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by Chris Martenson
Time to Prepare – Massive Federal Deficits Announced
PREVIEW by Chris Martenson
by Chris Martenson

In the magazine The Economist, they recently reported this interesting bit of news:

Federal Debt could go to 400% of GDP

On January 7th the Congressional Budget Office (CBO), a non-partisan outfit, released projections that show the financial crash and the resulting recession are already wreaking havoc with America’s finances. It reckons that the budget deficit will soar from $455 billion in fiscal 2008 (which ended last September 30th) to an astonishing $1.2 trillion in the current year. At 8.3% that would be the most as a share of gross domestic product since the second world war.

But the underlying picture is worse for several reasons. First, it does not include any estimate of the cost of Mr Obama’s planned fiscal stimulus, which he will seek from Congress soon after being inaugurated. Second, the CBO assumes all of George Bush’s tax cuts will expire as scheduled at the end of next year and that the Alternative Minimum Tax, a parallel levy aimed at the wealthy, is allowed to ensnare a growing share of the middle class each year.

One thing to understand about even the horrendous sounding “8.3% of GDP deficit” is that it is vastly understated. First, as they note in the article, not everything is being counted, such as the cost of the stimulus plan.

But second, even if such excluded costs were counted, it’s important to note that the way the government reports its fiscal condition would be illegal for any public company.

Federal Debt beginning to “go vertical”
by Chris Martenson

In the magazine The Economist, they recently reported this interesting bit of news:

Federal Debt could go to 400% of GDP

On January 7th the Congressional Budget Office (CBO), a non-partisan outfit, released projections that show the financial crash and the resulting recession are already wreaking havoc with America’s finances. It reckons that the budget deficit will soar from $455 billion in fiscal 2008 (which ended last September 30th) to an astonishing $1.2 trillion in the current year. At 8.3% that would be the most as a share of gross domestic product since the second world war.

But the underlying picture is worse for several reasons. First, it does not include any estimate of the cost of Mr Obama’s planned fiscal stimulus, which he will seek from Congress soon after being inaugurated. Second, the CBO assumes all of George Bush’s tax cuts will expire as scheduled at the end of next year and that the Alternative Minimum Tax, a parallel levy aimed at the wealthy, is allowed to ensnare a growing share of the middle class each year.

One thing to understand about even the horrendous sounding “8.3% of GDP deficit” is that it is vastly understated. First, as they note in the article, not everything is being counted, such as the cost of the stimulus plan.

But second, even if such excluded costs were counted, it’s important to note that the way the government reports its fiscal condition would be illegal for any public company.

by Chris Martenson
Tuesday, May 27, 2008

Executive Summary

  • In this report, I lay out my near- and intermediate-term investment themes.
  • My assessment is that the economic and financial risks are exceptionally high and possibly historically unique. This is no time for complacency. A defensive stance is both warranted and prudent. A 50% – 70% (real) decline in the main stock market indexes is a distinct possibility, and portfolios should be ‘crash-proofed.’
  • Heeding the calls that “a bottom is in” and “the recession could already be over” could be hazardous to your wealth.
  • The recession is just beginning and will be the worst in several generations.
  • Residential housing data is still accelerating to the downside, while commercial real estate is just beginning its long date with tough times. There is no bottom in sight for either.
  • Inflation for life’s necessities is up, and rising energy costs will likely keep certain items at persistently high – and rising – prices for a very long time.

Bottom line:  My assessment is that the financial and economic risks that currently exist are exceptional, historically unique, and possibly systemic in nature, and therefore call for non-status-quo responses. A defensive stance is both warranted and prudent. As for timing, my motto is, ‘I’d rather be a year early than a day late.’

Some Context

I am an educator and a communicator, and I focus on using the past to view the future. Some might consider me a futurist. I think of myself as a realist, and I try to let the data inform me about what’s going on. Of course, the extent to which the data is flawed represents the risk of being wrong.

My goal is not to simply inform, but to inform in a way that leads to you take actions. I want you to protect what you’ve got and prepare for a future that will, in all likelihood, be very different from the present. So different, in fact, that I think you should begin making changes to your lifestyle as soon as possible. In my own life I have found that the mental, physical, and financial actions I am advocating take a considerable amount of time to implement.

Broadly speaking, they are:

  • Adapting to a general decline in Western standards of living. The servicing of past debts, coupled with relentless fuel price increases and a recession, speak to a massive shift in our buying and consuming habits. We’ll all have to find ways to be happy with less stuff. This is actually a good thing.
  • Moving from a culture of “I” to “we.” The strength and depth of your community connections are going to increase in importance as time goes on. Needless to say, these connections cannot be manufactured overnight. They take energy and thoughtfulness, while trust requires time.
  • Giving up the belief (or the certainty?) that the future will be like today, only bigger, and filled with more opportunities for the next generation(s). Maybe it will, and maybe it won’t. I personally found this belief the hardest to let go of because it comes with a sense of loss. I finally progressed past this blockage when I began to believe that the future will simply consist of new and different opportunities than today. But that took work. And time.
  • Relying more greatly upon ‘self.’ I use this term broadly to include my entire region. While it may be true that oil and food will continue to flow to New England in sufficient and desired (required?) quantities, what if they don’t?

A Disclaimer and Some Good News

One thing that I cannot and will not do is give specific investment advice to individuals. For legal reasons, I cannot name companies or individual mutual funds, or anything else specific, except in the context of my role as an educator on these matters.

Which is fine by me, because I don’t want to be in the business of analyzing and recommending specific companies, bond offerings, or mutual funds.

To do this credibly and responsibly, I’d have to begin the immense process of sifting through all 20,000+ individual stocks and funds…and I simply don’t have the resources or time. Luckily, there are a lot of qualified people who do this professionally.

Rather, my work involves laying out themes against which specific investment opportunities and strategies can be assessed. I will lay out these themes, and even tell you what I’ve done in response, but it’s up to you to mesh them with your particular situation.

And now for the good news. For anybody who is interested, I (finally!) have a short list of investment advisors who have seen the Crash Course, largely agree with its premises, and are willing to work with people to manage their holdings accordingly. Imagine what it would be like to talk with an advisor who sees the same financial risks that you do, takes them seriously, and has already formulated a response to each of them.

I have no financial relationship with any of these advisors, will never take anything in return from them, and will not recommend one over another. You may request that I provide you with their names and phone numbers (never the other way around), but it will be up to you to make contact and assess the fit. However, I am thrilled to finally have a pool of financial advisors to whom I can refer people. What I get out of this is the satisfaction of knowing that I could help fulfill a very important need. Simply email me and I will forward their contact information to you.

My Themes

So, what does the future hold? Here I will admit that I cannot find any clear historical precedents against which to contrast our current state of affairs. The combination of a national lack of savings, record levels of debt, a failure to invest (in capital and infrastructure), an aging population, Peak Oil, and insolvent entitlement and pension programs has never before been encountered by humans. Worse, Alan Greenspan suckered, er, influenced the rest of the world to go along with the largest credit bubble in all of history, and so there are fewer ways to diversify internationally than might otherwise have been true.

Because the past can only provide clues, I’ve been analyzing and investing according to ‘themes’ that rely on equal parts of data, logic, and my faith that people will tend to behave as they have in the past.  And let me repeat that you can count on me to change my view when the data supports a shift.  Within the context of these themes, there will always be individual winners and losers. Threats and opportunities always exist side by side.  Our task is to choose wisely. My major themes for the next few years are:

Theme #1: Recession, or possibly a depression, due to the bursting of the largest credit bubble in history

My concern level is “high” and stretches from right now until late 2009 to 2010. Nobody alive has ever lived through the bursting of a global credit bubble, and history offers only clues and hints as to how this all might unfold. Your guesses are as good (or as bad) as mine. The recession/depression is going to be fueled by:

  • The return of household savings. If households returned to saving even just 5% compared to the current 0%, then the impact to the economy would be the loss of 3.5% of GDP. If this happened, all by itself it would contribute to one of the worst economic periods in modern times.
  • Job losses. As the credit bubble bursts, credit will become harder and harder to obtain, businesses will fold, and job losses will mount. Some regions, like Detroit (cars) and Orlando (tourism) will be especially hard hit. Certain job sectors will be particularly vulnerable, especially those related to discretionary or lavish spending.

