What A Difference A Week Makes!

Last week, as the Dow breached the 14,000 mark for the first time, bullish swagger on Wall Street went into overdrive. Some of the bulls that I'm often pitted against on television used the occasion to specifically heap scorn on my assessment of the U.S. economy and my investment advice. Although the attacks on my economic views were inaccurate on many levels, perhaps their largest oversight was that the Dow was propelled to its milestone largely as a result of multinationals that had seen their foreign earnings increase with the weak dollar. While many of these stocks set new 52 week highs, stocks primarily dependant upon the U.S. economy and American consumers were setting fresh 52 week lows. This divergence of performance provides strong evidence that the U.S. economy remains on track for a severe disruption.

More egregious however, was their dismissal of my investment advice. In their ridiculous attempt at a victory dance, they conveniently ignored the far superior returns produced by the foreign investments that I have consistently recommended for years. Given the unquestioned superiority of non-dollar investments, and the accuracy of my predictions regarding the continued weakness in the mortgage and housing markets, you would think the permabulls would have offered some grudging respect. But it seems their collective delusions regarding the "goldilocks" economy prevent them from acknowledging anything that doesn't serve to bolster their positions. So, despite a clear, well-documented, and unarguably successful track record, they simply assume that my clients have done poorly because I don't share their viewpoint. Their refusal to give me the slightest bit of credit for being right about anything might mean that they harbor a secret fear that I might be right about everything.

This week however, the preponderance of bad economic news on the U.S. economy finally trumped the good news coming from abroad. Perhaps the hardest pill for the market to swallow was Countrywide's admission that its earnings had been negatively impacted by late payments on its PRIME loans. This threw cold water on Wall Street's self-induced delusion that the problems in subprime had been contained. This notion had been so universally accepted that the very word "contained" has been conspicuously paired with subprime with almost every utterance.

However, from the onset I have repeatedly warned that subprime was just the tip of the iceberg. I have been writing about the dangers of the housing bubble for years. Here are some excerpts from my recent commentaries regarding subprime:

December 22, 2006, Subprime Disaster in the Making

The main problem is that the majority of these loans were made to people who really cannot afford to repay them and were collateralized by properties whose true values were but a fraction of the loan amounts. Once the music stops and prices return to earth, borrowers who put little or no money down may decide to simply mail in their house keys rather than make additional mortgage payments.

In addition, even those who can comfortably afford to pay may choose not too. Basically, zero-down, non-recourse mortgages give borrowers a free put option should real estate prices decline. The bigger the drop, the more incentive there is to exercise. Rather than throwing good money after bad, borrowers could simply return their over-priced houses back to their lenders and buy one of their neighbor's deeply discounted foreclosures instead.

Also, the idea that sub-prime foreclosures will not affect the broader market is absurd. These loans simply represent the weakest links in the mortgage/housing chain. Once they break the entire chain falls apart. The added demand from these marginal buyers helped produce and sustain the bubble. Remove it and the bubble deflates. Also, falling home prices and rising interest rates effect every homeowner, and the temptation to walk away from an upside down mortgage is not restricted to sub-prime borrowers.

March 9, 2007, The Worst is far from over

The current train wreck unfolding in the sub-prime lending sector provides a good preview as to what will happen to the entire credit-financed bubble economy when the funding dries up. Contrary to the self-serving rhetoric of Wall Street and housing industry shills, the entire mortgage sector is not insulated from sub- prime. In fact, sub-prime is just the tip of the credit iceberg. Beneath the surface lie similar problems in Alt-A and prime loans, where borrowers also relied on adjustable rate mortgages to purchase over-priced homes that they could not otherwise afford.

With the sub-prime market drying up, most first-time home buyers will be unable to buy. Without those 'starter-home" buyers, the trade-up buyers (most of whom have the ability to make down-payments and are therefore considered "prime borrowers") will be unable to sell their existing homes, and hence unable to trade up. This brings down the entire house of cards. Home prices must collapse, affecting all homeowners, regardless of their credit ratings.

