Saturday, December 31, 2005

HOUSING BUBBLE? Much bigger than housing bubble!

I wrote this paper in December 2005 to try and help others see the "Big Picture". I've been studying the issues for several years now, but only recently did I realize how interconnected the problems really were. The "Big Picture" of our economy (my perspective anyway) is not nearly as rosy as our government officials and the talking heads in the media portray it to be.

Hope you enjoy the read!

The vast majority of American consumers wake up every day completely oblivious to the enormous economic problems at their doorsteps. But why should they care? With two brand new SUV’s in the driveway of their highly appreciating suburban home (located next to a Starbucks where their daily $4 drink can be charged on Visa), and their ability to purchase a cheap, Chinese-made DVD player at Wal-Mart to hook up to their recently financed HDTV Plasma screen, life couldn’t be better. As long as the paychecks can keep up with the minimum monthly payments on their credit cards, autos and interest only mortgage, all is just fine... So is the way of life in America today.

The psychology of average America has changed during the last 15 years. Whereas saving for the future used to be the mantra to live by, it has been replaced by “consume for today”. Living with debt has become the new norm and saving money is out of fashion. Today, consumers rarely even care about an item’s bottom-line price. All they are interested in is a low monthly payment (hey, I can afford that!) and they keep on piling up these payments because they just have to have that brand new widget (which they don’t need). With a big thanks to Alan Greenspan, the lowest interest rates in over 40 years and the capability of using a home as an ATM machine, all of this was made possible. American consumers are graciously spending > 100% of their income today, with no end in sight. Heck… no big deal, they are just following the lead of the US government. With trade deficits running at 6% of GDP, why should anyone worry? Spend, spend, spend… All is well!

Looking forward: welcome to 2006 & 2007; Interest rates are on the rise, credit card payments have doubled (due to new laws), corporate bankruptcies are up (Delphi, GM, Ford, Delta, US, United and Northwest Airlines, etc), payments have increased on that adjustable rate mortgage, consumer prices are through the roof (food, electricity, gas, consumer goods, etc), Asian Central Banks are losing confidence in the dollar, and the consumer, who was already stretched to the max, can take it no more… How convenient for the US government & corporations to change the bankruptcy laws in November 2005 (a coincidence?); with the new law, people will no longer be allowed to completely walk away from debt--and it’s going to hurt them for many, many years!

The events that follow (due to the above mentioned issues)--will lower US consumer spending, increase mortgage defaults, cause auto sales to sag, increase the number of credit card defaults and will lead to falling home prices, layoffs, falling stock market, falling US dollar, etc. Ultimately, after 2 consecutive quarters of negative activity, we will enter a new recessionary period (probably late 2006, early 2007). The recession will start off slow, will gradually fester/get worse and will eventually set off a chain of events that could potentially lead to complete economic calamity (possibly worse than 1929) a couple of years later. Why do I feel this way? Let me explain.

There are numerous underlying fundamental problems with the US economy. From all exterior angles, to the common man, everything does look fine, but you have to look deeper—at the foundation of US economic rot. The problems we have are so huge, there is little we can do now except to try and individually prepare as best as possible (reduce debt and increase savings liquidity) and then brace for the long-term consequences.

I have identified several areas (below) that I feel are relevant to the current economic quagmire and will try, to the best of my ability, to touch on some of the details. The bottom-line analogy that I’d like for you to use during this reading is this: consider each of the issues below as individual dominoes and each depends on the others to either stay in place or to fall. When the first domino does fall (the recessionary catalyst), most of the others will follow suit… a chain reaction that cannot be stopped until all the dominoes are on their sides. Only then (after the calamity) can we begin to start picking up the pieces and reset the dominoes. By that time, however, life will have fundamentally changed!

The issues I plan to touch on:

- US Dollar Problems
- Enormous US Debt
- Massive US Trade Deficits
- Rising Inflationary pressures
- Housing Bubble
- Consumer Spending
- Outsourcing of US Jobs/Corporate Bankruptcies

US Dollar Problems: Allow me start with a little history on the US dollar. Throughout the history of the world, there have always been strong currencies, typically held by the superpowers of the day. Theses currencies were/are called Reserve Currencies. The Pound Sterling was the primary reserve currency for much of the world in the 18th and 19th centuries. But perpetual account and fiscal deficits financed by cheap credit and unsustainable monetary and fiscal policies used to finance wars and colonial ambitions eventually led to the pound sinking (sound familiar?).

Post World-War II, the US dollar took over the sterling’s dominant position and became the world’s newest reserve currency. The Bretton Woods Accord established a way to value the various currencies of the world relative to each other and tied only the US dollar (as the reserve currency) to a gold standard (meaning the value of dollars circulating must be backed by gold reserves).

