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Bubble Troubles - Part II
(September 20, 2002)
by James J. Puplava / Financial Sense Online
Yes, Virginia, There IS a Housing Bubble!
Americans live in a bubble economy that runs on credit. We borrow to buy homes, borrow to buy cars, and borrow to consume, educate, entertain or simply to make ends meet. Our economy runs on credit and so do our financial markets, which use leverage to enhance investment returns. It is hard to find a segment of our economy that doesn't run on credit. The U.S. financial system is one of the most efficient and innovative systems in the world for generating and distributing credit. There seems to be no end in obtaining credit through this financial system. Money, or in this case credit, is plentiful. It doesn't matter if you are a marginal borrower, live on welfare, here illegally, are a poor credit risk or have filed for bankruptcy, there is probably some institution somewhere willing to loan you money.
Plenty of Checks Without The Credit Check
There appears to be no check on the amount of credit available to finance consumption or investment. Credit expansion in the U.S. is now running at an annual rate of $2 trillion or 20 percent of GDP. As long as the Fed is able to continuously create new reserves within the banking system, banks are always rescued from losing propositions. This buddy system enables them to obtain fresh reserves (in most cases in larger quantities) and make new loans. Under the American system of finance, the Federal Reserve creates new money out of nothing and injects it into the banking system. This new money, once fed into the economy or the financial markets, becomes uncontrollable. The Fed can create credit, but it has very little control as to where that credit flows. Sometimes it goes into goods, as it did in the 70's, creating hard goods inflation. At other times, it goes into paper, creating asset inflation.
It is hard for most financial experts and economists to come to grips with the fact that nothing backs our system of money but debt. For that matter, it is even more difficult for many to understand that there will someday be a limit to that debt. If we had to pay back all of our debt, there would be no money left within the system. (See Grandfather Economic Report) In an introduction to a book on money by the economist Irving Fisher, Robert Hemphill, a credit manager at the Federal Reserve Bank of Atlanta, had this to say about our system of credit:
"If all the bank loans were paid, no one could have a bank deposit, and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash, or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless situation is almost incredible-but there it is." 1
The "Sense" of Wealth
The problem with credit is that those who borrow or use it feel that they are wealthier by its use. Borrowers of money may feel they have an asset, but that asset is directly offset by an equal liability. As long as the asset value remains the same, no wealth is created. The position on a financial statement is virtually the same. If a person or a corporation borrows $10,000 and invests that money in an asset, that asset is offset by an equal liability of $10,000. If it is a good investment, it appreciates and real wealth is created. However, when malinvestments are made in the economy or when debt is used for consumption by the individual or the corporation, the asset is used up or depreciates leaving the liability the same. A loan of $10,000 is a liability that some day must be repaid.
The problem arises when assets deflate in value or when they are consumed. When this occurs, the collateral that backs the loan becomes insufficient. This forces the borrower either to repay the loan out of income, postpone repayment through additional borrowing, or relinquish ownership of that asset through bankruptcy or default. This adjustment process of cleansing excessive debt created during a credit boom leads to a credit bust. The credit bust in turn produces a recession, or under extreme credit excesses, a depression. George Reisman in his book "Capitalism" explains the consequences of unchecked credit expansion in his review of the occurrences that led to the Great Depression.
"The disastrous monetary contraction of the period 1929-1933 can be explained on the basis, first, of an undue increase in the quantity of money, coupled with the conviction that the Federal Reserve System would prevent any future depression. These factors reduced demand for money and raised the velocity of money to levels that could not be sustained in the absence of a continued rapid increase in the quantity of money. This continued rapid increase in the money supply did not occur. When, as result the demand for money finally increased and velocity correspondingly fell, the effect was reduced spending, hence reduced revenues in incomes, and thus a decreased ability to pay debts.
