house publication in 2005.
When the huge boomer generation shuffles off, the nation's housing
needs will wane. That will create an oversupply unless builders see it
coming and reduce construction. Judging from the recent overbuilding
binge, though, their forecasting abilities leave a lot to be desired.

NECESSARY EVIL

Observers with a Calvinist streak see a housing crash as not only
necessary but also positive. It will force Americans to live within
their means, which will enable the U.S. to work off some of its
towering debt, says Peter D. Schiff, president of Darien (Conn.)
brokerage Euro Pacific Capital, who was early in predicting the crash.
In 2005 the share of gross domestic product devoted to residential
construction reached the highest since 1950, when the U.S. was racing
to house the baby boom generation and make up for the lack of
construction during the Depression and World War II. Now, says Schiff,
"if there's any construction, it's going to be factories, oil
exploration, mines." He takes almost unseemly delight in predicting
tougher times ahead: "Americans are going to have their credit cards
taken away from them by the lenders. We're going to turn the American
economy into a cash economy."

Foreclosure counselors such as Mildred Wilkins foresee similar
changes, except in looking back they put more of the blame for the
fiasco on builders and lenders and less on borrowers. "We have been
fed the illusion that acquiring a home was a magic key to stability,
to wealth-building," says Wilkins, who travels the country advising
lawyers and others on how to handle foreclosures. Even though she is
president and founder of an Indianapolis company called Home Ownership
Matters, which promotes responsible ownership, Wilkins says she never
believed the "poppycock" that homeownership was a sure path to wealth,
calling it a myth foisted on lower-income Americans by politicians
serving the builders and bankers.

The sense of betrayal is probably most intense among the working-class
families who were supposed to be the greatest beneficiaries of easy
access to low-down-payment mortgages. The less-pricey outskirts of
expensive cities such as Los Angeles and San Francisco are precisely
the areas where the biggest share of recent buyers are underwater on
their mortgages. Cindy and Larry Chaffold, who live in the desert east
of Los Angeles in Apple Valley, bought a house for $216,000 in 2005
that's now appraised at $190,000. Cindy was ready to hand the keys to
the bank until she got her loan modified. Says Chaffold: "I have been
screwed, chewed up, and spit out."

HARKING BACK TO FDR

If home prices really fall an additional 25%, Washington's rescue
program is likely to seem seriously inadequate. So far the Bush
Administration is pushing two main ideas: FHASecure, which offers new
mortgages to certain well-qualified borrowers, and Hope Now, a
private-sector program to streamline the modification of unaffordable
loans. But FHASecure isn't open to people who are underwater on their
mortgages?in other words, those who most need help. And the Hope Now
alliance doesn't seem to be coping successfully with the mounting
backlog of loan delinquencies. The other big Washington initiative, to
crack down on loose lending practices, could be ineffective and even
counterproductive, because it's making loan funding less available
right when it's needed most.

The next big reform ideas may hark back to President Franklin D.
Roosevelt. Many of the housing market's props today?including Fannie
Mae and the Federal Housing Administration?were launched during the
1930s. If things get bad enough, say some analysts, it could raise
interest in renewing another innovation of the Depression years, the
Home Owners' Loan Corp., which lent money directly to hard-pressed
borrowers to prevent foreclosure. If enough banks get into trouble,
Congress might even create something roughly parallel to the 1980s-era
Resolution Trust Corp., which cleared up the savings and loan crisis
by shutting down weak thrifts, thus wiping out the investments of the
owners, and then selling off their assets to the highest bidders.

And with homeownership no longer seeming like such a sure thing,
national housing policy could become more evenhanded toward renters.
Congress is weighing the creation of a National Affordable Housing
Trust Fund that would build, rehabilitate, and preserve 1.5 million
units of housing for the lowest-income families over the next 10
years. The national homeownership rate has already fallen about one
percentage point from its peak, to 68.2% in last year's third quarter.


However things unfold, the changes are likely to be wrenching. The
bigger the boom, the harder the fall.

Links

The Good?

Several markets are still booming. In Australia, median prices in
Melbourne rose about 25% in 2007 and could surge past higher-priced
Sydney within a year, according to a Jan. 26 editorial in Melbourne's
Herald Sun. China's Xinhua Financial Network reported on Jan. 24 that
property prices in 70 large Chinese cities rose 10.5% in December from
the previous year, despite "several directives aimed at squeezing
liquidity from the market"?confirming that bubbles aren't easy to pop.

The Bad?

But in other places, price growth is slowing or reversing.
BusinessWeek (MHP) reported on Nov. 21 that on the outskirts of
Spanish cities "you'll find a forest of half-built apartment towers
and townhouses." In Ireland, traditionalists welcome the market's
sudden cooling. A Jan. 24 column in the Kildare Nationalist rued the
way a construction boom had spoiled the appearance of 800-year-old
Athy. "The once-compact market town...has been extended and reshaped
almost beyond recognition," the columnist wrote.

?and the Silver Lining

Prices are falling in Britain as well, and to some analysts, that's
just fine. On Jan. 28, The Times of London ran a commentary by a
geography professor Chris Hamnett titled, "Great news! House prices
are down." His point: By making homes more affordable, a big price
drop will be good for the market's long-term health.

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