Back in January I posted a short piece on how banks tend to pile into whatever is hot just as it’s about to implode. Bank of America’s acquisition of credit card giant MBNA, at a time when consumer debt was setting records was, I predicted, the deal that would put an exclamation point at the end of history’s longest credit boom.

Okay, maybe that was a little premature. The real orgy, it seems, is just beginning:

Earlier this week, money center bank Wachovia agreed to buy Golden West Financial, California’s second largest S&L, for $25 billion. The deal gives Wachovia 120 new branches in California and more than doubles its home-loan portfolio. And—get this—almost all of Golden West’s mortgages are adjustable rate. ``We now have the geographies that we have coveted in this deal, and we will focus on these high-growth markets,'' said Wachovia CEO Kennedy Thompson.

The next day, MarketWatch ran an article titled “Wachovia deal may force more mergers”, which concluded that other banks will now feel compelled to make big acquisitions “to avoid losing ground in the huge California market.” And then today Bloomberg reports that Merrill Lynch is shopping around for a major mortgage lender. As amazing as it sounds, the big banks are suddenly hot to get into real estate, especially California real estate.

So…let’s take this piece by piece, working from broad to narrow:

Household debt. In 1990 American families owed banks, car dealers and credit card companies about $3.6 trillion. Today we owe nearly $12 trillion. The cost of servicing this debt eats up about 17% of disposable income, a level typically associated with the onset of recession. AND since much of this debt is in the form of variable rate mortgages and adjustable rate credit cards, its cost is ratcheting up as rates rise across the yield curve. Not the profile of a society about to make mortgages a growth market.

The housing market in general. That some formerly hot markets are imploding is common knowledge by now. But it’s still fun to see the numbers and hear the stories.

From the Honolulu Star Bulletin, May 6:  Honolulu home sales down 41% year over year in April, and Maui condo sales off by 50%. 

The New York Times, May 9: The inventory of homes for sale in the Fort Lauderdale area has quadrupled, year over year, to 20,000.

Dow Jones Newswire, May 8: “Preliminary reports from builders Hovnanian Enterprises Inc. (HOV) and Toll Brothers Inc. (TOL), whose quarters ended April 30, indicate demand is falling faster and more sharply than previously thought, and that the pullback is no longer confined to hot markets that had seen sharp home price run-ups in the past few years. Hovnanian's orders fell 20% in its fiscal second quarter - an about-face from the 5.5% order growth reported in its fiscal first quarter. Toll's orders declined 32%, which is steeper than the 29% dropoff posted in its fiscal first quarter.

For Toll, the order decline was across the board as all of its geographical regions reported year-over-year decreases in demand. Chairman Robert Toll attributed the declining demand to higher cancellations and to speculative buyers who are dropping out of the market and putting the homes they recently acquired up for sale. Although Toll said his company doesn't sell to speculators, ‘we have certainly been impacted by the overall increase in supply.’"

According to real estate consultancy Majestic Research, new-home sales in all 40 markets it tracks fell during February and March. Some examples: 

Washington, D.C., -22%
Tucson, Ariz. -50%
Phoenix -37%

The major homebuilders, instead of pulling back in the face of falling sales, are apparently trying to make it up on volume. According to Dow Jones, “Toll Brothers plans to open 80 communities during the next six months, and expects to wrap up fiscal 2006 with 295 subdivisions, up from 230 in fiscal 2005.”

As all those adjustable rate mortgages ratchet up, it’s getting harder for last year’s marginal homebuyers to make ends meet. According to real estate consultancy RealtyTrac, “A total of 323,102 properties nationwide entered some stage of foreclosure in the first quarter of 2006, a 72 percent year-over-year increase from the first quarter of 2005 and a 38 percent increase from the previous quarter.”

The California housing market. 80% of San Diego homebuyers chose adjustable rate mortgages in both 2004 and 2005. Home sales are down 46% in Sacramento, 30% in San Francisco, and 50% in Los Angeles/Long Beach, year-over-year. From the New York Times: “A house at 57 Marina Boulevard in San Rafael, across the bay from San Francisco, was originally listed at $1.45 million. The owner recently dropped the price to $949,000 when a competing house on the same street lowered its price to $959,000, from $989,000…In Marin County, the prices of about a quarter of all listings have been reduced….In Santa Cruz, inventories have tripled to 124 days, from 42 days.”

As for the idea that California’s population will keep growing because everyone wants to live there, real estate analyst Rich Toscano at Piggington.com notes that San Diego’s population actually shrank in 2005. "But it's even worse than that, because much of the population growth of recent years has been due to births. Until Countrywide goes live with their Fetal Lending Division, we can probably just focus on migration: people moving in and out of San Diego (or, put another way, population growth with the effects of births and deaths removed).” Analyzed this way, it turns out that for three years running, more people have moved out of San Diego than have moved in—and the trend is strengthening.

More from the New York Times: “For the first time in nearly a decade, you can smell the anxiety. The listing agent for a four-bedroom home on Scripps Trail in San Diego informed other agents in the multiple-listing service that a "very, very motivated seller will entertain all reasonable offers" and "will help with closing costs." The house was listed in September at $810,000. After a previous price cut, the seller is now willing to entertain offers as low as $685,000. But they didn't attract much interest…Inventories in the San Diego area have risen 25 percent in the last year, to more than 19,000 unsold homes, a record.”

And on a personal note, my little town in northern Idaho is crawling with transplanted Californians. A neighbor (and recent immigrant from Sonoma) is a real estate appraiser, and says that the last five houses he’s done have been for Californians moving in.

A final word from Rich Toscano: “There has been zero upward price pressure this spring, for the first spring in who knows how long. It looks like things are truly going to start falling apart.”

Classic short. What does all this mean for banks? Well, since they make money by lending it out and getting paid back, a crash in home sales and a spike in defaults would seem to be a bad thing. As Fleckenstein Capital’s Bill Fleckenstein put it in early April:
 
“It is indeed the financial institutions that are most at risk in the real-estate market (which is not to say that consumers and speculators won't get hurt). The lenders will bear the brunt of the pain, because in many cases, they loaned the entire purchase prices of many homes. As I have said often, the housing bubble has been more a lending bubble. It will be the impairment of the financial institutions that will stop the flow of credit to the real-estate market. In turn, that will accelerate the collapse in house prices somewhere along the way.”

So Wachovia has done us two favors with one stroke of a pen. First, it has validated the idea that the longer a credit expansion goes on the crazier bankers become. Second, it has handed the Sound Money community another classic short. When the housing crash moves from business section to front page, and stories of dispossessed formerly middle class Californians are everywhere, and bad loans are chewing through bank income statements like demented termites, the owners of Wachovia LEAPS puts will be rich. Load up the wagons!