The last, in turn, resulted in bank failures and an actual decrease in the quantity of money, as fiduciary media were wiped out under the fractional reserve monetary system at the time. The decrease in the quantity of money caused a further decrease in spending and, concomitantly, a further decrease in revenues and incomes, and thus an even greater reduction in the ability to repay debt, with the result of still more bank failures and still a greater reduction in the quantity of money. The cumulative fall in the money supply between 1929-1933 was approximately 27 percent, reducing the money supply in 1933 below where it had been in 1921." 2
Walking The Tightrope - The Fed's Balancing Act
This "monetary play" is where we are today. The U.S. monetary system is extremely unstable, careening from one financial crisis to the next. Under our present course of action we could end up with major inflation, deflation or both. The Fed and the government are pulling out all stops to prevent deflation from occurring, while at the same time creating conditions that could lead to inflation. The mechanism used to forestall deflation by the expansion of credit is giving birth to the other malady -- inflation. The Fed is carrying on a high wire act whereby it hopes to inflate the economy and the financial system by keeping the system supplied with ample credit in an effort to forestall deflation. If inflation starts to occur, it hopes to switch gears in time in order to raise interest rates and contract credit in an effort to prevent greater inflation. The Fed is now caught in a trap of its own making. Either outcome will be disastrous for the economy. It is my opinion that we will see the occurrence of both maladies as both these emerging storm fronts collide with each other. This situation will be explored in greater depth in "Epilogue to The Storm," the final conclusion to "The Perfect Financial Storm."
Credit creation in the U.S. continues unabated with the Fed reporting that consumer and business debt expanded at the fastest rate in over a decade. Non-financial debt grew by 7.8 percent during the second quarter, a jump from the 4.8 percent rate in the first quarter. 3 Despite deteriorating income and balance sheets, debt is still accumulated at a high enough rate to be setting records. At the current rate of debt accumulation, our entire economy will eventually be made up of debt. Unfortunately for America, we will never reach that point. The spigot will eventually be turned off as delinquencies, bankruptcies and defaults start to rise, setting the stage for a contraction of the money supply through debt liquidations and bank failures. Under the gold system, the quantity of money within the economy was limited to the ability of an economy to produce goods. Today in the U.S., the increase in the quantity of money is limited only by the restraints of government action. Nothing backs our system of money other than faith and a strong military. Guns and ammunition are consumed or destroyed and faith can evaporate when fear takes over.
The Great Debate: Is it or isn't it a real estate bubble?
This easy credit situation leads me to discuss the current debate of whether the U.S. real estate market has become another bubble waiting to deflate. It has been 314 years since Joseph de la Vega wrote his "Confusion de Confusion." It was 161 years ago that Charles Mackay wrote his magnum opus "Extraordinary Popular Delusions and the Madness of Crowds." Both books are as relevant today as when they were written centuries ago. One of the difficulties of asset bubbles is that they are difficult to discern when you are in the middle of one. The reader may be familiar with all of the recent discussions prior to September 11 on whether the U.S. economy was in a recession or whether the stock market had fallen into a bear market. The terrorist attacks of 9-11 gave the experts a way out of their dilemma. The recession, the drop in corporate earnings, the bear market that followed now had a convenient scapegoat. Corporations used this time to write off impaired assets created through goodwill as a consequence of excess premiums paid to acquire companies. Analysts and anchors could now admit freely what nobody was willing to discuss prior to last September's terrorism: the U.S. economy was in recession and the stock market had declined into a bear market. The myth of a new era and new paradigm economy all seemed to vanish into thin air. The myth of the Fed's invincibility still lingered as Wall Street clamored for more rate cuts and more money. The Fed was more than eager to comply. The Fed moved aggressively to supply credit and lower interest rates in an effort to resurrect the markets and keep the economy out of recession. It failed on both accounts. The rate cuts began at the beginning of the year failed to forestall a recession or prevent the stock market from heading lower.
If there was any measure of success, depending on ones view of economics, it could be judged by the new bubble it created in the mortgage markets. The mortgage bubble gave birth to two additional bubbles in consumption and in real estate. Last week I discussed the mortgage and consumption bubbles. This week's supplement will be devoted to the bubble in real estate. Like the stock market bubble that preceded it, many self-interested parties defend the current bubble in real estate. Various statistics are used to excuse the jump in real estate prices with lower interest rates being one of them. Others, such as creative financing and the creative way in which statistics are manipulated, have been used to defend the latest in a long line of bubbles created by Mr. Greenspan. For example, the rise in mortgage debt is dismissed by the rise in real estate prices. This argument holds up only as long as prices remain afloat. The minute prices start to deflate, those large debt balances will look more ominous.
