Another topic of interest I don't see get much press as a driver of the housing bubble relates to the tax free treatment of the first $250K or $500K in gains on a primary residence. Although there's much press on how our government spurred the housing bubble with a liquidity bail out based on money supply and cuts in interest rates, I think the effect of these tax credits are hugely underestimated in terms of a wholesale change in American "investment psychology". An additional driver I would suggest which also gets little press is the massive proliferation of derivatives by financial institutions to off load and disperse mortgage loan risk and the lax regulatory environment promoted by the prior and current Fed.

Regarding mortgage backed securities, just to be clear, there seem to be two related issues:

1) This practice allowed a huge proliferation in the number and kind of lenders which effectively increased the money supply and was inherently inflationary compared with prior historical periods where money supply was controlled via the Fed.

2) Competition among these lenders and the perception that risk could be shared or off-loaded completely via mortgage backed securities and other related derivatives lead to a progressive relaxation of lending standards which effectively further increased money supply. When the financial system is stressed, these products may not perform as expected, just as portfolio insurance of the late 80's failed to function properly during periods of illiquidity. There seems to be so little transparency few if any have insight into the magnitude of the problem or how poorly the system might function when stressed. We have created a true Frankenstein, yet the Fed repeatedly commends this approach and lauds it's virtues to add market efficiency and lower risk.

There seems to be a real potential that a faltering real estate market will be create tremendous hardship not only directly to homeowners but also to every American if it spurs a major recession (with the potential to spread internationally). Should that occur, I think history will show the root cause to be a bad combination of monetary and fiscal policy (ie, Fed's bail out mentality, insufficient monitoring and regulation of mortgage backed securities and related derivatives, and excessive tax breaks on real estate). The real shame is that I feel we did it to ourselves since monetary and fiscal policy was the music that was played which would have had no effect if we didn't dance obligingly via a change in homeowner/investment psychology ultimately rooted in a modicum of greed.

"One comment that Mr. Wright made again and again was 'until we have an organic culture we will never have an organic architecture.' His point is that architecture is the result of the choices individuals make and it expresses the culture they make up and in turn are influenced by. The Usonian house is not just another way to “style” a building - it is about a different way of living; a way that, today, is alien to the mainstream of our American culture. The usonian way is about relating differently to the Earth, to life and to all living beings - it is an integrated, natural life-style. Sustainable, evolving, sensory, engaging - it is to be surrounded by beauty and to live in harmony."

to be one of my favorite books: The Enigma of Arrival by V.S. Naipaul.

"The story works on so many levels, it's hard to summarize. Summer vacationers looking for a "Road Trip" story won't be disappointed. High School and College juniors and seniors pondering their next steps will be inspired."

This ignores the standard deduction. (I think it's now close to $10K for married tax filers?) Thus, the net savings on taxes may be zero, depending on other deductions. (Admittedly, even a moderately sophisticated buyer --one who actually does the math and is depending on the mortgage interest deduction to make the buy decision work-- probably has other deductions.)

Also, I noticed you omitted real estate taxes in your example. On a $400K house at 2% (less in California, more in other locales), that's another $8K. Admittedly this is also deductible, so "only" a $2,960 deduction. In addition, Property Tax is among the first tax deductions you "lose" when you hit the AMT (Alternative Minimum Tax) which may be a big surprise if/when Congress fails to extend the current rules.

A small, but significant point left out of your analysis is the opportunity cost lost of the $80K (down payment). That's about $4K per year at 5% interest, which should be put into any equation evaluating losses. That increases their total losses because the $80K, of course, was tied up in a losing investment when it could have been earning interest.

I recently did an analysis of rent vs. own when it comes to having a large downpayment (we sold our house a year and a half ago, and are now renting). My analysis showed that the larger the down payment available, the higher the total increased cost, compared to renting. Ironically, the less money you have in the bank, the closer the numbers become (rent vs. own). In the case of a 50% down payment, the cost to own vs. rent was a multiple of 15X! The majority of this came from the loss of income from the down payment, and included all elements of the equation (prop taxes, insurance, tax breaks, maintenance, etc.).

I hadn't seen anyone analyze this previously (as everyone seems to have no money these days), but it's a real question when you consider people (like me) who would be trading up versus renting.
Here's my quickie analysis.

Much of the rhetoric about oil is overheated. The world is not running out of the stuff. With present technologies, proven and probable reserves of oil wil be sufficient for decades ... an array of existing but not widely applied technologies would make it economically feasible to extract oil from tar sands or shale, or to convert coal to liquid fuel.

Proven reserves are largely guesswork and easily manipulated for political or financial reasons. The Saudi reserves, for instance, have never declined, no matter how many billions of barrels have been pumped--at least according to their "official numbers." This beggars the imagination, but people like Mr. Crook are glad to accept what simply cannot be. For a detailed, exhaustive and very persuasive account of how little cheap oil remains in Saudi Arabia, see Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy It is incomprehensible that Mr. Crook has no knowledge of the large body of evidence which suggests "proven reserves" have approximately the same reality as Aladdin's Magic Lamp.

Your question about the "best solution" to our long-term health care cost dilemma...aaah, now you are asking me to tame a monster! But I have a few opinions. Here goes.

First, I do feel that Canada and England and other socialized medicine countries are absolutely the wrong direction for the U.S. Why? Because socialized medicine strips people of "choices." It rations care. In Canada as you probably know, provinces are given a certain amount of money per year. And when those funds run out, that's it. Doors close if they run out in October, November or whenever. And people have to wait till next year.

My wife has an Australian friend. She lives here now but her family is still in Australia. Her mother had a degenerative hip. She was put on a waiting list for a hip replacement---since it was not "life threatening." She waited and waited. Finally after several months she got the hip replacement. But there was a problem. An infection set in. They treated the infection and she stabilized but it became apparent she needed to get the first hip replacement fixed/replaced. Back on the waiting list!!!

I am not an expert on socialized medicine but I do know when you take away choices and restrict access to private care then what inevitably happens is the quality of care degrades. You're saying, "we'll only pay this much for that." And so you only GET this much for that. Whereas if you allow people the ability to pay whatever the going price is for something, you'll usually get the best money can buy..and why not?

Now here's what I would do and I've thought about this a lot. I feel as a country we need to have a serious "conversation" about healthcare. Debate the points, pros and cons and make the hard decisions.

One of the first things we should be educated about is the "real" cost of healthcare. People are oblivious to what things cost! The truth is we've been spoiled. We've been shielded from paying the $70 a doctor charges retail. (and on the other hand, we've been gouged by $10 aspirins and stuff like that!). So the first thing I would do is try to bring some transparency to the public...eg. MRIs cost $1,000....X-rays cost $350... Shed all the bureaucratic layers and parties involved in the transaction.

The second thing I would talk about is the purpose of "insurance." The true purpose of insurance is to protect you in the event of an accident or illness. But not just any accident or illness. But something that has severe financial repercussions and is unpredictable and unexpected.. Things like infections...diseases...kidney stones in the middle of the night....stuff like that. Insurance should be purchased for these high-dollar setbacks that come every so often and can wipe us out if we don't carry insurance. People may not like this, but I think this means we revisit high deductible plans.

The far more controversial part of this is the following: Americans are over-medicated, overweight and way too dependent upon doctors to "practice" their medicine upon them. We need to eat healthier, get more exercise and only see the doctor when we're willing to pay the cost ourselves.. For the "little" things that insurance doesn't cover...e.g. sinus infections.

The tough question is what do we do with the 40 million+ Americans who don't have health insurance? The question we need to address is, do we believe that all Americans should have access to quality medical care? Ok yes, I think we do. All Americans, regardless of income, should have access to basic healthcare---emergencies, serious illness, etc. And for the majority of us (all except 40+ million!) if we come down with hepatitis we go to Kaiser, we pay our $50 copay...but we don't die and we get the quality healthcare we need.

But let's talk about those 40 million+ Americans who are uninsured. This is where the rubber meets the road, isn't it? Since the mid 1990s with the passage of HIPAA (Health Insurance Portability and Accountability Act) we've had guaranteed "access" to medical coverage. Employees leaving jobs and who take COBRA are guaranteed access to a plan once they exhaust COBRA. But at what cost???

The law doesn't guarantee a a low cost plan or even an affordable one. Lots of 50-somethings are definitely "uninsurable." They're taking medications and have conditions which no insurance company wants to pay for---and who can blame them? They're in business to make a profit.

Truly this topic is quite complex and I'm certainly not doing it justice in a few paragraphs. I'm sure my ideas need much rounding out and I'm sure many would say I'm just plain wrong! But I've wrestled with this. I deal with these people in my business. I feel what this country needs is to keep a private healthcare system alive. We shouldn't go the socialized route, as that would be disastrous.

But here's an idea for you: Why not make health insurance like auto insurance? Make it mandatory that everyone over 18 (and out of the house) pay for a "standard" plan. This plan would cover only serious illnesses, hospitalizations etc. (not routine office visits, x-rays etc, preventive check-ups, which are expensive and drive up the cost of health insurance!).

The premiums for this standard plan could be based on age, health and ability to pay. So for example a young 20 yr-old kid with no money and in good health (and a low risk to the system) would pay very little. An old, sick but rich person would pay the most. An old, sick and poor person would be given special consideration because they don't have the means to pay. In fact anyone below a certain income level would pay little...but it's important they pay something.

The idea is to make insurance easily understandable. Make the cost of it simple and fair for everyone and not penalize the rich just because they have the means to pay. They may be rich but represent little risk to the system because they're as healthy as an ox and they haven't been to the doctor in years!!

