Mortgaging The Farm

Nothing comes from nothing

Nothing ever could

The Sound of Music

“Equity Shrivels as Homeowners Borrow and Buy” declares the New York Times headline.

“So what?” replies the New Era believer. “Instead of equity in an unproductive asset, a house, they have stocks – equity in profit-making businesses. Everybody is better off.”

In most people’s view of things, mortgaging the house is a shrewd move. At least, it has seemed shrewd. For almost anytime during the last 18 years, both real estate prices and stock prices were rising faster than the net cost – including tax advantages – of a mortgage.

The shrewdest thing to do, in fact, was to buy the most expensive house you could possibly afford, in the most expensive and fashionable area…and then mortgage it at more than its market value. The mortgage might cost, net of taxes, only about 6%. But property in places such as San Francisco or Manhattan, Silicon Valley or the Hamptons, was rising at 15% to 30% annually.

What’s more, by investing the mortgage money in growth stocks, you had a chance to profit as fully as possible from the last great asset boom of the 20th century.

The NY Times reports that few people missed the trick: “The average home owning household owed lenders 46% of the market value of its residence during last year’s third quarter, up sharply from about 30% in 1982 and 40% in 1991… For a typical family with a home worth the median market value of $144,000 late last year that meant their equity was $77,760 while their debt was $66,240.”

Gone are the days when American families celebrated paying off the mortgage – breathing a sigh of relief and enjoying the security of knowing that, even in a pinch, they would not be out on the street. People are so confident of America’s economic miracle they’ve given up ownership of part of their own homes in order to participate.

What would happen if the prices of homes and stocks go down – as they tend to do at the end of an asset bubble?

“In a longer recession,” said Mark Zandi, chief economist at Economy.com in West Chester, PA, “housing prices would weaken and many homeowners could easily find themselves owing more on their homes than the homes were worth.”

But in today’s letter I intend to forebear from spelling out the obvious consequences of a bear market. Instead, I want to explain why the prosperity of the late ’90s was a fraud. As you will see, the declining equity that Americans have in their homes is not so much a threat to their future wealth – as an indication that wealth has already disappeared. Like an illicit lover hiding in a closet, the fact merely awaits discovery.

The head of the household will discover it in due course – and in the old fashioned way. Eventually, his portfolio statement will reveal that his stocks have fallen. About the same time, news will spread that neighborhood houses are not selling quite as fast as they used to…and that sellers are getting less for them.

Even worse news could reach him, too. Perhaps he will find that his employer requires fewer overtime hours from him…or that he is out of a job altogether. Thus, will his clever financial strategy – which worked so well during the upswing of the credit cycle – prove ill suited to the inevitable contraction.

But, you and I, dear reader…we cannot wait for the light of experience to light up our path. We have to use our imaginations…we have to try to anticipate these events before they happen so that we can prepare for them. And that will require poking around in the most dismal corners and attics of the most dismal science.

To that end, I refer to the work of Dr. Frank Shostak, an Australian economist, quoted at length in Marc Faber’s most recent newsletter. “Wealth is always generated by means of land, labour and capital goods – i.e. tools and machinery,” writes Dr. Shostak.

A man with $100,000 in savings and no house can exchange the accumulated sweat of his brow for a house. So far, so good. But what happens when he then takes out a mortgage for the house – for the full amount – and invests the money in IPOs? Now, he owns the house, subject to the mortgage, and $100,000 worth of stocks. The mortgage company now has a $100,000 asset too…and companies whose stocks he bought also have $100,000 in cash.

This transaction, rehearsed millions of times, brings a flood of cash to the stock markets – which raises stock prices. The investor with $100,000 worth of stocks soon finds that his stocks have gone up. His house, too, has increased in value. So he doesn’t mind spending some of his new wealth on a higher standard of living. And the companies on Wall Street, flush with cash, don’t hesitate to put it to work – hiring more people, buying advertising, launching yet more risky ventures.

