Let's Hope She Still Has Her Voice

I am glad I am not Ben Bernanke. Or George W. Bush. Or the head of the OTC, Fannie, Freddie, or Ginnie, or the Secretary of the Treasury. Or a CEO of any of the major lenders.

One reason is that I do not at all understand the machinations occurring in the financial markets right now. I do understand a few basic themes :

• when supply is low and demand is high, prices go up


• when supply is high and demand is low, prices go down


• when people cannot afford to pay their debts, they default


• when risk is high, investors look for high yields


• when a man is broke and his credit is bad, he goes without

I also see the following things in the marketplace :

• incomes have not kept pace with expenses for the majority of Americans


• residential real estate lending provided much of the means for consumption in the past decade


• there are far more houses in the market than there are buyers who can afford them


• the loans that were made in 2005-2006 are at their peak for their first reset

For a decade I have been warning that the use of Home Equity Lines of Credit are not only dangerous, but have the effect of robbing the Average Joe's piggy bank. Most Joes have no idea that when they borrow against their home, they sell an interest to the lender. They do not stop to consider that when Sharkey loans them the money, he expects to make a profit. Therefore, the interest he takes in the home is ALWAYS greater than the amount of money lent. In good times, this fact is difficult to visualize. Joe rarely thinks about his home as a savings account; he is often told that it is an investment. Nothing could be farther from the truth.

An investment is a vehicle for providing a return on capital. An investment that does not keep pace with inflation is a bad deal. A home is a place to live. No matter where Joe wants to live, he must pay rent. If the price of houses goes up, the landlord will raise the rent. If Joe buys the house, and sells an interest to Sharkey at a fixed rate, he has purchased a form of rent control. Then, if the price of houses goes up, Joe's monthly rent stays the same, and the equity he builds in the house becomes a hedge against future rent inflation. The hedge is usually not very high, because while land does not suffer from obsolescence, the improvements (der hut?) will depreciate (translation : deteriorate) and will need repairs from time to time. Joe will normally pay for those repairs out of his pocket.

Over time -- the life of the improvement or the life of the owner, whichever comes to an end first -- it is almost certain that the cost of maintaining and repairing the improvement will, with any inflation, equal the total equity Joe has in his home. New roofing, siding, windows, furnaces, water heaters, paint, carpeting, cabinets, etc. will have to be purchased and installed at least once (and maybe more -- figure three times for a water heater) during the typical 30 year amortization period. Joe will also need to address the cost of taxes and insurance. If Joe does not need to touch his equity in that time period, he will indeed have a lump-sum amount available if he would sell his home. But --

What if Joe borrows against that equity? For one thing, it is almost certain that the interest rate charged for a second mortgage or a line of credit will be higher than the rate on the first mortgage. If it is not, then Joe has been sleeping at the wheel and should have already refinanced his principal balance at a lower fixed rate. By borrowing against his equity, Joe has just raised his own rent. If he uses the money to repair his home, he might have made a wise move, especially if the cost could not be paid out of pocket and the repair was essential for maintaining the structure or systems and preventing further deterioration. Use of the equity for any other purpose is foolish unless Joe is fully willing to surrender to Sharkey (who is really his landlord, you see) control over the monthly rent.

What if Joe does not borrow against the equity, but sells the house he now owns free and clear and buys another? If he pays the same amount for his new home that he got for his old home, he will have actually gotten a raw deal unless his intent was only to move to a new location. If he moved up in the world and bought a more expensive home, he will borrow again; the cost of fancy digs is higher rent. A home is not an investment; at best it is a forced savings account and rent control device.

Alas, Joe has been suckered by Sharkey into a cash-out refinancing or a HELOC. Worse yet, Sharkey has convinced Joe that since house prices are rising, the value of Joe's house must be increasing, and therefore Joe can borrow MORE than the difference between what he originally paid and what he still owes. And, even worse, Sharkey has talked Joe into an adjustable rate loan -- a loan which Joe is qualified to take on at its lowest increment, but which he has no hope of keeping up the payments on after it resets a time or two.

By now we see that Average Joe has no idea what he is doing. (But if you ask him, he will tell you how good a deal he got from Sharkey. At least until the first reset of his loan.) Joe sells Sharkey the rest of his interest in his house, and spends the money on a new pickup and a bassboat and a cute car for the wife; they also go to Disney World and watch the Pirates of the Caribbean without catching the joke underneath. And, guess what? His neighbors, Harry and Sam and Bebop (have to be multi-cultural in this neighborhood, you know) do exactly the same thing. Twenty-four months later they each get a letter from Sharkey. Sharkey is raising their rent by 2% of the total amount they each owe.

