Déjà Vu...and It Wasn't Pretty

It seems that across all markets, we’ve been here before. Retracing previous levels in equities, fx, bonds and commodities. This is not unusual or worrying as the market rally reverses somewhat. What is worrying I believe is the recent trend of revisiting previous practices, in hope they will rescue those in trouble.

Now, the world, its wife and extended family know that the credit crunch was caused by asset price (house) inflation, overleverage and an underappreciation/lack of understanding of the risks involved in CDOs and CDS. The ratings agencies played a big part too of course, but if Joe Schmo on mainstreet was asked to list the causes, the agencies probably wouldn’t make an appearance. Anyway, no one should know the hazards of overleverage of the undercapitalised better than the lenders themselves. So it was surprising last week to see the return of the 125% mortgage in the USA through Fannie and Freddie. There’s a good article here about the trouble those in negative equity could get into by swapping into one of these loans, especially as in the US, they’ll be moving from non-recourse to a recourse loan.

Now the UK has joined the party with Nationwide offering 125% mortgages those in negative equity! 3 year fixed at 6.73% on 95% and then 7.23% on the remaining 30%. Nice! What this all seems to presuppose is that house prices are at very low levels. Oversold perhaps? The result of panic selling? Here’s a chart from Nationwide showing house prices adjusted for inflation (see attached file). They’ve fallen for sure, but are only back on trend. Given this is the biggest financial shock since the Great Depression, is it credible to believe they stay on trend or even bounce from here? Certainly back in 91-92 they fell below that and in line with typical recessions took about 6 years to bottom from their 1989 peak.
Looking also at first time buyer/house price, according to Nationwide, (you can look at all this stuff here) the average is 3.3. This is from a series going back to 1983 which I think is probably a pretty good time to start given you’re looking at the start of the credit mentality around then. At peak, through 2007, it was at 5.4 and at present it is at 4.2. We’re also only 2 years out from peak prices. So what if, and it’s not a big if, house prices don’t go up anytime soon? These takers of the 125% mortgages are going to have locked in the negative equity, borrowed their original mortgage and the locked in loss on top of that and moved onto a more punitive rate. It wasn’t pretty before and it won’t be pretty this time.

Perhaps even more jaw dropping is that MS, and you’ve got to admire the gumption, is going back to the tried and erstwhile trusted alchemy of turning toxic assets into a sure thing. They’re repackaging downgraded CDOs into…AAAs!! I can’t help thinking that it wasn’t pretty before and it won’t be pretty this time.