3rd Scenario

Building off the Polly-anna and the muddling through scenarios of the housing and credit markets, this post is a more pessimistic scenario that has greater uncertainty, higher risk premiums and more things cascading forward in a positive feedback loop.

In this scenario, investors, regulators, lenders and creditors believe that the entire mortgage and collatoral backed securities markets have systemic problems. Alt-A and Prime A mortgages are exhibiting fewer problems than subprime because underwriting and tracking systems were somewhat effective at sorting risk. However there were significant problems based on the incentive that no one gets paid for denying a person a loan, and there was a collective race to the bottom of credit quality for three to five years. Everyone believes they know revelations of problems will continue into the intemediate future but they don't when or what will be revealed.

There is also systemic mistrust of the credit rating agencies as they screwed the pooch royally as evidenced by all of the CYA downgrades in the past couple of months. Uncertainty is very expensive and that means either lenders will not lend money or they'll lend it at much higher interest rates. For instance Bear Stearns just issued debt at near junk level of interest rates despite the fact that Bear Stearns is still rated as an A+ credit risk. People with money don't trust their reporting and information systems right now.

Since people do not trust their reporting and information systems, they will want to be compensated for their anticipated increased exposure to risk. That means higher interest rates, lower capital spending, lower non-residential construction spending, and higher general interest rates. And this could start spelling out a big problem. This fall is the local peak in ARM mortgage resets for prime, Alt-A and subprime borrowers. A dominant strategy for a lot of borrowers was to either count on housing appreciation (which no longer is happening) or low interest rates to allow for an easy re-financing back into either teaser rate territory OR cheap long term fixed rates. Under this scenario, this will not be happening as frequently or as widely on the credit ladder as people had anticipated a year or two ago.

This problem puts people in a bind. Minimal real wage gains as well as inflation ex inflation in food, energy, medicine and education are putting people over the barrel and deeper in debt. The debt was managable as long as their was cheap credit and easy rolling over available. That may be changing. Mortgage payers now either must refi at higher rates and credit ratings (the cheap rates today are for a much higher FICO score than the cheap rates were 3 years ago), or find something in their already stretched budget to cut back on as they suck it up and pay the higher, reset monthly mortgage payment.

Not everyone will be able to do this. And thus the currently high rate of foreclosures and delinquincies will continue to increase, and thus credit costs should also increase until either there is significant real wage gains in the economy, which will be tough because consumers will be cutting back on consumption spending, or enough people get kicked in the ass and all of the marginal loans and not-so marginal loans are either renegoatiated or foreclosed. And that could get ugly.