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HOUSING FUTURES, TECH PAST

Much as home builders and mortgage associations and national realtors and REIT managers would like to deny, strong parallels exist between the housing bubble and the tech stock bubble in 1999. We all know how the Nasdaq stock index faltered badly, gave up the ghost, and experienced a dizzying bust heard around the world. Over the course of the last year, in my head several item factors have been logged to put a face on that parallel. With only a little extra effort, the laundry list of similarities has grown to the cited symphony of musical notes ringing in near perfect harmony. Why should they not ring in harmony? Major bubbles have nearly identical characteristics, feeding mechanisms, and public psychology. Before describing the residential housing futures contract, subsidized and actively encouraged, let’s examine some past tech stock bubble parallels to the modern day housing bubble.

PARALLELS OF HOUSING TO 1999 TECH STOCKS

A summary perusal can make a powerful case of parallel. On a valuation basis, tech stocks had extraordinarily high price earnings ratios in 1999 and early 2000. Housing has a valuation of the nation’s entire property at least 5% above the rent (plus homeowner imputed rent) last seen at peak in 1988. Stocks enjoyed rosy brokerage firm opinions before their bubble burst, with certain vested interest to the broker that earns fees. Housing has lax appraisal standards, pressure to meet a given appraised value, and departure of many respected professionals who refuse to yield. Stocks benefited from liberal margin requirements, set a record of $21.4B in Nasdaq margin debt in May 2000 (eclipsed by $23.7B in February 2005), which gave a giant assist to stock share demand. Housing has been powered by liberal rates below 6.0% on a 30-year mortgage. As you have seen in many similar advertisements, bad credit is not an issue !!!

Little discussed is the need for an acceleration (not just continuation) in mortgage funds in order to maintain a constant stable housing price structure. A bubble has, by nature, a voracious appetite. The federally sponsored mortgage pool growth in 2002 was $328.1 billion. In 2003 the federal mortgage lending growth was $330.9 billion. In 2004 against a background of Fanny Mae accounting fraud, executive option tampering, and extensive scrutiny, mortgage fund growth petered off to $53.5 billion. Absurd pro-forma accounting enabled tech stocks to count all good numbers and push aside many bad numbers, to produce exaggerated earnings reports each quarter. They maximized profits for investors to see, but mimimize profits for the IRS to see. Mortgage applications are a feeding frenzy partly because income verification is almost a collusion between applicant and the mortgage underwriter, who merely sells that contract to Freddie Mac or his bloated wife Fanny Mae. High analyst earnings estimates for tech stocks were the norm, just like property faults are easily overlooked in a hot housing market.

Kickbacks are more and more reported for brokers from companies issuing stock, as favors were granted. Unfortunately, the norm has become the hand-off of cash at closing to the mortgage applicant, for the purpose of supplementing the down payment under the guise of identified inspection fixes. Sometimes, a tech firm would have an aging product line, or simply be involved in a hot niche, the result of which was to lift the share price. Even houses with problems, like decaying exterior, or partially completed roofs, or outdated kitchens & bathrooms, or stinky carpets, sell well in a hot market. Nasty surprises in the form of hidden costs from legal fees, patent settlements, R&D costs, were easily hurdled in a rising tech stock bull market. Housing easily sidesteps balance sheet obstacles by citing inflated rent income, lowballing utility costs, and more.

Excessive debt-asset ratios for high-flying tech stocks was never a problem, perceived easily to be overcome by gigantic new revenues from the next whizbang technology and attendant devices. Tiny down payments for home mortgages have become the norm, with 12% of new mortgages now logging in at zero percent down payment, after clever methods are used to finance the down payment itself (such as second mortgages at the get-go). Private mortgage insurance is often averted through clever finance terms. The newest rage, interest only loans, has removed the concept of principal repayment altogether, and adding to the risk of negative home equity status. By means of executive options and secondary stock issuance, tech companies diluted their base of outstanding shares, often in abusive fashion. New home construction adds briskly to supply in an obvious bubble in the housing market, even as justification abounds for shortage of available lots and land. Not without their gears & levers, tech firms were able to direct stock buyback programs in order to lift their share values in a misappropriation of corporate funds. Certainly, motive of enriching executive stock options helped the buyback process along. Home owners abuse debt and assist their homestead enhancement by means of room additions, bathroom additions, or back decks & patios, which lifts the property value but adds to debt.

