2006: The Year of Charting Dangerously (Part 1)
The Babylonians began celebrating New Year about 4,000 years ago as the season of rebirth and resolutions after the first day of spring (Vernal Equinox). And the 2-faced Roman god of beginnings, Janus, who lent his name to the first month of the year, is depicted as having 2 faces to look in opposite directions, the past and the future. The New Year is the time to remember and learn from last year's successes and failures and the time to make resolutions with hopes of doing better. Interestingly, the most popular new year resolution in the original Babylonian tradition was to settle debts, to return borrowed farm equipments. This ancient tradition is not totally lost today. Paying off debts is still a popular new year resolution nowadays. And with the net saving as a percent of gross national income (Chart 1) dipped below zero for the first time in the 3rd quarter of 2005, it may be more of a necessity to do so than honoring the tradition.
While it's possible that one can seek relief from bankruptcy, income growth, or more borrowing, the new bankruptcy legislation has made it difficult for average consumers (not corporations) to seek debt relief, the real personal income has shown signs of retreat since the beginning of 2005 (Chart 2), and the potential housing price decline may restrict further borrowing.
The monthly change of the national median home sales price has been in a downtrend since it hit the 6.22% high in April 2005 (Chart 3). The decrease of 3.18% in September 2005 from the previous month was the new low since the 2.63% decrease in January 2004. Actually, the housing price doesn't even have to decline to wreak havoc. Just the pause in price appreciation and selling activity may be enough to erode the structure of our economy.
Once the rise in home price pauses, any increase in loan amount means higher loan-to-value ratio and higher risks for lenders. And since refinancing incur additional cost and the majority of refinancing is to extract cash from equity, most new loan transactions will result in higher loan amount. Lenders require higher interest rate premium for higher risks (or higher loan-to-value) loans. Therefore, even without any impact from the bond yields, higher interest rate premium raises borrowers monthly mortgage payments. And higher payment increases risk of borrower default, which increases lenders' nonperforming asset portfolios.
And, it's no accident that even Fannie Mae's least risky loan, its single family conventional loan, delinquency rate had risen over 12% in 7 months, from the April 2005 low of 0.57% to 0.64% in November (Chart 4). And, the effect of the stagnant home selling price is even more telling in a portfolio lender's financial statement.
World Savings is one of the major specialty portfolio lenders that focuses its lending guidelines on home equities rather than incomes and credits, and it keeps most of its loan portfolios in house (thus a portfolio lender). World Savings has great quality control and audit, and it would normally lend to anyone who has decent credit and at least 25% downpayment. This common sense practice makes a lot of sense while the home prices rise steadily. It's very unlikely for anyone, with or without income verification, to default on their loan when they invest so much cash equity in the property. And, in the past few years, World Savings was able to lowered its nonperforming assets & troubled debts rate from 0.51% of total assets in 2003 to just 0.28% in June 2005. With over a hundred billions in total assets, this represents the difference of hundreds of millions of dollars.
However, I started paying close attention to this ratio when it ticked upward by just 0.01% in October. As a technician, any reversal, no matter how minor, in a long trend is considered very significant. And, in November's financial statement, this ratio went up 0.02%, to 0.31% (Chart 5 red arrow).
The rise in mortgage loan delinquency rate could lead to credit tightening, which could eventually shut down the home equity ATM machine and hamper consumer spending. And we know that consumer spending represents 70.20% of our economy. But a bearish housing market does more damage still.
For one thing, half of all American private sector jobs created since 2001 have been in housing related industries. A slowdown in selling activities will have a very significant impact on the employment picture, which in turn will have a significant impact again on the consumer spending. Chart 6 shows that the percent change of number of units sold nationwide from month to month has been in decline since it hit the high of 4.5% in April.
With record-breaking number of people joining housing related industries every month, fewer units of homes sold means fewer workers in these industries getting paid. In order for real estate brokers, mortgage companies, appraisal services, and title insurance companies, etc., which have moved into more luxurious and spacious office buildings, to stay profitable or just to stay in business, a massive layoff in 2006 is a high probability.
And so, 2006 will be the year of living dangerously for American consumers who'll have no prospect of real income growth, no savings, no capital gains in their homes to draw money from, and fewer jobs in the once booming housing related industries. But unfortunately, that's not all.
Please tune in next week for Part 2 of our discussion.