But here's the second part: On top of a basic health insurance plan---which has a high deductible---we have private health plans with more comprehensive coverage for those who are able and willing to pay extra. These plans would be similar to what we have now...with a a lot of competition based on price and coverage. Those who want more insurance protection, and who have the means to pay, simply "buy up" to what they need.

Anyway, that's a very rough draft of a "solution" to the long term health care challenge. First people need to understand why we have insurance. Second we need to make health care a more efficient and "transparent" market. Just because it involves health doesn't mean we can't talk about cost. After all, buying and selling is going on!! Third we need to get healthy again and stop running to the doctor for every ache and pain. Fourth we need high deductible, low cost plans (which Bush has been advocating).

And last but certainly not least, we need to build a healthcare system that will last thru the 21st Century. To achieve this we must create a system where everyone pays in and everyone receives care, regardless of their ability to pay. But we keep the private healthcare system for those who want to pay more for more coverage.

I probably need about 15 more points...but hey, that's a start!!

Many people don't seem to understand that if you put $100,000 down on a million dollar house . . . and the market drops just 10% . . .you lost your $100,000 of savings/equity and may not ever see it again.

"What I wish you to consider however is the 1% Shiller number and inflation. When you draw a straight line from 1986 you ignore both. Shiller does not and there is another issue. Inflation indicies since 1986 have been adjusted downward 3 times. Taken into account your straight line then curves up at a compound 1% on top of inflation at the old measure not the new one. OKAY, big deal. We are still on the same page but I see prices only 1.8x trendline while you are showing 2.3x overvaluations. Of course if you look again at your graph and adjust for my "corrections" you see c1970 and c1995 as periods of some undervaluation which in the fullness of time seems reasonable does it not? We come back together at the end because ultimately we need to dip below trend to return to trend. So, your return to norm is my bottom of the market." (emphasis added)

"1. 20 years of 1% increment is not 20%. Its 1.01 times 1.01 20 times and minus 1. Thats roughly 22%.
2. Anyway, 20 years of 1% over inflation 3% means 4% of increment. $100 in 1986 equals $219 in 2006 (1.04 times 1.04 20 times). Its not 198%.
3. Your straight line in the graph is totally biased, according to my measurement, it will end up around $355,000 in 2006, which is also very close to calculation of 161,000 x 2.19 = $352,590.
4. Even if today's price of $715,000 dropped, it won't take 1 day but rather many years to drop. Last time, it takes six years (1989 to 1995). Count into historic inflation of 3%, and 1% of housing appreciation over that, somwhere near 37% haircut is more reasonable assumption. I won't go through the math again.

What I think is: the inflation threat will be high, our currency will be devalued to compensate that 37% haircut. So the real deflation might be smaller than that. I believe there is a 'Bubble', but not as extreme as you claimed." (emphasis added)

As inflation rises, typically so do the value of "hard assets" like gold, real estate, collectable Stratocaster guitars, etc.

But wait. If mortgage rates rise to 13%, who can afford to pay $700,000 for a house? That's the gotcha. No one can. That's the flaw in the idea that higher inflation will support housing prices. If you would like a historical example, look no farther than 1982-85. Housing prices ran up rapidly in the late 70s, as interest rates were low even as inflation rose to 10% a year.

To keep inflation from accelerating out of control, Paul Volker and President Reagan raised interest rates to 15%, effectively ending all lending for autos and houses. The automakers, unable to sell cars with cheap loans, laid off hundreds of thousands of workers and lost billions. Home building dried up and blew away, as did real estate sales--who could qualify for a mortgage at 15%?--and of course, housing values sank, too.

It was called "stagflation": stagnant economy, wages and employment coupled with high inflation. The "medicine" is high interest rates, which causes housing to drop back to what is affordable. Care to know what a $600,000 mortgage costs at 13% interest? Try $6,637 per month on a 30-year fixed mortgage. How many people can afford that?

As I have noted here before: housing prices are correlated to the interest rate--period. If interest rates double from 5% to 10%, then housing will drop by 50% because people can only afford to pay so much for housing. You can finesse all kinds of numbers, but it all comes back to affordability. Once interest rates rise, housing necessarily plummets beause there are simply no buyers who can afford the inflated prices.

I don't want to get too technical here, but there's also a fatal flaw in the idea that the dollar will drop through the floor. If euro banks are paying 4.5% and U.S. Treasuries are paying 9%, which one are you going to buy? The Treasuries, of course--and in so doing, you'll be buying dollars--which guess what, puts upward pressure on the value of the dollar. So as interest rates rise in the U.S. due to inflation, the dollar may well rise rather than fall. So we may well get deflating housing and appreciating currency at the same time.

Three other realities will send house prices plummeting to below-trendline levels: the complete lack of buyers, oversupply of housing due to foreclosures and the loss of jobs. As this chart reveals, virtually everyone who isn't poverty-stricken or in prison already owns a house. As foreclosures rise (see patrick.net for the latest news on foreclosure rates rising dramatically) then the current oversupply of homes will climb to unprecedented heights--an ascent which will be accelerated by massive job losses in the housing sector, which as CNN reports below, is fully 20%-25% of the entire $12 trillion U.S. economy. Housing slowdown to be widely felt:

"Housing accounts for between a fourth and a fifth of the GDP (gross domestic product)," said Walter Molony, spokesman for the National Association of Realtors, referring to the broad measure of the nation's economic activity. "So many other industries see sales tied to the purchase of a home. We get calls from Singer sewing machines about our home sales statistics."

That means that if the National Association of Homes Builders is correct and there are 150,000 fewer new home sales this year compared to the 2006 record, that's 375,000 fewer construction jobs, or the equivalent of about three companies the size of General Motors.

If the industry itself is predicting a direct job loss of 375,000--never mind the furniture salepeople, countertop manufacturers, and all the other millions of people indirectly employed by the housing industry--then you can bet the reality will be much worse.

So take your pick: a decline in median house prices from $715,000 down to "only" $350,000 or a slightly more severe drop to $315,000. Will it really make any difference? Sadly, probably not.


May 17, 2006


Why Post-Bubble Rents Matter


Why are post-bubble rents important? For one thing, they will, with enormous consequences, set the official rate of inflation and thus future interest rates. As described here in The Housing - Inflation Connection, the cost of renting housing is fully 40% of the Consumer Price Index (CPI). As rents dropped during the housing boom, they artificially suppressed the CPI. If rents ever rise, they will quickly boost the CPI.

The big question is: will rents fall or rise as the housing bubble deflates? Given that part of what is causing the bubble to pop is overbuilding--the number of new condos and houses has outstripped demand--then common sense suggest rents will drop as desperate owners will lower rents to fill those hundreds of unsold units with tenants.

That sounds reasonable--but then why does the Federal Reserve's Susan Bies think rents will actually rise? Rising rents may push CPI higher, Fed's Bies says.

Noting that the CPI's gauge of housing costs is based on rents, Bies told a banking conference in answer to a question: "We've come through a period of weaker rents. Now, housing has really sort of peaked ... that may rejuvenate rents and so you may see may see that, in turn, higher (CPI) inflation going forward."

Bies said, however, the Fed focuses more heavily on the core personal consumption expenditures price index than the CPI.

You've probably read about "chain deflators" and all the arcane mechanisms by which the "official" rate of inflation is calculated, but any consumer can tell you inflation has been rising at a far faster clip than the official rate--however it's massaged. The "true" CPI has been artifically suppressed for the past 4 years because the housing boom dramatically lowered rents. In that sense, the Fed will be hoist on its own petard if the long-suppressed CPI breaks above the "true" rate.

Why does this matter? Because bond traders expect the yield on a bond to exceed the rate of inflation. If inflation is tripping along at 5% annually, who would be dumb enough to buy a bond--which could drop precipitously in value should the dollar decline--which pays only 5%? You're nor making a dime on your investment, even as you're taking on a major risk of the dollar losing value.

While the Fed governors have the luxury of playing around with chain deflators and the like, the bond market is the body which actually sets the long-term (mortgage) interest rates. If buyers of U.S. Treasury bonds start to get nervous about a rising CPI as evidence of rising inflation, they might demand a larger premium of risk--in other words, "show me the money or I'm not buying your bond." If bond rates rise to 8%, mortgage rates won't be far behind-- they will probably be ahead.

And what do rising mortgage rates mean for the housing market? Declining prices, higher Adjustable Rate Mortgage (ARM) resets and thus more foreclosures as cash-strapped homeowners go broke. Ouch. But then maybe rents will fall as all these hundreds of thousands of units come on the market.

Not so fast. There are countervailing forces which could, as Ms. Bies suggests, actually cause rents to rise. How is this possible? There are a number of factors:

It's actually cheaper to board up multi-story condo buildings than maintain them for a handful of tenants. Managing and maintaining such buildings is an expensive business, and so occupancy rates have to be relatively high to justify keeping them open.

Boarded up or unfinished highrises were a common sight in Asian cities such as Bangkok after the Asian Contagion financial crises of the late 90s. If the builder or developer goes bankrupt, the lender is also not going to enter the rental housing business. The lender itself may well be pushed into bankruptcy should multiple developers and builders go bust. That would be the normal course of events in an over-building bubble such as this one.