An investor deluge occurred throughout the 1990 decade via the retail movement in mutual funds, as well as the individual pension participation in 401k and IRA accounts, which surely loved tech stocks. Liquidity in mortgage finance for the last decade or more has been powered by Fanny Mae and Freddie Mac, a veritable centrifuge in recycled mortgage money. Banks and agencies originated the mortgages, as federal associated (Govt Sponsored Enterprises) recyclers returned the same money for the next mortgage to be approved. By 1999 the last tech stock buyers were little retail investors, investment clubs, cocky little snot-nosed kids, and unprepared daytraders. The housing movement has lately resorted to paid television advertisements appealing to minorities and others who might not otherwise have been able to enjoy the benefits of home ownership. It is clear to some that the last buyers of housing are being actively recruited. Tech firms engaged in a final climax of mergers & acquisitions late in the 1990 decade. In my view, the Time Warner buyout of America Online and the Uniphase (fiber optics) buyout of JDS Fitel can be identified as leveraged overpaid acquisitions at the top. Countless others occurred. In the housing world, property owners can overdo home extensions, or over-extend with purchases of second homes, or excessively draw on cashout extractions, only to leave themselves vulnerable. The exposed fraud was magnificent in Wall Street in recent years. Cases against Enron, WorldCom, Adelphia, Global Crossing, Tyco, Imclone, and Computer Associates were given the greatest focus of attention. Let’s not overlook Microsoft and their regular ongoing practice of anti-trust violations (see Netscape, Sun Micro, Real Networks), whose frequent high profile fines tally as mere cost of doing business. The FBI reports the incidence of mortgage fraud tripled from 2003 to 2004, in cases such as collusion among buyer, mortgage broker, and appraiser. Fraud has increased tremendously in the housing market, with little publicity over subterranean activity.

Early in the 1990 decade, the Japanese bust resulted in approximately $700 billion to flee from their deflationary wreckage as both stocks and housing declined in Japan despite falling interest rates. The climax in foreign involvement led Daimler Benz to overpay and acquire Chrysler, which today is highly resented by old school Europeans. Correspondingly, the entire housing phenomenon is powered by Asian funding indirectly. The Yen Carry Trade by Asian hedge funds exploits a 3.0% differential between US and Japanese long-term interest rates. The yawning US trade gap translates into a gargantuan trade surplus which Asians recycle into US Treasury Bonds. Direct Asian central bank intervention, often overnight under the cloak of darkness, offers regular USDollar support by means of USTBonds. Asian bond support is absolutely critical to the housing movement.

No tech stock frenzy would have been so robust without a cheerleader, an ideologue, a priest, a wizard, an alchemist, a true Pied Piper. Federal Reserve Chairman Greenspan argued quite incorrectly that high productivity enabled high stock values late in the 1990 decade. He argued that fast speed of information flow enabled high stock valuations. Then tech stocks fell 50% to 90%. He fails to comprehend productivity at all. The productivity was shared across industries, which resulted in higher fixed costs for companies, even as they had to suffer lower profit margins. The shared technology was deployed by all competitors. The internet exposed price differentials, thereby leveling the playing field. Consumers were the primary beneficiaries. More efficient supply chain networks did lower some costs, but added to disruption risk in tighter Just-In-Time inventory management. Corporate profits went into decline. Greenspan continues to harp on the wrong tune, like a fool who cannot comprehend borrowed toys in a romper room.

In the housing world, the pervasive housing bubble served multiple purposes. It masked the horrible after effects of the stock busted bubble. It provided a quick and easy savings account to raid for consumer spending. It enabled household credit card debts to be consolidated, even for a renewal of new revolving credit extension. In short, the new housing bubble prevented (or delayed) the economic recession so dreaded. Greenspan back in 2001 almost singlehandedly jawboned the long-dated bonds to lower yields, with statements that he wished for mortgage rates to go down. This past autumn and winter he offered more incorrect justification, if not heretical rationalization. He claimed first that household balance sheets had been repaired and were in excellent shape, the best in years. He also claimed that housing inflation was indeed blessed as legitimate “wealth generation,” utter heresy for any central banker. There exists no precedent of a bubble avoiding its dissipation phase, where values decline. The trigger could be sheer gravity, and the absence of the accelerated credit (air) supply needed in growing quantities. No shortage of hot air from Greenspan though. He now inconsistently criticizes Fanny Mae for its inadequate capital base, sprawling hedge book, and hedge practices. Yet, slow to realize, Fanny Mae is a monster built in his own back yard.

