I received an interesting Email from Wesley G. on housing containment theory presenting a case as to why things won’t be so bad following the housing bust. Wesley G. writes:

Mish, below is some commentary from a friend and a quantitative analysis of why ‘it won’t be that bad’. I would like to hear your quick comments. Thanks. Wesley G.” What follows is the body of the email from Wesley.

First of all, I’d be the last person to discount either the short-term or the lasting effects of the implosion of the sub-prime markets, here in the US, but more particularly in Great Britain and Spain, where the problem is likely at least one order of magnitude worse. The housing markets in those countries have been in a “bubble” for a number of years. But that’s another story, so let’s concentrate on the US market.

For a starting point, let’s say that there are indeed 7 million properties (the numbers in the analysis you showed me) that have mortgages which are at risk of default. The US has, by some estimates, about 100 million households (300 million people with about 3 persons per household, on average). One would think, therefore, that approximately 7% of the households in the country are at risk of defaulting. Let’s also say that it’s likely that 80% of this number will default and that 50% of that number not only default but will fail to negotiate a work out and be able to stay in their homes. This represents about 3% of the nation’s housing stock. The other 3% that are workouts will result in a pretty hairy financial loss by hedge funds, etc. But the total loss is unlikely to be more than 20 cents on the dollar. After all, the average banker would much rather re-negotiate the interest rate downwards and write off a portion of his investment than to go through the hassle of foreclosing and having to auction off the property at even greater losses.

Focusing on the 3% that will lead to foreclosure, I think we need to ask several questions,

1. Who owns these units?
Well, at least a material portion of them belong to “flippers” and other investers who thought that the housing market would go up forever. In many cases, they’ll be forced into bankruptcy but they will re-join the workforce somewhat worse the wear.

Many of the remainder likely belong to individuals and families that should never have bought in the first place. They’ll move back into rental housing where they should have been to begin with. In many instances, the cost of bankruptcy is so high that the banks will just stop chasing them.

2. What happens with the units?
The units will turn over and either get sold as rental units or sold to home-buyers at deeply discounted prices. As a result, the housing market will continue to be sluggish for 3-4 years in the parts of the country most overbuilt like CA and FL.

3. What are the likely losses?

If the average at risk housing unit in the country is worth about $200,000 (pre-default) we can anticipate that upwards of 3 million units will land on the market over the next several years. My guess is that investors will pick them up and rent them for about $135,000 on average. After all, assuming standard fixed rate mortgage with 20% down and 7% interest rate, $5,000 in closing costs, the carrying cost is about $10,000 annually, including mortgage payments, taxes and insurance. This translates in to a rental payment of about $1,200 per month, leaving a reasonable return on investment, etc. This is well within the reach of most people who were going under trying to make $2,000 per month payments.

So, once again, we see that after it all washes out, the question remaining is how much equity is going to get washed down the drain. By my calculations it’s the
total of 20% of 3 million units @$200,000 and 35% of 3 million units $200,000. The total likely loss is, therefore, about $315 billion. While this is a lot of money, you need to ask yourself the question, how much equity was lost in the stock market in 2000?

Seems to me the country can afford it and will move on after a brief but painful recession. The pain will be felt by five groups; i)the people losing their homes, ii) those trying to sell their homes into a housing price downturn, iii) people in the housing industry who lose their jobs while the market remains overbuilt. iv) investors who bought property to flip and now must unload at potentially deeply discounted prices or hold on until the market improves and v) the holders of all those securities who now must live through a period of unknown value while they lose their shirts (this is where most of the money will get lost – I’m heartbroken)

Most of us will just keep on truckin’….

Thanks Wesley, it’s an important issue and it keeps coming up. There have been many such theories presented and they all revolve around a similar theme: The problems are primarily related to subprime and not every subprime is going to default.

Well things rapidly spread from subprime to Alt-A and now to prime. But still, as your friend states, the majority of mortgages are not going to default. So what’s the big deal? The big deal is that such analysis only looks at the seen. It does not look at the unseen consequences or at related problems. Both of which are huge.

The Seen and the Unseen

Consider all the people working in the mortgage industry, who just recently lost jobs. There have been hundreds of thousands of them in the last six months and staggering numbers in August alone as discussed in Mass Layoffs Soar. Where are those people going to get jobs? For those that do find jobs, will they be as high paying?

Consider all the people still working in homebuilding. A huge number of homes are still being built even though the numbers show enormous drops on a percentage basis. More significantly, homes are still being built far faster than they are being purchased. The inventory of homes for sale is sharply rising. Calculated Risk has some stunning charts of housing inventory and here is one from July.

One quick look should be enough to convince you that prices still have further to drop, and housing construction is still too high. Where are those housing trade people going to find jobs when they are laid off?