Which scenario is correct? Perhaps both. My photo of the two stately Victorian homes in the Haight-Ashbury district of San Francisco provides a visual metaphor of how the rental market may develop. Rental units in desirable locations with good schools and close proximity to jobs and shopping districts will likely be rewarded with substantial increases in rent, even as thousands of houses and condos languish empty in overbuilt, distant or otherwise unattractive locations. The bland Victorian represents these perfectly good but utterly undesirable homes which may not attract renters at a price which enables the owner to cover his/her costs.

Thus it may well turn out to be a bifurcated market in which a million foreclosed units sit vacant even as rents are rising in desirable locales which were not overbuilt. This would truly be the worst of all possible worlds, as rising rents would jack up the CPI even as lenders foreclosed on thousands of homes and then went bankrupt themselves as mortgage rates rose in lockstep with the CPI.

Implausible? People who have witnessed the aftermath of overbuilding coupled with rising mortgage rates won't think so--they've seen rows of empty forlorn buildings and houses before.


May 16, 2006


After the Bubble: Rents and Housing Values


Why do bubbles burst? One reason is that the supremely unprofitable nature of the bubble asset becomes abundantly obvious. For instance, housing. Back in the overheated real estate market of 1980-81, (Yes, Virginia, we had bubbles in the past, too) I recall an older real estate attorney shaking his head in dismay as he told me, "It makes no sense to buy a house as an investment now, but people keep buying them anyway." His point was that people were buying into a substantial monthly loss which they presumed/hoped would be more than offset by appreciation.

My friend's point was simple: if an investment doesn't make money in the here and now, it's a lousy investment. As buying a second, third, fourth or fifth house or condo has become a popular investment alternative to a boring, low-yield bond or underperforming mutual fund, my friend's observation becomes highly relevant. It makes no business sense to count on appreciation if you're digging yourself a deeper financial hole every month.

This is, of course, how bubbles form. With interest rates low, safe investments like certificates of deposit and bonds are unattractive; they're barely treading water above the rate of inflation or even losing ground. So the speculative, risky investments attract investors. As the money pours in (to gold, old cars, Chinese Internet stocks, copper futures, real estate, etc. etc.) then the asset prices rapidly inflate, attracting even more money to a "sure thing," "wave of the future," "real value," etc. etc. At some point, the punchbowl of cheap and easy credit is withdrawn, and the bubbly-drunk guests are stunned to find their high-flying jewel-encrusted carriage reduced to a mere pumpkin.

Can't sell that condo or house? "Just rent it out." Fine; but how does rental housing stack up as a business in the real world? Let's take a look. First, a caveat. Any scenario or extrapolation can be nitpicked or challenged in dozens of ways; quibbles abound when someone has a vested interest in discrediting a line of reasoning or evidence.

So don't take my word for it. If you're thinking of renting out your vacation or investment property, go talk to some landlords with five or ten years of experience. As this chart shows, the historic ratio between housing and rents--that is, the snapshot of housing as an actual business rather than a speculative gamble--has reached hitherto unknown heights. "Just rent it out." Easier said than done.

For starters: no uninsured worker ever fell off the roof of a municipal bond. No CD was ever trashed by vengeful tenants, and the plumbing bill for a savings account never rocked you back on your heels. Then there's the uncomfortable fact that rents have declined in many locales since the 2000 heyday, or have been flat for years: Bay Area rents stay the same. As the first chart shows, rents nationally have barely kept ahead of inflation. In other words: even as housing has shot up, rents have remained flat or even declined. Anyone expecting to make money on rising rents may be sorely disappointed. According to Barron's, Rental income nationally has fallen to $147.8 billion from the peak of $186.6 billion back in April 2002.

OK, let's crunch some numbers. Let's take a property purchased for $500,000 that rents for $2,000 a month. Is this a good business? Maybe a $500,000 house rents for more than $2,000 in your city, but in my region, since $500,000 only gets you a rundown bungalow in a lousy neighborhood or a small condo, you'd be lucky to get even close to $2,000 rent for your $500K investment.

First off, unless you "fudged" (i.e. lied) on your loan application, claiming that the property was your principal residence, an investment property carries higher loan rates and requires a 20-25% down payment. So let's assume you put down $100,000 and incurred another $5,000 in loan and closing costs, meaning that your investment in the property has to yield at least what the $105,000 cash would earn in a muni or high-grade corporate bond--at least 6% (but 7% is certainly available) or $6,300 a year.

Next is your loan balance of $400,000. Let's say you have an interest rate of $6.5%--very good for an investment property.The payments of principal and interest, according to the calculator at MSN Money, would total $2,528 per month.

For maintenance, let's assume your condo fees are about $400, or general upkeep on the house (maintaining the yard and typical repairs) will run an equivalent amount. (Remember that every once in a while there will be large bills for items such as replacing old sewer lines, a new furnace, a new roof, tree trimming, a new countertop or bathroom floor, etc., unless it's a brand-new house.)

Then there's management fees, which run about 6% of rent (even if you handle this yourself, your time isn't free), so that's 6% of $24,000 annual rent or $1,400 ($120 a month). Insurance varies widely around the country but let's plug in $100 a month ($1,200 annually). Property taxes also vary widely, but let's assume 1% annually is fair (though it's much higher in many locales such as New York, Texas and California). That's $5,000 a year or about $400 a month.

Since it's unwise to assume the property will never be vacant, let's shave 10% off the annual rent as an allowance for vacancies, reducing the $2,000 per month to $1,800. (Note that realtors are pleased to wave huge summer rental numbers around during the sales pitch but the reality is that many vacation homes sit empty unless someone spends major money advertising and promoting the property.)

As expenses add up to about $3,500 per month, that leaves a net loss of $1,700 per month, or $20,400 annually. But wait, you say--what about depreciation? Fine. The first thing to note about depreciation is that it comes back to haunt you when you sell the property, as all your depreciation is "recovered" when it comes time to pay the tax on your gain (if any). And remember, as an investment, there's no $500,000 giveaway on the gain; you pay tax on dollar one of that gain and recovered depreciation. Also note that you can only depreciate the building, not the land, so you can't depreciate the full $500K value.

Taking a standard 40-year depreciation (let's say the building is $350,000 of the $500K price, yielding an annual depreciation of $8,750), your loss is knocked down all the way to $11,650: about a $1,000 out of pocket a month, even counting depreciation. And let's not forget that you're foregoing $6,300 in net income by leaving the $105,000 cash in a losing investment.

You can quibble--but I got a loan at 5%, rents are going up in my area, I'll maintain the place myself, etc. etc.--but the bottom line is unavoidable: this is a lousy business proposition unless you can collect at least $3,500 rent per month for the property. Then there's the risks I mentioned. If you try to save money by hiring unlicensed, uninsured workers, and one gets injured, you could be facing a lawsuit which your homeowner's insurance may be unwilling to settle.

There are no guarantees in the rental housing business. You may not be able to find a decent tenant no matter how much you advertise, or you may get a tenant who suffers some family trouble or medical emergency and as a result can't pay the rent. The rental housing business is not risk-free. Neither are bonds, of course, but a short-term CD isn't going to get a stopped up toilet or suddenly stop paying the rent.

"Just rent it out." Sure, but be aware it isn't that easy and it almost certainly isn't profitable--unless you bought ten years ago in a desirable neighborhood and have spent serious money keeping the property in tip-top shape.


May 15, 2006


After the Bubble: How Low Will It Go?


How low will housing go as the bubble bursts? For an answer, let's turn to Irrational Exuberance by Robert Shiller (recommended here on May 3).

Shiller's book, which presciently predicted the collapse of the Nasdaq stock market in 2000 just weeks before that mighty bubble broke, has been re-issued with an analysis of the housing bubble. Shiller's key takeaway is that historically, housing in the U.S. rises, at best, at 1% per year not including the effects of inflation, that is, "real" appreciation. This chart depicts what history suggests will happen to housing prices: to return to this historically supported level, housing in the San Francisco Bay Area must drop 56%.

Impossible! you gasp in dismay. They're not making any more land, the population is growing, etc. etc. etc., all the "common sense" reasons given for why housing is in a permanent uptrend. Funny, but that sounds just like the truisms given when tech stocks like PALM and SUNW were over $100, just before they began their long, slow agonizing decline to $5. The Internet did "change everything" and it continues to grow rapidly, but those realities did not translate into overpriced $100 per share stocks rising to $200, as widely predicted at the time. Why?

There are two fundamental reasons why any bubble bursts: a statistical phenomenon called "reversion to the mean" and the deeply unprofitable nature of the bubble as a business is eventually revealed. Although reversion to the mean has technical definitions, for our purposes we can understand it as the law of averages; that is, a series of data will eventually revert back to the average. The farther it rises from the average, the higher the probability it will revert or return to historic averages. If the elk population explodes one season, for instance, then disease, overgrazing and a subsequent rise in predators all act to bring the elk population back down to historic norms.

In the world of investing, the growth stocks of the 60s, labeled the "nifty 50," rose to great heights before falling back to earth once their price-earnings ratios rose to nose-bleed levels. In other words, the amount of money they were making simply didn't support the price of their stocks. For an explanation of reversion to the mean which relates to investment, visit the coffeehouse investor.

Reversion to the mean is a statistical phenomenon, not an explanation. The underlying mechanisms for a reversion to the mean have been explored here in previous posts, and in many other sites: a veritable flood of cheap and easy money inflates the bubble, which inevitably deflates when loose lending standards are tightened and interest rates rise.

Nothing fancy here; it's also called "the business cycle." Natural growth rises to excess when excessive liquidity gooses it, and then collapses when that liquidity is withdrawn or begins to cost real money.

