Backwards Walking - II

“You must admit it’s getting better, it’s getting better all the time…”
The Beatles

“The official Gross Public Debt is back up to $5,740 billion,” reports the Mogambo Guru. “The lie known as, ‘The Great Debt Buyback Hoax’ is now exposed. True, the debt level stopped getting bigger for a couple of years, but it never declined. This indicates that we didn’t go farther into debt. But that is a long, long way from actually reducing it.

“And government debt will accelerate from here. Consider that during the peak of economic boom when tax revenues were flooding into Washington, the best they could do was meet expenses. Now, Congress has stepped up its spending even as the Treasury reports that tax revenue is shrinking. The shortfall has to be made up from, as always, debt.”

Thus does the greatest nation in the world, the world’s only superpower, blessed with the greatest central banker who ever lived and more communications technology per square mile than any civilization in history, begin walking backwards.

Who would have imagined it, a few years ago? That was when the stocks were still rising at 18% per year and Alan Greenspan was still alive. But, the prosperity that stocks brought proved to be as foamy as the head on a draft beer or the Federal surplus. A few months later – it was gone. As the Federal Reserve itself calculates it, stockholders have backed down from a asset value of $12.3 billion to just $8.7 trillion since the end of ’99.

$4 billion of stock market losses rarely goes unnoticed. Since the end of ’99, more people have come to agree with us – perhaps 2 out of a hundred – that it was all an illusion. The rest remain convinced that this is merely a pause in the inevitable forward march of progress, perhaps with a little retrogression while we wait.

Harry Dent, for example, believes the Dow may drop down to the 7,000 level – before resuming its race to the stars. James Glassman still expects the Dow to hit 36,000 – eventually. Abby Cohen expects extraordinary growth in stock prices – even in the current year!

But many Americans have become skeptical of stock market forecasts. They now know that share prices can back up as well as go forward. So, they’ve turned their attentions to another asset class, one presumed to have no reverse gear. That is the subject of today’s letter – not the nation’s public backwards walking mortgage, but its private ones.

A “backwards walking mortgage” is what people in the industry call a mortgage in which the mortgage payments fail to keep up with the accumulated interest, so the principal gets bigger. If the mortgage walks backwards long enough, or if real estate prices fall, the mortgagee could soon be “upside down”; he would owe more on his house than the house is worth. At this point, a man who measures his wealth by his real estate holdings has a negative net worth. He no longer feels the burden of wealth upon his shoulders…because he is bankrupt, busted, broke.

Ever since 1945, homeowners have been trading more and more of their homes for ready cash. At the end of WWII homeowners had mortgaged only 15% of the value of their houses. Forty years later, the percentage had risen to twice that amount. But then, the desire to tap into the purchasing power of one’s own home seems to go the way of all flesh in the boom years. By 1998, owners’ equity had fallen to its lowest level ever…Americans’ mortgages had walked backwards to the point where they owned less than 55% of their own homes.

America could perfectly well get rich – even as a nation of renters rather than homeowners. Your editor rents his principal residence – an apartment in Paris – and feels none the worse for it.

But Americans typically count their wealth in square feet of housing space multiplied by the caliber of the neighborhood. This is their main capital asset. When real estate values go up, they feel richer. And unlike stock prices, property prices never fall – or so it is believed.

A chart from the Office of Federal Housing Enterprise Oversight reveals no contrary evidence. For the last quarter of a century, every quarter has produced a positive movement in U.S. housing prices. While Americans have lost $4 trillion on their stockholdings since the end of ’99, they have gained nearly a trillion on their real estate. Property is, once again, the big item on Americans’ balance sheets and their main chance of capital gains.

So sure must Americans be that home prices will continue to levitate that they spend the equity almost as soon as it appears. The rate of refinancing has skyrocketed to 50% of mortgage originations, up from just 15% a year ago. Fannie Mae’s “book of business” shot up at a 21% rate in July. And Fannie, sibling Freddie, and half-wit cousin the Federal Home Loan Bank system, have now accumulated $3.2 trillion in debt – an amount equal to a third of the nation’s GDP.

“Living standards can only be increased in two diametrically different ways,” writes Dr. Kurt Richebacher. “The normal one is for the long run and occurs through capital accumulation, that is, through saving and capital investment. The other one, the abnormal one, is for the short run and occurs through capital consumption, that is, through dissaving and massive borrowing…for consumption. America is practicing the second combination with abandon.”

Reducing the facts to their essentials, homeowners are borrowing against their main assets – and spending the money. The cars, home theatre systems, and vacations they buy lose their value quickly. But the debt remains. As more and more houses are refinanced, the nation’s homeowners walk backwards – rather like Amazon.com or TheStreet.com – using capital to finance current operations. They stay in business, but they get poorer by the day. How long will it be before they fall down?

We will see, dear reader, we will see.

Your ever-optimistic correspondent, enjoying the spectacle…

Bill Bonner
August 22, 2001

“We got in kind of a bubble situation…” explained Tom Seibel, describing the progress of the technology sector over the last 5 years.