Joe and Harry and Sam and Bebop each get together with their wives to discuss this new development. Harry's wife, Zelda Sue, tells him he was stupid, walks out, gets a divorce, and the house has to be sold for the settlement. Joe's wife and Bebop's wife agree with them that they had better sell their houses; the signs go up the next day. Sam has a heart attack over the whole matter and his widow is forced to sell to settle the estate. Suddenly, there are four houses for sale on Joe's block.

Think : when supply is high and demand is low, prices go down. Three months later, all four houses are still on the market, and the four neighbors (OK, so they do miss old Sam) are now busy trying to undercut each other with the prices. Sam's widow gets desperate, and sells the house for the loan balance just to get out from under it.

Think : when people cannot afford to pay their debts, they default. Harry gets fed up with the situation and disappears; he does send Joe a postcard from Ecuador where he has a new job with a pharmaceutical company.

Think : when risk is high, investors look for high yields. Bebop finally gets a buyer, but has to do a short sale. His credit is no good, but he does manage to get another house in a poorer section of town, buying it on Land Contract at 15% interest (but look at the bright side -- it's a fixed rate!).

Think : when a man is broke and his credit is bad, he goes without. Joe? Joe is evicted by the foreclosure order. He and his wife are living in the pickup, and they aren't planning any vacations for a while.

Wait a minute, you say. You forgot the first one : when supply is low and demand is high, prices go up. No, I didn't forget the first one. Sharkey convinced Joe that prices were going up. Sharkey had an appraiser who would hit his numbers. Sharkey quoted government figures that painted a rosy economic picture. Sharkey lied; he didn't tell Joe that the neighborhood was overbuilt and that there were lots of empty houses to go around.

So here is a snapshot of the economy. For a decade it was buoyed by consumer spending while American industrial production fell and imports rose. For a decade the Sharkeys convinced people that they could borrow their way to prosperity. For a decade the economy was based on mortgage fraud and government economic deceit. For a decade, the money supply was artificially inflated by low interest rates, and foreign investors were suckered into buying overvalued mortgage backed securities.

All good things (and all bad things) come to an end. When the money supply could no longer be stretched because the foreign balance of payments was causing imported goods to rise in cost, interest rates were raised. At the same time, the adjustable rate mortgages began to reset, and the borrowers could no longer afford their rent. As they began to default in large numbers, sales prices on existing homes began to drop in a competitive spiral. As the money supply tightened, new constructions became harder to sell, their prices also declined, and defaults among the buyers of more recent new homes rose, again dragging prices downward.

When it became apparent that the margin of profit on the adjustable rate mortgages was declining, the investors began to look for more profitable venues, and as they sold their securities, first the sub-prime lenders, and then the mainstream lenders began to suffer from a lack of cash to continue lending, even to good credit risks.

We are now in the second full year of this debacle. The peak number of first-time resets is now occurring. That means that the peak number of foreclosures from default will begin in about six months. Through this entire time period, some real estate sales have been occurring. As I examine the lending data, it is appalling to see the high percentage of 100% finances; a huge number of homes in the past two years, in the face of the subprime melt-down, have been financed with 80% conventional fixed first mortgages and 20% adjustable second mortgages to make the down payment. I can easily see strong foreclosure activity occurring as far along as three years from now, short of draconian measures on the order of nationalization of the lending industry and restructuring of the loans.

America has been cash poor for some time now. Foreign investors, lured by the seeming stability of the mortgage backed securities, provided a significant portion of the cash that fueled residential real estate finance and consumer spending, all the while piling up an imbalance in foreign debt. The recent forced buyout of Bear Stearns at the command of the Federal Reserve did little but lower foreign confidence in the securities. There are other brokerages just as upside down in their portfolios; an investor needs to ask whether the risk of losing equity in a fire sale such as the Bear sale is worth taking on.

Remember that it was the oversupply of money created by the Fed's low interest rate policy that drove the consumer spending and foreign payment imbalance. The willingness of the Fed to lend money to the troubled lenders by allowing them to borrow against shaky securities cannot make our foreign trading partners see the dollar as a currency worth holding. The lowering of the discount rate will make taking on additional debt backed by US assets even less palatable. It could even be that lowing the discount rate could make mortgage lending more difficult since there would be fewer foreign investors willing to risk such a low-paying venture. And what will Big Ben do if lowering the discount rate does not cure the problem? Lower it to 0%? Offer to PAY investors to take Fed money?

We are living in interesting times. As I said above I do not understand what is happening in the financial markets. I only know one little saying that might fit the situation.

"it ain't over until the Fat Lady sings."