Fire Cloud...
An irregular marking on the exterior of Native American pottery: usually resulting from burning fuel coming in direct contact with the vessel during firing

Monday, 24 November 2008

The Katrina Depression

Main Street, America

Today the Government sunk an additional $20 billion into Citibank and guaranteed them against losses of another $300 billion on their mortgage portfolio. They're swapping treasury bonds for bad mortgages.

We stood by in stunned disbelief three years ago as we watched our Government fumble and mismanage the Katrina disaster and its aftermath. There was plenty of warning. We knew the storm was coming three days in advance. We watched the disaster unfold on TV. Apparently our government officials were too busy to watch TV and seemed unaware of the catastrophe for nearly a week.

I told my neighbor that it looked like a $50 billion problem in the making as we watched Katrina move slowly north that weekend. A year earlier, I told him that adjustable rate mortgages would cause big problems for homeowners sometime in the future.

The last depression, in my opinion, was caused largely by speculative and unsound lending practices. You could put down $1,000 and borrow another $9,000 from a local bank to buy common stock on margin. The resulting wave of bank failures after Black Monday depressed economic activity and increased unemployment for a decade.

This time lending practices became even more bizarre. Mortgages were bundled into strips by the originators and sold as securities. Insurance was purchased in the form of credit default swaps. The issuers of this insurance did not have assets to cover the losses. Despite this, the rating agencies ranked these bundles of mortgages as investment grade securities. These were called CDOs or Collateralized Debt Obligations.

We all know about the subprime mortgages. Those were issued to folks with bad credit ratings. What the hell! The commercial banks and mortgage companies got fat fees for originating the mortgages and passed most of the risk on the Fanny Mae, Freddy Mac or investors. The Investment Banks racked up huge profits securitizing the mortgages and passing them along to foolish investors.

Then there were the ARMs or Adjustable Rate Mortgages. These came with a low initial monthly payment. Several years later the payments reset, sometimes to more than twice the original payment.

There were also “No Doc” mortgage loans where the borrower was not required to provide and documentation about income. The bankers amusingly called these “liar loans”.

Even more insane were the “pay option” mortgages. Here you pay a low teaser rate of interest only until your mortgage balance hits perhaps 125% of the original loan and then your payments reset to maybe triple the original monthly payment.

The speculative bubble in housing prices caused by insane monetary policy and Republican deregulation of our banking system sprang a leak and started to deflate two years ago.

We are a long way from the bottom of this economic death spiral. Houses still cost three times as much to buy and maintain as they do to rent. Even with millions of homeowners “underwater” (which is why I call this is the Katrina Depression) on their mortgages, home values will continue to decline for probably another five years until 2013. As a result, even strong borrowers will simply walk away from their mortgage obligations in droves, piling up an increasing supply of ever less valuable housing for sale.

The mortgage modification programs being implemented by banks right now will not be effective. They simply reduce interest rates and payments, sometimes adding the reduction to the mortgage balance. This keeps the homeowner trapped in an unsellable home until eventually and inevitably they walk away, leaving the bank with a bigger problem down the road.

If you own an investment home or a second home, a bankruptcy judge can modify the terms of your mortgage in bankruptcy. The judge’s options include reducing the interest rate AND reducing the principal balance of the mortgage. Due to a 1978 modification of US bankruptcy laws, this option is not available if you actually occupy your home and need it for shelter.

A further wrinkle is that most mortgages are simply serviced and not owned by banks. When a bank services a loan, it has no incentive to modify the mortgage terms. On the other hand, the bankers get paid “cost-plus” to foreclose on the home and nobody is auditing the cost or the plus.

For years, we have been living with an economic engine supercharged and overheated by cheap and freely available consumer credit. I feel a little sorry for the Chinese and the Russians. They were largely unaffected by the Great Depression. Now that we have sold them on the benefits of the capitalist economic system, we introduce them to the Katrina Depression. Surprise!

Our economic hopes rest squarely on the shoulders of Obama. I think he is “The One”...Maybe I'll rent The Matrix again today and wake up from this bad dream.

-Bob the Blogger (aka Phred Firecloud)

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