The bubble farce

Bill Bonner - Tue 03 Oct, 2006

...That public spectacles begin as a fraud, progress into farce and end in disaster is one of our daily dictums here...

 
 
"Lenders gone wild," runs the headline of an article at MarketWatch:

"More than a year after Alan Greenspan warned of the 'potential for individual disaster' from a new breed of mortgages that were helping to fuel the US housing boom, federal regulators are finally trying to do something about it.

"Bank regulators knew more than a year ago that lenders were aggressively marketing interest-only and payment-option adjustable-rate mortgages to consumers who didn't fully understand what they were buying. Studies show that a large number of borrowers with simple ARMs don't understand the terms and underestimate the amount their mortgage payment could rise. Nontraditional ARMs are even more complex."

That public spectacles begin as a fraud, progress into farce and end in disaster is one of our daily dictums here. We have spent so much time and so many pages describing the lies behind the housing bubble that our readers must be tired of hearing about it. So, now we move on – to the farce.

That too, has been described at length, but at least it is more entertaining. For here, we move from humour in the abstract to slap-stick to real life stories of people whose brains have been turned into suet pudding by the lure of big money from US house-price increases. Nothing was too absurd or preposterous for them to believe, it seemed. Buyers bought condos before they were built, intending to flip they were sold; no, before the water was even turned on. Householders believed they could 'take out' equity from their houses and never have to put it back. Hustlers quit their jobs at dotcom start-ups in order to become mortgage-brokers. Financial engineers devised new and innovative ways to leverage the witless homeowner into a house he couldn't afford and could never hope to pay for.

MarketWatch continues:

"The US housing credit bubble led to the growth of exotic loans, which, in a vicious spiral, drove prices even higher, said one observer. In a bubble, 'the financing gets progressively worse. At the end, you get nuttiness,' said Dean Baker, an economist for the Centre for Economic and Policy Research, a Washington think-tank.

"Finally, prices got so high that 'the only way people could buy houses was by bending the rules,' said Baker, who's been warning about the real-estate bubble for years. In the Orwellian parlance of the mortgage industry, loans that ignore the true ability of the borrower to pay for the loan are called 'affordability' products. Most of the exotic loans have low introductory interest rates that ultimately adjust to market rates, usually after two years. Some loans require that only the interest be paid, putting off the day when the borrower must start to pay down the principal. Some of the loans allow borrowers to make a monthly payment that doesn't even cover the interest, resulting in a negative amortization when the unpaid interest charges are added to the principal. And most of such loans sold in the sub-prime market have large prepayment penalties that make it expensive to refinance."

None of this will come as news to our long-suffering readers. But it is sure to come as a shock to US homeowners who haven't read us. A $200,000 ARM, for example, can rise from a $643-a-month burden in the first year to a $1,578-a-month burden in year 6, by which time, the principal would have risen to $214,857, according to a Market Watch source.

How will the nation's economy hold up as all these loony mortgages are reset, rescheduled, and regretted? So far, the masses are betting on more soft landings than at O'Hare or Heathrow. From Florida comes more news that the bubble in housing is not only deflating, but that it is taking down a lot of people with it. One builder has cut his prices by 30%, says our source. And that is after throwing in new appliances for free.

Yes, a few marginal borrowers will go belly-up, the optimists admit, but everything else will be okay. But here at the Daily Reckoning, we don't trust what people say. We'd rather place our faith in what they do. And the Wall Street Journal tells us that what consumers are doing right now is...still consuming. Meanwhile, Wall Street is still near an all-time top; apparently investors are as fearless - or as clueless - as consumers. That no one seems to register any fear is remarkable, given the catastrophic consequences of any misstep. Never before have so many people owed so much money to so many others. Never before has there been so much debt and never before have so many complicated, contradictory debt-backed investments been stretched and spun so far out into the financial galaxy.

Are we right to worry? We don't know...but we spent yesterday re-reading some of our Daily Reckonings from the last seven years. We can sum them up for you as follows: Sometimes right; sometimes wrong; never without an opinion.

What we were right about was the tech bubble and the price of gold. But what we failed to see was how the feds, working hand in glove with the financial industry, would be able to keep the bubbles boiling up. We figured that the central lie of central banking – that you can create 'wealth' simply by putting more liquidity into the system – would have caught up to them by now.

But no, not at all. People still have faith in stocks, bonds, and the dollar.

We saw what looked to us like a great top-out of the stock market in January of 2000. Sell the Dow; buy gold, we said. Since then, stocks have gone down but the Dow has gone right back up. Still, you would have done well to sell the Dow 6 1/2 years ago. If you'd bought gold, instead, you'd be up about 140%. And even if you'd just put the money into 91-day T-bills, you'd be ahead of the game, because, most of the Dow stocks are still well below their highs…with GM and Intel off 60% and Microsoft down by 50%. Home Depot and Merck are both off by about 40%.

Altogether, since January 2000, if you had held the 30 Dow stocks, reinvesting the dividends, you'd be up only 12.7%. Adjust that number for inflation and you'd actually be down nearly 10%. A money market fund, by contrast, would have put you ahead by 20% in nominal terms and less than 2% in real terms.

Stocks were no place to be, post-2000. And now, the US housing bubble too seems to be losing air. And we have to wonder: can they do it again? Can they create yet another bubble? One that will prop up stocks and housing a while longer?

More to come...


Regards,

Bill Bonner
The Daily Reckoning