Epidemiology of the Credit Crunch

There is so much chatter, yet no one is mentioning the obvious. What if this credit crisis extends beyond the subprime realm? It already has, but no one really ever discusses broad social ramification or risk. We talk about subprime borrowers and their high default rates. Subprime default rates are very high and have been consistently rising. There is every indication that that this will continue at least through the first six months of 2008. What seems more important and gets no attention, is the steady rise of prime rate mortgage delinquency and foreclosure action. The Mortgage Bankers Association (MBA) issues regular reports on just this subject. Their second quarter 2007 report - released on September 06, 2007 makes this very clear. Subprime defaults are much, much higher and rising more quickly. The trend in prime mortgages is also clear. The bigger issues seem to be the contagion of financial stress and the loss in America's net worth.

Perhaps the default virus has a contagion pattern, an economic epidemiology. In this case we would expect this to spread through the population like a disease. Who is most at risk? The low income, all borrowed out recent home buyer would be the epidemiological equivalent of an individual with a compromised immune system. Thus, this population could be expected to be hit first and hardest by the default bug. So far it has been first and hardest hit. Most remain content to talk, act and plan for the virus to be contained to the most vulnerable group. This seems a short sighted and poor way to plan. There is something very distasteful about the quarantine of discussion. It is reminiscent of the early foot dragging and discussion of the AIDS virus as GAIDS, a gay only disease. Let's take up the prudent exercise others have neglected. Let's ask the obvious and important question today in this blog.

The Bug

What is causing all this illness in the credit world? Why is there such high and rising mortgage payment default? First it is worth saying that every case has micro issues that are specific to it and generalizations like this one are always a little dangerous. I would suggest that the defaults are symptoms of a different underlying ailment. That ailment is the presence of too many folks who were dependent on low and falling mortgage interest rates and rising home prices. Many people- not all- purchased homes because and only because they and their lenders were sure that they could always refinance at ever lower rates and that their houses would only ever increase in value. Thus, monetary policy, credit market conditions and rising home demand had to perfectly align to allow these folks to keep making their home payments. The housing stars did not stay perfectly in place. No sooner did the astrological pattern shift, than those must delicately placed began to fade. These folks are not all continuing to pay their mortgage bills. Refinancing is either not an option, or not one that solves the problem. House prices are stagnant to falling and months of unsold inventory homes clog the sales pipeline. Millions bought inflated price homes near the end of the long boom with borrowed money at teaser low intro rates and counted on rising home prices and easing loan conditions. Needless to say someone else believed this too. We know this because they had to be given loans. Hundreds of billions in sub-prime, Alt A and Alt B loans were made, bough, sold, bundled and sold again. So many believed in the never ending rise in real estate prices and cheap easy credit that huge global markets formed based on this. On the lunatic fringe people spoke of a global savings glut that Americans were heroically rising up to borrow.

The most vulnerable always get sick first. In a market economy with an asset bubble, the most vulnerable are highly indebted, income constrained buyers late to arrive in the inflated bubble. The low/no money down subprime buyers of 2005-2006 would be the most vulnerable. This is exactly where the defaults are highest. That is the easy part of the story, here comes the hard part. There is plenty more where that comes from! As house prices stagnate and fall, delinquencies rise and lenders get scared and hurt. Falling prices and smarting lenders mean the pain grows and spreads. Like a virus learning and mutating as it passes through a population, the lethality and transmission alters as the bug passes through various phases and host populations. Our population is ripe for contagion. Debt growth has risen much more rapidly than overall economic growth. Debt growth has risen much more rapidly than disposable personal income growth. Debt fueled growth became a key part of our economy and kept families spending and feeling OK about their situation.

The subprime episode is act one. It will be the most dramatic and host the most violent swings, saddest stories and greatest losses. It will not be neatly contained. It has already broken out of the phase one host population. The sense that all will be well elsewhere is comforting. It is also hocus pocus. Car loans, credit card loans and general economic conditions will be influenced and pushed down. Most Americans have one significant asset as wealth, their home. The housing bubble produced fabulous increases in paper wealth. These are already running in reverse. Not just for subprime borrowers, for the nation and tens of millions of affected home owners. In the period between 2001 and 2007 the value of household real estate saw a paper increase of $8.5trillion. This is greater than the combined increase in value of all pension reserves, mutual fund shares, stocks and life insurance policies. The net worth growth in America since 2000 is a story of house price inflation. This house price appreciation was accomplished by borrowing an additional $4.8 trillion in mortgage debt. Thus, we now owe $10.15 trillion in home mortgages on our real estate valued at just under$21 trillion. Those valuations are falling and will fall further. The debt will remain! Massive downward pressure on household net worth and reduced further opportunity to borrow again home price appreciation is now guaranteed for the near future.

The credit crunch and economic weakness is not a subprime issue it is a debt and asset inflation issue. So far there has been more talk than action and much of the talk is misdirected. The only solution widely discussed involves various schemes to make more credit available at lower prices. This is better than nothing but, is exactly how we created the present set of problems. We know that debt pain has risen and will continue to rise. We built a paper boom in debt fueled house price inflation. The strain measures of household and mortgage debt cost are released quarterly. The Federal Reserve releases this information as The Household Debt Service and Financial Obligations Ratios . Since our recent housing bubble began inflating the cost of debt service- paying off debts- has been rising very quickly. In 2001 mortgage debt cost a little over 9% of disposable personal income and overall debt service came in at just over 15% of income for the average American household. Mortgage debt- at today's very low interest rates- now consumes more than 11.5% of income and total debt service payment consumes 18% of income. The average household mortgage payment rose 29% as a percentage of income since 2000. There was a 16% increase in total debt service as a percentage of disposable personal income . The speed and extent of debt growth created the pressures that are leading some to default. This is not a subprime only issue and we are still in the early phases of reckoning with fallout from a debt stressed public. It will take a while longer to get an idea of how bad the fallout will be and how widespread it will be. It is already savaging balance sheets, investment decisions, firm net worth and corporate profits around the world. None of this is to say that we can't or won't be able to understand and respond to the situation. It is only to say that an honest and complete assessment of the situation is necessary and still generally lacking from discussion.