Trouble in Squanderville                      

 

By Mike Whitney 

04/16/07 "ICH " -- -- Two years ago, anyone who wrote about the housing bubble was dismissed as a conspiracy nut. Now hardly a day goes by that the headlines aren’t splattered with the details of the massive meltdown in the real estate market.

What changed? The facts are essentially the same today as they were back then. In fact, the “Economist”--as well as many independent journalists--had already shown that the Fed’s low interest rates had inflated the biggest equity bubble in history which could potentially bring down the entire economy.

Now, all of a sudden, the media is acting as if the problem sprouted up overnight?

Why?

The notion that the media was unaware of what was going on is ridiculous. The business pages in America’s newspapers are written by some of the country’s “best and brightest”; most of them have MBAs which they earned at our finest universities.

Is it possible that they were oblivious to the trillions of dollars that were funneled into the real estate market to unqualified loan applicants? Or that they didn’t know that the rising prices had no relation GDP, increases in wages or productivity.

Is it possible that some of our best educated business prognosticators don’t understand the effects of low interest rates or the speculative bubbles they naturally create?

It’s simply not possible----the effects of interest rates are the first thing that one learns in Econ 101.

The real problem is that the media obfuscates information that conflicts with the interests of management or their constituents. Their main goal is to promote consumer spending regardless of its effects on the nation’s economy. In this case, they managed to hide an $11 trillion economy-busting bubble and nudge us ever-closer towards catastrophe. That takes a pretty talented public relations team. In fact, we've probably underestimated how powerful and persuasive the corporate propaganda-system really is.

While housing prices rose at 10% to 20% per year, the American people were duped into believing that such huge leaps were just part of the normal business cycle---just supply and demand. They never dreamed that the surge in prices was engineered at the Federal Reserve through artificially low interest rates. Everyone believed that things were just hunky-dory---that it was springtime in “the land of the free and the home of the chronically indebted”. Those who disagreed were derided as doomsayers or lunatics.

It didn’t seem to matter that the skyrocketing prices had no historical precedent. After all, housing prices ALWAYS go up---everyone knows that. Even questioning the “irrational exuberance” in the real estate market was tantamount to heresy. Housing wasn’t like the dot.com fiasco—where zillions of dollars were sluiced into a hyper-inflated, speculative frenzy. Housing is the brick-n-mortar expression of the American dream---a rock solid investment from top to bottom---a vital part of the American psyche as true as Old Glory or the Continental Congress in 1776.

Now that the housing market has begun to unwind, the “spendthrift” American consumer is already being lambasted in the media. It’s another example of “blaming the victim” while absolving the architects of this low interest coup at the Central Bank. It’s their monetary policy that created this mess. Their choices will inevitably lead to millions of defaults.

But how will the rest of us be affected by the impending correction in housing? Is there something we should be doing to protect ourselves?

The firestorm in subprime mortgages is just the first of many troubles that could put housing in a permanent swoon while sending the greenback into a downward spiral. That means that everyone needs to arm themselves with knowledge---dig up the facts and make informed judgments on the basis of objective data and sound reasoning.

Don’t expect help from the media----they will continue to offer Pollyanna scenarios for a situation that is certain to get progressively worse.

Last week, a report on CNBC announced that “Mortgage Delinquencies Hit Record High in First Quarter”. The article is another bleak account of the millions of people who are losing of their homes because they cannot make their payments after their loans reset. This phenomenon is expected to accelerate well into 2008 and perhaps beyond.

The news was softened by a report from the Bureau of Labor Statistics (BLS) which claimed that 180,000 new jobs had been created in March. But that’s all baloney. The country lost another 16 thousand manufacturing jobs in the same period and construction labor has been falling for a year. Chuck Butler of the Daily Pfennig noted that the fantastical numbers were conjured up by using the BLS “Birth-death model” which creates “ghost jobs” out of thin air (much like the way the Fed creates credit) In other words, the BLS job figures are nearly as unreliable as the core rate of inflation (CPI) which excludes food, energy (as well as) modifying rising housing costs.

Think about that: How does the government calculate inflation without evaluating fixed prices on basic necessities? It’s a complete fraud. The only thing the CPI is good for is computing price-hikes on the cheap Chinese widgets purchased at Target or Walmart. Most people judge the declining value of the dollar by their trips to the gas station or supermarket. They know that the dollar is tanking and they don’t need Fed chief Bernanke to tell them its all in their mind.

Nevertheless, Wall Street rallied on the jobs report which (temporarily) allayed fears about the downturn in sub-primes.

Hooray for the “faith based” stock market!

It is common practice to water-down bad economic news by using manipulated statistics provided by the government. But a closer look at the facts will convince even the biggest skeptic that the housing market is flat-lining and won’t revive anytime soon.

Wherever you live in the United States---you WILL lose equity on your home in the next few years. The magnitude of Greenspan’s bubble makes that a certainty. Some markets will experience greater losses than others, but as prices decline and inventory increases, everyone will lose some equity.

