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As I peered about this week searching for indications that the housing market malaise has spread to other markets, several prime candidates emerged: 1) Weakness in the durables orders. ‘Durables’ are consumer items meant to last three or more years and a new house consumes a lot of them. Washing machines, water heaters, and stoves would be examples. 2) A drop in trucking tonnage (all the materials to build houses arrive by truck). 3) Significant stress in the subprime bond market. What in the heck is a ‘subprime bond market’ you ask? Subprime bonds are the financial equivalent of loaning money to your no-good, drunken uncle. Sure, he might pay you back, with interest, or he may not, with “not” enjoying a sizable advantage over “might” when he’s on a binge. Subprime bonds are loans made to people &/or companies that have less than stellar prospects for paying the loans back. An example would be an interest only mortgage made to a person that has missed loan payments in the past and has a spotty work history. Subprime loans have high interest rates and are usually the first to go belly up during an economic downturn, which makes sense since the borrowers involved typically have shaky cash flows and low financial reserves. One large and potentially dangerous part of the subprime market is encompassed within the pleasant sounding name “asset back securities”, or ABS market. As the name implies, these are pools of loans backed by some sort of asset. They could be a pool of credit card receivables, a pool of auto loans, or a pool of home equity loans. One feature of an ABS is that all the loans in the pool share a similar risk profile. Imagine that all of the loans in a given pool had been made to men like your drunken uncle, and you’ll have the right mental image. OK. Why do we care about all this? In normal times the proportion of risky mortgages would be quite low but these aren’t normal times. Under Alan Greenspan’s guidance the Federal Reserve allowed bank-lending standards to plummet and Bernanke hasn’t seen fit to correct that situation. I doubt they’ve ever been lower. In far too many cases, mortgage applicants were allowed to state their income (usually lying in grand fashion while doing so), while obtaining an interest-only negative-amortization loan with a piggyback so that they could walk away from the signing with cash and a loan-to-value ratio in excess of 100%. I wish I were joking, but I am not. In 2005, 25% of all mortgages option ARMs where the borrowers overstated their income by 50% or more.
Here’s how the Washington Post summed it all up (emphasis mine in all cases below): It's been more than a year since we've heard from those who denied there was a housing bubble. But just when you're feeling hopeful again, you get reports like yesterday's Wall Street Journal piece reporting that delinquency rates are suddenly soaring on all those loosey-goosey subprime mortgages. They are starting to cause real heartburn for pension funds and other investors who bought securities backed by those mortgages on the theory that they were no more risky than a Treasury bond. "We are a bit surprised by how fast this has unraveled," Thomas Zimmerman, head of asset-backed securities research at UBS, told the Journal, removing his head from the sand. Trust me, Tom, you ain't seen nothin' yet. After the subprime loans come the 100 percent, interest-only loans, followed by the meltdown in the overbuilt multi-family housing sector. How did all this happen? How did all these risky sub prime loans get written? The example provided by this recently failed subprime mortgage company is instructive: Former Washington Huskies football player Scott Greenlaw led the mortgage company he founded to dizzying heights — 400 employees, a sprawling new headquarters and kegs of beer at staff meetings. Now he's selling his house to avoid bankruptcy as creditors line up with lawsuits. Merit employees proudly posted their résumés, plus photos of their luxury cars and drinking parties, on various Web sites. One loan officer had come to work fresh from being a Hooters Girl. Another solicited clients for two endeavors: writing mortgages for Merit and selling marijuana paraphernalia on the side. Indeed, several Merit loan officers boasted online that doing drugs was a favorite pastime. "Let's get hopped up and make some bad decisions," wrote one beside a photo of himself grinning broadly. Ha ha ha! “Let’s get hopped up and make some bad decisions”. After all the fancy talk about ABS this and subprime that it turns out that you really need look no further than the story above to grasp where we are headed and why. Not that I have anything against hopped up Hooter’s girls pushing mortgage loan products after leaving a kegger, mind you. I’m just thinking that maybe there’s some room for improvement somewhere in that process. Sarcasm aside, fraud is a key characteristic of periods defined by loose lending standards and abundant, easy credit. Relaxed lending standards and fraud gave us the S&L crisis in the mid-1980’s and we will uncover massive amounts of fraud this time as well. That’s just how these things work. Just how much the fraud will contribute to the overall crisis remains to be seen. Of course we have nothing to worry about in the housing market because government figures reveal that house prices remain firm, right? Unfortunately, as this New York Times article reveals, the government numbers do not mesh with reality. The truth is