STRATEGY:  Remain alert. Cut spending, reduce debt, and build savings. Be prepared to revisit portfolio assumptions and tactics on a more frequent (Quarterly? Monthly? Weekly?) basis.

WINNERS:  If a deflationary recession/depression, cash and high-grade bonds. If an inflationary recession/depression, energy, commodities, and consumer staples. In either case, only a very select group of stocks will perform well. The rest will suffer big losses.

LOSERS:  Stock index funds, low yielding stocks, and non-investment grade bonds. Everybody who failed to take this prospect seriously and plan properly.

Theme #2: Inflation is here and rising

(This is a near-term concern). I will remain concerned about inflation until I see my fiscal and monetary authorities begin to behave rationally.  At present, the only concern I see on their parts is to ‘reflate’ the banking system at any and all costs.  One of those costs is inflation.  My full list of inflation concerns is as follows:

  • Dollar weakness. Even if the rest of the world experiences no inflation, if our dollar falls, we will still see rising prices for oil and all of the other essential products we import.
  • Supply and demand mismatch (for oil and grains especially).  If there is a long-term imbalance created by the fact that the earth can no longer provide a surplus of the things that humans want/need, then prices for the desired items will consume an ever-greater share of our respective budgets.
  • Structural inflation (e.g., higher oil prices make steel more expensive, leading to higher drilling costs, leading to higher oil prices….etc).  Once a structural inflation spiral gets started, it is a very difficult thing to stop. Such is currently the case for food and fuel.
  • Monetary inflation (growth in MZM & M3 are at historical highs).  And it’s not just the US.  Inflation is spiking all over the world in lockstep with exploding money supply figures. One of the hallmarks of the Great Depression was a nasty series of competitive devaluations by various countries, as they attempted to preserve their manufacturing jobs by making their products appear cheaper than others.  This is a very ordinary and predictable response, as it represents both the appearance of ‘doing something’ and the path of least resistance.  That makes it practically irresistible to even an above-average politician.
  • Likely actions by fiscal and monetary authorities.  Spending and easing, respectively, are heavily weighted towards inflation.

STRATEGY:   Buy your essential items early and often.  Stock up your pantry and find ways to store more items in and around your house.  Don’t hold cash or cash equivalents, and avoid long-dated bonds, especially those offering negative real returns (i.e., a yield below the rate of inflation).  Be prepared to move out of paper assets altogether and into tangible wealth. Productive land might be one avenue to explore.

WINNERS:  Commodities, and stocks with a positive inflation sensitivity and/or strong pricing power (like energy and consumer staples companies).

LOSERS:  Bonds paying a negative real rate; companies with low pricing power.  Remember, it’s your real return that matters, not your nominal return.  The Zimbabwe stock market is up tens of thousands of percent this year.  Unfortunately, their inflation is up hundreds of thousands of percent.  Stocks that don’t keep pace with inflation are another way to lose.

Theme #3: Potential banking system insolvency

(This is also a near-term concern).  Yes, the Fed was able to patch things up for a while.  No, the danger has not passed.  Financial stocks are still getting killed in the market, and I am keeping an especially close eye on Lehman Brothers (LEH), as their stock took a particular beating at the end of last week (May 21 – 23, 2008).  It won’t take too many more major financial companies going bust due to derivative-based wipeouts before the whole system goes into shock.  Beyond that, here’s the basic data that gives me the most concern:

  • Financial companies are holding $5 trillion (with a “t”) in level 3 assets, which utterly dwarfs the Federal Reserve balance sheet (what remains of it) and possibly even dwarfs the borrowing ability of the US government.  Level 3 assets are an accounting gimmick that allow executives to place whatever value they deem appropriate on ‘hard to value’ items, like bundles of subprime mortgages that really aren’t worth all that much.  Needless to say, there’s some incentive to, shall we say, be generous with the estimates of value.
  • Certain derivative products, specifically credit default swaps and collateralized debt obligations, total in the tens of trillions of dollars, and their markets are in disarray.  Counterparty risk is unknown and possibly unknowable.  The risk here is unacceptable.  If these markets spin out of control into a series of cascading cross-defaults, my main question will be, “What will happen to our financial system?” which leads to, “What will happen to financial investments?”
  • Total bank capital stands at $1.1 trillion, but the potential total losses across all residential and commercial real estate are much higher than that.  While a massive public bailout is probably in the cards, that will take time, and even I am shocked at how fast the housing market is deteriorating across several extremely large markets (notably all of CA, FL, Las Vegas, Phoenix, and Denver).  Again, the pace of the collapse is what defines the risk here, while the magnitude is without historical precedent.

STRATEGY:  Don’t have all your eggs in one basket – use several highly-rated banks. Remain liquid and alert; be prepared to access and move your funds away from troubled institutions as a tactic to avoid becoming enmeshed in a receivership process.

WINNERS:  People with their dollars held by strong banks, and those who don’t have all their wealth tied up in the banking system and are holding cash, gold, silver, and other sources of liquid, non-dollar-denominated wealth completely outside of the financial system. Having strong, dependable community networks to help manage the transition period.

LOSERS:  Everybody who is late to recognize that bank failures have begun and/or has their money tied up in an insolvent bank.  If a generalized bank system failure does occur, we all lose, to some degree.

Theme #4: Peak Oil

This theme offers both tremendous risk and enormous opportunity.  This used to be a medium-term concern of mine (2-10 years out), but has recently become a near-term concern.  I happen to believe it is here right now, and the only thing that could mask it for a bit longer would be a global depression.  A recession probably wouldn’t do it, though, because through all of history the largest ever yr/yr drop in global oil demand was a mere 0.4%, and that was after a particularly nasty recession back in the 1970’s…meaning it will take more than a garden-variety recession to produce the required 2%-3% drop in demand to mask declining oil production.

STRATEGY:  Begin to whittle down your dependence on energy as a means of reducing the energy portion of your daily budget.

WINNERS:  Energy investments of all sorts, ranging from traditional to alternative and from producers to servicers.  Those with the lowest proportion of spending on energy and access to alternative modes of heating, cooling, and transportation.  My prediction here is that once Peak Oil is generally recognized, solar systems will suddenly develop multi-year waiting periods.

LOSERS:  An enormously wide range of companies that are built around cheap energy. Certain SUV-dependent auto manufacturers come to mind. 

Theme #5: Boomer retirement

The retirement of the baby boomers will result in drawdowns that will exceed Gen-X buy-ups.  To whom are the boomers going to sell all of their assets?  Or, what happens when Cal-Pers (et al.) becomes a net seller rather than a net buyer?  (This is a long-term concern…as in, 10 years out).  Unfortunately, this retirement boom will create demands upon financial investments, concurrent with vast national needs to re-tool our energy, sewage, water, electrical, and transportation systems.  Here I am expecting a toxic combination of both falling asset prices (in real terms) and rising tax bills, as our politicians attempt to simultaneously fix everything they’ve been ignoring for the past two decades.

STRATEGY: Begin reducing total exposure to everything in which boomers are overinvested. This includes stocks, bonds, and McMansions. Avoid living in places or houses that require too much reliance on energy or have especially weak or overextended governments. Vallejo, CA (now bankrupt) is an example…tax bills there are remaining constant, even as services crumble and disappear.

WINNERS: Sectors that service retiring boomers.

LOSERS: High p/e ‘growth’ stocks, low dividend stocks, and other investments whose gains largely depend on persistent and sustained buying pressure. Second homes located in less than prime areas, especially those far from urban areas and therefore requiring large amounts of gasoline to access. 