Are you prepared to sweat it out while your investment diminishes day by day or sell now and be done with it?

Here’re some of the numbers that might help:

There are roughly 75 million housing units in the USA. About 25 million of those homes are owned free and clear. That leaves 50 million homeowners with sharing (roughly) $10 trillion in total mortgage debt. The risk of “resets” (that is, monthly payments that will go up after the introductory period of time) will affect 75% of all mortgages. (Some reports have already indicated that 80% of sub-prime mortgage holders have said that they will have difficulty paying the newly-adjusted payments)

4.5 million homeowners will have to come up with lump-sum, “balloon payments”. 10 million have taken out piggyback loans to avoid a down payment on their original purchase. 12 million have either 2 or 3 mortgages outstanding. And, of the homeowners who have taken out “conventional” loans via FHA or VA, nearly 10% are having difficulty making their payments.

Get the picture? The problem is not safely “contained” in the subprime market as Bernanke and Paulson confidently suggest. This is a massive economy-battering tsunami which is sweeping through the real estate market on its way to Wall Street. (60% of the mortgages have been “securitized” and sold off to hedge funds and insurance companies)

By the time the dust settles, the stock market and the mortgage industry will be reeling. We are likely to see the first bank failures since the late 1920s and, perhaps, one or two major hedge funds will go under. Collateralized mortgage debt has been integrated into the stock market, insurance industry and banking business. Any downturn in housing will inevitably ripple through the entire system.

A sizable amount of the current mortgage-debt is in the ARMs. These are the virtually “untested” adjustable rate mortgages that Business Week called “the most dangerous loan of all time”.  ARMs account for roughly $3.5 trillion in single-family mortgage debt. Most of these loans will reset from 2007 to 2010 putting additional pressure of homeowners to come up with higher payments while the “real value” (equity) of their property continues to decline.

Clearly, there’s little incentive to hang on to one’s home when values are going down. Millions of frustrated homeowners are bound to simply leave the sinking ship and vamoose. This will increase the inventory of unsold homes and put the market in an even deeper coma.

Already more than 14% of subprime borrowers are either late on their payments or in some phase of foreclosure. The percentage of Alt-A loans (the next category up from subprime) has also doubled in the last few months--illustrating that default contagion is spreading through the system as many analysts had suspected. And, while the Fed chief Bernanke promises a “rebound” in housing; realists in the subprime lending business are boarding up their offices and calling it a day. The anticipated meltdown will eliminate 20% of potential home purchasers and dry up $600 billion of liquidity.

1 out of 5 potential home-buyers will vanish almost overnight. Who will take their place? The industry is already frantically looking for anyone who can fog a mirror to sign on the dotted line. The fall in demand will be the death knell for new home builders as well as for the overall housing market.

Alan Greenspan’s involvement in the housing bust has been fairly well chronicled. In February 2004 he made comments which were taken as an endorsement for the many zany financing schemes (ARMs, “no doc” liar loans, interest-only loans, piggyback loans etc) which provided trillions of dollars in mortgages to unqualified applicants. (who were frequently the victims of predatory lending practices)

Greenspan said:

“American consumers might benefit if lenders provide greater mortgage product alternatives to the traditional fixed rate mortgage. To the degree that households are driven by fears of payment shocks but willing to manage their own interest-rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.”

Ah ha! So we don’t need rules anymore? The guidelines for issuing standardized loans are just rubbish? Forget down payments or all that fixed-rate 30-year mumbo-jumbo. That’s all history---Maestro Greenspan forsees a brave new world of creative financing where the traditional laws of economics are hereby suspended.

The outcome of this nonsense was entirely predictable. Now that the market is plummeting, the blame is being shifted to profligate consumers. But the problem originated at the Federal Reserve; that’s where the responsibility lies.

Of the 50 million or so active mortgages, it’s estimated that only 12 million are “risk free,” that is, conventional loans with 20% down and a fixed rate. All the rest contain one or more of the potential hazards we discussed above. If prices continue to decline, as nearly everyone now anticipates, we’ll begin to see the real vulnerabilities of the loose lending standards. The greatest danger is if millions of mortgage holders simply decide that it is not in their interest to be yoked to an asset of depreciating value---and simply default on their loans. This is a real concern since nearly 30% of homeowners (roughly 22 million people) have less than 20% equity in their homes. If prices decline at all, they could quickly lose all the principle on their investment and be left with negative equity. We can expect that more homes will be put on the market to forestall this eventuality.

The government takes this threat seriously and has initiated Senate hearings to investigate ways to stem the tide of foreclosures and keep more people in their homes. Senator Chuck Schumer, who is acting chair of the Joint Economic Committee, has recommended that the government provide hundreds of millions in aid to struggling families who are trying to meet their new payment schedules. But the amount of money the Congress can provide is miniscule compared to what is really needed. It won’t have any effect on the enormous increases in loans or help the ten of millions of besieged mortgage holders.