Another argument that is used is that there isn't a huge overhang of housing inventory. That may be true as long as the real estate market holds up. The overhang in supply will come from bankruptcies and defaults from marginal buyers as they lose their jobs. As the job market continues to weaken, and more companies slash payrolls in an effort to control costs and conserve cash, more homeowners will be without a source of income to make their monthly payments. Then additional supply will enter the markets to compete with new construction to give us excess supply. That may be one reason that new construction is starting to contract. On Thursday, the Commerce Department reported that new housing construction fell unexpectedly in August for the third consecutive month. New home starts fell 2.2 percent in August. 4
Source: CNN Money
Still another argument that is used to defend the bubble is the fact that not all localities within the U.S. are experiencing a boom in prices. This may be true, but that does not take away from the fact that in most areas of the country, prices have become inflated due to increased demand as a result of lower interest rates and available credit.
Picture This: Large Cap, Medium Cap & Small Cap
A better understanding of how this bubble is taking shape is through an analogy to the stock market. The large metropolitan areas, especially on the east and west coasts, can be viewed as large cap stocks. Like the stock market bubble that preceded the real estate bubble, the greatest appreciation has been in the large cap metropolitan areas. The large metropolitan areas on both coasts are like the Cisco, Intel, AOL, JDS Uniphase, and Lucent of the housing bubble. The mid caps are the affiliated suburbs with small town communities equal to the small caps. The further you get away from the large metropolitan areas, the smaller the degree of asset inflation you'll find in real estate. The exceptions are the resort communities that have become the playground for the rich.
Annual Median Price Change 2Q2002
|NY/NJ/Long Island Area||22.3%|
|Los Angeles Area||18.0%|
|Anaheim/Santa Ana, CA||16.6%|
|Source: National Association of Realtors|
Across the U.S., prices have risen substantially over the last 4 years. Nationwide, the median price of a home is now $162,800 up 7.3 percent from a year ago. 5 In places such as my own town of San Diego, they have been rising over 20 percent a year for several years now. This year they are already up 21.3 percent as of the second quarter. In other hot areas such as Nassau/Suffolk, New York, they are up 29.6 percent. San Francisco, Washington D.C., Boston, Miami, and Orange County California prices are rising at double-digit rates. These large metropolitan areas have become the equivalent of the large-cap tech stocks.
Buying Into Bigger
In addition to rising prices, people are buying bigger homes. We keep expanding the concept of what it means to be middle class to include bigger and more luxurious homes. There once was a time when an average home included only bedrooms, a kitchen, dinette, laundry room and living room. People actually used the living room as opposed to today where the living room has become the museum room where the finest furniture goes on display but is seldom used. Over the years, middle class homes have been expanded to include rooms only found in the mansions of the wealthy. We have added formal dining rooms, family rooms, studies, gyms, media rooms, niches, guest rooms, butler pantries, and the catchall bonus room. Many of these concepts have been expanded to include a his and her study to go along with a two-earner household. Media rooms have turned into actual home theaters and the two-car garage has been replaced by the three and four-car garage.
An example of a major developer in my town will give you an idea of what I mean by expansion. This developer is a large builder of luxury track homes with eight community sites currently under development. The smallest community has models ranging from 3,200 to 4,300 square feet. The other communities increase in size with a new project due to come on stream soon with models ranging from as small as 4,400 to as large as 5,800 square feet. Costs are usually running about $200 per square foot including the cost of the land. To that cost, you add the additional cost of options with include additional cabinets, window sills, upgraded carpet, granite counters, alarm system, appliances, extra insulation, electrical outlets and lighting, and many other amenities -- all costing extra. In addition to that, there are add-on property taxes, open space fees, association fees, sewer assessment fees and a myriad other government fees (taxes really) that must be included in the cost of living the middle-class life style in southern California.
