The Prime Dilemma

Courtesy of flickr/Jeff Turner

Courtesy of flickr/Jeff Turner

Just because the unemployment rate dropped from 9.5% to 9.4% does not mean we are out of danger. This is how I think the economy will unfold. The scenario is consistent with what I have been posting for the last six months:

  • Many people want to believe the recession is over. Any piece of less bad news is considered good news.
  • Yes, we will see perhaps +3% real growth in Q3 and positive growth in Q4. That does not mean the recession is over.
  • The pop in growth is largely due to government intervention. The maximum stimulus impact will occur between now and the end of the year.
  • Much of this government spending is simply “shifting” consumption expenditures. Cash for clunkers is a great example. People buy a subsidized car right now rather than next year or the year after. While we get some economic action today, it takes away from what would have happened in the future.
  • Unemployment will continue its climb (but at a slower rate). We will likely hit 11% early next year. I have referred to this as the major risk the economy faces.
  • What is not well understood is that loan defaults are beginning to surge now and will continue for a number of years.
  • This surge in defaults (during and after severe recession with high unemployment) will cause a greater than expected impairment in the value of prime mortgages.
  • The prime defaults (along with other loan defaults – I pick on prime because it is the largest category) will cause a second wave of trouble for financial institutions.
  • Risk aversion increases in the face of new economic uncertainty. Growth falls again. The double dip.

Prime Problems

Last month there was a very surprising report by Moody’s that estimated that 30% of mortgages were underwater. This caused a considerable stir in markets.

Consider this intelligence emailed to me from a Mortgage Consultant for one of the big five banks:

“With the recent surge in refinances, calls through the 800 number have been directed to local mortgage loan officers such as myself. I have personally fielded hundreds of calls from potential customers trying to refinance.. Today I got a call from someone who has a prime mortgage at a new condo development. He was not underwater, but wanted to know how to get a modification because he had just depleted his savings and was not able to continue making payments.. I also spoke to another friend today (a former mortgage loan officer, now unemployed) who is trying to do a modification.. He also has equity in his home but has depleted his savings.. It appears that the bank will be willing to reduce his rate by deferring the interest.. In other words, a negative amortization loan. However, even a rate reduction will not prevent an unemployed homeowner from defaulting (when the payment goes from $4k to 3,500?) These are just two examples of customers whom I’ve spoken with today.. but the list goes on…
I could give dozens more examples but I’ll keep it at that for now unless you’d be interested in hearing more.”

It goes like this. People are drawing down their savings to pay these mortgages (the prime ones too). When they run out, they are delinquent. They try for modification but that just buys a little more time. They are underwater. They default. Default is not a social stigma. Everyone is defaulting. There is safety in numbers. Indeed, you might prefer to default on your mortgage than default on your credit card. You need your credit cards to buy necessities.

Yesterday, Deutsche Bank put a report out that suggested that 25 million homeowners could be underwater. That’s an extraordinary 48% of all those that have mortgages. It is a huge jump from last month’s forecast by Moody’s of 15 million homeowners.

What does this mean?

It means that the degree of impairment of loan values is a lot larger than financial institutions have allowed for — and much higher than the Treasury’s stress test “adverse” scenario. Remember the so-called adverse scenario had an unemployment rate of 8.9% in 2009 and 10.3% in 2010!

50% underwater means that the assumed loss rate on prime mortgages will be much higher than 3-4%. That is really bad news because prime mortgages are the largest single loan class.

You don’t need much of a surprise in impairment to wipe out the capital of the financial system.


It is definitely good news that we lost “only” 247,000 jobs last month. It is less clear that this rate of decrease will be sustained. Remember, right now is the period of maximum government spending. We expect some relief in job creation. However, as the government spending moderates, the real issue with whether employment will continue to heal — or will the job losses climb again?

I am in the camp of increased job losses. I do not believe that 9.5% is going to be the “peak” unemployment rate.

Why did the rate go down to 9.4% even though we lost 247,000 jobs? It is a result of a mysterious contraction in the labor force of 422,000 people.

We also need to take into account that these data are noisy and subject to revision.

Why are we following Japan’s playbook?

The US is following the Japan script of the 1990s:

  • throwing (printed) money at every problem,
  • increased government intervention and throwing good money at bad
  • distortion of credit away from small and medium sized companies (small/med firms drive employment growth),
  • reduced job mobility as underwater homeowners are incentivized to stay in good houses with bad loans,
  • spending on projects that do not necessarily increase future productivity.

There is really only one thing missing:

  • raise taxes.

With a $1.8 trillion dollar deficit, you wonder how long it will take before taxes are on the table. Indeed, the idea is being floated around already.

Download the Deutsche Bank Mortgage research report here.

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