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The Daily Reckoning | Wednesday, December 29, 2010 A look back on what everyone else was calling the "recovery," Delinquencies, foreclosures and other unshakable 'homing' trends, Plus, Bill Bonner on the choose-your-own-adventure market narrative... ................................................................................................. The Daily Reckoning Presents The next installment of our 'Best Of' Series for 2010. In the following column, which first appeared in these pages back in June 8, Whitney Tilson offers some prophetic words on the anemic housing market. Bill has more notes on this further down, but first, a look back... The Housing Non-recovery Whitney Tilson [This following was excerpted from Whitney Tilson's presentation to the Value Investing Congress in Pasadena, California on May 5, 2010. Whitney Tilson is the founder and Managing Partner of T2 Partners LLC and the Tilson Mutual Funds.] Two years ago, we stood up here on this exact stage and delivered a very downbeat presentation on the US housing market. We return today to provide an update...and a new forecast. In early May of 2008 housing prices had already been declining for two years. The Bear Stearns hedge funds had blown up a year earlier. NovaStar and New Century Financial had also blown up a year earlier. The subprime crisis was well upon us. And many, many people thought that this was going to be contained to subprime. But we announced that the data led us to believe the contrary and we delivered our analysis in a presentation entitled, "Why We're Still in the Early Innings of the Bursting Housing and Credit Bubbles." We concluded that things were terrible and that there was no sign of a bottom. Obviously, that forecast was on target. So where are we today? Two thirds of American homes have mortgages – 56 million mortgages outstanding. A little over half are owned or guaranteed by government entities. 35% are held on the balance sheets of banks and thrifts, and 15% are so-called private label securities that went to Wall Street. This last piece was the sub-prime stuff that was some of the very worst mortgage debt ever written. It's very easy to get complacent about the mortgage market, as housing prices have stabilized and foreclosures have stabilized, you know, 'we don't have to worry about that anymore.' But I'd argue to the contrary, let me show you why. Fourteen percent of America's 56 million mortgages are already delinquent or in foreclosure. So if you multiply 56 million by 14%, that means that 7.8 million people right now are not paying their mortgages. 7.8 million homeowners have been delinquent for 30, 60 or 90 days...or are in foreclosure already. 91% of the people who are currently not paying are never going to get back to current, according to recent statistics. So that means that of 7.8 million people not paying their mortgage, 7.2 million are never going to get back. So that's a problem. 7.2 million homes. 7.2 million mortgages will go into foreclosure...eventually. And the real story is even worse than the nearby chart suggests. Because of loan modification programs, the government, banks and servicers have dramatically slowed down the foreclosure process. The banks have been modifying everybody, slowing down the foreclosure pipeline and not taking properties onto their books. So what this means is that the rate of NON-foreclosure on delinquent borrowers is climbing sharply. As the nearby chart illustrates, 24% of the people who have not made a mortgage payment during the last two years have still not been foreclosed on. That's how clogged the foreclosure pipeline is. So what's going on? Well, there are a lot of modifications going on the past year. But modifications don't really work very well. It turns out that even when you cut someone's mortgage payment by 50% or more, half of them still default within 12 months. The re-default rate is astronomical...even when you cut the monthly payments dramatically. So why is that? Because the real driver is people being under water, people who have no 'skin in the game.' Basically what we did in this crisis is we gave American homeowners a $2 trillion "call option" on home price appreciation. But when the value of their properties fell below their debt levels, they handed the keys to the lender; that's what people do. And that's what American homeowners have done. To some extent American homeowners are now minimizing the human toll of losing homes and so forth. Purely as a group, on an economic basis, they're the only rational players in this bubble. They've pocketed $2 trillion in cash and now, when the value of the property falls below their debt, they're walking away. As it turns out, the unemployment rate isn't really much of a driver of default rates. Instead, it's all about home equity...or the lack thereof. So what does the future hold? Foreclosures are starting to spike back up as the trial 'mods' are failing and moving into foreclosure. If we're very lucky, home prices will stabilize here. But if interest rates go up, and if we don't properly