This should not be confusing, even to the novice observer. For tech stocks, the bubble force was uncontrolled debt. In the housing market, the bubble force is uncontrolled debt. This should not be confusing, even to the novice observer. For tech stocks, investment was all the rage as psychology took over. In the housing market, ownership and speculation are all the rage as psychological factors continue to drive the movement.

THE NEXT LEG

The credit supply machinery is in the repair shop. Both Fanny Mae and Freddie Mac occupy the twin-bay repair shop. The economy has been put at risk. Its critically important giant centrifuge is not operating at even half speed. Many are the financial umbilical cords stretched from homes to car loans, student loans, second homes, boats, vacations, medical payments, education plans, home extensions, home entertainment systems, home adornments, basic consumer spending, and much more. The dependence by the US Economy upon the housing sector is incredibly great, and very under-stated. So far, higher energy costs, higher borrowing costs, more heavy handed credit card practices, have all contributed to a shock wave within financial markets exactly during the income tax week of April 15th.

Next on the road to housing distress is what can be called “property tax tyranny.” Local cities, towns, and municipalities recognize the deep well of available new taxes, against a backdrop of their own severe fiscal distress. Most areas have undergone increases to property tax levies. Since wages are struggling, as property values rise, on a relative basis household income has fallen even as taxes have risen. In this sense, the housing bubble has brought us a horrendous regressive tax in rising property taxes.

Suburban commuters are vulnerable. At the same time of the housing bubble, energy costs have risen. Commuters must shell out a disproportionate amount of money toward fuel costs which the urban dweller keeps low and the bus/train/trolley rider avoids. For this reason, my personal expectation is for housing prices to falter in suburbia first, while at the same time urban properties will enjoy a thrust of the housing bubble blowoff top. As Sport Utility Vehicle sales plummet, so might suburban properties dependent upon commuter schedules on outlying roadways.

THE RESIDENTIAL HOUSING FUTURES CONTRACT

The USGovt actively encourages home ownership. The tax structure permits home mortgage interest to be tax deductible, thereby inducing renters to save toward their starter house. In time, home owners trade up to larger houses as families grow, needs grow, or businesses grow. A home mortgage contract requires an investor to post a margin cash position called a down payment which can be 20% or more for conservative owners. However, in recent years, the norm is to minimize the down payment (margin posted) to 10%. With the aid of second mortgages and “under the table” kickbacks from the seller, down payments are reduced in the cash amount. Leverage is enormous. To aid the movement, the Federal Reserve, with its incredibly lax monetary policy and encouraged monetary inflation, has offered a stiff favorable tailwind for housing investors (or speculators). A vast derivative pyramid has been constructed to support the mortgage and bond industry. You can be guaranteed that 99% of homeowners have no knowledge of this system littered with mortgage backed securities, strips & floaters, as well as REMIC conduits.

Owning a house nowadays has become an adventure into the highly leveraged and risky futures trading pits. Homeowners unwittingly have morphed into bond speculators under contract occupation. Delivery is not taken; instead the home is occupied !!!

Requirements to open a futures contract trading account are far more stringent than for a stock account. A degree of sophistication is required. Risks are great, leverage is great, gains & losses can be great. No such demand and qualification is required to open up a homeownership futures contract, known as a mortgage. In fact, the USGovt via its GSE agencies has actively enabled widespread participation, even encouraged the lower income groups to buy here. Instead of regulation and tightness at the top, we have laxity and more liberal abuse. New homeowners seem unaware of the risk of complete and total loss of their investment, the down payment, if they have one at all. Negative equity is a very real potential in coming years.