To borrow from Tolstoy: every healthy market is the same, but every bubble bursting is unique in its misery. There are plenty of absolutely bubblicious markets in the U.S. (and indeed, the world--check out Shanghai is you want a real fright), but I chose the one close to home: the San Francisco Bay Area. Shiller's analysis works on any bubble, anywhere, but obviously, the less dramatic the rise, then the less dramatic the decline.

This chart provides a very clear picture of what a bubble looks like: a slow rise in values which suddenly turns up in a hockey-stick ascent to unsustainability. Note that the decade between 1986 and 1997 ended with housing values a bit above the historic line, but not by much. During all those years of flat-to-modest appreciation, the population was also growing, they weren't making any new land, etc. etc.--all the conditions were present which are trotted out to justify the bubble. Note that the hockey-stick rise began as the Nasdaq bubble created hundreds of billions in new wealth in the late 90s.

Let's go over the numbers. According to the Bureau of Labor Statistics, $100 in 1986 equals $178 in today's (devalued) money. To that 78% rise due to inflation we add Shiller's 1% per year appreciation in "real" terms, which adds up to a historically supported value 98% above the 1986 median price of $161,000. In other words, a reversion to the historic mean will bring Bay Area median prices down from $715,000 to around $315,000--a decline of $400,000.

This is the inescapable conclusion of Shiller's analysis and historical trends dating back to the 19th century. It cannot be denied; but you can of course retreat into denial. Sadly, that's what most investors did back in the dot-com heyday. As stocks tumbled, every brief uptick was embraced as the "bounce back" to the good old days, and every such bounce was a sucker's rally, leading only to further precipitous declines.

For the median prices in Boston, Austin, Raleigh and the Bay Area, go to median housing price data from 1986 to to 2005 courtesy of the University of Texas.

And a tip o' the hat to my colleague Marinite, proprietor of the excellent Marin Real Estate Bubble, for reprinting the chart on his blog.


May 13, 2006


Financial Chickens Coming Home to Roost


Allow me to quote my entry from May 6:

"The Fed meets on May 10. Mark your calendar: May 11 the decline starts and then rapidly picks up velocity. The "smart money" has been exiting all month while the con was set. Reality has a nasty habit of trumping wishful thinking."

With the stock markets in a free-fall, it would seem the call was correct. While I would like to claim the mantle of financial genius, it was actually easy; so many chickens are coming home to roost, the henhouse was bound to collapse. Here are just a few of the issues with lit fuses:

Let's start with an expose of a very risky practice: borrowing money against one's stock and bond portfolio, a.k.a. margin debt, to spend on consumerist frivolities. As reported by the Wall Street Journal: Margin Loans Make a Comeback: Wall Street Pushes Investors to Borrow Against Portfolios to Buy Cars, Homes

UBS AG's wealth-management division says about 75% of its more than $10 billion in securities-based loans are used for purposes other than buying additional securities, including for purchasing real estate and cars or for paying tax bills and a child's tuition.

"Things can go very wrong with a margin loan," says Sue Stevens, director of Morningstar Inc.'s financial-planning practice. Although such loans can help meet short-term cash needs, she recommends that investors pay the loan back within three months, since the markets can shift quickly.

In total, margin debt at New York Stock Exchange member companies, as tracked by the exchange, was $222.78 billion in February, the most recent month for which figures are available, up from $173.22 billion at the end of 2003. That compares with a peak of $278.53 billion of margin debt outstanding in March 2000. For Wall Street, margin lending is becoming a bigger contributor to revenues.

With the prime rate at 8%, that margin debt isn't so cheap anymore. And as stocks plummet, some of those unwise investors will get margin calls, requiring them to sell stocks to bring their cash back up to at least 50% of their account value. Then that selling drops the market more, triggering more margin calls...I think you see the direction this takes: down.

Here's a snapshot of stock speculation running wild from Yahoo Finance on Friday, May 12:

"Schwab reports April activity that includes: Net new assets brought to the company by new and current clients in April 2006 totaled $4.6 bln. Total client assets were a record $1.300 trillion as of month-end April, up 22% from April 2005 and up 1% from March 2006. Client daily average trades, which include Schwab Investor Services asset-based trades and Schwab Institutional asset-based trades, were 293.3 thousand in April 2006, up 44% from April 2005 and up 5% from March 2006."

What do you reckon is driving a 44% increase in trading? Could it be speculation? The short answer is: what else drives trading up 44% in one year? Is it the smart money dumping and the soon-to-be-impoverished investors buying wildly? And where did that 22% increase in assets come from? Borrowed off some real estate, perhaps?

Here's an editorial from the Wall Street Journal, decrying the lack of a sensible energy policy in the nation:

When the House had a chance to take a positive step to increase gasoline supplies and lower prices last week by making it easier for oil companies to expand their domestic refinery capacity -- Northeastern Republicans teamed with Democrats to bring the measure down. The U.S. now consumes 21 million barrels of oil a day but has a refining capacity of only 17 million. As usual, the loudest Congressional complainers about high gas prices voted as a bloc to keep supplies precariously low.

The key takeaway here is that the U.S. isn't just dependent on foreign suppliers of raw oil--we are also dependent on foreign refiners. If you think gasoline is expensive now, what do you reckon would happen if anything happened to disrupt that 4 million barrels a day of refined petroleum products being shipped to the U.S.?

For a quick look at housing, let's turn to the S.F. Chronicle: Cooling market squeezing Bay Area developers:

At GreenCity Lofts, a 62-unit development in Emeryville that touts sustainably-harvest wood floors and edible landscaping, 1,100-square-foot lofts that recently sold for about $650,000 are now being offered at $499,000.

That's a 23% drop in a matter of months. How do the buyers who paid $150,000 more for a smallish loft feel now? Just like everyone else who overpaid last year--lousy, angry, scared, and maybe in a mood to sue the developers.

Here's another staggering real estate tidbit from the Wall Street Journal on negative equity:

A full 29% of people who took out mortgages or refinanced in 2005 have no equity or negative equity in their homes, according to Christopher Cagan of First American Real Estate Solutions, a data provider. That's a shocking figure, compared with 10.6% of people who took out mortgages in 2004.

And a final wrap-up of the housing bust from the Wall Street Journal: Night of the Living Debt:

The biggest and most underrated development in the U.S. economy over the past year is that the personal-savings rate went negative. In other words, Americans spent more money than they made last year -- for the first time since, oh, the Great Depression. The average worker hasn't participated in the economic recovery. Inflation-adjusted hourly and weekly wages are still below where they were at the start of the recovery in November 2001, points out the Economic Policy Institute.

As we all know, people made up for this by borrowing more, primarily from their homes. As short-term rates rose, however, home-equity loans and low-cost mortgages became less attractive. Home prices seem to be stalling out.

So let's see: we have no coherent energy policy, margin debt is being used to finance consumer baubles and second homes, a third of recent home buyers have either no equity or negative equity-- and what exactly is going to persuade them to make payments when money gets tight?-- wages are flat, but really, folks, everything's great. Please repeat this mantra until your critical facilities cease functioning: energy costs don't matter anymore, real estate is simply "returning to normal," unemployment is low, the GDP is growing healthily and everything is peachy.

If you're having trouble swallowing that mantra, try doubling your daily dosage of Zombiestra (TM).


May 12, 2006


Identity and Landscape


These comments from Chinese film director Chen Kaige (of "Farewell My Concubine" fame) address a topic which is both profound and rarely noted: the rooting of personal identity in the landscape, architecture and neighborhoods of a nation.

Chen, 53, can barely recognize his hometown of Beijing. He grew up in a traditional household during the Cultural Revolution. What he sees now is a polluted, crowded city that has gradually replaced its older architecture with cold, modern designs.

"It's no longer the city that I love," says Chen, who is thinking of moving elsewhere for the benefit of his two sons, ages 9 and 6. "Beijing was famous for its blue skies in the past. Also, traffic is a nightmare. It's ridiculous. The world has really gone mad. I feel like I've been cut to pieces, culturally. It was hard to find my identity."

"I feel uneasiness nearly every day," he says. "If we make ourselves more money but we are not a happy people, then what's the point? A high price has been paid. The culture has been lost. The values have changed."

This instantly resonated with me, for it expressed a key theme of my novel I-State Lines: the grounding of one's personal and cultural identity in the moral and physical landscape of one's country.

The two young characters in my book feel no affinity whatsoever for the landscape of malls and advertising which pervade America, nor do they feel anything but loathing for the consumerist ethic which has taken over the American soul. They are drawn to farmland, open spaces, and cities with real neighborhoods, not sterile McMansionlands. They are seeking their own identities by working their way across the U.S. in search of authentic landscapes and work--productive work, not shuffling papers or feeding the greed implicit in a consumer-driven economy.

Be the first to identify the stretch of river behind me and Ashton Erler, and I'll send you a copy of my book. So email me! (Hint: it's east of the Rockies--way east.)


May 11, 2006


The Housing-Savings-Recession Connection


You may have noticed that I always source data from either official government sites or mainstream media sources. Why? To avoid sounding like just another panicky doom-and-gloomer. In other words, if The Economist, Wall Street Journal, Barron's, BusinessWeek and Foreign Affairs are reporting the same points, then it's much more difficult to dismiss it all as so much balderdash. It depends, of course, on one's definition of doom-and-gloom; for some, it's planetary disaster, while for others it's a deep economic recession. I consider the latter not so much doom-and-gloom as simply part of the typical business cycle. It is a healthy and indeed, necessary tonic to over-borrowing and over-spending.