The privately owned banks are also getting involved through an organization called Neighborhood Assistance Corporation of America. Despite the cheery name, the NAC is an industry backed group founded by Citigroup and Bank of America that is aggressively seeking out troubled lenders so they can rewrite loans to make it easier for people to keep their homes. This “home rescue” effort illustrates how concerned the banks are about the soaring rate of foreclosures and the effects that millions of defaults will have on the banking industry.

Another group, called the “Mod Squad” is a “roving 50-person team of problem solvers who work for Texas EMC Mortgage a subsidiary of Bear Stearns.” Similar to the NAC, the Mod Squad will provide “custom crafted solutions for borrowers who can no longer afford their mortgages at current rates and terms”.

   Clearly, the banking and mortgage industries are trying desperately to save themselves from the credit tsunami they see forming on the horizon. Perhaps, renegotiating individual mortgages will do the trick and keep people in their homes. But time is running out and attitudes towards real estate are quickly souring.

The slump in housing comes at a time when the country is already headed towards recession and the dollar is facing its fiercest challenges to date. Foreign investment is drying up and, despite the Fed’s “jawboning” about interest rate increases; the pallid dollar has continued its downward trend removing any possibility of a quick economic recovery.

The stock market will undoubtedly fall as housing continues to deteriorate. Interest rate relief from the Fed will probably not help. As John Hussman of Hussman Strategic Growth noted, “The idea that stocks will do particularly well if the Fed cuts rates is an idea that’s not well supported by the data,” History shows that Fed rate cuts “generally do not take the stock market higher” when stocks are at their present valuation. Hussman anticipates a “consumer-led pullback” for the first time in 15 years.

Hussman’s observations are consistent with the decreases in home equity which have already reduced consumer spending. Accordingly, the IMF also has revised its GDP projection (downward) for the US in 2007 to 2.2%. A falling dollar will only put greater pressure to retail sales and job growth.

At the same time, the massive Current Account Deficit is causing central banks around the world to jettison the dollar. This is a huge long term problem that may end the dollar’s reign as the world’s reserve currency. The world’s Central Banks now hold the lowest percentage of dollars since 1999. It has dropped from 72.6% in 2002 to 64.7% in 2006. Recently many nations have made clear their intentions to diversify out of the dollar so this trend can be expected to increase.

Also, American corporations have built a manufacturing Frankenstein in China that is now beginning to show signs of independence. With $1 trillion of US reserves, China can directly affect interest rates in the United States and, thereby, determine economic policy. This was not what the policymakers had in mind when they drew up the blueprint for “integrating” China into the American-dominated system. US elites sacrificed America’s manufacturing sector to the god of globalization by outsourcing whole businesses to China. Now they must face an emergent Asian Dragon that is prepared to dominate the 21st Century. China has no intention of being America’s pawn.

The United States now faces a number of grave economic challenges---global trade imbalances, a depreciating currency, a falling stock market and a deflating housing bubble---All of these are similar in at least one respect. They are all self-inflicted wounds which derived from profit-motivated foolishness, lack of political vision or ideological fixation. America’s downward slide is entirely its own doing. No one helped.

  Corporate tycoon Warren Buffett summarized our current predicament best in a speech he delivered 2 years ago. He said:

“Through the spring of 2002, I had lived nearly 72 years without purchasing a foreign currency. Since then Berkshire has made significant investments in several currencies. …To hold other currencies is to believe that the dollar will decline….Our trade deficit has greatly worsened, to the point that our country's "net worth," so to speak, is now being transferred abroad at an alarming rate.

More important, however, is that foreign ownership of our assets will grow at about $500 (currently $800 billion) billion per year at the present trade-deficit level, which means that the deficit will be adding about one percentage point annually (now 1.5% annually) to foreigners' net ownership of our national wealth. As that ownership grows, so will the annual net investment income flowing out of this country. That will leave us paying ever-increasing dividends and interest to the world rather than being a net receiver of them, as in the past. We have entered the world of negative compounding -- goodbye pleasure, hello pain”. (Warren Buffet, “Thriftville versus Squanderville”)

  Buffett is right. America is selling itself in bits and pieces and calling it “prosperity”. Both political parties are responsible.

Conclusion: Political Turmoil Ahead

There’ll probably always be some doubt as to whether the $11 trillion housing bubble was merely an accident of misguided monetary policy or if it was part of a larger plan to shift wealth from the middle class to the ultra-rich. By seducing working class people with low interest rates, policymakers were able conceal the real effects of the unfunded tax cuts, currency deregulation, and the humongous trade deficits. As time goes by, however, the effects of those changes are becoming more apparent. The country has undergone an unprecedented expansion of personal debt which has engendered the greatest wealth gap since the Gilded Age. The deep economic divisions and polarities suggest that we may be headed for political turmoil. The present uneven distribution of wealth is inimical to democratic institutions. We should anticipate trouble.