The unmistakable trend has been gradual rise in home values over the decades. That does not stop nasty down drafts from occurring, like what happened in 1973 to 1975, from 1980 to 1983, and from 1988 to 1994. In the high stakes game of futures contracts, if the underlying contract declines in value, the investor is required to post additional margin against the position, or else liquidate for a heavy loss, sometimes at a total loss of the account. Not so with housing mortgages, where no margin maintenance is enforced, NONE. In my past, a friend had bought in 1987 a modest condominium in Salem, Massachusetts. At one point, she was underwater by $50 thousand on her $120k property, holding a $100k mortgage. The bank did not call in the loan, thankfully for her. A housing decline this time around might see millions of mortgage holders deeply underwater. One must wonder if banks will call in the mortgages and force sale at a loss, a feature written in the contract fine print. If Fanny Mae and Freddie Mac proceed through bankruptcy, will the next Resolution Trust Corporation force liquidations, salvage agency equity, and heap hardship upon the unsuspecting housing futures investors?

Rather, look for distress to occur slowly, despite Herculean efforts by the USGovt to prevent the inevitable damage. Why? Because the entire system called for the housing bubble to side step the stock bubble bust, the entire system requires a housing bubble to enable consumer spending, and now the entire system desperately needs the continuation of the housing bull market to avoid a crippling series of events. Recession and stagflation are a real possibility upcoming.

Instead of the Herby Homeowner having to deal with “marked to market” value and status of the residential futures contract, quite the opposite effect enables rampant consumer spending. Home equity loan credit lines are marked to market, with offered loans for the spendthrift occupants and owners. If property value rises, more spending power. If property value drops, no margin call on the mortgage, but also likely curbed home equity credit. The public has abused the privilege given them. They have turned their homes into an investment bank, an ATM machine dispensing cash, a sanitization fund to cleanse over-extended credit card accounts, a virtual sugardaddy to fund extravagance. Soon, the tide turns back.

THE BIG BATH

This link came to my attention, a rather expansive (somewhat overwhelming) weblog of articles on the housing bubble. Special thanks to my buddy Hiro F for sharing it with me. It is well worth a perusal if you need some sway to conclude not just a bubble, but a wicked big bubble this way lies in housing, ready to give off massive vented gas and render damage downwind much like the volcano at Mt Saint Helens. Or will it become the biggest bath American homeowners will ever experience? They might emerge clean, too bad it might be cleaned out of a major portion of their life savings. The website is managed by Patrick Killelea in the Bay Area of California. The following graphic was made by Rick LaForce and appears on the website listed. Many thanks to them for the tremendous treasure trove of not so trivial tracked sources. Finally, a picture is worth a thousand words. A tragedy this way comes.

