It's almost impossible to pick up a newspaper or turn on the tube without hearing about rising interest rates and the negative consequences associated with their ascension.  I continue to read and hear that rates above 5% will stop the housing recovery (assuming we're currently recovering) in its tracks.  In case you skimmed over the last sentence too fast I will repeat it because I believe it's very important; rates above 5% will stop the housing recovery in its tracks.  How?  Why?  Are you kidding me?  The historical risk free rate of return is 4.5% to 5.0%.  Are we suggesting that housing risk necessitates no, or even a negative, risk premium?  Current and historical default rates suggest otherwise...

I'm not that old or young for that matter, but I do remember the interest rate on my first house; it was 8.6% which was a pretty average rate at the time.  I'm sure many of you can remember paying rates well into double digits.  How in the world could we afford to pay a rate that was 72% higher in my case and maybe 200% higher in yours? 

Leverage and affordability.

We bought what we could afford to buy under normal circumstances - we had to have skin in the game (a down payment), and our DTI ratio was actually representative of what we could afford considering our fixed and variable expenses.   Over the years consumers and companies have been overleveraging at an alarming rate.  Take a look at the following slides:

Our consumption and debt are increasing while our savings is decreasing a rate much faster than our income is increasing.   Even my 12 year can look at these graphs and fundamentally understand that this is a recipe for disaster.  How did this happen?  Basically, everybody wanted more for less.  I'm not suggesting there's anything wrong with more, after all, more is at the heart of capitalism.  However, the undisciplined pursuit of more is more indicative of our situation and another matter altogether.    

Companies wanted more so they levered up and increased output.  Consumers wanted more so they borrowed more to get more of what the companies were producing.  Financial institutions wanted more so they got real fancy with all kinds of securitization vehicles and fancy acronyms (SIV's, CDO's, CMO's MBS, etc), all so they could lend more money to both companies and consumers so they could produce and consume more. This worked for a period of time, during which everyone was fat and happy, that is until..... good times went bad.  Now everyone, and by everyone I mean the entire global economy, is in a world a hurt. 

So what's our reaction to all this under-saving and over-consuming?

Stimulus, aka borrow more and spend more.  The government is planning to spend trillions of dollars in fiscal stimulus to spur the economy and they're planning to pay for it by levering up.  Sound familiar?  What exactly is stimulus?  Webster's defines stimulus as "something that rouses or incites to activity".  The Federal Government is taking the place of companies and consumers and spending where we can't.  It's giving the money to banks to lend because they ran out; literally in many cases.  Does this make sense to anyone?  Are we really solving are problems or are we just adding to them and delaying the inevitable to a future point in time?

It was just reported that the foreclosure rate on prime mortgages has doubled in the last year (now at 12.07%) and currently outpacing subprime defaults.  According to First American Corelogic, loans in default as of February totaled $717B.  Obama's Housing Rescue Plan calls for 75B in stimulus to be spent in preventing foreclosures.  This will allegedly save about 10% of homeowners from going into foreclosure.  However, if our future is indicative of our past, we can expect over 50% of these modified loans to go back into foreclosure within six months. 

We all know why the subprimes and Alt-A's are defaulting - these loans should have never been given in the first place, but what's going on with these new defaults?  Prime mortgages are defaulting due to changes in employment or unemployment as the case may be.   It's not the rate that's killing these deals it's the payment!

 Look at the following graph:

House prices, automobile prices and so many other consumables have simply outpaced our ability to pay for them.  So we borrowed and borrowed and borrowed.  However, this debt is fixed - it's not relative to our income.  If your income drops or even worse stops, your bank doesn't reduce your payment relative to your decrease in revenue.  What do you do.... The best you can for as long as you can but at some point, you default.  Interest rates aren't the problem, asset prices are the problem and I suggest they need to reset much further for real affordability to come into play again and allow consumers to purchase these assets while maintaining appropriate ratios of debt and equity relative to income. 

I haven't heard anyone or read anywhere that anyone is predicting unemployment to decrease anytime soon.  Most expect it to climb throughout the remainder of this year, stabilize in 2010 and begin to recover in 2011.  If this is true, most ABS are going to see default rates continue to rise at horrific rates.  Banks are preparing for this inevitability by increasing their loan loss reserves, but are they reserving enough?  Probably not. 

Mohamed El-Erian refers to our evolving situation as "The New Normal".  Is it, or are we striving for more of the same?  I agree that we will eventually get there, but in the interim, we have stimulus.  People are calling for more recapitalization, more bailouts, more MBS purchases, more treasury purchases, more stimulus, more of "something that rouses or incites to activity" in an effort to recapture the "old-normal", which we all loved too much and by all means, was unsustainable.  

I understand the alternative is not pretty but I suggest that it will eventually become a reality.   I agree that we need to revert to the "old normal", but it's the really old "old normal" that I'm referring to.  Purchase what we can afford and purchase it with the appropriate mixture of debt and equity relative to our income.  We also take business cycles into account because we will forever continue to have good times and bad. 

As the old saying goes, "you hope for the best but prepare for the worst."  This doesn't mean that when good times go bad, you look for the Fed to bail you out.  It means you do the best you can and take your lumps; it means you reap what you sew.