Accelerated mortgage defaults likely choice to deleverage household debt

Households likely to deleverage debt with underwater mortgage defaults: Report

by JON PRIOR — Monday, December 20th, 2010, 11:02 amsticking_it_to_the_man

Bank of America Merrill Lynch analysts said the most likely way households will deleverage roughly $1 trillion in excess debt is through the default of more underwater mortgages.

Home prices in the Standard & Poor’s/Case-Shiller 20-city index have dropped 28.6% from the peak in the summer of 2006. This has led to more than 10.8 million homes, or 22.5% of the entire U.S. market in negative equity as of the third quarter, according to the analytics firm CoreLogic. And while that percentage is down from the 50 basis points from the previous quarter, negative equity remains the primary factor holding back a recovery in the housing market and the overall recovery.

Analysts said the collapse in home prices means the asset value supporting Americans’ debt is no longer there.

Home values were an illusion created by excessive debt. Americans were offered free money for nothing more than owning a house. This made houses very desirable which prompted more buying and drove prices higher. As prices moved higher, banks were willing to give out more and more free money in order to entice Americans to buy more houses to get more free money.

It was a Ponzi scheme.

The collapse in values is simply a reversion to what prices would have been if we hadn’t inflated a massive housing bubble.

“It’s the holidays and talk of deleveraging needs would appear to be sacrilegious or even un-American,” BofAML analysts said. “Most of the deleveraging will come through default of underwater mortgages, although less consumption likely will be part of the equation as well.

But consumers are not alone. Excess debt is also an issue in municipalities and sovereign nations. Recent increases to interest rates will put more need for the U.S. to begin implement fiscal constraint.

“At a minimum, the vast amounts of excess debt permeating the developed economies will act as a drag on growth for some time,” analysts said.

Of course there will be less consumption. We are no longer giving out hundreds of thousands of dollars of free money to Ponzis. Until we start doing that again, consumer spending will be down. Hopefully, we won’t be giving Ponzis billions in tax subsidies and bailouts in the next cycle, but you never know.