http://patrick.net/housing/crash.html

NEWS TIDBITS

	A Federal Reserve survey showed healthy regional manufacturing activity, easing concerns of slowing economic growth. “The market is moving on the stronger than expected Philly Fed. Keep in mind, the market has been battered by fears of a slowing economy. But this is evidence to the contrary. Add to that, Greenspan saying that stagflation does not appear to be a risk, and the market is reacting,” said Todd Clark, head of listed trading at Wells Fargo Securities. The Federal Reserve Bank of Philadelphia said its business activity index rose to 25.3 from 11.4 in March. Wall Street economists had expected the index to ease to 10.0 in April. This contrasts with last week’s data from the Empire Mfg Report, which showed a drop from 20.2 to 3.1 to stir the markets. Investors should harken back to the last several reassurances made by Greenspan, regarding the benefits of massive tax cuts, transient low energy prices, low adjustable mortgage rates, strong household balance sheets, and stable housing prices. Stagflation can be totally counted on in future months and years. Listen to Greenspan’s topics, and ignore his words, since his topic is the next likely crisis arena. He has become a monetary drug dealer, and acts like a monetary drunk driver.
	Oil prices fell below $54 per barrel as signs of slowing economic growth threaten to undermine demand and strong OPEC production swells supply. Light crude dropped 96 cents to $53.07 per barrel, nearly $5 from the all-time peak at $58.28 struck earlier this month. Oil prices have eased from record peaks on signs that higher energy costs and rising US interest rates are starting to dampen a surge in economic growth which last year fueled the fastest rise in consumption for a generation.
	Saudi Oil Minister Ali al-Naimi said that the ability of the kingdom and other OPEC producers to control price rises had been weakened by the growing influence of large funds and by refinery bottlenecks in consuming nations. “Despite our best efforts, Saudi Arabia and OPEC have had little ability to curb the rapid rise in prices.” Naimi said Saudi Arabia will work to keep spare supply capacity of at least 1.5 million barrels per day even as it pumps hard to meet strong world demand. Beware though, that most spare capacity is loaded with sulfur content (sour crude) and other impurities, as they stretch to meet demand. Too much low quality crude mixed in means certain refineries cannot process the oil into gasoline or distillate products.
	President Bush, who will meet the Saudi Arabia de facto leader Crown Prince Abdullah on Monday in Texas, has said he is seeking a clear answer from the Saudi government about the size of its spare oil production capacity. Let it be known that the Saudis have become very angry at comments made, and have publicly refuted insinuations of slack cooperation. Their ability to respond is limited. While the president claims to understand that the Saudis certainly do not command millions of barrels of spare output like in years past, the Saudis are reportedly scraping the bottom of the barrels to achieve output quota levels.
	Customs data showed that China, the world’s second biggest oil consumer, imported 2.7 million barrels per day (bpd) of crude in March, a jump of 23% from the same month last year and up from an average 2.25 million bpd in January and February. But total imports for the first quarter were 29.64 million tonnes, down 1.6% from a year earlier, signaling a possible slowdown of demand growth. China’s economy grew by 9.5% in the year through the first quarter, official data showed. Analysts said the pace of growth could force Beijing to further tighten investment and credit curbs.
	Federal Reserve Chairman Alan Greenspan warned that unless lawmakers come to grips with spiraling federal deficits, the economy was at risk of stagnation “or worse.” He went on to say that “Projections make clear that the federal budget is on an unsustainable path, in which large deficits result in rising interest rates and ever-growing interest payments that augment deficits in future years,” before a Senate Budget Committee hearing.
	Initial jobless claims plunged 36,000 last week. New claims for state unemployment insurance benefits fell to 296,000, the lowest level since early February and the largest one-week drop since 73,000 in early December 2001. A Labor Department analyst said calculations used to adjust for seasonal factors had trouble taking into account the Easter holiday, which at late March was earlier than usual.
	The USDollar extended a slide this week, hitting one month lows against the euro currency after a surprise jump in consumer prices battered US stocks and shifted the focus back to structural woes in the US Economy. The data raised worries about the possibility of stagflation in the United States (high inflation and stagnant growth) clouding the outlook for capital flows into the United States. The USDollar has been torn this year between the negative impact of the US huge current account deficit and the need to attract foreign capital to offset the gap. In contrast the world reserve currency has benefited from an accelerated rise in US interest rates. “People are becoming more and more worried about whether the Fed might be too optimistic in its economic assessment,” said currency strategist Kristjan Kasikov at Calyon. “Rising oil prices suggest we should be selling the dollar.” The USDollar has fallen about 2.5% from two month highs against the euro set last week, and nearly 2.0% from early April peaks against the Japanese yen. The Leading Economic Indicator for March fell 0.4%, indicating more slowdown and sluggishness ahead. However, it is really just an index dominated by the stock market indexes.
	Foreign Minister Li Zhaoxing (easy for you to say!) commented on issues regarding its fixed currency policy. Asked about US pressure for China to float their yuan currency and the possibility of Beijing changing its policy, Li said any decision would be based “on the actual conditions of China and the interests of both the Chinese and our neighbors, even the whole world's interests.” Beijing has said that while it is committed to eventually allowing the currency to float freely, it will do so only gradually and after tackling other problems in the economy such as a sickly banking system.
	The largest US brewer Anheuser Busch announced Berkshire Hathaway, the holding company run by billionaire Warren Buffett, has acquired a significant stake in the company. Hmm, beer!
	Stock volatility has grown markedly in the past few weeks. Several 100-pt down moves in the Dow have been followed by occasional 100-pt up moves. The volatility measured in the VIX is rising, which is a bigtime danger signal of further imminent stock declines. There are many moving parts at work, and some of being sharply adjusted.

TODAY’S MARKET

Today the Dow Jones Industrials wrapped up at 10,219 (+206), S&P at 1160 (+22.4), Nasdaq at 1962 (+48.6), TENS yield 4.300% (+8.9 bpt). Currencies closed with Euro at 130.7 (-0.31), JYen at 93.97 (-0.04), Can$ at 80.80 (+0.06). Metals finished with gold at 433.5 (-2.3), silver at 721.7 (-12.0), copper at 148.4 (-2.6). Energy ended with crude oil at 54.20 (+0.17), natural gas at 711.0 (-4.4), unleaded at 162.46 (+3.29). Prices are at major futures contracts.

Jim Willie CB

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