Since 70% plus of the U.S. economy is based on consumer spending, how can we possibly avoid a recession if the credit well funding much of it runs dry? Since home equity has been the principal asset collateralizing that credit, how can consumers keep borrowing and spending when housing prices fall? I heard one commentator on CNBC claim that the U.S. economy was in great shape except for housing. To me that's like a doctor telling a patient that he is in great health, except for the javelin sticking out of his chest. If housing is going down, there is no way on earth the entire economy does not get caught in its undertow.

March 14, 2007, From the subprime to the Ridiculous

With the meltdown in the subprime mortgage sector now laid bare, many on Wall Street desperately cling to the notion that the pain will be localized. The prevalent delusion is that the overall mortgage, housing and stock markets will be little impacted by the carnage ravaging the subprime sector.

Those who think that the subprime market is unrelated to the broader economy do not understand that the problem is not just the fiscal responsibility of marginal borrowers, but the inherent weakness of the entire U.S. economy. It's just that the sub-prime sector, being one of the most vulnerable spots, is where the problems are first surfacing.

The bottom line is that far too many Americas, not simply those with low credit scores, have borrowed more money then they are realistically capable of repaying. The credit boom was created by initially low adjustable rate mortgages, interest only, or negative amortization loans, and an appreciating real estate market that allowed homeowners to extract equity to help make mortgage payments. Now that real estate prices have stopped rising, and mortgage payments are resetting higher, borrowers can no longer "afford" to make these payments.

Significantly, most sub-prime loans involved low "teaser" rates that lasted for only two years. In contrast, teaser rates for most prime ARMs typically last for five years. This difference, rather than any inherent distinction in the fiscal health or credit worthiness of the borrowers, explains why the delinquencies are so much higher in the sub-prime sector.

In reality, the problem goes way beyond housing. Nearly every big ticket item that Americans consume is paid for with borrowed money, with foreign lenders supplying the credit. Without access to low cost credit, the spending stops. When the spending stops the service sector jobs associated with robust spending will disappear as well. Without paychecks, even those with low fixed-rate mortgages and high credit scores will not make their payments.

March 22, 2007, Don't Uncork the Champagne Just Yet

One of the biggest bones the Fed threw to the markets in its last statement was its failure to directly mention the problems developing in the mortgage market. This omission suggests that the Fed is not overly concerned with the subprime crisis, or the possibility of that weakness spreading into the broader mortgage market or the economy in general. In other words, a problem isn't a problem until the Fed says it is. This ignores the fact that the Fed is reluctant to actually identify a problem, no matter how severe; for fear that such recognition alone might spark an even greater panic.

So with the apparent blessing of the Fed, Wall Street can now borrow a page from the Las Vegas promotional playbook and claim that "what happens in sub-prime stays in sub-prime." Unfortunately, like an out of work showgirl with a folder full of embarrassing photos, the problems with subprime will soon show up on everyone's doorstep.

June 28, 2007, Subprime Shoes Continue to Drop

The meltdown in the subprime mortgage market is inexorably spreading throughout the U.S. economy. Bear Stearns' reluctance to mark down the value of their overpriced CDOs is mirrored by an equal desire among homeowners to hold tight to their fantasies of real estate riches. Just as CDOs are not worth the "marked to market" value conveniently assigned by Wall Street, homes throughout the country are not worth anything near the asking prices listed on "For Sale" signs. Wall Street may be able to buy some time by bailing out troubled hedge funds to keep their worthless subprime mortgage investments off the market, but no such safety nets exist for strapped consumers looking down the barrel of resetting adjustable rate mortgages. Inventories will continue to balloon until reluctant home owners come to their senses and slash prices.

However, as I have been writing for years, the biggest losers in the real estate bubble will not be the borrowers who took advantage of easy credit, but the lenders who foolishly underwrote the loans. Some will lose 100% of what they invested, and those who used margin may lose even more.

The main problem was that Wall Street, hungry to feed the profit-rich CDO market, convinced the mortgage industry to abandon all traditional lending standards. In prior years, when borrowers were required to make sizeable down-payments, lenders were assured that borrowers would not knowingly commit themselves to mortgages that they could not afford, and that sufficient collateral would exist were defaults to occur. In addition, by verifying incomes and assets, lenders gained further assurance that loans would actually be repaid.

Once lenders dropped down payment requirements, the stage was set for the unfolding disaster. The advent of no-documentation loans, especially ARMs with teasers rates, interest-only payments and negative amortizations, further allowed risk free speculation to run rampant. Is it any wonder house prices rose so high when Wall Street allowed so many people to gamble with other people's money?

If borrowers actually had to put their own hard-earned money down, they would have thought twice before committing themselves to mortgages they could not afford. But once Wall Street took all of the risk out of real estate speculation, there was no reason not to roll the dice. So borrowers lied about their incomes and stretched to meet payments because if home prices kept rising all the profits would belong to them. For years it was a stunningly successful bet that minted real estate tycoons by the hundreds of thousands. And, if prices reversed course, they had nothing to lose, as they put nothing down. Buyers could walk away from their bad bets none the worse for wear, leaving lenders to cover their losses.

However, amidst the hysteria and oblivious to their own roles in perpetuating the bubble, lenders also believed that real estate prices could only go up. With such assumptions, defaults seemed unlikely and ultimately riskless (a foreclosed property worth more than the underlying mortgage is a boon). Also, in many cases, as hedge fund managers made huge profits by risking their client's money, both the borrowers and the lenders had no skin in the game. All the risks were transferred to those who purchased the re-packaged loans, and who are now left holding the bag.

All of the pundits and so called "experts" who did not see this coming still do not appreciate the magnitude of the mortgage disaster and how it will impact the housing market in general, the economy, the stock market, the dollar, interest rates, inflation, and the price of gold. They are content to believe government hype about the resilience of the American economy.

The curtain has yet to close, but if you listen closely you can hear the fat lady warming up in the wings. It has been one hell of a show, but there will be no encore. For those holding toxic mortgage paper there is nothing left to do but sue. However, even those who do not own this stuff are not in the clear. A much larger disaster looms for holders of U.S. dollar denominated assets in general. It will not be long before our foreign creditors realize that Uncle Sam is the biggest subprime borrower of them all and will similarly mark down the value of its debts as well.

More proof that the problems that initially surfaced in "subprime" are now emerging in other areas was evidenced by the horrendous losses being reported from home builders Beazer and Pulte and several more high profile companies blaming earnings shortfalls on weakness in the housing market. Still more evidence that the credit problems are anything but contained is Wall Street's failure to arrange for the sale of 12 billion in loans necessary to finance the Chrysler buyout. This calls into question the whole private equity buy-out craze, which had been a major driver of recent stock market gains.

Finally, today's GDP numbers revealed very slow growth in consumer spending. As ARM payments reset higher, home equity continues to vanish, and consumer prices continue to rise, actual declines in consumer spending are also likely in future quarters. In fact, to produce a 3.5% annualize gain in 2nd quarter GDP, the government assumes an annualized inflation rate of only 2.7%. My guess is that were a more accurate inflation measure used, the result would reveal what millions of ordinary Americans are actually experiencing -- that the recession has already begun.

Even with all of this irrefutable evidence that the credit rug is being pulled out from under the feet of American consumers, Wall Street's permabulls nevertheless remain undaunted in their blind optimism. Their one-way views are so myopic that they are blinded by their own arrogance. They are completely clueless regarding the fragility of America's bubble economy or the phony nature of a prosperity based on low cost, no questions asked consumer credit. Now that those doing the lending are rethinking the wisdom of doing so, the party is coming to an end. However, the permabulls have barely noticed that the music has stop playing and will likely be among the last to leave. Unfortunately for them, or anyone foolish enough to have confused their mindless cheerleading with legitimate investment advice, they will be broke by the time they finally do.

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