The Path

While it is possible, I do not anticipate a one-way slide to the bottom, wherever and whenever that may be. I lean towards the ‘stair-step’ model, where a series of sequential shocks and relatively placid periods mark the path to the future.  The three possible scenarios around which I  form my thinking (and actions) are:

  1. No change.  The future looks just like today, only bigger, and no major upheavals, shocks, or recessions happen.  The Fed and Congress are successful in fighting off the deleterious effects of the bursting of the housing bubble, and everybody carries on without any major changes or adjustments.  This is not a very likely outcome.  Probability:  1%.
  2. A series of short, sharp shocks.  Moments of relative calm and seeming recovery are punctuated by rapid and unsettling market plunges and marked changes in social perspective.  Think of the food scarcity and riots, and you know what this looks like.  One day there is low awareness about food scarcity, and the next day shortages and prices spikes are making the news.  Soon enough, relative calm returns, prices fall, and order is restored, but prices somehow do not recover to their previous levels, leaving people primed and alert for the next leg of the process.  I see this as the most likely path forward.  Probability:  80%.
  3. A sudden major collapse.  Under this scenario, some sort of a tipping point causes a light-speed reaction in the global economic system that requires shutting down cross-border capital flows.  Banks would no longer be able to clear transfers and accounts, which would wreak all sorts of havoc upon our just-in-time society.  Food and fuel distribution would be the most immediate concerns.  There’s enough of a chance of this scenario occurring, and the impacts are potentially so severe, that you should take actions to minimize the impacts to yourself and loved ones.  Probability:  ~20%.

Which of these three scenarios will actually unfold is, of course, unknown.  This is why I maintain an alert stance, and why I am constantly sifting the news and posting my thoughts in my blog.  Should a serious event warrant, I will send enrolled members an alert outlining the data and actions you should consider.  I have not yet sent out a single alert because no single event has crossed my threshold. If (or when) you receive one from me, it will be about something I take very seriously.

Of course, nobody can make all the changes that are required at once, or even over the next year.  Rather, there is a list of things that each of us, depending on our circumstances, should consider doing over the next few years.  I break them down into three tiers of actions.  Tier I actions are ones that you should do immediately.  Tier II are ones that you would do only after finishing the Tier I actions.  Tier III are longer-term actions that come after the first two are done, or can be worked in parallel, if time, money, and energy permit.

Let me close with this:  My sincerest hope is that you begin the process of adapting your lifestyle, right now, to the new future that awaits.  If you are waiting for the signs to become any clearer than this, you are waiting too long.

What are you waiting for?

Charting a Course Through the Recession
PREVIEW by Chris Martenson
Tuesday, May 27, 2008

Executive Summary

  • In this report, I lay out my near- and intermediate-term investment themes.
  • My assessment is that the economic and financial risks are exceptionally high and possibly historically unique. This is no time for complacency. A defensive stance is both warranted and prudent. A 50% – 70% (real) decline in the main stock market indexes is a distinct possibility, and portfolios should be ‘crash-proofed.’
  • Heeding the calls that “a bottom is in” and “the recession could already be over” could be hazardous to your wealth.
  • The recession is just beginning and will be the worst in several generations.
  • Residential housing data is still accelerating to the downside, while commercial real estate is just beginning its long date with tough times. There is no bottom in sight for either.
  • Inflation for life’s necessities is up, and rising energy costs will likely keep certain items at persistently high – and rising – prices for a very long time.

Bottom line:  My assessment is that the financial and economic risks that currently exist are exceptional, historically unique, and possibly systemic in nature, and therefore call for non-status-quo responses. A defensive stance is both warranted and prudent. As for timing, my motto is, ‘I’d rather be a year early than a day late.’

Some Context

I am an educator and a communicator, and I focus on using the past to view the future. Some might consider me a futurist. I think of myself as a realist, and I try to let the data inform me about what’s going on. Of course, the extent to which the data is flawed represents the risk of being wrong.

My goal is not to simply inform, but to inform in a way that leads to you take actions. I want you to protect what you’ve got and prepare for a future that will, in all likelihood, be very different from the present. So different, in fact, that I think you should begin making changes to your lifestyle as soon as possible. In my own life I have found that the mental, physical, and financial actions I am advocating take a considerable amount of time to implement.

Broadly speaking, they are:

  • Adapting to a general decline in Western standards of living. The servicing of past debts, coupled with relentless fuel price increases and a recession, speak to a massive shift in our buying and consuming habits. We’ll all have to find ways to be happy with less stuff. This is actually a good thing.
  • Moving from a culture of “I” to “we.” The strength and depth of your community connections are going to increase in importance as time goes on. Needless to say, these connections cannot be manufactured overnight. They take energy and thoughtfulness, while trust requires time.
  • Giving up the belief (or the certainty?) that the future will be like today, only bigger, and filled with more opportunities for the next generation(s). Maybe it will, and maybe it won’t. I personally found this belief the hardest to let go of because it comes with a sense of loss. I finally progressed past this blockage when I began to believe that the future will simply consist of new and different opportunities than today. But that took work. And time.
  • Relying more greatly upon ‘self.’ I use this term broadly to include my entire region. While it may be true that oil and food will continue to flow to New England in sufficient and desired (required?) quantities, what if they don’t?

A Disclaimer and Some Good News

One thing that I cannot and will not do is give specific investment advice to individuals. For legal reasons, I cannot name companies or individual mutual funds, or anything else specific, except in the context of my role as an educator on these matters.

Which is fine by me, because I don’t want to be in the business of analyzing and recommending specific companies, bond offerings, or mutual funds.

To do this credibly and responsibly, I’d have to begin the immense process of sifting through all 20,000+ individual stocks and funds…and I simply don’t have the resources or time. Luckily, there are a lot of qualified people who do this professionally.

Rather, my work involves laying out themes against which specific investment opportunities and strategies can be assessed. I will lay out these themes, and even tell you what I’ve done in response, but it’s up to you to mesh them with your particular situation.

And now for the good news. For anybody who is interested, I (finally!) have a short list of investment advisors who have seen the Crash Course, largely agree with its premises, and are willing to work with people to manage their holdings accordingly. Imagine what it would be like to talk with an advisor who sees the same financial risks that you do, takes them seriously, and has already formulated a response to each of them.

I have no financial relationship with any of these advisors, will never take anything in return from them, and will not recommend one over another. You may request that I provide you with their names and phone numbers (never the other way around), but it will be up to you to make contact and assess the fit. However, I am thrilled to finally have a pool of financial advisors to whom I can refer people. What I get out of this is the satisfaction of knowing that I could help fulfill a very important need. Simply email me and I will forward their contact information to you.

My Themes

So, what does the future hold? Here I will admit that I cannot find any clear historical precedents against which to contrast our current state of affairs. The combination of a national lack of savings, record levels of debt, a failure to invest (in capital and infrastructure), an aging population, Peak Oil, and insolvent entitlement and pension programs has never before been encountered by humans. Worse, Alan Greenspan suckered, er, influenced the rest of the world to go along with the largest credit bubble in all of history, and so there are fewer ways to diversify internationally than might otherwise have been true.

Because the past can only provide clues, I’ve been analyzing and investing according to ‘themes’ that rely on equal parts of data, logic, and my faith that people will tend to behave as they have in the past.  And let me repeat that you can count on me to change my view when the data supports a shift.  Within the context of these themes, there will always be individual winners and losers. Threats and opportunities always exist side by side.  Our task is to choose wisely. My major themes for the next few years are:

Theme #1: Recession, or possibly a depression, due to the bursting of the largest credit bubble in history

My concern level is “high” and stretches from right now until late 2009 to 2010. Nobody alive has ever lived through the bursting of a global credit bubble, and history offers only clues and hints as to how this all might unfold. Your guesses are as good (or as bad) as mine. The recession/depression is going to be fueled by:

  • The return of household savings. If households returned to saving even just 5% compared to the current 0%, then the impact to the economy would be the loss of 3.5% of GDP. If this happened, all by itself it would contribute to one of the worst economic periods in modern times.
  • Job losses. As the credit bubble bursts, credit will become harder and harder to obtain, businesses will fold, and job losses will mount. Some regions, like Detroit (cars) and Orlando (tourism) will be especially hard hit. Certain job sectors will be particularly vulnerable, especially those related to discretionary or lavish spending.