that the official numbers on house prices — the last refuge of soothing information about the real estate market on the coasts — are deeply misleading. Depending on which set you look at, you’ll see that prices have either continued to rise, albeit modestly, or have fallen slightly over the last year. In reality, homes across much of Florida, California and the Northeast are worth a lot less than they were a year ago. The auction in Naples may have exaggerated the downturn in the market there, but not by much. Tom Doyle, a Naples real estate agent, estimated that a typical house there, sold in the normal way, would go for about 20 percent less than it did the previous fall. In the Boston area, prices have fallen about 10 to 15 percent since the middle of 2005, estimated Chobee Hoy, who owns a real estate brokerage firm in Brookline. Jerome J. Manning, who runs the Massachusetts-based auction company that conducted the Naples sale, told me he thought that values had dropped about 20 percent around Boston. (The government, meanwhile, says the average price rose 1 percent from last summer to this summer. But here’s all you need to know about how well the government tracks the Boston market: the index excludes any mortgage larger than $417,000.) Whaaaaat? How could this be? Official numbers called into question? By the New York Times? If you ask me, pointing out that reality is far different from official proclamations seems like something that should be reserved for the old USSR. Or perhaps modern Britain: The cost of living for many British households is up to four times the Government's published rate of inflation, The Daily Telegraph can reveal. Millions of families are experiencing inflation far beyond the official rate of 2.4 per cent, new research suggests. The Government was last night accused of neglecting hard-up families as the research shatters the illusion that the Consumer Price Index - used by the Bank of England to set interest rates - represents the true cost of living as experienced by many households According to the study, pensioners' costs rose by 8.9 per cent in the 12 months to October. This is an amazing article. Stunning really. A UK paper commissioned their own study of inflation statistics (hint, hint US press) using the government’s own data and found vast differences between the rate of inflation claimed by the government and what was being experienced by various classes of people. John Williams of Shadow Statistics explains the how’s and why’s of this far better than anybody and I invite you to take a tour at his site if you are not already familiar with the motivations and methods of our government in producing deeply flawed, if not fraudulent, economic statistics. But imagine if you were a pensioner in the UK and were experiencing an 8.9% rate of inflation but were being compensated by a government that had adjusted your pension check for a 2.4% rate. It wouldn’t be long before you’d be unable to provide for yourself. When confronted with the inadequacy of their methodology, how did the UK government see fit to respond? They said: A spokesman for the Office for National Statistics said: "The CPI and RPI are specifically not intended to measure what people often refer to as 'the cost of living'." Well than, what are their inflation gauges ‘specifically intended to measure’ if not the ‘cost of living’? The price of dying? The cost of survival? I didn’t realize there was any other proper intended use for an inflation measure besides tracking the cost of living. Really I am stumped by this particular rationalization Moving on, one other item you should keep a close eye upon is the amount of insider selling of stocks that we are experiencing. While companies have been using profits (and new debt) to repurchase record amounts of their stock off the open market, thereby supporting stock prices, the executives of those same companies have been dumping their personal shares at the fastest clip since 1987. December 7, 2006 -- America's corporate chiefs are unloading their own stocks at one of the boldest paces in 20 years. In cases of the very rich, such as Microsoft's Bill Gates and Google's top brass, the executives are selling a whopping $63 for each $1 of stock they bought, says a report by Bloomberg. In November alone, leaders of public companies dumped $8.4 billion worth of stock they owned as insiders, most of it awarded as compensation, bonuses or other management incentives. Because they are better positioned than anybody, insiders generally do not dump their stock if they think their company prospects are good. In the past, high levels of insider selling have been a reliable indicator of impending economic weakness. In summary, housing has clearly weakened to the point that we are now seeing stress both directly and indirectly as durables, trucking and mortgage based ABS securities have fallen off. Further confirmation of impending weakness is provided by the massive stampede of insiders getting out of their own company stock. The only place we haven’t yet seen the weakness is in the stock market itself but there are any number of valid reasons why there should be more gauges on your dashboard than the stock market index levels. Keep your eye on the data, decide for yourself what’s really going on, and think about how you can protect your personal finances from any coming weakness. In the meantime, try to avoid getting hopped up and making some bad decisions. All
the best,
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