deal with those 7.85 million people who aren't paying their mortgages and those delinquent mortgages turn into foreclosures, look out below! Today about 17.2% of homeowners are underwater. But if home prices drop 10% from here, 27% of homeowners would go underwater. In other words, a 10% drop in home prices would cause a 56% increase in the number of people underwater...which would almost certainly lead to another surge in defaults. So I really think the housing market is on a precipice right now, where we need some very strong intervention by the government, by the banks and the servicers to offset what, in the absence of strong action, would be a resurgence of foreclosures, which would lead to a fresh drop in home prices, which will lead to even more defaults... And you can get into the vicious cycle that we were in back in '07 through '08. One big problem in all of this is second liens. You have $842 billion in second liens outstanding and the majority of them are owned by the Big 4 banks. And you have this bizarre situation where American consumers are not making the $1,200 monthly payment on their first lien, but maybe just to prevent harassing phone calls from debt lenders, they are paying the $150 second lien. Well, that means that the banks are looking at this and they're holding all of these second liens at par, even if the first lien has already gone bad. This situation makes the banks very reluctant to approve a short sale, since that would completely wipe out the second lien. Because if you write down the first lien, the second lien is a zero. Of course, banks just don't want to do that because it's a huge amount of money that would wipe out the equity of these Big 4 banks, if they were to mark these second liens to zero. This is a big problem. Then there's commercial real estate. The majority of commercial real estate loans that are coming due, nothing is happening on them. They don't get refinanced, but they don't get foreclosed on either. It's "extend and pretend" or "delay and pray." That's what's going on with commercial real estate. Net-net, there's more pain to come in the real estate market. Regards, Whitney Tilson, for The Daily Reckoning Bill Bonner The Storyline Changes... Bill Bonner And now over to Bill Bonner with today's reckoning from Los Perros, Nicaragua... Whoa! Markets are supposed to be quiet between Christmas and New Years. Everyone's supposed to be out of town. On vacation. But yesterday, gold went up $22. What's the story with gold? It went up in a single day by more than 100% of the price of gold 100 years ago. Recently, we looked at a chart of 100-year performance of various investments. It showed that stocks did better than anything else. But gold was #2. Before you get too excited about those numbers, remember that numbers lie. The results depend on when you take the measure. At a stock market top, stocks will look like they out-performed everything else forever. At a stock market bottom, stocks will appear to have been losers ever since the Flood. No matter what you invest in, there will be times when you are up and times when you are down. Unless, of course, you pick a bad stock or a bad currency – in which case, you'll be down forever. Since we're in a holiday mood, we're going to let you in on a major financial secret: Investments go up and down. The storyline changes. Yep. Tell your friends. Gold included. But how do you know when they are going up...or when they are going down? Ah, there's the rub...there's the game right there. In order to have an answer, you have to have a story in your mind...a narrative that explains what is going on. "That's my problem, now," said a dear reader last night. "I can't figure out what the major storyline is." Our friend is way ahead of most investors. Most do not realize what they are doing. They follow a story without realizing that it is just a story. All stories are fiction. Even if it is supposed to be history. The historian has to ignore most of what history tells him. Otherwise, his story would have no meaning. He gives it meaning only by taking out the parts that don't fit. When we try to figure out what is going on we are really trying to understand the major storyline. When we look at it years from now...who will be the hero? Who will be the villain? Who will win? Who will lose? Of course, we don't know the answer...but we're always guessing...always trying to understand how the story turns out...even before it is over. Most investors, however, think the tale is not just fiction. They think their stories are God's Own Truth. In the run up to the crisis of '07 – '09, for example, most Americans came to believe that housing always went up. The story was simple enough. The population was growing. Foreigners were moving in – many of them illegal. There were restrictions on where you could build houses. Family size was falling (requiring more individual housing per person). People were getting richer. And houses were such a good investment that more and more people wanted to buy more and more houses. They thought the story would go on for many more chapters...with