STRATEGY:  Remain alert. Cut spending, reduce debt, and build savings. Be prepared to revisit portfolio assumptions and tactics on a more frequent (Quarterly? Monthly? Weekly?) basis.

WINNERS:  If a deflationary recession/depression, cash and high-grade bonds. If an inflationary recession/depression, energy, commodities, and consumer staples. In either case, only a very select group of stocks will perform well. The rest will suffer big losses.

LOSERS:  Stock index funds, low yielding stocks, and non-investment grade bonds. Everybody who failed to take this prospect seriously and plan properly.

Theme #2: Inflation is here and rising

(This is a near-term concern). I will remain concerned about inflation until I see my fiscal and monetary authorities begin to behave rationally.  At present, the only concern I see on their parts is to ‘reflate’ the banking system at any and all costs.  One of those costs is inflation.  My full list of inflation concerns is as follows:

  • Dollar weakness. Even if the rest of the world experiences no inflation, if our dollar falls, we will still see rising prices for oil and all of the other essential products we import.
  • Supply and demand mismatch (for oil and grains especially).  If there is a long-term imbalance created by the fact that the earth can no longer provide a surplus of the things that humans want/need, then prices for the desired items will consume an ever-greater share of our respective budgets.
  • Structural inflation (e.g., higher oil prices make steel more expensive, leading to higher drilling costs, leading to higher oil prices….etc).  Once a structural inflation spiral gets started, it is a very difficult thing to stop. Such is currently the case for food and fuel.
  • Monetary inflation (growth in MZM & M3 are at historical highs).  And it’s not just the US.  Inflation is spiking all over the world in lockstep with exploding money supply figures. One of the hallmarks of the Great Depression was a nasty series of competitive devaluations by various countries, as they attempted to preserve their manufacturing jobs by making their products appear cheaper than others.  This is a very ordinary and predictable response, as it represents both the appearance of ‘doing something’ and the path of least resistance.  That makes it practically irresistible to even an above-average politician.
  • Likely actions by fiscal and monetary authorities.  Spending and easing, respectively, are heavily weighted towards inflation.

STRATEGY:   Buy your essential items early and often.  Stock up your pantry and find ways to store more items in and around your house.  Don’t hold cash or cash equivalents, and avoid long-dated bonds, especially those offering negative real returns (i.e., a yield below the rate of inflation).  Be prepared to move out of paper assets altogether and into tangible wealth. Productive land might be one avenue to explore.

WINNERS:  Commodities, and stocks with a positive inflation sensitivity and/or strong pricing power (like energy and consumer staples companies).

LOSERS:  Bonds paying a negative real rate; companies with low pricing power.  Remember, it’s your real return that matters, not your nominal return.  The Zimbabwe stock market is up tens of thousands of percent this year.  Unfortunately, their inflation is up hundreds of thousands of percent.  Stocks that don’t keep pace with inflation are another way to lose.

Theme #3: Potential banking system insolvency

(This is also a near-term concern).  Yes, the Fed was able to patch things up for a while.  No, the danger has not passed.  Financial stocks are still getting killed in the market, and I am keeping an especially close eye on Lehman Brothers (LEH), as their stock took a particular beating at the end of last week (May 21 – 23, 2008).  It won’t take too many more major financial companies going bust due to derivative-based wipeouts before the whole system goes into shock.  Beyond that, here’s the basic data that gives me the most concern:

  • Financial companies are holding $5 trillion (with a “t”) in level 3 assets, which utterly dwarfs the Federal Reserve balance sheet (what remains of it) and possibly even dwarfs the borrowing ability of the US government.  Level 3 assets are an accounting gimmick that allow executives to place whatever value they deem appropriate on ‘hard to value’ items, like bundles of subprime mortgages that really aren’t worth all that much.  Needless to say, there’s some incentive to, shall we say, be generous with the estimates of value.
  • Certain derivative products, specifically credit default swaps and collateralized debt obligations, total in the tens of trillions of dollars, and their markets are in disarray.  Counterparty risk is unknown and possibly unknowable.  The risk here is unacceptable.  If these markets spin out of control into a series of cascading cross-defaults, my main question will be, “What will happen to our financial system?” which leads to, “What will happen to financial investments?”
  • Total bank capital stands at $1.1 trillion, but the potential total losses across all residential and commercial real estate are much higher than that.  While a massive public bailout is probably in the cards, that will take time, and even I am shocked at how fast the housing market is deteriorating across several extremely large markets (notably all of CA, FL, Las Vegas, Phoenix, and Denver).  Again, the pace of the collapse is what defines the risk here, while the magnitude is without historical precedent.

STRATEGY:  Don’t have all your eggs in one basket – use several highly-rated banks. Remain liquid and alert; be prepared to access and move your funds away from troubled institutions as a tactic to avoid becoming enmeshed in a receivership process.

WINNERS:  People with their dollars held by strong banks, and those who don’t have all their wealth tied up in the banking system and are holding cash, gold, silver, and other sources of liquid, non-dollar-denominated wealth completely outside of the financial system. Having strong, dependable community networks to help manage the transition period.

LOSERS:  Everybody who is late to recognize that bank failures have begun and/or has their money tied up in an insolvent bank.  If a generalized bank system failure does occur, we all lose, to some degree.

Theme #4: Peak Oil

This theme offers both tremendous risk and enormous opportunity.  This used to be a medium-term concern of mine (2-10 years out), but has recently become a near-term concern.  I happen to believe it is here right now, and the only thing that could mask it for a bit longer would be a global depression.  A recession probably wouldn’t do it, though, because through all of history the largest ever yr/yr drop in global oil demand was a mere 0.4%, and that was after a particularly nasty recession back in the 1970’s…meaning it will take more than a garden-variety recession to produce the required 2%-3% drop in demand to mask declining oil production.

STRATEGY:  Begin to whittle down your dependence on energy as a means of reducing the energy portion of your daily budget.

WINNERS:  Energy investments of all sorts, ranging from traditional to alternative and from producers to servicers.  Those with the lowest proportion of spending on energy and access to alternative modes of heating, cooling, and transportation.  My prediction here is that once Peak Oil is generally recognized, solar systems will suddenly develop multi-year waiting periods.

LOSERS:  An enormously wide range of companies that are built around cheap energy. Certain SUV-dependent auto manufacturers come to mind. 

Theme #5: Boomer retirement

The retirement of the baby boomers will result in drawdowns that will exceed Gen-X buy-ups.  To whom are the boomers going to sell all of their assets?  Or, what happens when Cal-Pers (et al.) becomes a net seller rather than a net buyer?  (This is a long-term concern…as in, 10 years out).  Unfortunately, this retirement boom will create demands upon financial investments, concurrent with vast national needs to re-tool our energy, sewage, water, electrical, and transportation systems.  Here I am expecting a toxic combination of both falling asset prices (in real terms) and rising tax bills, as our politicians attempt to simultaneously fix everything they’ve been ignoring for the past two decades.

STRATEGY: Begin reducing total exposure to everything in which boomers are overinvested. This includes stocks, bonds, and McMansions. Avoid living in places or houses that require too much reliance on energy or have especially weak or overextended governments. Vallejo, CA (now bankrupt) is an example…tax bills there are remaining constant, even as services crumble and disappear.

WINNERS: Sectors that service retiring boomers.

LOSERS: High p/e ‘growth’ stocks, low dividend stocks, and other investments whose gains largely depend on persistent and sustained buying pressure. Second homes located in less than prime areas, especially those far from urban areas and therefore requiring large amounts of gasoline to access. 

The Path

While it is possible, I do not anticipate a one-way slide to the bottom, wherever and whenever that may be. I lean towards the ‘stair-step’ model, where a series of sequential shocks and relatively placid periods mark the path to the future.  The three possible scenarios around which I  form my thinking (and actions) are:

  1. No change.  The future looks just like today, only bigger, and no major upheavals, shocks, or recessions happen.  The Fed and Congress are successful in fighting off the deleterious effects of the bursting of the housing bubble, and everybody carries on without any major changes or adjustments.  This is not a very likely outcome.  Probability:  1%.
  2. A series of short, sharp shocks.  Moments of relative calm and seeming recovery are punctuated by rapid and unsettling market plunges and marked changes in social perspective.  Think of the food scarcity and riots, and you know what this looks like.  One day there is low awareness about food scarcity, and the next day shortages and prices spikes are making the news.  Soon enough, relative calm returns, prices fall, and order is restored, but prices somehow do not recover to their previous levels, leaving people primed and alert for the next leg of the process.  I see this as the most likely path forward.  Probability:  80%.
  3. A sudden major collapse.  Under this scenario, some sort of a tipping point causes a light-speed reaction in the global economic system that requires shutting down cross-border capital flows.  Banks would no longer be able to clear transfers and accounts, which would wreak all sorts of havoc upon our just-in-time society.  Food and fuel distribution would be the most immediate concerns.  There’s enough of a chance of this scenario occurring, and the impacts are potentially so severe, that you should take actions to minimize the impacts to yourself and loved ones.  Probability:  ~20%.

Which of these three scenarios will actually unfold is, of course, unknown.  This is why I maintain an alert stance, and why I am constantly sifting the news and posting my thoughts in my blog.  Should a serious event warrant, I will send enrolled members an alert outlining the data and actions you should consider.  I have not yet sent out a single alert because no single event has crossed my threshold. If (or when) you receive one from me, it will be about something I take very seriously.

Of course, nobody can make all the changes that are required at once, or even over the next year.  Rather, there is a list of things that each of us, depending on our circumstances, should consider doing over the next few years.  I break them down into three tiers of actions.  Tier I actions are ones that you should do immediately.  Tier II are ones that you would do only after finishing the Tier I actions.  Tier III are longer-term actions that come after the first two are done, or can be worked in parallel, if time, money, and energy permit.

Let me close with this:  My sincerest hope is that you begin the process of adapting your lifestyle, right now, to the new future that awaits.  If you are waiting for the signs to become any clearer than this, you are waiting too long.

What are you waiting for?

by Chris Martenson
Monday, December 17, 2007

Executive Summary

  • A series of government bailouts attack the symptoms, utterly failing to address the root cause.
  • The bailouts were for the big banks, not you.
  • House prices need to decline in price by 30% to 50%, and they will.
  • Trillions of dollars of losses lurk in ultra-safe pension bond funds and small Norwegian towns, as well as in some unlikely places.
  • Current crisis is one of solvency, not liquidity.

Q: “Has the housing market bottomed, is it soon to bottom, or is it in the process of bottoming?”

A:  No, nope, and no.

There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.

~ Ludwig Von Mises

In order to get at the question of ‘Just how bad is the current housing crisis?’ we need to understand the dimensions of the problem. It is a complicated mess if one considers all the scenery in detail, but it’s startlingly simple when viewed from a distance.

scenery

The threat to our banking system is described by the extent of the mortgage losses, and those will depend on how far (and how fast) house prices fall, together with the impact of outright fraud. Below we shall explore the (very) simple reasons that explain why house prices must fall by 30% to 50%. Each one can be lumped into a category of fraud, reducing demand, or boosting supply.

  • House prices rose far above income gains. Too far. They became unaffordable, and now they are in the process of correcting back to affordable levels. What goes up must come down. Simple as that.
  • Mortgage lending standards are tightening up, leading to fewer people qualifying for loans. Fewer qualified buyers means demand will drop and prices will fall. Simple as that.
  • More than one out of every four homes sold in 2005 and 2006 were sold to speculators, and now house prices are at or below 2005 levels. This means that the speculators’ investments are wiped out (and then some, considering transaction costs). Speculator demand is gone, and will not return for many years. Less demand equals lower prices. Simple as that.
  • Developers overbuilt the national housing stock by a very large amount, in part to meet the false speculator demand; I calculate somewhere in the vicinity of two to three million excess units. We have too much housing stock, and it will be a minimum of three years before population gains naturally work it off. All things housing-related will be in recession until that oversupply is worked off. Simple as that.
  • Even though the subprime foreclosure crisis is much closer to the beginning than the end, already hundreds of billions of dollars of losses have been recorded by small towns in Norway, in state and municipal investment funds, and by institutional money market funds. While big banks have managed to stuff all these investment channels with dodgy mortgage paper, they themselves remain as exposed to real estate loans as they’ve ever been. Truly, there is no historical precedent to inform us to how bad this could get. I estimate somewhere between $1 trillion and $2 trillion in losses, which means that the entire capital of the entire US banking system could be wiped out. This is an issue of solvency, not liquidity, and therefore this is a major crisis that goes far beyond the official actions and statements to date. Simple as that.
  • In summary, real estate supply, demand, and price are severely out of whack and can only be fixed by a significant decline in prices, which means that a whole lot of individuals and financial institutions are in trouble as a consequence. It all adds up to one simple conclusion: Banks, pensions, hedge funds, and money market funds will all have to dispose of a whole lot of bad paper. Possibly up to $2 trillion dollars worth, if my calculations are correct, meaning that the potential exists for the entire capital of the US banking system to be wiped out.

Now you have all the information you need to understand why there really are no policy fixes to this mess (e.g. ‘freezing interest rates’), only an inevitable date with lower house prices. If you care to continue, below I provide my supporting data for the above statements.

From a purely logical standpoint, house prices need to fall to match those at the start of the bubble in 2000. Why? Because otherwise we have to believe in The Free Lunch. For The Free Lunch to be true, it must be possible for a person to buy a house, do nothing except sit on a couch drinking beer for the next 5 years, and get rich in the process. Examining 70 past examples of asset bubbles, we find that The Free Lunch has never worked before. It’s not going to work out this time, either.

To illustrate, I put together the chart below by combining data from two government sources, the Census Bureau for income and the OFHEO for housing price gains.

House Price To Income

What is immediately obvious is that house prices and income gains have historically tracked each other very, very closely through the entire data series until about 2000, where house prices pull significantly away from income gains. I have marked two historical housing bubbles (1979 and 1989) with arrows, noteworthy because they were well supported by income gains and therefore seem insignificant when viewed on this graph. But that in itself is noteworthy, because, as both homebuilders and house sellers during those periods can attest, it means that even a very slight departure between the blue and the red lines can be quite painful. It also means that we have no historical precedent for the territory in which we currently find ourselves.

So, onto the primary question: “What would be required to bring house prices and income gains back in line?”

The answer to that is either:

  • An income gain of 51%
  • A decline in house prices of 34%

Of the two, income gains or house price declines, which seems more likely? Before you answer that, you should know that the average income gain over the past 6 years has been 2.3% per year (not inflation-adjusted). At that rate it would take 21 years, or until 2028, to close the gap. In the meantime, house prices would have to remain frozen at today’s prices. In a normal world, we would see a bit of both, with house prices falling and incomes rising to meet somewhere down the road.

However, I expect house prices to do most of the heavy lifting, and I am expecting a decline of even more than 34%, possibly as much as 50%, because of the correlated job losses that will result from the housing wipeout. An outsized proportion of the meager job gains recorded since the recession of 2001 were in some way linked to housing. The ripple effect of job losses will extend far beyond realtors and mortgage brokers, and into window manufacturing, lumber, plumbing fixtures, nail salons, BMW detailing services, and so forth.

My calculations are therefore in rough alignment with those at economy.com:

NEW YORK (Reuters) – Housing markets from Punta Gorda, Florida, to Stockton, California, will crash and suffer price drops of more than 30 percent before the housing crisis is over, a report from Moody’s Economy.com said on Thursday.

On a national level, the housing market recession will continue through early 2009, said the report, co-authored by Mark Zandi, chief economist, and Celia Chen, director of housing economics.