I used to be rather sanguine about the future until I began looking at the data--nasty habit, that, looking for clues to the future in data and charts. It really plays havoc on your most cherished illusions, prejudices and ideological truisms.

With that flourish of trumpets, let's start with economist Martin Feldstein's article in the current issue of Foreign Affairs, The Return of U.S. Savings.

The U.S. savings rate has been falling for decades. But that downward trend will likely soon be reversed, as factors such as rising mortgage interest rates force Americans to start saving more. The change will ultimately be for the better, but in the short term it could cause serious problems for the United States and its trading partners unless they start preparing immediately.

"The savings rate of American households has been declining for more than a decade and recently turned negative. This decrease has dramatically reduced total national savings despite a rise in corporate saving. In 2003 and 2004, the combined net savings of households, businesses, and government were only about one percent of gross national income -- the lowest level in at least 50 years.

This sharp decline in saving has had important implications for the United States and for the global economy. It has reduced productivity-enhancing net business investment in the United States to less than four percent of GDP and made the United States increasingly dependent on capital from the rest of the world to finance that investment.

At the same time, the decreased national savings rate -- and the increase in consumer spending that it implies -- has induced a rise in U.S. imports. Those imports have contributed to the growth of output and employment in many countries around the world."

Let's see if these charts align with Feldstein's assessment. The first chart shows both the steady decline in savings into negative-number territory--that is, Americans are spending more than they earn, including wages, dividends and interest--and the recovery in household wealth from the 2000 dot-com debacle. That increase in household wealth enabled the borrowing spree which has driven consumer spending up even as savings sank to negative numbers.

Though real estate has risen at astonishing rates since 2000, the second chart reveals that home equity has actually been declining. How is this possible? Easy--the magic combination of rising home equity and loose money which stimulated huge consumer borrowing.

Here is clear evidence of that massive borrowing. Even as interest rates dropped to multi-decade lows, the percentage of peoples' incomes devoted to debt service has risen to new heights, as shown in chart 3.

How can we be sure that it's rising real estate values which are underpinning all this borrowing? Look at chart 4. Even as GDP has risen steadily and the stock and bond markets have soared from their 2002 lows, housing has risen to an uprecedented percentage of GDP, far exceeding the value reached at the last boom-bust cycle top in 1990.

Chart 5 shows that the immense extraction of home equity which has been sustaining consumer spending has come to an abrupt end. As house prices stabilize, borrowing costs / mortgage rates rise and household debt payments reach historically unsustainable levels, borrowing ceases.

This is the point at which Feldstein predicts American households will start saving by restraining their spending. As a corollary to that reduction in consumer spending and a rise in savings, we might also posit that households will also begin paying down debt--a trend which we can see in chart 3 as the economy slowed in the early 90s.

For more on these trends, check out these articles from BusinessWeek: why more households are feeling flush

Home is where the worth is

What's the net result of such a massive reallocation of income to savings and repayment of debt, away from consumption? It's called a balance-sheet recession:

Although repairing balance sheets is the right and responsible thing to do, when many simultaneously shift their priorities from spending maximization to debt minimization, Adam Smith's Invisible Hand reverses its normal direction and shrinks both the economy and the money supply. (edited excerpt)

For more on the phenomena, check out Japan's balance sheet recession (BusinessWeek)

So here's the Housing-Savings-Recession Connection. As borrowing costs dropped and housing values rose, it made little sense to save money and all the sense in the world to borrow huge sums of "free lunch" money from all that home equity wealth and spend it freely. Now that interest rates are rising and housing prices are leveling or dropping, people have stopped borrowing. If Feldstein (and history) is right, households will start saving again, and using some of those savings to pay down debt. This will trigger a balance-sheet recession, in which consumers "repair" their balance sheet by spending less and paying down consumer debt.

Is there any other possible interpretation of these charts?


May 10, 2006


The New Disease We Just Know You've Got



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No doubt you've heard of bi-polar disease, depression, anxiety disorder and restless leg syndrome. Maybe you've dodged all those bullets, but before you sigh in relief, answer this simple quiz:

Have you ever had trouble getting to sleep?

Sorry, but you suffer from quatro-polar disorder. Yes, you. You're a classic case, and don't try to deny it. The first step to getting well is to admit it: your mood swings not just up and down, but sideways, and in both directions. (Unless you're a right-wing nut or left-wing fanatic, in which case you swing only up and down and left or right, which makes you a hardcore sufferer of the dreaded, incurable tri-polar disorder.)

Fortunately, there's a cure--one which your overworked doctor can easily be convinced to prescribe, should you rush in and demand Zombiestra (TM). But only do so if you have full drug coverage in your medical plan, or if you're filthy rich. Only then will you be able to afford the wondrous relief to everyday life which is Zombiestra (TM).

You may have mis-diagnosed yourself, thinking that buying all sorts of worthless junk just made you a normal, healthy American consumer. Wrong! That's a sure sign of quatro-polar disorder. Ditto for being irritable or having trouble sleeping enough. Just because you have a two-hour commute and have to get up at 4 a.m. to beat the traffic, or that thanks to layoffs and rising workloads, you're working 10 hours a day just to keep your job--that's no excuse! You're suffering from quatro-polar syndrome, to be sure.

Fortunately, there's Zombiestra (TM). (First check with your insurance plan to make sure they cover diseases which are newly "discovered," then hound your overworked doctor for the prescription. Be proactive. Don't take no! It's your right to be over-medicated with drugs which only work 20% of the time.)

Studies show that about 3% of the population suffers from mental disorders that can be greatly alleviated by psychotropic medications. Unfortunately, this leaves 97% of the population beyond our reach. Here at Astra-Zastra, we started with the intention of doing good but decided instead to do well--very well. Making piles of money just didn't satisfy our greedy stockholders, so we set out to make veritable mountains of profit.

And that means enlarging our customer base to you. Yes, you. Unless you don't have any medical insurance. Then to heck with you, buddy, suck it up. Work it off. Go talk to your pastor. Whatever. Just don't ask us for a handout. We've got places to go, things to do, congresspeople to see, so shove off. Get lost, scram.

Anyway, back to our problem. We need something to sell to you, a basically average human being. Our marketing people hit on a brilliant scheme: convince you, a gullible, know-nothing-about-science, easily swayed by fad, unhealthy, lazy, just-want-a-pill-quick-fix American, that you had a previously unknown condition that would magically be cured by our absurdly overpriced drug--oops, we mean medication. (That sounds so much more soothing than "drug," doesn't it?)

They key, we discovered, is to identify symptoms which everyone has from time to time--irritability, sleeplessness, restlessness, a desire to shop, etc.--and turn them into symptoms of a horrible disease which needs correcting.

Everyday life--getting irritated, for instance--is no longer the normal human condition; it's a disorder. In other words, were you a zombie, an organism without emotions or stress reactions of any kind, you wouldn't need Zombiestra. But alas, you are human, and therefore you have emotions. Too bad, because that means you're ill. And you very desperately need Zombiestra (TM).

Of course nothing's perfect, so even Zombiestra only works for about 20% of the populace--the same percentage that reported feeling better after they took a sugar-pill placebo. And it does tend to cause bed-wetting, heart palpitations and extreme road rage, but we've got medications to counter those side-effects as well.

So for maybe $500-$600 a month in meds, you're out the door and feeling nothing. Or. worst case scenario, all the symptoms which were supposed to be alleviated are still present--you're still racking up charges on your Visa cards--plus you wet the bed, have heart palpitations and experience hyperventilating road rage. What could be better than Zombiestra (TM)?

Note: Zombiestra is not a real drug. For more on this topic, read this article from BusinessWeek Magazine: As diagnoses of once-rare illnesses soar, doctors say drugmakers are "disease-mongering" to boost sales.



We have a winner! David L. correctly identified Friday's photo as the James Dean Memorial in Cholame, Calif., near the site of his fatal accident. Dave gets a copy of my novel I-State Lines as a prize. Daz and Alex visit Cholame on page 246, just in case you already own a copy.


May 9, 2006


The New Road to Serfdom: A Negative-Equity Mortgage


The current issue of Harper's features a lead article entitled "An Illustrated Guide to the Coming Real Estate Collapse" by Michael Hudson. Here is a precis of the piece.

Thanks to Marinite, proprietor of the Marin Real Estate Bubble blog, I read a lengthy 2003 interview of economist Michael Hudson on Alexander Cockburn's always-provocative website Counterpunch: The Coming Financial Reality. Hudson is a big-picture guy with a non-standard view of our economic system and the housing bubble.

Hudson identifies several key points in all great speculative bubbles: a government which fosters the conditions for a bubble, and a speculative mindset which eschews actual investment for "making money with money." Referring to the classic South Seas Stock Bubble, he says:

Every stock market bubble in history, starting with the South Sea and Mississippi bubbles in the 1710s in Britain and France, has been sponsored by government. The driving force has been the government's attempt to cope with debt obligations beyond its foreseeable ability to pay. Creating a bubble has been a way to solve their public debt problem--and to pay off political insiders at the same time, thereby killing two birds with one stone.

Modern governments are not politically able to simply default on their debts--at least, not debts owed to their own bondholders in their own currency. The problem has to be solved through "the marketplace."

Stocks in the South Sea and Mississippi Companies were issued in tranches, permitting people to buy on margin with only a small proportion as down payment, so that they could quickly double their small initial payment as the stocks were engineered upward in price. It seemed that money could be made off money itself. This is a basic illusion that is necessary for bubbles to take off.