higher prices every year. Housing...or homing, as we call it here at the Daily Reckoning...was a 'can't-lose' investment. At least, that was the story. And most people weren't aware that it was just a story. And not a particularly good one. What was wrong with it? It was too simpleminded. Like everything else, homing goes up and down. And the higher it rose, the farther it had to fall. Even today, there are still many people who believe the homing-can't-go-down story. They've had to edit it slightly – 'homing-can't-go-down-for-long,' they now say to themselves. Back in the 2002-2007 period, we kept warning that the story was fraudulent. Property in Baltimore, for example, hit a high in the late '20s. In real terms, it NEVER recovered. More outrageously, we reminded readers that real estate in Rome probably hit a high in the first century AD, during the reign of Emperor Trajan, when the empire reached its limits. It has been downhill ever since – for two MILLENIA. By the Middle Ages, goatherds grazed their flocks among the ruins of Rome. By the 18th century, tourists from England were picking up pieces of the wreck of the coliseum and taking them home with them. And now US real estate is in decline. So, what's the story? Our guess is that real estate prices in the US hit their peaks in 2006. Because American power reached its zenith at the end of the 20th century. From now on, some areas will prosper. Some won't. But nationwide, in real terms, real estate will probably never recover. Or, at least not in our lifetimes. And what's this? The latest report from Bloomberg tells us that the trend continues: "The S&P/Case-Shiller index of property values fell 0.8 percent from October 2009, the biggest year-over-year decline since December 2009, the group said today in New York. The decrease exceeded the 0.2 percent drop projected by the median forecast of economists surveyed by Bloomberg News. A wave of foreclosures waiting to reach the market means home prices will remain under pressure in 2011, representing a risk to household finances. Federal Reserve policy makers this month said "depressed" housing and high unemployment remained constraints on consumer spending, reasons why they reiterated a plan to expand record monetary stimulus. "We'll remain in negative territory for several more months," said Dean Maki, chief U.S. economist at Barclays Capital Inc. in New York, who forecast a year-on-year drop of 1.3 percent. "The housing market does remain weak and none of the recent data suggest a substantial pickup." Eighteen of 20 cities showed a decrease in prices in October, led by a 2.1 percent drop in Atlanta, and decreases of 1.8 percent in Chicago and Minneapolis. Denver and Washington were the only two that posted gains. Six markets, including Atlanta, Charlotte, Miami, Seattle, Tampa and Portland, Oregon, reached their lowest levels in October since prices started to retreat. "The double-dip is almost here," said David Blitzer, chairman of the index committee at S&P. Sales aren't "giving any sense of optimism." The drop in prices represents a setback for housing after values recovered earlier this year, thanks to an $8,000 homebuyers' tax credit that lifted purchases. Reports earlier this month showed the housing market is stuck near recession levels even as the broader economy is recovering. "The housing sector continues to be depressed," Fed officials said in a statement after the gathering, at which they reiterated a plan to expand record monetary stimulus and said economic growth is "insufficient to bring down unemployment." Of course, the real estate story is not the only one. There are a million stories in the naked city. But we're not interested in them all. We're interested in the major financial stories. And we have some ideas about what they will be...in 2011, and beyond. Stay tuned. Regards, Bill Bonner, for The Daily Reckoning ................................................................................ Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor atjoel@dailyreckoning.com More Risk Appetite for Fiscal Gluttons his week, between Christmas and New Years, is always slow. Traders have mostly taken the week off. The Dow was down a little yesterday. Gold was up a little. Nothing to get excited about. 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The Amphora Report's 2010 Topics in Review (1 of 4) The Daily Reckoning: Now in its 11th year, The Daily Reckoning is the flagship e-letter of Baltimore-based financial research firm and publishing group Agora Financial, a subsidiary of Agora Inc. The Daily Reckoning provides over half a million subscribers with literary economic perspective, global market analysis, and contrarian investment ideas. Published daily in six countries and three languages, each issue delivers a feature-length article by a senior member of our team and a guest essay from one of many leading thinkers and nationally acclaimed columnists. Cast of Characters: Bill Bonner Founder Addison Wiggin Publisher Eric Fry Editorial Director Joel Bowman Managing Editor The Mogambo Guru Editor Rocky Vega Editor