Other areas in less attractive parts of town are much less. Yet the median price of a home here in San Diego has jumped to $361,900 this year. A former employee of my firm who took a job in Washington D.C. a year ago was surprised to find out on a recent visit that a condominium her friend had bought for $170,000 and sold last year for around $275,000 was now going for $370,000. A jump of close to over $100,000 in one year and a rise of over $200,000 in four years -- and no one sees this as a bubble?
My friend the mortgage broker has told me many stories of individuals and households who have pushed the upper limits on getting into a home. The Wall Street Journal recently published a story about a local couple who pushed the envelope to get into a bigger home with a mortgage payment that was double their last home. A willing loan officer showed them how to package their application to qualify for a home despite their growing credit card problems. In the case of this couple, their new monthly payment would eat up 60 percent of their take home pay and exceed 36 percent of their gross income. These new homeowners have racked up an additional $20,000 in new credit card debt to fix up and furnish their new home. This has brought their current credit card balances up to $50,000. The couple feels that their real estate broker talked them into making the purchase. The broker blames the couple's problems on their free spending ways. Essentially, this couple exemplify most in today's America. No one is at fault. We are simply victims of the system. 6
There are other stories about this town I love that are similar to other large cap bubble markets in the U.S. In San Diego County, 1 in every 5 renters spends at least 50 percent of their income on housing. According to the California Association of Realtors, only 20 percent of San Diego households earn enough to afford a median price home. The federal government's barometer of housing affordability recommends spending no more than 30 percent of income on housing. 7 Lenders have raised that bar to allow couples like the ones discussed in The Wall Street Journal to go as high as 60 percent.
Problematic or Symptomatic?
There are other stories like this told in newspapers around the country. Some see the situation as problematic, but very few list them as symptomatic of a bubble. References to a bubble are made then explained away by some statistical fact. Home equity has declined over the years as shown in these graphs. This figure is distorted by the inclusion of many retirees and wealthy families who own their homes outright. Their debt-free homes are averaged in with mortgaged homes, which make the stats look even better.
There is trouble on the horizon, but nobody really wants to admit it. Home prices are rising faster than most buyers' income. David Wyss, Standard & Poor's chief economist, calculates that average home prices are now 2.8 times average annual disposable income. Wyss says that when this ratio exceeds 2.5 to 2.6, prices have become too expensive. Ratios that run above those levels have been associated with market tops. 8 The problem of higher housing prices is that as more and more homeowners lose their jobs, they will be unable to make their payments as is now occurring with FHA loans. Current FHA delinquencies are now over 11.81 percent and still rising. Delinquencies for all mortgages are at 4.77 percent. As more economic data comes in, it appears that more homeowners are having trouble meeting monthly mortgage payments. Foreclosure rates are increasing, although lenders are still loose with the purse. That may change as the unemployment rate increases with even greater possibilities of a double-dip recession. The current rate of unemployment rate is 5.7 percent versus 4.5 percent a year ago. Even the unemployment rate may not reflect the real employment picture since a person is no longer considered to be unemployed after his unemployment benefits run out. The Help Wanted Index and job layoffs announced by companies this quarter are rising again after leveling off.
Consumer-Led Recession Yet to Appear
Housing bulls are apt to cite that delinquency and unemployment numbers are lagging economic indicators. However, a consumer-led recession has yet to begin. The first recession was led by business. The American consumer never retrenched during the business downturn that is still with us. Instead, the consumer ramped up his borrowing and spending, helping to moderate the softness in business. However, as businesses continue to try and control costs, unemployment will accelerate. This will eventually bring the mortgage and consumer-spending binge to an end. It will be the combination of a falling dollar, rising interest rates, and rising unemployment that will usher in the next phase of this recession. This next phase will be led by households and consumers with the greatest impact upon the financial sector. The charts of Fannie, Freddie, MGIC Investment Corp & J.P. Morgan Chase are a portent of the future.
