A $4 Trillion (yes a "T") Hangover

As many of my clients and friends know, I am a data geek. So be prepared for what is about to follow (and for those of you with insomnia – I may have found your cure).

There was an article/analysis done by Dhaval Joshi, chief strategist for London based hedge fund RAB Capital. I found it referenced in Barry Ritholtz’s blog article on July 15. WARNING: lots of data to digest in the linked article. Granted, I am generally suspect of data analysis put forth by hedge funds (there always seems to be an ulterior motive) but in this case, the data appears to be well thought out and dissected from several different perspectives.

Here is a quick summary, it is Joshi’s perspective that the US housing market has approximately $4 Trillion of excess mortgage debt (which represents 30% of current GDP). His article goes on to make the case through statistical and graphical analysis of historic trends in the housing market. For those of you interested in the macro operation of our housing system, I highly encourage you to give it a read.

The analysis addresses several factors we all agree are present in the current market, excess inventory, negative equity in a large portion of the current housing stock, escalating default rates, etc. Midway through the report, however, there was some data I found quite interesting for the potential impact it could have on our ongoing market. Joshi covers the issues of why homeowners default on their mortgages, more specifically the current trend toward “strategic defaults."

Joshi references a recent Federal Reserve analysis that found the cause of strategic defaults vary considerably based on a particular event. In the Fed’s analysis (as reported by Joshi), if a homeowner is considering a strategic default on the basis on negative equity alone, the average borrower doesn’t walk away until the property is really upside down (average negative equity of 62%). However, the report noted that borrower’s will strategically default much sooner ("much, much earlier" was the language in the report) should interest rates increase. The report noted higher interest rates were even more significant in triggering defaults than higher unemployment (in the case of borrowers with negative equity).

The reason this caught my eye is the impact this could have should the Fed decide to adjust interest rates as the economy begins to recover as a hedge toward managing inflationary pressures. Talk about being caught between a rock and a hard place!! Inflation can wreak havoc on our economy (as seen in the late 70’s and early 80’s) but at the same time, increasing interest rates to combat that economic dirge could cause a steep increase in the number of strategic defaults. So, anyone want to be on the Federal Reserve’s Board of Governors when that decision has to be made?