The gold standard caused major problems in the 1960’s when France (under the London Gold Pool) called America’s bluff and demanded gold for payment of debt, rather than US dollars. Due to the rapid loss of US gold reserves, Nixon had no choice but to abolish the Bretton Woods accord in 1971 and he took the US dollar off the gold standard (it was $35 per ounce then; today it is > $500).

Once removed from the gold standard, the US dollar became a fiat currency (tied to nothing tangible and backed only by the word of the US government) and the Fed could print money at will. It remained, however, the world’s dominant reserve and was the baseline upon which all other currencies floated and were traded.

As the world’s reserve currency, the US has been able to, year after year, import goods from the rest of the world (for consumption) and pay for it with dollars. These dollars are then used by foreign central banks to purchase US debt instruments (US treasuries and the like) from the Fed. It’s almost comical, as the treasury securities they purchase are created out of nothing, are backed by nothing and require absolutely no savings by any American consumer. The Federal Reserve just prints them at will and “promises” to repay the debt.

To quote a Robert Blumen comment (from the Ludwig Von Mises Institute—an educational center for the Austrian School of economics): “The current international monetary system, like a bad horror movie, is a sort of return of the living dead Bretton Woods. A vestige of the agreement places the dollar at the center of international finance, and securities denominated in fiat U.S. dollars are the most widely held reserve asset. Dollars that were accumulated under the promise of convertibility are now held in such large quantities by most major central banks that they cannot be sold without destroying the value of the remaining asset.” What he said in layman’s terms: Central Banks (Mostly those of Japan, Korea, China and India) are currently holding > $2.4 Trillion dollars in US securities (helping to finance our US debt). If these Central Banks ever try to cash these securities -- even just the hint of one of the banks thinking about it (the smell of blood in the water if you will), a rush to exit the dollar cashing door will ensue (a first out mentality) and this will cause a dollar crisis--the dollar will collapse and the worldwide economic system will be in complete shambles. Understanding the potential ramifications, all the foreign central banks can do is hold on to these fiat assets (catch-22). Essentially, they are holding on to US checks they are unable to cash.
Central banks (aware of the quagmire they are in) are already starting to become leery with the huge debt levels and increasing trade deficits (~ 6% GDP) of the US, and are starting to diversify their holdings in Euros. Just the lean toward diversification alone is enough to cause the dollar some problems. So, the question is, what can be done about these dollar problems? Answer: Unless the US begins to reel in deficit spending quickly (which I don’t see happening), a dollar crisis is pretty much a foregone conclusion. It’s not a matter of if--it is when. When the dollar eventually does collapse, the world will probably enter into a depressionary period and when over, another currency will have to pick up the reserve, after which the dollar will be relegated to a minor spot in world finance.

Enormous US Debt:
Take a look at the current US Debt Clock. This figure is the Total Public Debt Outstanding as owed by the US government. It is money the government owes to others, financed through treasuries, bonds, mutual funds, foreign banks, etc and is backed by nothing except the word of the US government. The huge $8.1 Trillion dollar debt, in and of itself, is a problem, but the bigger issue is how quickly it is growing. In 2004, the total US debt was less than $7.3T. In 2003, it was less than $6.5T. At current rates of spending, US debt will rapidly overtake the upper congressionally authorized debt ceiling of $8.3T and it (the ceiling) will need to be raised again in early 2006. The new upper limit, when set, will probably be somewhere in ballpark of around $9T, but with no slowdown in sight, the US government will reach that new level in ~ 18 months. It’s pretty scary stuff. How high will we (and the world) allow it to go without consequence? For what it’s worth, my bet is: Not for much longer!
Now, if we look at the TOTAL $40T combined debt of US Households, Business, Government and Financial sectors, the picture gets even scarier. How in the world will we ever get out of this pickle?

Answer: WE WON’T! We’ll just keep increasing the cumulative debt up to the point that a major financial event (depression, dollar crisis, etc) is experienced. This event will naturally solve the problem through defaults, bankruptcies, devalued currency, etc. Don’t believe for a moment that the Federal government has a “master plan” to solve this. They will try to apply band-aids where possible, but it is far too late for a major fix. All they can do is now is pick up the pieces (like the rest of us) when it’s all over.