Slaves to Debt and Time is Running Out
What will lead this next leg down in the economy will be the consumer. Just as the consumer helped to moderate the business recession that began in 2001, the consumer will be at the forefront taking us deeper into recession during the next leg of the downturn. The cause of consumer capitulation could come from several sectors. The growing number of layoffs will be at the top of the list as the most obvious one. But the main factor will come from crushing debt levels that have made consumers and households slaves to debt. What appeared as a boom and a new era during the 90's was in fact the largest and most reckless credit bubble ever recorded in this nation's history. Spurred on by Fed policies of unlimited credit and easy money, consumers piled on debt, depleted their savings, spent carelessly, and speculated wildly in the financial markets.
Just as Paul Volcker will be remembered as the Fed Chairman that restored monetary discipline, Alan Greenspan will be remembered as The Father of The Greatest Bubble in our nation's economic and financial history. To say that Fed policies under his tenure were reckless and irresponsible would be too kind. Greenspan became the chief finger-pointer of the "new era' mantra. In point of fact, it was his policies that created the greatest credit bubble of any nation in the history of the world. Greenspan became the incarnation of the 20th century equivalent of John Law, the Scottish banker and father of central banking that set France on its path to revolution. Alan Greenspan also became a defender of the expanding role of derivatives in the financial markets wanting them to remain unregulated. His response was reactive rather than proactive to any derivative crisis. He preferred to use the Fed as lender of last resort through its response policies. It didn't matter whether it was the peso crisis, LTCM, Russia, Y2K, or 9-11. The response was always the same: flood the markets with cheap money and ample liquidity and in the process, reinforce the "moral hazard." The result is we got more of what we were trying to avoid, as the 90's were a period in which one financial crisis followed another.
Truth AND Consequence
Now the U.S. economy faces the severe consequences of reckless Fed meddling with the credit system as the consumer and corporate debt bubble begin to deflate. To understand the magnitude of this bubble one must look back at the 90's to see what these reckless policies wrought. A recent article by Liz Pulliam Weston of Money Central highlights the heavy burden that consumers face with the following facts:
Now the U.S. economy faces unwinding the consumer bubble which includes the mortgage bubble which has fed into the consumption and real estate bubble, and lastly the stock market bubble, the subject of next week's Bubble Troubles Part III. The fact that we are still debating whether we are in a real estate bubble is a sure sign that we are in one. The arguments that money has to go somewhere, and therefore it is now real estate, supports this bubble thesis. Nothing gets a bubble going like rising prices. Rising prices become a self-reinforcing mechanism attracting new investors or buyers to pay even higher prices or buy bigger and more luxurious homes. The bond market and mortgage bubble is providing the means to an end. Lower payments allow buyers to buy bigger and more expensive homes. Lower credit standards are allowing marginal buyers like the unfortunate San Diego couple written about in the WSJ article to trade up to larger homes. This has led to rising rental vacancies as more marginal borrowers trade paying rent for making mortgage payments.
Most experts agree that the housing bubble will end with higher mortgage rates. A rise in mortgage rates will end the refi boom, which is feeding into consumption. When consumer spending starts to retrench, the housing and consumption binge will come to an end with severe consequences for the economy. It could become a reinforcing downward spiral that feeds on itself. As consumers retrench, businesses will be forced to cut back. One can expect the Fed to fight this retrenchment with ample credit and lower rates, but that will not be so easy. The course of interest rates is now in the hands of the bond market with foreign owners having the greatest say. Their major ownership of our Treasury market as well as their ownership of agency bonds and corporate debt will give them undue influence over our financial markets. It is easy to see how this cycle will unfold. Once it begins it will be difficult to turn back.
There are now emerging signs that the housing bubble is beginning to deflate. Friday's Wall Street Journal featured "The Mansion Glut" in their Weekend Journal section. A record number of $30, $40 and $50 million dollar mansions are flooding the market. In the case of one mansion owner, she recently reduced the price of her Long island North Shore mansion by $15 million to $35 million. In the words of the owner "I may have to own the house for a while." The WSJ article featured many stories of high-priced mansions that have been on the market for three years or more. The easy days of the stock market bubble that created instant millionaires and billionaires are over. Many of the former wealthy have now been forced into more plebian life styles.