Saving, stock and bond speculation and real estate speculation do not by themselves lead to new investment. In fact, the higher speculative and financial returns are, the less incentive there is to actually tie down money in building new factories and expanding business.

Hudson makes many other fascinating points in the interview, but for now, let's focus on the connection to the housing bubble. What can be gleaned from his analysis?

20. Negative equity traps debtors

This is the conclusion to the great housing bubble Hudson foresees: millions of indebted households paying interest on mortgages which are greater than the value of their homes. The interest will be collected by a new "rentier" class of mortgage holders who are not even capitalists, in the sense that they are not creating value or wealth with their capital and knowledge, but living off the "new serfs" who will struggle for decades to pay off their massive mortgages.

Bleak, it's true--especially if it turns out to be true.


May 8, 2006


Housing Bubble Bust Will Take Down the Global Economy


The U.S. housing bubble deflating will take down the global economy. Here's how.

1.   The U.S. economy consists largely of consumer spending. The level of this dependence is unprecedented. (see chart to right) As consumer spending goes, so goes the economy. The last time the economy was even close to being so dependent on consumer spending was 1950. After World War Two ended, the demand which had been pent up during the war years, when civilian production had been curtailed in order to manufacture war materials, was finally unleashed. As defense spending fell, consumer spending rose. Now the demand stems not from needs being unmet but from cascades of "cheap money" borrowed from home equity. (see below)

2.   The global economy is heavily dependent on the U.S. consumer. As this chart shows, every major economy runs a current account surplus, i.e. trade surplus, with the exception of Britain, which has a modest trade deficit. But fundamentally, the U.S. offsets all these surpluses with a truly massive trade deficit. In other words, U.S. consumers buy all our trading partners' surplus production. If the U.S. consumer stops buying, these trade surpluses vanish and these nations slip into recession.

While some wishful-thinking pundits claim domestic demand can make up for faltering U.S. demand, I think the sheer size of the U.S. deficit gives the lie to such hopes. It is currently running at over $800 billion a year--a staggering amount which smaller economies cannot possibly replace. (Recall that the U.S. economy dwarfs all others).

3.   U.S. consumers have financed this vast spending spree by borrowing stupendous quantities of money from their home equity. As the chart reveals, Americans' home equity actually rose in the 1990s. (Since this graph displays extraction of equity rather than growth of equity, the -$100 billion notched in 1995 means that homeowners "extracted" a negative number--that is, their equity rose by $100 billion.)

As you can see, homeowners have been withdrawing equity from their homes at an unprecedented rate for the past few years--a fact I documented in my May 2 entry, "Housing Wealth Effect Shifts into Reverse." Here's how much money has been extracted from home equity since 2000--about $2.5 trillion:

2000 | $204 bil.

2001 | 262 bil.

2002 | 398 bil.

2003 | 439 bil.

2004 | 599 bil.

2005 | 751 bil.

4.   U.S. consumers are spending far more than they earn ( i.e. disposable personal income.) This reliance on borrowed money for household spending is unprecedented.

It's difficult not to be staggered by this chart, which shows that U.S. consumers are spending hundreds of billions in excess of their actual earnings. The connection between this chart and the preceding ones is obvious: Americans have extracted vast sums from their home equity and spent it in the global marketplace, creating mind-bogglingly massive trade deficits with other nations.

5.   Is this unprecedented borrowing and deficit spending sustainable? We all know the answer is no. Clearly, this enormous debt machine is entirely dependent on the continuing rise of home equity. Now that home prices have leveled off or dropped, U.S. homeowners can no longer count on heady increases of equity to fund their future borrowing.

6.   Housing need not drop precipitously to cause a precipitous drop in home equity extraction. House prices need only stop rising to cut off the incredibly vast flow of borrowing/home equity extraction. (Rising interest rates will also help to staunch the flow.)

7.   Once this monumental extraction of equity dries up, so will consumer spending. As you can see on this chart, wages have been basically flat since 2000. Therefore, consumer spending cannot be attributed to wage increases; it can only be attributed to this equity extraction. Once that dries up, consumer spending will drop significantly: by roughly $600 billion a year, or 5% of the entire U.S. GDP. This would return consumer spending as a percentage of the GDP to levels which are more in line with recent history.

8.   Once U.S. consumer spending plummets, our global trading partners will immediately feel the pinch. Once their export sales and earnings drop, their economies will slide into recession. (Recall that exports are a much larger share of their economies than they are in the U.S. economy). Noted economist Martin Feldstein draws the same conclusion in the current issue of Foreign Affairs: The Return of U.S. Savings.

The links of the chain cannot be denied; as the U.S. housing market rolls over into decline, it will take home equity borrowing with it, which in turn will take the U.S. economy and thus the world economy down into a prolonged recession. Skeptical? Watch what happens in October 2006.


May 6, 2006


Is the Stock Market on the Same Planet as the Economy? Obviously Not


With the Dow Jones Industrial Average flirting ever so charmingly with its all-time high-- Go team, go! Rah rah rah!--I have to wonder: is the stock market on the same planet as the real economy? Obviously not.
 
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Since when are rising energy prices and interest rates good for business? Since never. Rising oil costs seep into every crevice of the economy, forcing businesses to either raise prices or make less profit--neither one being positive for customers or the bottom line. Ditto for rising interest rates: they squeeze everyone's customers and saddle businesses with higher borrowing costs.

Oil and interest rates are rising, the dollar is falling, the housing boom is rolling over--and yet the stock market hits a 6-year high. What planet are buyers of stocks on? Certainly not this one. The rah-rah cheerleaders like to say that markets always rise when the Fed stops raising interest rates, but this is wishful thinking.

As rising energy prices infiltrate the cost of transporting goods--i.e., virtually everything consumers and businesses buy--everyone has less money to spend on other stuff (i.e. discretionary spending). As interest rates rise, everyone with adjustable rate mortgages and/or credit cards pays more--as will all the people rushing to change their adjustable-rate mortgages into fixed-rate ones. So how is beggaring every customer good for business? It isn't.

The next delusion chanted by the rah-rah crowd is that business spending will take up all the slack as indebted consumers cut back spending. There's one little problem with that scenario. What moron builds up his production and inventory just as his customers are cutting back spending? This makes absolutely no business sense. My customers will be spending less, so I'll sink billions into new software, plant, workers and inventory. Yes, I will if I want to destroy my business. Otherwise, I'll pare expenses and watch my sales very very closely.

Here's the real reason for the stock market's fairyland climb: Bubble follows bubble follows bubble. As the Dot-com stock bubble expired, dropping the NASDAQ from 5,300 to 1,100, the psychology of the Free Lunch--money for nothing but playing with money--transferred seamlessly to the real estate market, driving it to unprecedented classic-bubble heights. As this "free lunch money" (all $2.5 trillion of it) gushed into homeowner's pockets, about 2/3 was spent (according to Fed estimates cited in previous entries) but some flowed into other investments such as the resurgent stock market.

Bubble follows bubble follows bubble. Borrowed money has also been flowing into precious metals, art, you name it: every asset class is now in a bubble, thanks to the trillions released by super-low interest rates and unlimited liquidity/low credit standards.

Market technical analysts know that "market internals" (advance-decline lines, number of new lows to new highs, volume, etc.) have been deteriorating for months. This deterioration has been masked by the rising index numbers; but the "health" of the advance as measured by technical indicators is akin to the racing heartbeat of the cardiac patient on the treadmill. Boy, his pulse is rising very healthily--until his over-worked, unhealthy heart blows a gasket.

Cynical chart watchers like me suspect another force is at work--the sucker's rally. It works like this. "Smart money" (hedge funds and other institutional players with billions in hot money) bids the stock market up by buying the heaviest-weighted index stocks--the large-cap stocks like Exxon, Microsoft, GE, etc.--which goose the indices up regardless of how well the smaller companies are faring. Then, once the "retail trade" (i.e. us poor dumb small-fry with our IRAs and 401Ks) buy into the "rally" and start buying, the "smart money" sells their shares at the top and awaits the inevitable roll-over and decline.

The Fed meets on May 10. Mark your calendar: May 11 the decline starts and then rapidly picks up velocity. The "smart money" has been exiting all month while the con was set. Reality has a nasty habit of trumping wishful thinking--or a smart con.


May 5, 2006


Friday Quiz: Where Is This? Part 4


Too fast to live, too young to die, my, my.

This week's entry is a memorial to an American Immortal, anti-hero/ rebel James Dean. But where is it?

Naturally, the two young mavericks in my novel
I-State Lines, Daz and Alex, guide their gloriously patched together '62 Dodge Lancer to this hallowed spot. The appeal of James Dean is, I believe, embedded in the mythic nature of his American Identity; his few roles were so iconic that he became much more than a promising young actor.

In both Rebel Without a Cause and Giant, Dean is of course a Rebel against the conformist pathway expected of him, but he is also an Innocent, anguished by conflicts with his father and class/social restrictions. (In Giant, he is a working-class roughneck who strikes it rich in the Texas oil patch.)

Dean is also Everyman in the films, a "regular guy" whom we can identify with, and a Searcher, a seeker of some meaning beyond the confines of the narrow lives endured by those around him. It is truly amazing to see Dean swagger onstage as the rich but deeply uncomfortable oil tycoon in Giant, drunk to the point of inhibitions lost, boiling over with a powerful mix of resentment, pride and flickering spark of moral outrage.

