Go, Go, Godzilla

How much further away could the peak in the housing boom be now that the 40-year mortgagae has reared its ugly head?

This monster of financial leverage was last seen traipsing around the bewildering streets of Tokyo fifteen years ago. What happened after that is well known, but obviously, not well known enough. Now after a long hibernation, he has returned with Fannie Mae's decision to start purchasing these mortgages. (I thought that this institution was supposed to start taking on less risk!?) Combine this loan feature with another highly popular mortgage, the interest-only, or IO (which describes the borrower's state in perpetuity) and you have a combustible combination. Let the fireworks begin!

Some basic facts about these devices of financial destruction. A fully-amortized 40 year loan builds equity at only half the rate of the traditional 30 year variety. For example, after 5 years the longer term has only accumulated 3.5% equity in the home versus the 30 year's 7%. Also, after the shorter term loan has been paid off, the 40 year version still only has 50% equity built up!! Of course, nobody stays in their home for 40 years, so who cares? When you can reduce your monthly mortgage hit from $600 to $550 a month per $100,000 , why worry about 2045? On a $500,000 fixer upper, two-bedroom "cottage" in San Diego with zero-down, that is a "savings" of $250 a month. Wow, now I can have my house and a daily low-fat, vanilla mocha, soy, low-foam latte too!! How about if housing prices drop 1% a year for the first five years? This buyer would be "underwater" to the tune of $7,500. That's a lotta java! "No problem. I've got a zero-down, interest-only, 40 year mortgage and if the house has dropped in price when my banker starts asking for principal payments in five years, I will just hand him or her the keys." With almost 50% of San Diego buyers going the IO route this year, this may be a popular mindset. But with new bankruptcy laws going into effect in a matter of months, there may be a big surprise in store for these buyers.

Eighth Inning

Dallas Fed President Richard Fisher's recent comments serve to define the end-game to the bubble economy, even if, unlike Mr. Fisher I don't know how it will play out. But in the past few months, some interesting and worrisome developments have occurred. Here are some of the nasty little details:

POLITICAL DEVELOPMENTS

Recent unrest in Uzbekistan and Kyrghyzstan should be seen as dangerous signals to our foreign policy makers, yet these incidents seem to be underappreciated. While I don't think that a political upheaval in Kyrghyzstan will lead to World War III or a global meltdown, these events seem emblematic of a region which has become key to the world's security. It would appear that along with Pakistan and Iraq and more recently, Syria and Iran, the US is set on turning this area into a hotbed of radical Islamist activity. The seeds are being sown for the Middle East and Southwestern Asian states to become radicalized for a long time to come. With a large portion of the world's oil supply being drilled and/or transported in these areas, the long-term implications are for higher oil prices.

The brinksmanship going on between the US and China over currencies and tariffs is bothersome. While I don't believe that a full-blown trade war is likely, mistakes can happen and history is littered with examples of wars which never should have happened, but somehow, for even the most inane of reasons, did. Still, I think that it is more likely that we will see an actual shooting war further in the future, fought by proxies ("civil war" in Taiwan?).

The new bankruptcy law, entitled the Bank Abuse Prevention and Consumer Protection Act, comes at an interesting time. AFTER Americans have accumulated a massive debt load, Congress comes along and changes the rules. As long as it served their interests, banks were willing to go along with overly easy bankruptcy procedures which allowed debtors to clean the slate and start up a new cycle of indebtedness. My cynical side tells me that the banks now see the size of the their liability as being potentially fatal and are looking for Congress to make sure that the massive debts they have encouraged consumers to take on are actually repaid. This legislation is at least twenty years to late or ten years too early. To change the rules in the middle of the cycle (the peak) is not only unfair, but dangerous. The unintended consequences of this act will be very painful and will be felt far and wide.

With all of the zero-down, negative amortization, interest-only, adustable rate nonsense being offered in the mortgage markets, it is obvious that abuses are widespread in the industry. There are now rumors that Elliot Spitzer is investigating the sub-prime lending companies. My personal opinion is that 90% of lending these days is sub-prime. But you can already see the headlines of 2006 and 2007, as Mr. Spitzer furthers his career by ferreting out the abuses in this most overheated of "industries". Stay tuned....


ECONOMIC/FINANCIAL DEVELOPMENTS

In a related matter, there are reports that the government watchdogs are concerned about these very same lending practices and are or will be tightening up the standards at Fannie Mae and Freddie Mac. As I literally heard a commerical for a 1% rate and $99 fee mortgage as I was writing this missive, I would humbly submit it is too late and they might as well leave the barn door open, as it will not make a difference.

An even more troublesome development is the stagnation of the housing markets in the other Anglo countries. Reports from Australia and the UK indicate that the housing markets there have stalled, with even some modest price declines having been registered. How long before these problems reach American shores? Once it has been popped, the housing bubble in the English-speaking countries (and yes, Virginia, there is a housing bubble) will leave these countries with a massive hangover and will likely mark a massive shift in wealth to the Asian countries, which have provided much of the liquidity for the boom. Although it will be interesting to see how it plays out in China, which has its own real estate bubble. My guess is that everyone will get hurt. But the key to getting ahead is getting hurt less. That is what happened to the US in the Great Depression and set the stage for US domination in the remainder of the 20th Century.

In the long run, these developments will be devestating for the US dollar. But in the short-term, the dollar should be bolstered as interest rates in the US rise or at least firm, while overseas rates stay low and as the economy weakens there should be increased competition for dollars required to service massive indebtedness. Of course, this will eventually lead to another "easing", where the new Fed chief tries the magic of easy money, once more. But this will likely lead to a dollar meltdown, as foreigners escape a currency with miniscule returns and little integrity. After all, they can get that at home.

Dropping bond yields are telling us something. We won't know what it is for sure until later, when we will curse ourselves for not seeing it earlier. But the standard interpretation would be that the Fed's rate increases are working, slowing the economy. Whether this leads to a recession or not only time will tell, but it would only take three or four more increases at a "measured" pace to invert the yield curve and put the odds of a recession near certainty.

Even at today's yields, the carry trade which banks and hedge funds have been taking advantage of for the past few years is becoming less and less profitable, day by day. So even if the Fed stopped hiking today, the bond market may do the work for it anyway, by lowering long-term yields enough to reduce the spread to unprofitable levels.

STOCK MARKET

There has been some discussion of the old adage, "Sell in May and go away", recently. But my take on it is a little different. In a world in which everything has been turned on its head, looking at developments while standing on one's own head may be the best strategy. In the case of the stock market, since it is my belief that we are witnessing a cyclical rally in the midst of a secular bear market, we should expect some of the typical behavior of the market to change. Since typically, the market is choppy or corrects during the late spring/summer months in a bull market environment, we should not be surprised to see stocks firm during these months in a secular bear environment. This is what I believe is happening right now. But beware, as this rally will not last forever. It is my belief that the rally has only a few weeks left before the secular bear trend reasserts itself. Then the two year plus rally from Oct 2002 or March 2003, however you would like to count it , will be over and the bear will return with a vengance. A return to 1633 on the Nasdaq 100 is quite possible and it is quite possible that would be an excellent selling level that will not be seen for many years after. The smart money is aware that we are in a "blow-off" phase of the speculative mania which has gripped this country for the last ten years and those who are wise will take these next few weeks to prepare for the mania to end. The harsh daylight of reality will be a sobering experience for Americans who do not take the time to prepare for the end of the ninth inning.