Real Estate Insiders Bailing Out
The rest of the housing market seems to be holding up. As the bond market continues to deflate, mortgage rates continue to come down. Rates on 30-year fixed mortgages fell during the latest week from 6.18% to 6.05%. Despite lower mortgage rates, new home construction fell by 2.2% in August, the third consecutive month in a row. Housing developers may be getting cautious. Executives in the housing industry have been big sellers of their stock recently. Top execs at Pulte Homes, Centex, Lennar and other major builders have been sellers of company stock throughout this whole year. When insiders are bailing out of their stock, it is a sure sign that industry profitability is about to turn. What they are doing is no different than telecom execs and technology CEOs before the tech bubble bust. While Wall Street recommended buying technology stocks, the insiders were bailing out. It is the same story with housing stocks today. Wall Street continues to recommend them as a strong buys.
|Pulte Homes||8 buys||5 holds|
|Centex||10 buys||2 holds|
|Lennar||10 buys||1 sell|
|Source: Bloomberg, Financial Markets|
In typical bubble fashion, the peak of a housing cycle has Wall Street issuing strong buy ratings, with a few holds (translated: sell).
The Bust Factors
In addition to rising interest rates, which could come as result of a falling dollar or a foreign exodus out of our financial markets, there are other factors that don't bode well for the housing bubble. Rising prices may eventually make housing unaffordable. Rising expectations of a never-ending price appreciation may fail to materialize as all bubbles eventually end with disappointment. A return of higher interest rates will also have a devastating impact on ARMs and limited-term fixed rate mortgages. The limited-term mortgages will have to be refinanced at higher rates; while monthly payments will go up on ARMs. This will severely strain the monthly budgets of plentiful and marginal borrowers. One characteristic of this housing and mortgage bubble is that credit standards have been reduced across the board. Lenders no longer bear the responsibility of their loans with so much of today's lending -- whether it is mortgage debt, installment debt or credit card debt -- offloaded on to the financial markets through the securitization of loans.
The combination of credit-related asset deflation in the stock and real estate markets, combined with rising interest rates, will have a lethal effect on debt-strapped households. The housing bubble will deflate gradually. It will take time, maybe years, for it to unwind. Fortunately for homeowners, the price of their homes doesn't appear as a ticker tape across a computer screen nor is it listed in the newspapers each day. The only visible sign of distress will be the increase in for sale signs in the neighborhood. Judging by what happened in the last recession, housing prices peaked several years after the recession and would take close to a decade to recover and rebuild pricing momentum. Right now homeowners, like stock investors, are in a state of denial preferring to act like ostriches rather than face reality. What could trigger the unwinding of the housing bubble? Several events could burst the bubble - a dollar crisis, the unwinding of the bond market bubble, and the second capitulation phase of a bear market in stocks. The stock market bubble, which is still with us, is the subject of Part III and the final chapter of Bubble Troubles coming soon. ~ JP
1 Griffin, G. Edward, The Creature From Jekyll Island, American Media, 1998, p. 185.
2 Reisman, George, Capitalism: A Treatise on Economics, Jameson Books, 1996, p. 524.
3 "Debt Climbs at Fastest Rate in Over 10 Years, Chicago Tribune, September 16, 2002.
4 Hughes, Slobhan, "U.S. Housing Starts Fall 2.2% to 1.609 Million Pace," Bloomberg, August 19, 2002.
5 Wise, Christina, "Housing Prices Defy Recession, But Experts Agree It's No Bubble," Investors Business Daily, September 9, 2002.
7 Kim, Queena Sook, "Foreclosures Hit Record Levels," The Wall Street Journal, September 10, 2002.
8 Weisber, Lori, "Local Housing Costs Drain Family Budgets," San Diego Union Tribune, August 27, 2002.
9 Hilsengrath, Jon & Patrick Barta, "New Home Sales Jump 6.7% As Buyers Ignore Economy," The Wall Street Journal, August 27, 2002.
10 Weston, Liz Pulliam, "House of Credit Cards is Ready to Collapse," MSN MoneyCentral, September 2002.
© 2002 James J. Puplava
by James J. Puplava
September 20, 2002
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