Clearly, the explosion of exotic mortgages - sub-prime; interest only; pay-option, with negative amortization, et al - in recent years, as shown in Chart 2, have been textbook examples of Minsky's speculative and Ponzi units. And as Bill Gross explained long ago, such mortgages have been the food of the Plankton, the first-time homeowner, driving the homeownership rate to record highs, as displayed back in Chart 1, while also fueling accelerating home price appreciation. But as Minsky had forewarned, eventually this game must come to an end, as Ponzi borrowers are forced to "make positions by selling out of positions," frequently by stopping (or not even beginning!) monthly mortgage payments, the prelude to eventually default or dropping off the keys on the lenders' doorstep. That is happening. And true to form, Ponzi lenders are now recognizing their sins of irrational exuberance, repenting and promising to sin no more, dramatically tightening underwriting standards, at least back to Minsky's Speculative Units - loans that may not be self-amortizing, but at least are underwritten on evidence that borrowers can pay the required interest, not just the teaser rate, but the fully-indexed rate on ARMs. From a microeconomic point of view, such a tightening of underwriting standards is a good thing, albeit belated. But from a macroeconomic point of view, it is a deflationary turn of events, as serial refinancers, riding the back of presumed perpetual home price appreciation, are trapped long and wrong. And in this cycle, it's not just the first-time homebuyer - God bless him and her! - that is trapped, but also the speculative Ponzi long: borrowers who weren't covering a natural short - remember, you are born short a roof over your head, and must cover, either by renting or buying - but rather betting on a bigger fool to take them out ("make book", in Minsky's words). Thus, the supply of plankton is twice drained. Which means that the bigger fish in the domestic and global economic sea are going to be living on leaner diets. It also means that any given level of central-bank enforced short-term policy rates will become ever more restrictive with the passage of time. That is nowhere more the case than in the United States, where mortgage originators' orgy of Ponzi finance stifled the Fed's ability to temper irrational exuberance in housing with hikes in the Fed funds rate. More specifically, as long as lenders made loans available on virtually non-existent terms, the price didn't really matter all that much to borrowers; after all, housing prices were going up so fast that a point or two either way on the mortgage rate didn't really matter. The availability of credit trumped the price of credit. Such is always the case in manias. It is also the case that once a speculative bubble bursts, reduced availability of credit will dominate the price of credit, even if markets and policy makers cut the price. The supply side of Ponzi credit is what matters, not the interest elasticity of demand. Bottom Line The ongoing meltdown in the sub-prime mortgage market would not matter, except for those directly involved, except that it marks the unraveling of Ponzi finance units that, on the margin, were the plankton of the bubbling property sea of recent years. As the bubble was forming, riding on first-time homebuyers with first-time access to credit on un-creditworthy terms, and first-time speculators riding the same with visions of bigger first-time fools to take them out, all looked well. But as Minsky warned, stability is ultimately destabilizing, as those who require perpetual asset price appreciation to make book are forced to sell to make book. Such is reality presently in the U.S. residential property market, which has flipped from a sellers' market on the wings of buyers with exotic mortgages to a buyers' market of only the creditworthy. This state of affairs need not produce a U.S. recession. But it does unambiguously render any given stance of Fed policy more restrictive: a tightening of credit supply based on underwriting terms means that any given policy rate will elicit reduced effective demand for credit. And that's the stuff of seriously easier monetary policy to come. Just as mortgage demand seemed inelastic to rising short rates when availability was riding relaxed terms, so too will demand seem inelastic to falling short rates when availability faces the headwind of restrictive terms. It may be a while before the Fed accepts and recognizes this, waiting for these Minsky style debt-deflation dynamics to become evident in broader measures of the economy's health, notably job creation. But make no mistake: A Minsky Meltdown in the most important asset in most Americans' asset portfolio is not a minor matter. Bill Gross' Plankton Theory ain't just a theory, but a reality. Once the Fed begins easing, it will be a long journey down for short rates. Your thinking the "plankton will be in short supply" analyst, John F. Mauldin johnmauldin@investorsinsight.com
Interesting stuff. I guess in concept, the plankton aren't so much the young couple new home buyers...instead they are the folks who used exotic loans...not necessarily the same group because there were some established well-to-do folks out there who still used exotic financing methods. But what is interesting is that if you extend the plankton analogy, you have to accept that the "plankton" just don't disappear. They are still there, and they still need a place to live. They will have to rely on others, such as landlords, to provide housing for them. The number of people who need housing is not decreasing...but is increasing with the population. In light of the (bolded) quote above, and the fact that these people will still need housing, it is logical to assume that this presents an opportunity to the landlords to buy on the cheap and rent out to the plankton. But this transfer, while not gradual, may not occur sharply, and may not generate as sharp declines as were caused in the 80's where rates went extremely high (think of it as poison in the ocean across all food chains) or in the 90's in california where the tech sector tanked (think of it as an undersea volcano forcing the fish out). The fact is that these "plankton", while they may have doubled over the last year as things went from "gangbusters" to "slow", still represent a small fraction (biomass?) of the fish in the sea. Typically, 0.5 to 1% is the normal foreclosure rate, and we've seen rates of of only half a percent nationwide recently. And mortgage rates are still low. So, IMHO, the plankton analogy doesn't hold much weight to me because it is hyperbole...the reality is that these plankton represent 1% (perhaps going to 2%) of all fish in the sea, across all sizes of fish. And these fish, though forced out of their conch shells and away from their reefs, will move into others...the need for a hide-hole will still exist. Yep, the transition will shake things up, and prices may dip in some areas, or that shake-up may be nearing an end. Some fish will get eaten and there will be some fish who take up residence in less comfortable places, but it will not be the death of the ocean. It will even be a boon to some. SM
Depends on the area. 85% of the plankton used exotic loans in san diego, and the population has gone down every year for several years now as people move away due to the insane cost of living here.
Don't get me wrong. I do think that 1 or 2% of the population going bankrupt can (or has) had an effect on prices. It doesn't take much to upset the applecart. Regarding San Diego though, I just read an article about it...isn't growth restricted on all four sides. The ocean to the west, the marine base to the east, and what is to the north and south again? I read that many people move beyond these geographic restrictions and commute a heck of a long way. What I'm getting at, is that though the population of San Diego may be going down, isn't the surrounding area's population going up as more people are commuting into San Diego to work there? SM