Like Dean's characters, Daz and Alex are also Everymen, Innocents, Explorers and Rebels, anti-heroes in the classic American mode of establshing an unbending independence, but also heroes in their awareness of, and sacrifices for, those around them.

I'll ship a copy of my book to the first person who identifies this location with some quick description which can't be picked up off the Web, i.e. evidence that they've actually visited this memorial. So email me!


May 4, 2006


High Energy Cost Solution Is Close To Home--And Work


Jane Jacobs, the writer who inspired the New Urbanist movement, died last week. In her honor, let's consider the connection between high energy prices and the places we live. Jacobs was a true iconoclast, a writer who came to her subject not as an academic expert or city planner but as someone who walked around New York with an unclouded observational eye. The book which resulted, The Death and Life of Great American Cities, first published in 1961, has long been considered the classic re-examination of all the assumptions behind the hollowing of American cities in favor of suburbs.

In the simplest terms, Jacobs' key insight is that the livability and indeed, the viability of any neighborhood or city is its diversity--of people, places to go, housing units, modes of transport--in every aspect of daily life. She saw suburbs as places which have been stripped bare of all but one type of housing (sprawling single-family dwellings) and one type of transport (autos). As a result, suburbs are inherently less adapted to human life than cities. There's very little you can do there except be at home. For everything else, you have to drive.

And what does ceaseless driving do? It burns irreplaceable petroleum, eats up time in endless commuting and fouls the air. One would think the obvious solution is to rebuild our suburbs so that we needn't drive so much, but instead the focus is not on driving less but on creating higher efficiency vehicles. This is akin to decorating the arrow lodged in your chest so it looks less painful.

The goal of New Urbanism is to re-establish diversity in cities and suburbs by building places which invite a diversity of residents, housing types, businesses and ways of getting around. This plan is of the Waterfront District in Hercules, Calif. across the Bay from San Francisco. It is a New Urbanist development worth examining, for it aggregates small owner-occupied businesses, retail, single family homes and some apartments all within walking (or biking) distance of each other. It occupies a bayfront site adjacent to a rail line and recreational open space. (I have written several articles about Hercules in the San Francisco Chronicle.)

The single most promising method of cutting commutes and driving time is to position housing and work places close together. This common-sense concept is called Workforce Housing, and perhaps the best way to achieve it is to build housing and mixed-use retail around and within the massive parking lots surrounding business parks. For an example, take a look at the project illustrated on the right, Duany Plater-Zyberk's plan for an aging business park near Washington, D.C.

For a nuanced and insightful look at the entire concept of modernity and how it has shaped our cities, I reecommend Marshall Berman's All That Is Solid Melts into Air : The Experience of Modernity (which I found quite by happenstance while browsing at Moe's Books, a treasure-trove used-bookstore haunt of mine.)


May 3, 2006


Housing Bubble Books


Unsurprisingly, a number of books have come on the market about the housing bubble. Titles include:

How to Profit from the Coming Real Estate Bust: Money-Making Strategies for the End of the Housing Bubble

Regardless of their other strengths and weakneses, all these books have remarkably self-explanatory titles. I reckon you could do pretty well with a volume (an extremely succinct one) which combined these titles into one: One Thing You Can Do To Protect Your Most Valuable Investment: Sell Now!

While I can't recommend these books because I haven't read them, I can recommend two works on the housing bubble. The first is a classic text on investment bubbles which was recently updated to address the housing bubble: Irrational Exuberance by Robert Shiller. In my opinion, this book excels in revealing the psychology which underpins every great bubble.

My second recommendation is for a small ebook, i.e. one you order and download online. Like many other readers, I am skeptical of self-published works and books from small publishers; as in, if this was any good, why isn't it published by a major publisher, praised by a major publication, and written by a famous authority? But as a new author myself (my first novel I-State Lines is being released next week), I also have a soft spot for self-published and small-publisher books because I know how difficult it is to get your work accepted by a corporate publisher, and how difficult it is once you do get it published to get it reviewed or even noticed in our crazy-busy, media-saturated world.

It's easy to recommend a book which has already received oodles of praise from the mainstream press, and hard to sort through smaller, lesser known works. There's another mechanism at work as well, one which has been tested occasionally over the years: if the author is already famous, then his/her work is automatically accepted as golden even if it's garbage, while actual literary masters' works (think Nabokov, Faulkner, Proust, Austin) get rejected as inferior when passed around as "new" work by "new" writers.

The only way to make a fair assessment is to be a critical reader of everything equally, which is always my goal. And we all know that most of what gets praised to the skies in the media turns out to be merely OK upon close inspection.

For a succinct overview of the current housing bubble and its causes, The single best text I've found is the ebook How To Prosper In The Changing Real Estate Market. I have emailed my positive views to the author, and he has seen fit to post my comments on his webpage (with my permission). I don't get a commission or remuneration of any kind from the author or publisher; I just think he's assembled a thorough, easy-to-read and well-documented report which supports the thesis that this is truly a bubble of epic proportions.
This ebook would be something you could send to a bubble skeptic whom you are trying to warn for their own good, as they will have a hard time refuting the data. It's also short (70+ pages), so anyone can read through it in an afternoon. The "special reports" on gold and foreign currencies are very brief and not much to go on (an opinion I also shared with the author), and the marketing presentation is a bit of an oversell to my taste, but the ebook is an excellent read, especially for those who don't pore over economic reports for fun like some of us. It cogently covers all the topics you'd address if you were trying to convince a friend to sell (or at least not to buy).

One would hope bubble skeptics would change their minds after absorbing these two texts, but the grip of euphoric manias is strong indeed. If you doubt this, ask yourself how many analysts predicted Sun Microsystems would drop to $3 when it was $60. The answer, to the best of my knowledge, is a big fat zero.


May 2, 2006


Housing Wealth Effect Shifts Into Reverse


Everybody loves the Wealth Effect on the way up, but they forget that it also has a reverse gear. We're about to rediscover that the Wealth Effect works just as well on the way down.

What's the Wealth Effect? Let's turn to the eerily familiar Bubble-topping month of December 1999 and the tireless rah-rah cheerleaders at BusinessWeek for an explanation:

One theory economists are revisiting to help them understand the market's clout is the "wealth effect" that Nobel Prize winner Franco Modigliani postulated in the 1950s. Simplistically, his idea was that if wealth increases, people buy more; if it decreases, they buy less. If they buy a lot less, you get a recession, or worse. Modigliani's research showed that for every $1 of new wealth, people spend about five cents more and vice-versa. Ludvigson and Steindel's New York Fed study pegs the effect at three to four cents per dollar gained or lost. That sounds small, but figured on $10 trillion in U.S. household investments, it's $300 billion to $400 billion -- spending that could depress the economy if it suddenly disappeared.

And disappear it did--and lo and behold, the nation did indeed slip into recession, albeit ever so briefly, as the mighty Federal Reserve lowered interest rates to 1% and cranked up the money machine. Other U.S. agencies did their bit as well by lowering credit standards so anyone with a job could get a mortgage without a down payment or even an application review. As noted here recently, according to the FDIC, only 74% of Americans have incomes above the poverty line, and 69.1% own a house. (The remaining 5% probably live in absurdly unaffordable locales like California which precludes them from buying.)

All that easy credit, plentiful money, low interest rates--surprise--created a housing boom. No one is more delighted with the Wealth Effect than Realtors, of course, who are more than pleased to trumpet the fantastic money-machine created by rising home values: Housing Wealth Has Greater Effect Than Stocks, New Study Shows. To summarize: stocks rise and fall over relatively short periods of time, and hence the Wealth Effect is smaller than that created by housing, which rises and falls in much longer cycles. (Only the Realtors' report didn't mention that housing can fall. That would be akin to Galileo whispering under his breath, "But the Earth does orbit the Sun" while facing the Inquisition.)

The Realtors' report also made rather smug mention of the fact that housing wealth is less concentrated than stock and bond wealth--a good point which we'll cover later. Other tidbits from the report include:

About 6 in 10 homeowners have more home equity than stock wealth.

According to the FDIC, In the first six years of this decade, the net increase of household wealth has been $5 trillion. Given the chart and data above, it is clear that the vast majority of that increase came in the form of housing equity.

For a snapshot of what the housing Wealth Effect has wrought in the real world, let's turn to Newsweek's recent article entitled So Long to the Wealth Effect? The piece lists the following data on how much money has been pulled out of that newly minted housing wealth via re-financing or home equity lines of credit. (This is from the Federal Reserve, except for the 2005 estimate which comes from the FDIC.)

YEAR | MONEY | SHARE OF DISPOSABLE PERSONAL INCOME

2000 | $204 bil. | 2.8%

2001 | 262 bil. | 3.5%

2002 | 398 bil. | 5.1%

2003 | 439 bil. | 5.4%

2004 | 599 bil. | 6.9%

2005 | 600 bil. (FDIC est.)($751 billion, US News & World Report )

Add this up and it seems Americans have pulled about $2.5 trillion out of their homes in a mere five years--virtually half of the entire bubblicious rise in household assets. According to the article, the Fed estimates that 2/3 or so of this stupendous sum was spent. So let's say $2 trillion was spent (think drunken sailors wandering through the inexplicable aisles of Ikea, etc.). That's a significant percentage of consumer spending, and a significant drawdown on home equity.

Home equity now accounts for 38% of the average household’s net worth—up from 27% in 2000. This means that the wealth of most American households is now concentrated in their homes.