At this particular moment in time, banks are about as heavily exposed to mortgages (as a total percent of assets) as they have ever been. Further, banks are holding an enormous quantity of commercial real estate loans, especially in the rah-rah areas such as Florida, the Southwest, and in California. The FDIC reported last year that more than 50% of all the banks in the southeast and west regions had exposure to commercial real estate loans that exceeded their total capital by 300% or more. Holy smokes!

Here’s how it happens. As the housing bubble takes off, people get into a buying frenzy, while builders get into a building frenzy. Soon enough, the commercial builders get excited and say to themselves “Saaaaay, would you lookit all these houses going up? We better build a few more malls and condos out this way!” They then go to a local or regional bank, who agrees that there’s no possible downside to building more shopping areas and condos, and so they loan huge amounts of money to these developers. When the inevitable bust comes, everybody acts surprised, and the banks go to the FDIC for a bailout. At least, that’s how it usually works. This time, because the amount of excessive building was so over the top and the banks were so unfavorably leveraged, I fully expect the FDIC to be inadequate for the job, which means Congress will have to get involved.

To put it in the simplest of terms, the total amount of bank capital in the entire country is a little over $1.1 trillion, while more than $11 trillion in real estate loans exist, meaning that a 10% to 15% loss on those loans would translate into the complete bankruptcy of the US banking system. What this all means is that we have a crisis of solvency, not liquidity. Currently the Federal Reserve has teamed up with European central banks to provide vast new sources of liquidity (unlimited, really) to the banking system. That is, banks can trade in their piles of dodgy loans for cash for a specified period of time. This gives banks access to cash. However, as currently structured, they have to buy those dodgy loans back at par, at some point in the future. If those loans are bad (which they are), then this maneuver by the Fed simply won’t work. Instead, we need wipe those bad loans out, which means we will lose a financial intuition or two (or thirty) along the way.

It is against this relatively simple backdrop of overly expensive, overbuilt housing that the government recently launched an awful, poorly conceived and named subprime bailout plan named the New Hope Alliance. “Hope?” Well, I suppose since ‘hope’ is what got us into this mess, it makes sense that the government might choose to use ‘hope’ to get us back out of it. “Hope” is not a sound strategy, which makes it a natural fit for the current housing crisis.

Since this new plan of Hope will not prevent house prices from falling, it is pretty much dead on arrival, at least as far as actually helping to solve the primary problem. The primary problem is how a lack of housing affordability will lead to a decline in prices, as brilliantly captured by this industry insider:

One final thought. How can any of this get repaired unless home values stabilize? And how will that happen? In Northern California, a household income of $90,000 per year could legitimately pay the minimum monthly payment on an Option ARM on a million home for the past several years. Most Option ARMs allowed zero to 5% down. Therefore, given the average income of the Bay Area, most families could buy that million dollar home. A home seller had a vast pool of available buyers.

Now, with all the exotic programs gone, a household income of $175,000 is needed to buy that same home, which is about 10% of the Bay Area households. And inventories are up 500%. So, in a nutshell, we have 90% fewer qualified buyers for five times the number of homes. To get housing moving again in Northern California, either all the exotic programs must come back, everyone must get a 100% raise, or home prices have to fall 50%. None, except the last, sound remotely possible.

Wow. A tenfold reduction in buyers and a fivefold increase in house supply. There is only one way for that to resolve, and that is through reduced prices.

As presented, the purpose of the program of Hope was to help prevent or delay foreclosures – as if they were the problem. Unfortunately, foreclosures are merely the symptom. The cause is the fact that people bought overpriced houses they couldn’t afford, while hoping that rising house prices would provide a ready source of cashout mortgage money. House prices are no longer rising, they are falling. That is the root of the current crisis, and this most recent government fix does absolutely nothing about it. So we can score the plan a zero on that front. Where the New Hope Alliance really breaks down and becomes a solid negative, though, is in how it undermines confidence in the sanctity of US contract law.

Dec. 7 (Bloomberg) — President George W. Bush’s plan to freeze interest rates on some subprime mortgages may prove to be a cure that breeds another disease.

“If the government goes in and changes contracts it will definitely have a chilling effect on the securitization of mortgages,” said Milton Ezrati, senior economist and market strategist at Lord Abbett & Co. in Jersey City, New Jersey, which oversees $120 billion in assets.

“When the government comes in and says you have contracted to have this arrangement and you can no longer have it, I think it opens the door for lawsuits.”

What’s being said here is that enforceable contracts are a vital component of the US financial industry. Heck, of the entire US way of life, since it is the trust foreigners place in our ‘system’ that gives them the confidence to loan us back the money we spent on their products. Without the trust that a given contract will be collectible, then those contracts either get written at a much higher price to compensate for the risk of not being paid, or they do not get written at all. So if part of the subprime crisis is reduced house prices resulting from reduced demand, would we expect a serious disturbance in mortgage contract enforceability to result in more or fewer mortgages written? Who will be able to afford significantly higher mortgage payments? Who will issue them? Who would buy them and hold them?

This is an important concept, because a huge prop to our economy over the past decade has been the flood of foreign funds that allowed us to enjoy low interest rates even as our trade deficit plumbed new depths. Part of the reason foreigners felt comfortable, if not confident, investing in the US, is that our contract laws and supporting legal infrastructure are exceptionally strong in protecting investors’ claims. Foreign investors bought many packaged mortgage products from Wall Street banks at a price based on expected returns that included future rate adjustments. That’s now at risk. This would be no different than your boss telling you that next year’s 5% raise, which you are counting on and have in writing, is actually going to be 0% – but could you please loan him another few hundred bucks?

So what was the purpose of the New Hope deal? Simple. It’s meant to bail out big banks and mortgage companies who simply do not wish to recognize the actual value of the mortgages they hold at current market prices. When houses enter foreclosure and then get sold, a price discovery event happens that ‘hits the books’ of the financial institution involved.

Here’s the best explanation of the week, courtesy of the San Francisco Gate:

Now, just unveiled Thursday, comes the “freeze,” the brainchild of Treasury Secretary Henry Paulson. It sounds good: For five years, mortgage lenders will freeze interest rates on a limited number of “teaser” subprime loans. Other homeowners facing foreclosure will be offered assistance from the Federal Housing Administration.

But unfortunately, the “freeze” is just another fraud – and like the other bailout proposals, it has nothing to do with U.S. house prices, with “working families,” keeping people in their homes or any of that nonsense.

The sole goal of the freeze is to prevent owners of mortgage-backed securities, many of them foreigners, from suing U.S. banks and forcing them to buy back worthless mortgage securities at face value – right now almost 10 times their market worth.

The ticking time bomb in the U.S. banking system is not resetting subprime mortgage rates. The real problem is the contractual ability of investors in mortgage bonds to require banks to buy back the loans at face value if there was fraud in the origination process.

And, to be sure, fraud is everywhere. It’s in the loan application documents, and it’s in the appraisals. There are e-mails and memos floating around showing that many people in banks, investment banks and appraisal companies – all the way up to senior management – knew about it.

However, this was actually the third bailout/remedy by the government. There were already two past bailouts that were simply not well publicized, and those are the ones to which you should be paying attention, because they involve vast gobs of public money.

The first was this eye-popping advance by the Federal Home Loan Bank system (FHLB) to the overall mortgage market in October:

NEW YORK (Fortune) — As the credit crunch hit hard in the third quarter, most banks were forced to cut back their lending. But one group of banks increased lending by an incredible $182 billion. Who were these deep-pocketed lenders — and are they capable of handling such a large rise in loans, especially at a time when credit markets are unsettled and mortgage defaults on the rise?

The lenders in question were the 12 Federal Home Loan Banks, set up under a government charter during the Great Depression to provide support to the housing market by advancing funds to over 8000 member banks that make mortgages. In the third quarter, loans to member banks, also called ‘advances,’ totaled $822 billion, a 28% leap from $640 billion at the end of June.

