I will argue that the most important first-order risk for financial markets derives from the likelihood that 10 million to 15 million households may walk away from their homes if – as likely - home prices fall another 10% in 2008 and further in 2009. When – in the summer of 2006 – this author argued that this would be the worst housing US recession in the last 50 years and that home prices would fall – from their peak value – by 20% such predictions were taken as being nearly lunatic. Too bad that this author ended up being too optimistic, not too pessimistic, about the severity of this housing recession. Indeed, this will end up to likely to be the worst housing recession in US history – not just in the last 50 years – and home prices may likely eventually fall by 30%, not this author’s “optimistic” 20%.Don't you love this guy? Again, I think it's more like 70%. Actually, it's meaningless in some areas that will be completely abandoned -- housing developments that were built in the last five years were only bought into with the idea that they'd be sold at a profit.
[N]ow that home prices keep on falling and an increasing number of home owners end up in negative equity territory voluntary defaults and “jingle mail” are surging. Is there then anything to be surprised about?There are only 300 million Americans. If we lived 15 to a house, that'd be everyone.
How many households will end up in negative equity territory and will thus an incentive to walk away from their mortgages? The answer to this question of course depends on how much home prices will eventually fall from their peak. A recent analysis by Goldman Sachs suggests that if home prices fall another 10% in 2008 after having fallen by about 8% from peak in 2007 (based on the Case-Shiller/S&P index) about 15 million households will be in negative equity territory. There are other estimates that are consistent with the Goldman Sachs one. Calculated Risk – a very well respected housing blogger – estimated that if home prices decline by 10% in 2008 the number of households with negative equity will be 10.7. But this estimate was based on a partial underestimate of the fall in home prices in 2007 relative to its 2006 peak (as the Case-Shiller data for all of 2007 were not available at the time of that estimate). Thus, the number of households with negative equity could be closer to 12 million. Calculated Risk also estimates that a cumulative fall in home prices of 20% implies 13.7 million households with negative equity while a 30% cumulative fall implies 20.3 million households with negative equity.
These figures are staggering considering that in 2006 the total number of households with mortgages was 51.2 million. So between 20% to 40% of households with mortgages may end up with negative equity in their homes and with a big incentive to walk away from their mortgages.Not to put any ideas in your head? But, banks aren't set up to process this many defaults. About six months from now you can probably stop paying your mortgage and expect to stay in your house for five or six years. At some point they may just assume they've evicted you, and their acquirer will fold your property taxes and utility fees into their operating expenses.
That would wipe out most of the capital of most of the US banking system and lead most of US banks and mortgage lenders – that are massively exposed to real estate – to go belly up. You would then have a systemic banking crisis of proportions that would be several orders of magnitude larger than the S&L crisis, a crisis that ended up with a fiscal bailout cost of over $120 billion dollars. And the scary part of this scenario is that – with home prices likely to fall by 20% or more – this scenario of systemic banking crisis is becoming increasingly likely.Let's take it as read that Barack Obama is the next President. What's he going to do about Greenspan's destruction of our banking system? It might not seem like a fair question, but it's pertinent. Banks do valuable things! I'll be a little sorry to see them go.