Thursday, August 16, 2007

Fly by the seat of your subprime pants 

Here's a good paragraph about the housing market, from someone who claims not to be a financial expert:
When you buy a house you are doing two things: 1) paying rent to yourself instead of someone else (and forgoing the opportunity for someone else to pay that rent to you), and 2) taking a long position in the asset class that is real estate in your local area. The type of mortgage you take out has no bearing on the rent you are "saving" (or forgoing) but it has everything to do with how levered your long position is in the asset class that is real estate. While the details of ARMs, neg-am mortgages, NINJA loans, no-money down deposits etc. are complex, essentially they all add leverage to that position. This is fine when prices are rising, but it also means you will lose all of your money (equity) when prices fall. Historically, home prices have never fallen, but they have never had such leveraged financing either.
Being leveraged when there's "a perfect storm for real estate" is not a good thing. Treasury Secretary Paulson has made it clear the Administration thinks things will settle down and that those that bore the risk of increased leverage are going to suffer the consequences.
[W]hen you go through a period like this, certain markets become illiquid and certain products become illiquid. [It takes time] for the market to better understand the risk and � the risk versus the benefits of certain investments before the money pours to the product and liquidity returns.
And from here,
There�s nothing in my judgment that we should be doing in terms of guaranteeing market participants against losses or in terms restraining risk-taking. The natural consequence of these excesses is there will be some entities that will cease to exist.
David Wessel in that article reports that Paulson believes the global economy is strong enough to pull us along a little bit and keep us away from recession. He also makes the point that the prime mortgage market looks fine, and Fannie Mae reported this morning that this is so.

There's some sideways noise this morning from having political pundits Robert Novak and George Will writing this morning on issues they don't quite seem to understand (in Will's case) or just engaging in rumor-mongering. Mark Thoma is quite right to note that St. Louis Fed President Poole's interview yesterday was a clear marker that the rate cut everyone thinks is coming now is not a done deal. See also (Tim Duy.) Poole is a notorious inflation hawk, so he's not a great weathervane, but neither is anyone fully ready to say it's time for a cut.

I agree with Nouriel Roubini on this point: We are experiencing real, Knightian uncertainty. It is kind of comforting to think you can somehow figure out there's only $40 billion or $200 billion at risk, but would you bet your house on it? When you read the reports, don't the percentages look like SWAGs? We don't know, and neither does Fed President Poole nor Treasury Secretary Paulson. It'll be fly by the seat of your pants time for the near future.

And what does that do to consumers? That's really the $64 question. Tomorrow's consumer sentiment report might give us a clue.