And now, “the economic downturn has spread to every geography,” said Carly Fiorina, with “no signs of improvement in the market before 2002.” Fiorina is living proof that an illiterate woman can make it to the top of a major tech company…and drive it into the ground as well as any man.

Abby Cohen, another woman at the top of her profession, lowered her targets for stocks. But she still expects the S&P to end the year at 1500 – about30% higher than it is today!

It is the 2nd half…we’ve just had the 7th rate cut… “So where’s the recovery?” asks a USA Today headline…And what happened to the federal surplus? “White House concedes near wipe out of surplus,” reports the Financial Times, as the nation’s mortgages – public and private – walk backwards again…more below.

But first, let’s check in with Eric:

*****

Eric Fry in New York:

– If you were squinting real hard, you might have spotted a little good news in yesterday’s headlines – very little.

– For one: Semiconductor equipment sales improved in July for the third month in a row. The numbers, although improving, still look more bust-like than boom-like. The July book-to-bill ratio was .67 – meaning that chip- equipment makers picked up $67 in new orders for every $100 in deliveries. By comparison, the ratio in July of last year was nearly twice as strong, at 1.22.

– The news really didn’t seem like much, but it was enough to attract investors back to their favorite semiconductor stocks. The Philadelphia Semiconductor Index (SOX) gained about 5%. The rest of the stock market followed suit.

– The Dow climbed 103 points to 10,277, while the Nasdaq rose 29 points to 1,860.

– “Good News” item No. 2: General Motors weighed in with an announcement that it would meet its previous forecast of 83 cents a share in earnings for the quarter ending in September. GM’s stock rose 3%.

– But while GM put on a brave face, Volvo laid bare the grim truth. The Swedish industrial group warned that its truck division will reduce production to combat a severe drop in orders from the United States.

– Said Tryggve Sthen, president of Volvo Global Trucks, “The situation in North America remains very grave.” Also making headlines was news that the American Gas Association miscalculated the nation’s gas storage levels by about 50 billion cubic feet last week. If that sounds like a big number, that’s because it is. To say the error was “significant” would be an understatement.

– AGA’s initial estimate implied that the nation had consumed a mountain of natural gas during the prior week, and gas prices soared 12% on the news. But this week, the AGA “corrected” its earlier estimate and, predictably, the natural gas price collapsed to a 16- month low of $2.80.

– It’s a wonder traders believed either number. The announced totals are so vastly different from one another that they undermine the “counter’s” credibility.

– It is noteworthy that on the very same day that the AGA reversed itself by announcing that natural gas supplies are abundant, the American Petroleum Institute (API) reported “smaller-than-expected” inventories of crude oil and gasoline.

– Gasoline supplies fell for the sixth week in a row and crude oil supplies posted their largest decline in two months. Obviously, somebody is using this stuff. If demand for crude oil and gasoline is not evaporating, it’s a fair bet that demand for natural gas will not go away either.

– “Today’s sell-off in the natural gas stocks just might be a buying opportunity,” says John Myers of Outstanding Investments. We’ll see.

– One Daily Reckoning reader offered an insightful modification to my suggestion yesterday that billions in VC capital simply went “poof”: “The imaginary market wealth that investors thought they had all went away to money heaven as market caps came down. The VC money, on the other hand, didn’t go poof. The VC money was spent – every dime of it. It was spent on everything from Ferraris to Faberge eggs. All that money changed hands, and that has contributed greatly to the mess we are now in. Great chunks of those billions were spent on routers, servers, high-end office furniture, and hundreds of other types of goods. Sales of everything boomed. For the suppliers, this was the equivalent of giving a condemned man his last meal.”

*****

Back to Bill in Ouzilly – with a couple additional notes…

*** Who’s making money in this market? Investors Business Daily reports that the leading mutual funds are down an average of 21% so far this year. But investors in gold are doing well. Ed Bugos of the Goldendar letter:

“Outside of the REIT index, there is not a better looking stock chart than that of the average gold chart today. And any analyst that can disentangle from their anti-gold bias should be able to spot that. Another fact is that gold has outperformed every single paper currency this year – including the dollar.” The DR Blue Team’s Gold pick is up 12%+…

*** “The Cold War ended 10 years ago this week, with a whimper,” writes Bob Bauman. “That was when the ‘red barons’ of the Soviet Communist party, the KGB, and the Red Army tried to oust Mikhail GORBACHEV. The effort died in drunken disarray after 3 days, only to be replaced by the alcoholic Boris YELTSIN atop his signature tank in Red Square.”

*** I’ve returned to the country to spend the last few days of summer. Earlier this week, we drove to Paris to check out a new school for Maria, 15. Maria has not been doing well in the French school system, so we’re going to try the international system…schools that teach in English and award the equivalent of U.K. or U.S. high school diplomas.

*** Does it make any difference what school Maria attends? Or if she attends any school at all? Carly Fiorina, Abbey Cohen, and Paul O’Neill all graduated from high school. I wouldn’t want Maria to turn out like them.

*** The school we visited proudly announced that it emphasized environmental studies: “Teaching children how to protect planet Earth…” To that end, students are indoctrinated with the latest green fads – whether it is sorting trash or using cloth diapers. The gods must be laughing…