This is a staggering amount of mortgage-buying activity. Where did this $182 billion come from? Did the FHLB just happen to have nearly $200 billion lying around? If not, how was it that the FHLB was able to find buyers for mortgage paper at a time when the mortgage markets were more or less frozen? What sorts of mortgages were purchased? Were they high grade or the subbiest of the subprime? In point of fact, it is a bailout, plain and simple. It is an egregious use of public monies that was not voted on, but is guaranteed, by the public. But the FHLB fiduciary stewards did not stop there. They went further, by advancing a stunning $51 billion to Countrywide Financial Corp, recently voted as most likely to fail by its classmates. How bad does this move smell? Bad enough for a US Senator to notice.

In a letter to the regulator of the Federal Home Loan Bank system, Sen. Charles Schumer said Countrywide, the largest U.S. mortgage lender, may be abusing the program.

At the end of September, Countrywide had borrowed $51.1 billion from the Federal Home Loan Bank system — a government-sponsored program.

“Countrywide is treating the Federal Home Loan Bank system like its personal ATM,” Schumer, a New York Democrat who heads the housing panel of the Senate Banking Committee, said in the letter. “At a time when Countrywide’s mortgage portfolio is deteriorating drastically, FHLB’s exposure to Countrywide poses an unreasonable risk.”

So what we have here is a case where the fiscal and monetary authorities are desperately shoving enormous amounts of money (and new policy) into a very stressed and ultimately unsavable situation. On a personal level, this bothers me a great deal. Partly because I have been prudent and saved and rented while waiting for the silliness to end, yet the very first response of my government is to punish me and reward the imprudent. But mainly because big bailouts doubly punish us all; first, by the inevitable inflation that results, and second, because our future options will be diminished by debt.

What needs to happen is very clear. The bad debts need to be wiped out. The mal-investments need to be written off.

So now that we know this thing is going to implode, the only relevant part left is to ask the questions, ‘How am I exposed, and how can I avoid having the bag passed to me?’

Here I will revert to my past recommendations:

  • Get out of debt.
  • Be very careful about where you keep your money. Already several high profile money market funds have suffered losses and closed down, returning less than the deposit amount to their clients. Expect this to get worse.
  • The dollar is in a precarious situation, especially if the Fed begins buying up bad debt for paper money in a big way. Gold. Silver. Top off your oil tank at home.
  • Be aware that pensions, municipal investment accounts, and even your bank are all highly likely to be exposed to the leveraged losses that are now upon us. If you are exposed here, figure out how not to be.
  • If you are a citizen of a country whose central bank insists on bailing out the monied elite (big banks) with your current and/or future tax dollars, use every possible avenue available to legally apply pressure upon your political representatives to prevent this from happening.

Now, go back to the top and re-read the quote by Ludwig Von Mises. It neatly describes everything you need to know. The preceding 20 paragraphs were my way of illustrating that there will be no voluntary abandonment of credit expansion. In fact, the data shows that our fiscal and monetary authorities are fighting that possible outcome tooth and nail. That leaves the dollar exposed to the risk of losing its reserve currency status as it heads towards international pariah status. Not that there’s anything wrong with that…unless you think we might, someday, need to import oil, or something made out of plastic, or electronics, or underwear, or …

Housing – Simple As That
PREVIEW by Chris Martenson
Monday, December 17, 2007

Executive Summary

  • A series of government bailouts attack the symptoms, utterly failing to address the root cause.
  • The bailouts were for the big banks, not you.
  • House prices need to decline in price by 30% to 50%, and they will.
  • Trillions of dollars of losses lurk in ultra-safe pension bond funds and small Norwegian towns, as well as in some unlikely places.
  • Current crisis is one of solvency, not liquidity.

Q: “Has the housing market bottomed, is it soon to bottom, or is it in the process of bottoming?”

A:  No, nope, and no.

There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.

~ Ludwig Von Mises

In order to get at the question of ‘Just how bad is the current housing crisis?’ we need to understand the dimensions of the problem. It is a complicated mess if one considers all the scenery in detail, but it’s startlingly simple when viewed from a distance.

scenery

The threat to our banking system is described by the extent of the mortgage losses, and those will depend on how far (and how fast) house prices fall, together with the impact of outright fraud. Below we shall explore the (very) simple reasons that explain why house prices must fall by 30% to 50%. Each one can be lumped into a category of fraud, reducing demand, or boosting supply.

  • House prices rose far above income gains. Too far. They became unaffordable, and now they are in the process of correcting back to affordable levels. What goes up must come down. Simple as that.
  • Mortgage lending standards are tightening up, leading to fewer people qualifying for loans. Fewer qualified buyers means demand will drop and prices will fall. Simple as that.
  • More than one out of every four homes sold in 2005 and 2006 were sold to speculators, and now house prices are at or below 2005 levels. This means that the speculators’ investments are wiped out (and then some, considering transaction costs). Speculator demand is gone, and will not return for many years. Less demand equals lower prices. Simple as that.
  • Developers overbuilt the national housing stock by a very large amount, in part to meet the false speculator demand; I calculate somewhere in the vicinity of two to three million excess units. We have too much housing stock, and it will be a minimum of three years before population gains naturally work it off. All things housing-related will be in recession until that oversupply is worked off. Simple as that.
  • Even though the subprime foreclosure crisis is much closer to the beginning than the end, already hundreds of billions of dollars of losses have been recorded by small towns in Norway, in state and municipal investment funds, and by institutional money market funds. While big banks have managed to stuff all these investment channels with dodgy mortgage paper, they themselves remain as exposed to real estate loans as they’ve ever been. Truly, there is no historical precedent to inform us to how bad this could get. I estimate somewhere between $1 trillion and $2 trillion in losses, which means that the entire capital of the entire US banking system could be wiped out. This is an issue of solvency, not liquidity, and therefore this is a major crisis that goes far beyond the official actions and statements to date. Simple as that.
  • In summary, real estate supply, demand, and price are severely out of whack and can only be fixed by a significant decline in prices, which means that a whole lot of individuals and financial institutions are in trouble as a consequence. It all adds up to one simple conclusion: Banks, pensions, hedge funds, and money market funds will all have to dispose of a whole lot of bad paper. Possibly up to $2 trillion dollars worth, if my calculations are correct, meaning that the potential exists for the entire capital of the US banking system to be wiped out.

Now you have all the information you need to understand why there really are no policy fixes to this mess (e.g. ‘freezing interest rates’), only an inevitable date with lower house prices. If you care to continue, below I provide my supporting data for the above statements.

From a purely logical standpoint, house prices need to fall to match those at the start of the bubble in 2000. Why? Because otherwise we have to believe in The Free Lunch. For The Free Lunch to be true, it must be possible for a person to buy a house, do nothing except sit on a couch drinking beer for the next 5 years, and get rich in the process. Examining 70 past examples of asset bubbles, we find that The Free Lunch has never worked before. It’s not going to work out this time, either.

To illustrate, I put together the chart below by combining data from two government sources, the Census Bureau for income and the OFHEO for housing price gains.

House Price To Income

What is immediately obvious is that house prices and income gains have historically tracked each other very, very closely through the entire data series until about 2000, where house prices pull significantly away from income gains. I have marked two historical housing bubbles (1979 and 1989) with arrows, noteworthy because they were well supported by income gains and therefore seem insignificant when viewed on this graph. But that in itself is noteworthy, because, as both homebuilders and house sellers during those periods can attest, it means that even a very slight departure between the blue and the red lines can be quite painful. It also means that we have no historical precedent for the territory in which we currently find ourselves.

So, onto the primary question: “What would be required to bring house prices and income gains back in line?”

The answer to that is either:

  • An income gain of 51%
  • A decline in house prices of 34%

Of the two, income gains or house price declines, which seems more likely? Before you answer that, you should know that the average income gain over the past 6 years has been 2.3% per year (not inflation-adjusted). At that rate it would take 21 years, or until 2028, to close the gap. In the meantime, house prices would have to remain frozen at today’s prices. In a normal world, we would see a bit of both, with house prices falling and incomes rising to meet somewhere down the road.

