Making (more) money from the falling housing market

US housing prices fell 14% March 2008 on March 2007.

14% is larger than the downpayment component of many US mortgages. Would your mortgage be greater than your house value if the house fell by 14%? How about in your first year of ownership? Mortgages like this are in negative equity, and owners should, ceteris paribus, walk away from the house. This is even more true if mortgage payments are now crippling to pay due to higher interest rates.

When people walk away, or if you cannot make those payments, then the banks will often foreclose on you – forcing the sale of the house. This is happening a lot in the USA, and increasingly in NZ. The implications are very serious – we are talking potential great depression stuff here.

That scares me – and has scared the market

Indeed the price of the mortgage backers Freddie Mac and Fannie Mae has dropped a bunch over the last week:

while over the last year both GSE’s (Government Sponsored Enterprises – called that because of their implied Government backing) have fallen – here’s Freddie: – sister to Fannie, which looks much the same.

So what are these Freddie and Fannie companies? Basically they buy individual mortgages, and either sell them as groups or keep them for themselves.

So here’s what a friend of mine wrote the other day:

Please explain to me how Fannie/Freddie can avoid going into the tank.  $5.3 trillion of mortgages & guarantees against $80 billion in capital, so a 2% default rate in their portfolio wipes them out.

Foreclosures are currently close to 2% of all mortgages, and while these have been concentrated in subprime loans (not a big part of the Fannie/Freddie mix), the next wave will be in ARMs, [floating rate mortgages]  where they have a huge portfolio.  And let’s keep in mind that they recently changed the threshold definition of a non-performing loan from 90 days to two years, so they are already carrying a sizeable unrealized loss load.

Yes, Treasury will bail them out, but I would be stunned if there were not an interim period while the Feds get their act together.  During that period, Fannie/Freddie would not be able effectively process transactions, which would produce a pretty good credit market lock-up.
Not to mention that if it isn’t handled cleanly, that $5.3 trillion could be viewed as US Government liabilities, effectively doubling the national debt in one stroke.  What’s that going todo the Treasuries market?

He’s not crazy – the situation is unsustainable.

So I bought some put options on Fannie Mae (the bigger of the two) and have made a very healthy return over the last week.

Meanwhile over the last few weeks I massively (for me) geared up on shorting residential housing company EQR, and after a hiccup one day I’m seeing a great return from that as well.

There is still plenty of value to disappear from the housing market in the USA, so get on the shorting bandwagon to capture the value. My portfolio is looking spectacular, although volatile.