But using "average houshold" is deceptive, for in reality the vast majority of assets are held by the top 10% of households, while the bottom 50% have virtually no wealth. Let's turn to the august Wall Street Journal for Wealthiest American Families Add To Their Share of U.S. Net Worth:

The top 1% held 33.4% of the nation's net worth in 2004, up from 32.7% in 2001, but still lower than a peak of 34.6% in 1995. In 2004, the wealthiest 1 percent owned 70% of bonds, 51% of stocks and 62.3% of business assets.

After the richest 1%, the Fed found that the next wealthiest 9% of families held 36.1% of net worth in 2004, down from 37.1% in 2001. Below them, families in the top 50% to 90% held 27.9% of net worth in 2004, a slight increase from 2001, while families in the bottom half saw their share fall to 2.5% of net worth in 2004 from 2.8% in 2001.

So the top 10% of households own 70% of the nation's entire assets and the bottom 50% own 2.5%. The vast majority of the stocks and bonds are held by the top 10%. This is important, because the rah-rah cheerleaders like to say that 50% of American families have a stake in the stock market. What they fail to mention is the stake is roughly equivalent to a $5 chip on a Las Vegas table with a $100 minimum bet.

In other words, the Wealth Effect of the recovered stock market is completely overestimated.

Diane Swonk, deputy chief economist at Bank One in Chicago, argues that the stock market is "not a dominant factor and is very hard to use as a faucet you turn on and off. 52.2% of households don't have a dime" in the stock market, said Swonk.

Here is the devastating conclusion which this data leads to: 70% of American households own a home, but 50% of households have virtually no wealth. What does that mean? It means 20% of homeowners are maxed out, borrowed to the hilt, with little or no home equity to their names despite being "homeowners." In fact, they own almost nothing and owe almost everything.

Some simple math reveals that about 20 million homeowning households are extremely vulnerable to the reverse Wealth Effect. (75 million homeowners + 33 million renters = 108 million households. 50% of 108 M = 54 M with almost no assets. 54 M - 33 M renters = 21 M homeowners with little if any assets.)

What happens to these 20 million homeowners once housing values decline and / or a recession kicks in? With no cushion in home equity or other assets, many will lose their homes. Yesterday, I may have shocked you by concluding that 5 million homes could go into foreclosure. Now, this number seems very conservative.

And what happens to the home equity of the "middle class" (the 40% between the poor 50% and the wealthy 10%) when 5 to 10 million homes get sold at foreclosure auction? Their home's value drops like the proverbial stone. And what happens to consumer spending, which has been so heavily dependent on drawdowns of home equity? It too drops like the proverbial stone. That's called the Wealth Effect in reverse.

As the above charts reveal, the rise in household assets since 2000 has been a chimera of borrowed money. Real wealth is the surplus capital accumulated by producing more than you consume--in simple terms, savings which are invested in productive assets. A house is not a productive asset, it is shelter and a repository of value only to the degree it can be profitably rented out as shelter.

The Realtors--and the rest of us--are about to find out the Wealth Effect works not just on the rise but also on the fall.

Scenarios for the Next U.S. Recession (FDIC report, March 23, 2006)

Gary North's view of the FDIC report


May 1, 2006


How Many Foreclosures Will Hit the Market?


OK people, stay sharp. We're going to thread our way through a lot of housing statistics and reach a mind-boggling conclusion: 5 million foreclosures, 5 million investment/2nd homes dumped on the market and bank/thrift losses of $500 billion. Farfetched? Read on.

First up is housing Bull Michael Youngblood, managing director of asset-backed securities (a.k.a. mortgage-backed securities) at Friedman, Billings Ramsey who states in this week's Barron's: "What dominates the mortgage market is income." In other words, if people have jobs, housing will continue to rise. He goes on to assert that interest-only loans are not more dangerous than fixed-rate mortgages. Leaving aside that Mr. Youngblood earns his living selling "securitized" mortgages (if people stop paying the mortgage, the value of the security plummets--not that you'd hear that from Mr. Youngblood), let's look at his thesis.

The chart above shows job growth in Colorado to be better than in the nation as a whole (unemployment is a low 4.7% nationally). Next, look at the chart of Colorado adjustable-rate mortgages (ARMs). Even as fixed-rate mortgage rates dropped to historic lows, over 50% of the loans in Colorado were ARMs.

According to Mr. Youngblood, everything should be hunky-dory. But the reality is that foreclosures are skyrocketing in Colorado, and are 3 times higher than the national average; from National Foreclosures Up 63 Percent From a Year Ago:

Colorado’s foreclosure rate leapfrogged to highest among the states thanks to a 31 percent increase in new foreclosures from the previous month. The state reported 5,392 properties entering some stage of foreclosure in March, a foreclosure rate of one new foreclosure for every 339 households — more than three times the national average.

So much for Youngblood's cheery (if baseless) thesis. Here is a state with strong job growth and plentiful ARMs--and foreclosures are leaping. The stark reality of foreclosures is not isolated to Colorado, as this chart of Texas foreclosures shows. The situation in Boston is equally perilous, as reported in the Homeowners stretched perilously from the Christian Science Monitor of 3/21/06:

Fully 27.1 percent of Boston's homeowners with a mortgage spent at least half their gross income on housing in 2004, according to the latest census figures available. Those costs, which include utilities and insurance as well as mortgage payments, were more than double the national rate of 11.7 percent and topped New York (25.9 percent), Los Angeles (26.5), San Francisco (20.4), and Chicago (20.3). Of the 25 biggest cities, only Miami had a higher rate (35.8 percent).

The number of homes sold in Massachusetts dropped a whopping 21 percent in January compared with a year ago, the largest year-to-year decrease in monthly home sales in a decade. As a result, home values have begun to soften.

Such pressures are forcing a rising number of homeowners to erase their debts by forfeiting their homes. Foreclosure filings in the county that includes Boston nearly doubled in January from a year ago, ForeclosuresMass says.

When 30-year, fixed-rate mortgages were standard, a rise in interest rates would have little effect on current homeowners. But in an era of adjustable-rate loans, it can exact a toll which is especially difficult for minorities, housing experts say, because they are most likely to hold higher-cost subprime loans.

USA Today chips in with this story on the woes facing the millions of homeowners stuck with ARMs: Some homeowners struggle to keep up with adjustable rates

When they refinanced their home two years ago to pay off some bills, Robert, now 78, was working as a deliveryman. But his employer went out of business last April. Now he and Lorraine, 72, a retired nurse, are both seeking work. The rate on their mortgage has jumped from 7% to 10.5%.

Now, the real estate market is cooling, interest rates are rising and tens of thousands more Americans are starting to have trouble paying their mortgages. Nearly 25% of mortgages — 10 million — carry adjustable interest rates. And most of them went to people with subpar credit ratings who accepted higher interest rates, according to the Mortgage Bankers Association.

Already, in West Virginia, Alabama, Michigan, Missouri and Tennessee, about one in five homeowners with a high-interest (subprime) ARM was at least 30 days late at the end of last year, according to the Mortgage Bankers Association. After 90 days, the foreclosure clock starts ticking.

These adjustable-rate loans were concentrated in the hottest markets, such as California, where about 60% of all loans last year were interest-only or payment-option ARMs. That's the highest such rate in the country.

Of the 7.7 million households who took out ARMs over the past two years to buy or refinance, up to 1 million could lose their homes through foreclosure over the next five years because they won't be able to afford their mortgage payments, and their homes will be worth less than they owe, according to Cagan's research. The losses to the banking industry, he estimates, will exceed $100 billion. That's less than the damage from the savings-and-loan crisis in the 1990s, which cost the country $150 billion.

The Browns in Missouri have had a happy ending. The lender, Saxon Mortgage Services in Texas, declined to discuss the Browns' case with USA TODAY last week. But within 24 hours of a call from a reporter, Saxon agreed to give the couple a fixed-rate loan at 7%.

Hmm, nothing like a little media snooping to pry a fixed-rate mortgage out of the woodwork, eh? This tale reveals how subprime lenders have taken advantage of desperate/ hopeful/ignorant homeowners who are stunned to find their rates rising 3.5% in one bound.

Realtors, of course, couldn't be happier selling empty condos and houses by the millions to unwary investors. Second Home Sales Hit Another Record in 2005; Market Share Rises

27.7 percent of all homes purchased in 2005 were for investment and another 12.2 percent were vacation homes. All together, there were 3.34 million second-home sales in 2005, up 16.0 percent from an upwardly revised total of 2.88 million in 2004. The market share of second homes rose from 36.0 percent of transactions in 2004 to 39.9 percent in 2005.

Vacation-home sales increased 16.9 percent last year to a record 1.02 million from a downwardly revised 872,000 in 2004, while investment-home sales rose 15.7 percent to a record 2.32 million in 2005 from an upwardly revised 2.00 million in 2004.*

As the market softens, investors are finding that they can't dump their units for love nor money. Here is a Washington Post story investors hurting; Doors Close for Real Estate Speculators After Pushing Up Prices, Investors Are Left Holding Too Many Homes.

Just for context: according to the National Association of Realtors, There were 7,072,000 existing-home sales in all of 2005, up 4.2 percent from 6,784,000 in 2004. This is the fifth consecutive annual record; NAR began tracking the sales series in 1968. According the U.S. Census Bureau, 1.3 million new homes sold in 2005.The Census Bureau also reports that there are approximately 75 million homeowners in the U.S., and 33 milllion occupied rental units.

Let's summarize: