Monday, November 20, 2006

Views on the Housing Market

As regular readers know, I am a housing bear. Together with that, I am actually an economic bear. I believe that this housing bubble collapse will lead to wholesale changes in spending patterns, particularly among boomer households, who are as a group woefully unprepared for the retirement that looms for many.

An asset price decline will lead to a negative wealth effect and coupled with actual income declines (most boomers are planning to have only 60-80% of their pre-retirement income in retirement, while they currently spend more than they earn), will lead to a major depression not seen since the 1930s.

In this article from John Mauldin, A. Gary Schilling, a noted Yale professor (and real estate bear) reviews all the reasons why the bear market in real estate is only getting warmed up. He makes frequent mention of how the real estate bubble resembles that of the 1920s. While Schilling does not seem to believe that we are headed to the 1930s he does mention the possibility. It is critical to understand that the depression of the 1930s was NOT caused by the stock market crash. The crash was indicative of (the decline) of other economic activity. The post-crash connection was made by anti-capitalist politicos who played up populist resentment of Northeastern bankers to win elections in 1932, 1934 and 1936. But here I digress.

The depression of the 1930s resulted from an attempt by the Federal Reserve to unmake a massive inflation in caused with easy money in 1926. In that year, the Bank of England wanted to return to the gold standard, and do so at it´s pre-WWI peg. While this action satisfied British egos, it was monumentally stupid. Wartime expenditures had led to a massive increase in pounds stirling in circulation, and gold supply simply had not kept up. So, when the UK returned to its peg, gold started flowing out of the country. The BoE was in danger of dropping the peg when it prevailed on the Fed to cut interest rates to reverse the outflow of gold. The Fed complied, and dropped nominal rates by over 100 basis points, and gold started flowing out of the US and to the UK where it could be put to work at higher rates.

This drop in rates, however, led to speculative borrowing in the US. It also led to a temporary increase in the price of farm products (which had enjoyed war-influenced high prices since 1915: the war had destroyed significant acreage in Europe, and the Continent was forced to import food, leading to high prices). All of this came to a head at the same time. By 1928, Continental acreage was coming back under tillage, increasing supply, while subsequent increases in interest rates (used to reduce speculative purchases of coastal real estate) meant that farm loans, and their interest payments now exceeded the revenue that family farms could generate. While this may seem laughable today, it was significant in a country where half the population still lived on farms. Banks failed all over the place, but most severely in the Midwest and West, where banking laws forced the Bank of Podunk to take deposits and make loans in Podunk. With such concentration of portfolios, substantially all of the assets of the bank (loans to the farmers of Podunk, secured with mortgages against the farms of Podunk) were devalued together. Once the banks failed, even farmers who weren't in default found themselves with their savings wiped out (remember, there was no deposit insurance).

But, I hear the reader say, we have much more sophisticated risk modelling today: banks have better risk management, they are no longer limited to lending in the neighborhood, through securitization, they can lay off significant risks (and purchase risks from other markets), the Federal Reserve has 80 more years of education under its belt, and we have deposit insurance.

All of these things are true, but what we need to recognize is that we have also transferred risk to individuals on a scale we have not had since before the Bad Deal. While this is not a bad thing (it enables those individuals to profit from the risk premia they have assumed, for instance), many of those risk-takers do not understand the risks they are taking. This means that they may not be insisting on the premiums they require. While there may be deposit insurance on savings, there is no such insurance on the equity and mutual fund portfolios that comprise the vast majority of the financial assets of Americans. The Federal Reserve seems just as willing today to make poor economic decisions in the interest of politics, namely the Greenspan inflation, which I have discussed often. Finally, let us not forget that Japan had all the same advantages when it entered its 15 year "lost decade". Asset prices still have nor recovered to pre-collapse levels. And the US lacks the significant exports and current account surplus that Japan has used to bolster economic activity.

This real estate collapse will be unlike any we have seen. I think Schilling´s projections of a 25% drop in prices is quite realistic. Only a major inflation can prevent it.

I continue to recommend defensive positions. An interesting suggestion of Schilling (who believes interest rates are headed lower as part of the deflation) is to purchase long zero coupon bonds. Prices of such bonds are going to skyrocket if rates decline to 3% as he believes.

I am looking to investigate this option seriously.

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