Massive Trade Deficits: 2005 looks like another record-breaking year! Too bad it’s not good-news. When all is said and done, the US will have exceeded $700B in trade deficits (over $2B each and every day of the year). This new record exceeds the all time trade deficit record of 2004 ($668 Billion)! These massive debt levels equate to roughly 6% of US Gross Domestic Product (GDP). That figure alone should be scary enough, as no country in the history of the world has been able to sustain this level of debt without some sort of financial repercussion (currency crisis, defaults, rampant inflation, etc). The only reason we haven’t felt the pressure yet is because the US Dollar, as we discussed earlier, is the world’s reserve currency. If/when it fails, it’ll most likely be followed by a worldwide depression. In an effort to hold this event at bay for as long as possible (holding off the inevitable), foreign central banks are continuing to finance this debt through the purchase of US securities (with the inability to cash out—as stated earlier). How long will this trend continue? My opinion: NOT FOR MUCH LONGER

So, what has the US government done recently to reign in the spending? Answer: Zilch, Zero, Nada, Nothing. It seems far too difficult a task for Washington to manage. All I can say is: start to prepare yourself now for the bread lines of tomorrow.

Rising Inflationary Pressures: In an effort to stave off a US recession after the stock market collapse in 2000-2002 and the 9/11 terrorist attacks, Fed Chairman Alan Greenspan cut the Federal Funds Rate 13 times (it was 6.5% in Jan 2001) over a period of two years--until the rate reached its lowest point (1% in Jun 03) in over forty years (some argue the Fed kept rates too low for too long). This aggressive Fed action, along with massive printing of money (increasing liquidity) and a lowered tax rate (remember the Bush income tax cuts?) stimulated the US economy and kept the recession very short. With a flood of cheap new money now available in the market, US consumers went on a spending spree. Well, here is where the well-understood law of supply and demand kicked in. Due to high demand of resources (lots of people w/money to buy limited resources), prices rose on nearly everything (homes, commodities, fuel, food, etc). Prices were rising so fast, the Fed had to do something to slow the inflationary pressures… so began the short-term rate increases we’ve seen during the last 18 months. With that said, the Fed was/is also in a pickle. He had to raise rates to: (1) boost foreign investor confidence in the dollar (which had been waning) and (2) slow inflationary pressures, but he couldn’t do it too fast for fear of bursting the housing bubble--created by the extraordinarily low rates (we’ll discuss the housing bubble in detail later).

Now that the Fed is increasing rates, the dollar is beginning to show renewed strength (albeit probably short lived due to our deficit/debt), but the housing market is beginning to slow. If the housing bubble does pop, the US will be in a world of hurt, as consumers have been relying on increased home equity (the wealth effect) for spending, and greater than 25% of US economic growth over the last 3 years has been dependant on the housing market. When this is taken away, an entire industry will collapse and massive ripple effects will be felt across the economy. Do you know any realtors or loan officers? You may want to tell them to start looking for a new line of work.
In addition, we are now nearing an inverted yield curve (where returns on short term investments outperform long-term)—a predictor of numerous past recessions.
What I foresee: The Fed will continue to increase rates for the next 2-3 cycles. This action will cause the US to experience an inverted yield curve and cool the housing market (eliminating the wealth effect). The US will then enter a recession ( probably late 2006/2007) where consumers will pull back on spending (causing further recessionary pressures). The lackluster performance of the US economy and our growing debt will cause foreign investors to lose faith in the US economy and begin further diversification of their holdings. This will, in-turn cause the dollar to lose value against other worldwide currencies and Americans will lose purchasing power… a downward spiral.

Housing Bubble: As we discussed earlier, the low interest rates brought on by the aggressive Fed lowering actions of 2001-2003 allowed the US consumer to borrow money very cheaply. Consumers took advantage of the situation to refinance their home, or they sold their home to upgrade into a larger one that they could now afford (because of these lower rates). Many others took out low rate homeowner equity loans to pay off high interest credit cards, remodel, buy a pool, new furniture, a new car or maybe even purchase a second home. In addition, many folks who previously couldn’t afford to buy a home (renters) could now afford to do so and decided to enter the market. Because so many people were now doing the same thing (buying new homes, refinancing, getting a second home, speculating on and/or flipping homes based upon future appreciation, etc) the costs of homes increased astronomically (again supply/demand situation). This new housing boon created a bubble that has been the main economic engine of the US economy for the last 3 years.

I would like to point out that another factor is also responsible for the run-up in home prices--new strategies in homeowner lending practices (Interest only mortgages, ARM’s, 40 year loans, etc) and significantly relaxed lending standards allowed more people qualify for homes that they could not otherwise afford and lenders took on much riskier loans to qualify people that had no business being in the market anyway. But it really didn’t matter to the lender, as they were not the ones taking the risk. After closing on the notes, they would sell the mortgages to Fannie Mae or Freddy Mac—two massive Government Sponsored Enterprises (GSE’s). These GSE’s would then repackage the notes as Mortgage Backed Securities, Interest bearing accounts, etc and then sell them on the open market, (to be bought up by your retirement plan investments, etc).
Note: Fannie Mae, the larger of the two GSE’s was recently charged with cooking their books (as many had suspected for years) and had to file a $10B loss in 2004. Some feel it is the 1st step towards its ultimate demise and it will go the way of ENRON—only it’ll have wider implications and could ultimately bring down the entire US economy.