“A pathetic side of the manipulation of credit in modern times,” wrote Freeman Tilden in his book, A World in Debt, in 1935, “is that the owners of capital, especially the little capitalists, are swept into a pool of adventure, in which the actual lending of the capital is on a great scale and performed by central agencies alleged to be so expert in debt-trading that it is better to entrust all to them. In this way loans are made and debtors accommodated, representing risks that the owner of the money, were he lending directly, would never dream of taking. It is supposed that the great professional lenders are vastly experienced, and possess almost magical discretion. The truth is that these pompous egotists throw money around, in prosperous times, with as much abandon as though it were confetti.”

“When money is printed – i.e. created ‘out of thin air’ – it sets in motion an exchange of nothing for money,” explains Shostak, “and then money for something – i.e. an exchange of nothing for something. An exchange of nothing for something amounts to consumption that is not supported by production. Since every activity has to be funded it follows that an increase in consumption that isn’t supported by production must divert funding from wealth- generating activities. In short, inflation, or rises in the money supply, creates an economic impoverishment.”

America has gotten poorer in the last five years – not richer. That fact will be the most sensational new discovery of the 21st century.

More to come…

Bill Bonner Paris, France January 23, 2001

*** Monday was a slow day on Wall Street. Not much action in either the Dow or the Nasdaq. The Dow fell 9 points. The Nasdaq fell 12 points.

*** Dell caused a little excitement – warning that selling computers was not as hot a business as investors had hoped. The stock fell…but came back before the end of the day. Gateway, by contrast, lost 9%.

*** Gold rose $2 to $267. The HUI – an index of gold mining companies – rose 7%. Homestake climbed again…it has moved up 50% in the last few months.

*** Is gold a good investment now? I don’t know if it is ever a good investment. But it might be a very good protection in case problems with securitization, derivatization, and globalization become worse than is popularly imagined.

*** And if books and articles on the subject are any indication, investor psychology may already be changing with regard to gold. Doug Casey: “Just as a spate of pro- gold books were published and did well in the marketplace back in the 70s, the same is happening [with anti-gold books] now after the 21 year bear market has bottomed. People like to hear positive, reinforcing things at the top of a market; and they love negatives at the bottom”

*** Bloomberg sees no fall off at the top end of the real estate market. In California, sales of million dollar houses rose 50% in 2000. In Manhattan, prices of apartments on 5th and Park avenues rose 47% – in the 3rd quarter!? That couldn’t be right, but that’s what it says. Prices in the Hamptons rose 41% in the 3rd quarter to an average of $680,947 for a single-family house.

*** Americans own $14 trillion worth of stocks and $11 trillion worth of real estate. Even a 10% decline in asset values would wipe out $2.5 trillion in wealth. But people tend to owe a lot more money against their real estate holdings than against their stocks. The New York Times reports that homeowners have borrowed against their own property as never before…

*** “The borrowing has been so extensive, in fact,” says the Times article, “that homeowners, after building up equity through much of the 1960’s and 1970’s, have let their ownership shares deteriorate over the last two decades to the lowest level on record… Now a slowing economy catches the average household owning less of a stake in its home than in any economic slowdown since the advent of the modern mortgage in the 1930’s.” More below…

*** “…The only thing that might reinvigorate the consumer is a replay of 1998,” writes David Tice in this month’s Strategic Investment. “That is, another refinancing boom.” When the Fed cut rates three times in the fall of 1998, Tice explains, it did more than bail out Long Term Capital Management. In fact, the Mortgage Banker Association’s index of refinancing quadrupled from the end of June to its peak on Oct. 9, 1998. Nearly 10 million U.S. homeowners refinanced their homes in 1998 alone. “Unfortunately, rather than shoring up the consumer,” Tice continues “the refinancing boom piled on more debt.”

*** Investors are now talking about the NEXT rate cut – expected next week. Will it be 25 bps? Or 50? But Jimmy Rogers is still wondering about the last one. “It is astonishing that they cut rates,” he wrote to Marc Faber recently, “The Dow is within a few percentage points of its all time high. The S&P is only down about 12%. Even the Nasdaq is just back to where it was two years ago. It’s certainly not at 10-year lows or at 16-year lows as is Japan. The man [Greenspan} is throwing fuel into a raging fire, which is going to consume him.”

*** Rogers expects the conflagration to ignite commodities. “We are in the early stages of the new multi-year bull market [in natural resources],” he writes.