And what about truckers hauling and shipping goods to build and furnish homes? Are those jobs safe? What about furniture makers? The answer should be obvious but few figure such metrics into their calculations when containment theories are presented.

What about places like Home Depot, Lowes, etc, that service small subcontractors or the do-it-yourselfer? Won’t there be a falloff in numbers of employees needed those stores?

And your friend is also forgetting about commercial leasing. What about the reduced need for office space in commercial just on account of lost jobs and businesses in the mortgage related areas.

Your friend needs to factor in the Commercial Real Estate Abyss.

According to the Implode-O-Meter 156 mortgage lenders that have blow up since December 2006. The easily seen effect shows up in the jobs count (but your friend’s quick analysis failed to take that into account). But the not as easily seen effect is the reduced demand for office space, that is now being overbuilt smack into a U.S. slowdown.

What “should be obvious is the fact that commercial real estate follows residential with a lag. As subdivisions are built, strip malls and stores follow. But what should be obvious, obviously is not obvious because the myth perpetuates that commercial real estate and corporate spending will be the savior in all of this. It won’t.

Commercial real estate won’t be the savior for the simple reason we do not really need more Wal-Marts (WMT) , Pizza Huts, Lowes, Home Depots (HD), Targets (TGT), Safeways (SWY), or Applebees (APPB). Nonetheless even though we still do not any more of those stores, they are still being built (again following residential with a lag). The stores being built now, were planned years ago. Look for future plans to be scaled back if not canceled. And thus look for one of the biggest sources of jobs to dry up.

But the unseen goes far beyond both directly related employment and real estate in general. to the heart of Wall Street. Willingness to finance LBO and junk bond offerings has dried up. Asset backed commercial paper is dead. Please see a Crisis in Asset Backed Commercial Paper.

The commercial paper crisis is not just contained to the US either. There is a run on the bank in the United Kingdom, bank failures in Germany, and pension plan problems in the U.S and Canada.

Sheeesh, I do not even have time to write all of that up except to say that Citigroup (C) as well as JPMorgan Chase (JPM), Lehman (LEH), and Bear Stearns (BSC) are all stuck with LBO commitments that the debt markets are now unwilling to fund. I talked about that in Swaptions and Financial Turmoil.

A serious effect of corporations being stuck with deals they do not want is rising borrowing costs for nearly everyone as well as more attention being paid to risk. The latter reduces the willingness to make deals. And rising costs of deals not only reduces the desirability of deals but it shrinks profit margins for anyone needing to roll over short term commercial paper.

Falling profit margins and layoffs go hand in hand. And right now foreclosures are soaring in spite of the fact that the unemployment rate is at or near all time low levels. What happens to customer ability to service debt, as well as bankruptcies and foreclosures when the unemployment rate rises?

The jobs picture is another one staring over the abyss. I talked about this in Moonbats Active Again in Massive Jobs Disaster.

Still another unseen fact is that people are more willing to spend money when home prices are rising than falling. This effect is just now starting to show up in retail sales. And with the housing ATM now shut off, credit card debt is rising rapidly even though retail sales are sluggish. How long will it be before credit card defaults lead to a shutdown in subprime credit lending?

Retail spending is 70% of the economy, and with rising unemployment in the financial and homebuilding sectors, comes less demand and rising unemployment at restaurants, nail salons, recreational boat stores, etc. What is the effect of this slowdown on corporate profits.

What affect will falling corporate profits have on stock prices? What affects will falling corporate profits have on pension plans and pension plan assumptions? On retirement decisions? On discretionary spending? On trips to the nail salon? On new car and truck purchases?

The Ripple Effect

The ripples just keep getting larger and larger and larger. And this is why containment keeps spreading outward.

What your friend did in effect, is throw a pebble into a pond saying “that’s not so bad” while ignoring every ripple and every subsequent ripple to come. Housing cannot be looked at in isolation as your friend and many before him have tried to do. One must look at the seen and unseen effects as well as all the ripples from each.

People can only keep on truckin‘ as long as they still have a job, a car or a truck, and can afford to gas up said car or truck. And many of those that make it will be forced to cut back somewhere, somehow, to do so. Housing Containment Theory ignores all of those ripples.

Containment theory also fails to take into account things we have no way of knowing yet such as Bush starting a war with Iran to spur jobs or the Fed fighting the housing bust so much it collapses the U.S. dollar.

Many more ripples are coming but we don’t even know what all of them are yet. What we do know is that ripples on a pond can not be contained once the rock hits the water. Yet foolish attempts by Congress, the Fed, and the Bush Administration to contain those ripples are themselves causing still more ripples that need to be analyzed! That is why housing containment theory is simply wrong, and likely wrong by orders of magnitude.

Mike Shedlock / Mish/