Bill Fleckenstein

Contrarian Chronicles3/12/2007 12:00 AM ET

Next: The real estate market freeze

As a result of the collapse of the subprime mortgage market, lenders will -- gasp! -- once again require down payments, filling the market with unsold homes and driving down prices.

By Bill Fleckenstein

The unraveling of the housing market, the magic bullet that "fixed" our unraveled equity bubble, is the news. Slowly, the popular press is waking up to what I've been discussing for many months now.

Dropping like subprime flies

Essentially, the subprime mortgage industry -- which lends to consumers with credit issues -- is gone. Alt A lenders, those one rung up the ladder creditwise, will be next. Together, they comprise approximately 40% of the market. If you were to go down the list of what were once the top 25 subprime lenders, you'd see that only a handful are still standing at this point. The Office of the Comptroller of the Currency recently enacted rules that, in essence, require lenders who provide mortgages using federally guaranteed depositor funds to behave in a somewhat intelligent fashion. Subprime lender Fremont General (FMT, news, msgs), by its own admission, owes its demise in part to that rule change.

What we don't yet know is the degree of credit-related insanity, which we'll only discover when the tide goes out -- the criminal investigation of New Century Financial (NEW, news, msgs) being one example of the rot that has already been revealed. We also don't yet know the ramifications for the dark-matter universe in collateralized debt obligations (CDOs), credit default swaps (CDSs) and other derivatives-related exotica. But I think it's safe to say that the surprises will be negative -- and large.

This credit collapse is an unequivocally important event. Because, as I've been writing, the ability of anybody with a pulse to get a loan for any amount is what drove the real estate market, and the real estate market is what drove the economy. Sometime in the next three to six months, the real-estate market will basically just freeze up. Of course, inventories are going to explode and prices will eventually drop rather dramatically as a vicious cycle feeds on itself.

The down payment makes a comeback

Since the pendulum swung as far as it could in the direction of reckless lending, which the whole bubble was about, it will now swing back toward the quaint notion of folks being lent only the amount of money they can reasonably be expected to pay back. And, the lenders will want their loans to have a margin of safety, in the form of down payments.

Sadly, it doesn't take a large imagination to conjure up how underwater many people will be, and how difficult it will be to sell houses -- or purchase them, for that matter -- as lending standards change. Thus, I believe the ingredients for the "next time down" are now at hand.

In the meantime, patience is required of those of us in that camp. Yes, there have been "fire drills" in the stock market on a handful of days, when folks headed for the exits. But folks have also headed right back into stocks as soon as they appeared to stabilize. Which just shows you that in the aggregate, folks do not understand that the economy was driven by real estate. Nor do they seem to understand that real estate is what will sink the economy.

Prescient view of a game gone askew

One who does is Lou Ranieri, sort of the father of the mortgage bond market. In a recent interview, he warned: "This is the leading edge of the storm. . . . If you think this is bad, imagine what it's going to be like in the middle of the crisis." In his opinion, more than $100 billion of home loans are likely to default. ("Just divide $100 billion by the average loan amount and you get a lot of people, a lot of families.") He also expects to see some form of bailout at some point, because "foreclosures in those amounts are politically unacceptable."

He could be right about the size of the problem. I could see that, although I don't have enough data to say how big it will be. If there is a bailout, that would certainly not be bullish for the dollar, though it would be very bullish for precious metals.

At the time of publication, Bill Fleckenstein did not own or control shares of companies mentioned in this column.

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