Wow, every single day brings a new front-page news article about mortgage financing. For the past few years, they were articles about rising home values and sales. Now the articles are about the rapidly dissolving mortgage market and hedge funds and the totally erratic prices of stocks. The tone and the topics have come full-circle.

increasing complexity of markets makes them more volatile

It is often hard to know what to make of these articles but one of the main take-aways is that the mortgage market is now very complex. The structure of the market has changed a lot since your parents bought their house decades ago and there is a lot of money changing hands along the way. All that capital sloshes from home buyers to banks to wall street to investors in other countries and back again.

the long-lost risk premium

Last weeks big news was that the market had suddenly re-discovered the idea of a risk premium. Banks were raising rates, asking for more information on potential borrowers, and the general money supply for loans started to get "tight".

the Fed's hot-beef injection

And instead of an orderly walk to the exits, someone screamed "Fire!" and it became a stampeed. On Thursday and Friday Federal Banks around the world "injected liquidity" into the markets. (Dont you wish people would say what they actually did instead of using jargon?)

It is hard to find an explanation for "injecting liquidity". I have heard two explanations. One: it means that government banks bought mortgages from commercial banks, thus giving the banks cash and removing some of their liabilities. (Isn't that a tax-payer funded bailout?) Two: it means that the Fed wanted to keep short-term interest rates at 5% so it was willing to loan money at that rate to anyone who asked. (Doesn't that defeat the purpose of charging a risk-premium for lending if you give riskier borrowers the same rate?)

Whatever the definition, an interesting fact was that the US injected about $50B but European banks injected about $200B. Isn't that the opposite of what you would expect since the cause of all this was supposedly home loans in the USA?

Moving forward we can hope that banks will go back to making loans the right way - expecting borrowers to actually show some evidence they can pay the money back. We can also hope that the hedge funds and "smartest guys in the room" will lose their shirts if not jobs, as they should, for creating this mess.

home(less) alone 4

We can also expect pressure on home prices as the cost of money (ie bank loans) increases and the supply of buyers shrinks.

What will happen when home prices flatten, even if they dont fall? How many people will find that they borrowed more money for a home than they can comfortably afford? There is a lot of talk about sub-prime borrowers but how many prime borrowers used ARM's and no-money-down loans to refinance their own house or to purchase investment property "risk free"? We may find out over the next two years.

Estimates are now roughly 2 million homes will go through foreclosure even though banks are already making extraordinary measures to help borrowers refinance (and continue to pay something). The "subprime" assumption is that these homes are all in the ghetto but how many of those mortgage defaults will be for wealthy neighborhoods?

I predict that poor minority "subprime" families wont be the only ones in trouble. There will be a lot of pain for wealthier families that took risks they did not understand because the "you cant loose!" media hype was so strong. (And the financial training in our education system is so weak.)

Expect a repeat of the dot-com and the Enron-pension stories.

mumbo-jumbo loans get more jumbo

One thing for those of us on the Left Coast to watch is jumbo loans. Fannie Mae and Freddie Mac buy about 1/2 of all mortgages from banks (which allows banks to make more loans). But they are restricted by law from buying any loans above $417k. Any loan above that amount is a jumbo loan and it is handled by private institutions.

Given that the median home price in Seattle is now about $420k, this is potentially a big deal. Just this past week Fannie/Freddie asked to be allowed to buy jumbo loans -- Congress said no. And the rates lenders are charging for jumbo loans went up more than the rates for regular loans. (As it probably should.)

So expect higher rates for loans over $400k, which again, will put more pressure on those $800k, $900k home prices that I see for very average-looking properties all over our area. Expect the drop to start in the SF Bay area, then LA, then San Diego and finally Seattle. (Which is also the order homes appreciated in.)

unwinding the unmeasurable

Another thing to watch for is being called the "great unwinding". Along with the mortgage boom there has been an options/derivatives boom. Warren Buffett has been warning about this boom, saying that it makes the risk of the great 1920's start market crash look mild in comparison. One of the problems with options is that they are almost impossible to measure but a recent WSJ article stated the total value of traded options at over $390 TRILLION.

The "unwinding" refers to all the hedge funds and other investors that bet heavily on options and what happens if those options fail to work as designed or companies bet wrong. We have already seen two funds from Bear Stearns that went belly-up for betting wrong. There are now articles from "quants", the big-giant-heads who write the statistical models that allow computerized option trading, that are saying the markets are behaving in ways the models do not predict -- ie they are losing money. (Ooops - garbage in-garbage out.)

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So expect more volatility. Expect more doom & gloom on home prices and mortgages. Expect more hedge fund loses, especially from banks and pension funds. And expect the politicians to stick their noses in and muddle everything up (or worse, expect them to bail out the big fish and let the little fish "learn a lesson").

As that Chinese proverb says: We live in exciting times.