The banking sector has taken an absolute beating over the last year as residential real estate losses surge and the penalty of lax lending standards comes home to roost. The sheer vertical lift off in delinquency rates and losses is astounding. Just take a look at the following charts.
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It's no wonder the banking sector has seen billions eroded in equity value over the last year, and their residential losses show no signs of slowing. The end is nowhere in sight as banks continue to tighten the noose on lending standards. Higher lending standards are decreasing mortgage demand as tighter lending standards makes it harder for potential buyers to get a loan and for existing homeowners to refinance their adjustable-rate mortgages (ARMs). This is leading to a spike in foreclosure rates in both subprime and prime loans as homeowners who were barely able to afford the teaser rate on an ARM cannot afford the higher reset rate.
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Banks are not only tightening lending standards for mortgage loans but for all consumer related categories. In fact, banks haven’t been this reluctant to loan to the consumer in 27 years going all the way back to the second quarter of 1981. Additionally, banks show no sign of reversing course as loans past due have surpassed levels of the last two recessions. Furthermore, not only has the level of noncurrent loans surpassed the last two recessions but so has the rate of deterioration. Growth in noncurrent loans is growing at an 81% year-over-year (YOY) rate of change, more than double the deterioration rate seen in the last two recessions.
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What’s important to realize is that these large losses are not the result of higher interest rates per se, but rather consumers living above their means. For example, interest rates were much higher in the last three recessions when the percent of all loans past due rose above 5% as shown in the figure below.
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What the above table shows is that it took lower levels of interest rates to produce the same default rate as consumers were living above their means with higher financial obligation ratios and lower savings rates in subsequent recessions. Not only did homeowners take on mortgages they could barely afford and decrease their savings rate to zilch, but they also used their homes as ATM machines where home equity loans ballooned after the 2001 recession. Banks are now paying for their lax lending as bank net charge-offs for home equity lines of credit surge to levels that are quite literally off the charts (Figure 13). Comments from JP Morgan’s head of retail business are provided below on the state of home equity loans.
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Figure 13
Here comes another headache for banks suffering from the mortgage downturn: Losses on home-equity loans are soaring, even at some lenders that avoided big blunders on subprime loans…
"These losses are well beyond what we would have modeled...and continue to get worse," said Charles Scharf, head of J.P. Morgan's retail business…
"This product was meant to help people do construction on their house, [and] do debt consolidation — not to take out every last dollar of equity in their home to finance a different kind of lifestyle," Mr. Scharf said. J.P. Morgan is "rolling our changes back to represent that kind of product." (Emphasis added)
This reckless debt binge and consumption by the U.S. consumer has led to an event that has never been witnessed before, and that is net homeowner equity falling below mortgage debt outstanding as home values plummet at a much faster rate than mortgage balances are being paid off with homeowner equity now below 50%.
Figure 14
Things aren’t likely to improve just yet as the supply and demand imbalances are roughly two-thirds of the way towards cyclical bottoms. Housing starts are fairly close to previous cyclical bottoms of roughly 800-900 (Ths., SAAR) with building permits approaching a similar number. A bottom in housing starts and building permits typically also signal a bottom in the decline of housing prices on a rate of change basis (Figure 16).
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Figure 16
As home builders slow down residential construction, the number of new home sales sold is nearing previous bottoms, and the month's supply of new homes for sale should be close to peaking after reaching previous cyclical levels of more than nine months. However, the level for existing home sales is greatly lagging the deceleration in new home sales as existing homeowners are not as willing to slash prices as homebuilders are as they hold out in hopes for a housing bottom, which will remain elusive until they lower their sales price enough to clear inventories.
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Overall, much of the housing pain is behind us though we are not out of the woods just yet; we are roughly two-thirds of the way through this housing recession. One way to measure housing’s downturn in terms of completion is its relative importance to GDP. As of the fourth quarter of 2007, residential fixed investment (RFI) was 4.1% of total GDP after peaking at 6.3% of GDP in late 2005. The last two housing cycle bottoms had RFI bottoming at 3.2% (1982) and 3.3% (1991), indicating we have a few more quarters for housing to decline ahead of us.
Figure 19
That we have several quarters of housing pain ahead of us is confirmed by the following chart that shows the correlation of bank willingness to lend to the consumer and RFI as a percent of GDP. Typically RFI’s share of GDP bottoms one year after banks end their tightening mode and begin to loosen lending standards. As banks are still currently tightening standards, we have at least another year of pain ahead of us with housing not likely bottoming until the second half of 2009. Additionally, housing prices will continue to fall until mortgage-related borrowing begins to pick up in relative terms of total consumer borrowing, which also has yet to put in a bottom.
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Today’s Market
Stocks gave back part of yesterday’s rally as traders took profits with nine out of the ten S&P sectors finishing in the red. The industrial sector was the only sector finishing in the green after Caterpillar’s announcement after hours yesterday that it raised its 2010 revenue forecast to $60 billion, up from its previous forecast of $50 billion. Also supporting the industrial sector was GE’s announcement that it reaffirmed its 2008 profit guidance and gave a better than expected long-term outlook.
The Dow Jones Industrial Average fell 46.57 points to close at 12110.24 (-0.38%), the S&P 500 lost 11.88 points to close at 1308.77 (-0.90%), and the NASDAQ shed 11.59 points to close at 2243.84 (-0.53%). Declining issues represented 60% and 54% for the NYSE and NASDAQ respectively, reflecting a mostly mixed market.
Treasuries rose with the yield on the 10-year note falling 11.3 basis points to close at 3.483%. The dollar index plummeted today, falling 0.95 points to close at a new low of 72.32. The falling dollar led to a new record in oil prices with crude surpassing the $110 mark for the first time.