*** You will remember, many of the Big Techs get a large part of their profits not from operations but from their investment portfolios. They frequently invested in other up-and-coming techs. Who would be in better position to know which new tech companies would succeed than their customers and clients in the industry? But Fred Hickey looked at Intel Capital’s positions and found it held the same turkeys that everyone else owned: CMGI, Corad Communications…eToys…and so forth. The value of Intel’s holdings fell from $5.85 billion on September 30 to $3.74 billion on December 30. “The portfolio’s decline,” comments Hickey, “is far worse than the Nasdaq’s, since Intel’s positions are primarily in second and third tier companies.”

*** California’s two big utilities are in default on their loans and could be pushed into bankruptcy any day. With $12 billion in debt between them, together they would comprise the biggest bankruptcy in U.S. history.

*** Bankruptcies rose 23% in Japan last year, leaving record debts of almost 24 trillion yen.

*** What’s wrong with the Japanese? Milton Friedman says it’s simple: they’ve failed to increase the supply of money at a fast enough pace. Maybe so. Could it be that simple? Not likely.

*** My son Edward, 7, was so impressed with the Pokemon phenomenon that he has been collecting the cards for the last year and a half and decided he wanted to be Japanese when he grew up. Alas, I read in the newspaper today that the Pokemon mania has collapsed. Rare cards that brought as much as $375 last April can now be purchased for only $100. The Pokemon bubble blew up at about the same time as the Nasdaq. Edward, my boy, you waited too long to sell.

*** “Warming of Earth Raises New Alarm,” says the front page headline in the International Herald Tribune. Uh oh…this must serious. According to the paper, an authoritative new report shows that “global temperatures are rising faster and higher than most experts feared only a short time ago – faster, in fact, than at any time during the past 10,000 years according to one climate scientist.”

*** “Some scientists say they believe that…an uneven warming process has already begun with the march of the Sahara desert into parts of southern Europe…” Wow…the Sahara is going to do to Sicily and Andalusia what Sherman did to Georgia!

*** This winter, and the last for that matter, has been unusually mild here in France. The temperature has only dropped below freezing on a couple of nights.

*** Steve Sjuggerud writes with what he believes is a real “no brainer” investment for a post-dollar, post-glacial world: “Here is Iceland government paper,” he remarks. “Right now in Iceland, we can earn a yield of over 11% in one-year Treasury notes. This is nearly twice what you can earn in one-year U.S. government paper, and Iceland’s government finances are in much better shape than the U.S. Over the long run, the currency of the country that saves is worth more than the currency of a country in deep debt. So in theory, Iceland’s krona should strengthen against the U.S. dollar. In practice, the Iceland Krona is fairly tied to the new European currency, the euro…”

*** Steve, by the way, is leading an investment discovery tour on the other side of the globe… to Argentina on March 29 – April 8th of this year. Apart from meetings with high-level Argentinean businessmen and government representatives, the trip sounds rather enjoyable: “our trip will take us to the ‘Paris of the Americas,’ Buenos Aires, where we’ll take in a tango, while enjoying the world-famous steaks,” writes Steve, “… and to a five star hotel in a tropical rainforest on the Brazilian border – overlooking Iguaza Falls, the world’s most spectacular waterfalls…”

*** And DR reader MK explains why cows in California are agitated: “The cutting of electricity and the scarcity of gasoline will wreak havoc with the dairy industry in California and the rest of the country. California is the largest dairy producing state in the country. I think it now produces more dairy and cheese products than Wisconsin. Cows that produce milk must be milked at least once a day or they stop producing. In today’s industrial age, they are usually milked by milking machines, not by milkmaids. The milk must be refrigerated… and shipped in refrigerated trucks. Product (milk, cheese and other dairy products) that cannot be refrigerated will either be dumped or sold to the government for lower price, because the manufacturers cannot afford the risk of selling bacteria/mold-infected products. A World Net Daily article reports dairy farmers were dumping milk yesterday… If the blackouts continue or get worse, things could get real ugly in a real hurry, not only California but the rest of the country, as well, because of our dependence on California for food.”