Recent evidence suggests that the Fed’s numerous short-term rate increases are finally beginning to have an effect on long-term mortgage rates and in-turn this is beginning to cool the housing market. Many folks, however, still believe that real estate is a “can’t-lose” investment. My gut feeling about the issue: When your taxi cab driver, hairdresser, co-worker and next-door neighbor all talk about how much money can be made in real estate and how you need to increase your real estate holdings, do you really believe that they are on to something? Do you really believe that real estate will continue to make people money indefinitely? Do you honestly believe the peak hasn’t already been reached? I remember the days before the tech stock market bubble—everyone was talking about how you couldn’t lose—buy, buy, buy. Rest assured, the big-money makers in real estate have already left the market and it’s all down hill now. Take a look at why real estate is different this time. When housing prices do plummet, the economy will follow suit.

Consumer Spending: Americans love to consume to excess (food, energy, appliances, autos, electronics, clothes, latest widget, etc) and they can’t seem to get enough. As previously mentioned, Americans used to save for a rainy day (probably due to personal experience in dealing with hardship—war, recession, depression, etc), but today, most Americans live for the here and now. For the first time in American history, consumers are now spending more than they earn and have a negative savings rate. How can they do that? By charging on credit cards, financing equity out of their homes, spending money they had in retirement savings, and the like.

The problem is: this excessive spending (negative savings rate) can’t go on much longer, as most American consumers are in debt up to their eyeballs. With credit card payments doubling next year, rising interest rates and consumer inflation on the rise, consumers will not be able to take on the additional expenses and eventually will have to pull back on their spending. The added impact of the American consumer being stretched so thin is: defaults on credit cards, auto loans and mortgages (remember all those new interest only mortgages and Home Equity Lines of Credit) will increase, causing corporate financial hardships. This in turn could lead to layoffs, bankruptcies and the like… another downward spiral.

The biggest problem is: the world-economy (China, India, Korea and many others) has become very dependent on US spending (a place to sell/export their goods), so when this spending pullback does happen (an absolute must & very soon), the world will probably end up in a recession… possibly the first domino to fall.

Outsourcing of US Jobs/Corporate Bankruptcies: The US was once a manufacturing powerhouse, but due to the high cost of US labor and in an attempt to compete in a global marketplace, jobs/manufacturing were outsourced to cheaper countries. Those home-bound US companies still trying to compete in the Global marketplace are reeling from higher labor costs, pension plans, union benefits, health care costs and the like. Just take a hard look at Delphi and General Motors. Next, looks at Ford--they are not too far behind. In addition, look at the United States airline sector— United Airlines, Delta Airlines, Northwest Airlines, ATA Airlines, US Airlines and most recently Independence Airlines--all are operating under bankruptcy protection .

Whereas the US used to be a manufacturing powerhouse, we are quickly moving towards a service-based, consumer nation and we currently live far beyond our means--on both a personal and government level. How can the US ever compete in the global marketplace when foreign entities pay cents on the dollar for wages and rarely care about health care and/or worker benefits? Answer: WE CAN’T… and the problems, bankruptcies, plant closings, layoffs, etc, will only get worse!

Summary: The US economy has far too many fundamental imbalances (dollar problems, debt problems, deficit problems, rising inflation, housing bubble, excessive consumer spending, corporate bankruptcies/outsourcing) and WILL experience a MAJOR correction in the not too distant future. I haven’t even touched on some of the other areas I feel put the US at risk for a major event (Credit Derivatives, Pension Crisis, Social Security Crisis, Immigration Crisis, Stock Market Bubble, Terrorism, New Fed Chairman, Bird Flu, Peak Oil, Elimination of M3 publication, Iran Oil Burse--trading in Euros, etc). But what I want you to take away from this reading is this: once that first domino does fall (probably due to a recession mid-to-late 2006 or early 2007), the other dominoes will follow suit, and it will take many, many years for the myriad of complex economic problems to work themselves out. The outcome will be extremely difficult, and life as we know it today will never be the same.

What can you do? Try to prepare yourself mentally for the change (as you will be one step further along than most) and then try to eliminate debt, look at the security of your job (change if need be) and then try to increase your saving (buy Gold or Silver) for that rainy day—or years.

Best regards,