Serious Money:American homebuilder Toll Brothers revealed last summer that the downturn it was encountering in residential construction was the worst it had experienced in more than 40 years of business, writes Charlie Fell.
The bull market cheerleaders on Wall Street dismissed such observations as their rose- spectacled analysts confidently declared that a bottom to the housing slowdown was close at hand.
The ivory-tower economists at the Federal Reserve in Washington concurred and went even further, arguing that problems in the mortgage market would be easily contained.
One year on and the blue-sky optimism has proved to be wishful thinking as the housing recession continues to deepen.
The bloodshed has reached financial markets as the esoteric financial instruments that enabled the sub-prime market to flourish have precipitated a liquidity crisis across credit markets. These illiquid and hard- to-value instruments have focused investor attention on comparable investment vehicles across the market for debt, which has precipitated cardiac arrest in the credit arena.
The Federal Reserve, which only a fortnight ago was more concerned with inflation risks than threats to growth, has been forced to act.
In a surprise move last Friday, it lowered the rate at which it makes emergency loans to financial institutions by half a percentage point. Furthermore, overnight maturities have been extended to 30 days while mortgage-backed securities are being accepted as collateral.
The actions suggest the Fed is taking the housing problem seriously at last.
The measures implemented by Ben Bernanke and his compatriots at the Fed are unlikely to work. Stock markets responded well to the news of a lower discount rate but credit markets, the intended target of Fed actions, remain dysfunctional.
Maybe, and only maybe, the world's debt investors have finally grasped reality and see that the liquidity crisis is a sideshow as detailed analysis of the underlying fundamentals suggests that serious solvency issues are not far away.
Liquidity crises are usually a temporary phenomenon as easier monetary policy enables solvent economic agents to roll over or refinance their debt. However, the meltdown in the US mortgage market is not just a liquidity issue but a fast-approaching solvency train-wreck.
Thousands of households are set to default on their mortgages while scores of mortgage lenders are on the verge of bankruptcy. More than 100 lenders have closed their doors so far and several more will follow suit in the months ahead.
Additionally, the collapse in new orders and high cancellation rates ensure that a number of homebuilders will also fold.
Financial innovation, low long- term interest rates and investors' hunt for yield created a classic credit cycle, which is now deflating.
Lenders no longer hold mortgages they issue; instead the exposure is sold to investment banks and then sliced and diced into mortgage-backed securities.
The lower tranches are then purchased by the investment banks and repackaged into collateralised debt obligations (CDO).
The net result is financial alchemy such that almost all sub-prime mortgages are eventually awarded investment-grade status.
This opened the door for all classes of investors, including pension funds and insurance companies, to accumulate positions. Investors are learning that a decline of just 10 per cent in the underlying collateral is sufficient to wipe out a CDO entirely. Risk is the price that investors thought they would never have to pay.
Financial innovation has increasingly separated the borrower and lender, which is a positive development in theory as potential losses are spread over a broad group of investors.
However, in practice the lender is less concerned about the loan's final outcome and underwriting standards inevitably suffer. Strong investor demand in recent years created a perfect environment for lending standards to become ever more reckless.
Standards in 2005 and 2006 were particularly reckless with option adjustable-rate mortgages (ARMs), which grant borrowers the option to make partial interest payments and negatively amortise the loan, accounted for four out of every five sub-prime mortgages originated over this period.
Mortgage payments can soar by as much 25 per cent upon reset and roughly $500 billion is due to be repriced during the first six months of 2008, more than all of 2007. Given that surveys cite these resets and not changes in economic circumstances as the most common cause of late payments, it is easy to see that the rate of default will continue to increase.
Adding fuel to the fire are so- called "liar" loans, where borrowers declare their income without any verification - a sector that accounted for roughly half of all mortgages originated in 2006. Research suggests that 60 per cent of all borrowers overstated their incomes by more than half.
This means that roughly one in three borrowers last year purchased a house well beyond their means. Once again, the only conclusion that can be reached is that defaults will rise.
The blue-sky merchants on Wall Street have been quick to argue that the recent financial market turbulence has no meaningful implications for the real economy. They are wrong.
This is a solvency crisis and an economic recession is on the way. Investors should focus on capital preservation or the return of capital as opposed to the return on capital.