However, I expect house prices to do most of the heavy lifting, and I am expecting a decline of even more than 34%, possibly as much as 50%, because of the correlated job losses that will result from the housing wipeout. An outsized proportion of the meager job gains recorded since the recession of 2001 were in some way linked to housing. The ripple effect of job losses will extend far beyond realtors and mortgage brokers, and into window manufacturing, lumber, plumbing fixtures, nail salons, BMW detailing services, and so forth.

My calculations are therefore in rough alignment with those at economy.com:

NEW YORK (Reuters) – Housing markets from Punta Gorda, Florida, to Stockton, California, will crash and suffer price drops of more than 30 percent before the housing crisis is over, a report from Moody’s Economy.com said on Thursday.

On a national level, the housing market recession will continue through early 2009, said the report, co-authored by Mark Zandi, chief economist, and Celia Chen, director of housing economics.

At this particular moment in time, banks are about as heavily exposed to mortgages (as a total percent of assets) as they have ever been. Further, banks are holding an enormous quantity of commercial real estate loans, especially in the rah-rah areas such as Florida, the Southwest, and in California. The FDIC reported last year that more than 50% of all the banks in the southeast and west regions had exposure to commercial real estate loans that exceeded their total capital by 300% or more. Holy smokes!

Here’s how it happens. As the housing bubble takes off, people get into a buying frenzy, while builders get into a building frenzy. Soon enough, the commercial builders get excited and say to themselves “Saaaaay, would you lookit all these houses going up? We better build a few more malls and condos out this way!” They then go to a local or regional bank, who agrees that there’s no possible downside to building more shopping areas and condos, and so they loan huge amounts of money to these developers. When the inevitable bust comes, everybody acts surprised, and the banks go to the FDIC for a bailout. At least, that’s how it usually works. This time, because the amount of excessive building was so over the top and the banks were so unfavorably leveraged, I fully expect the FDIC to be inadequate for the job, which means Congress will have to get involved.

To put it in the simplest of terms, the total amount of bank capital in the entire country is a little over $1.1 trillion, while more than $11 trillion in real estate loans exist, meaning that a 10% to 15% loss on those loans would translate into the complete bankruptcy of the US banking system. What this all means is that we have a crisis of solvency, not liquidity. Currently the Federal Reserve has teamed up with European central banks to provide vast new sources of liquidity (unlimited, really) to the banking system. That is, banks can trade in their piles of dodgy loans for cash for a specified period of time. This gives banks access to cash. However, as currently structured, they have to buy those dodgy loans back at par, at some point in the future. If those loans are bad (which they are), then this maneuver by the Fed simply won’t work. Instead, we need wipe those bad loans out, which means we will lose a financial intuition or two (or thirty) along the way.

It is against this relatively simple backdrop of overly expensive, overbuilt housing that the government recently launched an awful, poorly conceived and named subprime bailout plan named the New Hope Alliance. “Hope?” Well, I suppose since ‘hope’ is what got us into this mess, it makes sense that the government might choose to use ‘hope’ to get us back out of it. “Hope” is not a sound strategy, which makes it a natural fit for the current housing crisis.

Since this new plan of Hope will not prevent house prices from falling, it is pretty much dead on arrival, at least as far as actually helping to solve the primary problem. The primary problem is how a lack of housing affordability will lead to a decline in prices, as brilliantly captured by this industry insider:

One final thought. How can any of this get repaired unless home values stabilize? And how will that happen? In Northern California, a household income of $90,000 per year could legitimately pay the minimum monthly payment on an Option ARM on a million home for the past several years. Most Option ARMs allowed zero to 5% down. Therefore, given the average income of the Bay Area, most families could buy that million dollar home. A home seller had a vast pool of available buyers.

Now, with all the exotic programs gone, a household income of $175,000 is needed to buy that same home, which is about 10% of the Bay Area households. And inventories are up 500%. So, in a nutshell, we have 90% fewer qualified buyers for five times the number of homes. To get housing moving again in Northern California, either all the exotic programs must come back, everyone must get a 100% raise, or home prices have to fall 50%. None, except the last, sound remotely possible.

Wow. A tenfold reduction in buyers and a fivefold increase in house supply. There is only one way for that to resolve, and that is through reduced prices.

As presented, the purpose of the program of Hope was to help prevent or delay foreclosures – as if they were the problem. Unfortunately, foreclosures are merely the symptom. The cause is the fact that people bought overpriced houses they couldn’t afford, while hoping that rising house prices would provide a ready source of cashout mortgage money. House prices are no longer rising, they are falling. That is the root of the current crisis, and this most recent government fix does absolutely nothing about it. So we can score the plan a zero on that front. Where the New Hope Alliance really breaks down and becomes a solid negative, though, is in how it undermines confidence in the sanctity of US contract law.

Dec. 7 (Bloomberg) — President George W. Bush’s plan to freeze interest rates on some subprime mortgages may prove to be a cure that breeds another disease.

“If the government goes in and changes contracts it will definitely have a chilling effect on the securitization of mortgages,” said Milton Ezrati, senior economist and market strategist at Lord Abbett & Co. in Jersey City, New Jersey, which oversees $120 billion in assets.

“When the government comes in and says you have contracted to have this arrangement and you can no longer have it, I think it opens the door for lawsuits.”

What’s being said here is that enforceable contracts are a vital component of the US financial industry. Heck, of the entire US way of life, since it is the trust foreigners place in our ‘system’ that gives them the confidence to loan us back the money we spent on their products. Without the trust that a given contract will be collectible, then those contracts either get written at a much higher price to compensate for the risk of not being paid, or they do not get written at all. So if part of the subprime crisis is reduced house prices resulting from reduced demand, would we expect a serious disturbance in mortgage contract enforceability to result in more or fewer mortgages written? Who will be able to afford significantly higher mortgage payments? Who will issue them? Who would buy them and hold them?

This is an important concept, because a huge prop to our economy over the past decade has been the flood of foreign funds that allowed us to enjoy low interest rates even as our trade deficit plumbed new depths. Part of the reason foreigners felt comfortable, if not confident, investing in the US, is that our contract laws and supporting legal infrastructure are exceptionally strong in protecting investors’ claims. Foreign investors bought many packaged mortgage products from Wall Street banks at a price based on expected returns that included future rate adjustments. That’s now at risk. This would be no different than your boss telling you that next year’s 5% raise, which you are counting on and have in writing, is actually going to be 0% – but could you please loan him another few hundred bucks?

So what was the purpose of the New Hope deal? Simple. It’s meant to bail out big banks and mortgage companies who simply do not wish to recognize the actual value of the mortgages they hold at current market prices. When houses enter foreclosure and then get sold, a price discovery event happens that ‘hits the books’ of the financial institution involved.

Here’s the best explanation of the week, courtesy of the San Francisco Gate:

Now, just unveiled Thursday, comes the “freeze,” the brainchild of Treasury Secretary Henry Paulson. It sounds good: For five years, mortgage lenders will freeze interest rates on a limited number of “teaser” subprime loans. Other homeowners facing foreclosure will be offered assistance from the Federal Housing Administration.

But unfortunately, the “freeze” is just another fraud – and like the other bailout proposals, it has nothing to do with U.S. house prices, with “working families,” keeping people in their homes or any of that nonsense.

The sole goal of the freeze is to prevent owners of mortgage-backed securities, many of them foreigners, from suing U.S. banks and forcing them to buy back worthless mortgage securities at face value – right now almost 10 times their market worth.

The ticking time bomb in the U.S. banking system is not resetting subprime mortgage rates. The real problem is the contractual ability of investors in mortgage bonds to require banks to buy back the loans at face value if there was fraud in the origination process.

And, to be sure, fraud is everywhere. It’s in the loan application documents, and it’s in the appraisals. There are e-mails and memos floating around showing that many people in banks, investment banks and appraisal companies – all the way up to senior management – knew about it.

However, this was actually the third bailout/remedy by the government. There were already two past bailouts that were simply not well publicized, and those are the ones to which you should be paying attention, because they involve vast gobs of public money.

The first was this eye-popping advance by the Federal Home Loan Bank system (FHLB) to the overall mortgage market in October:

NEW YORK (Fortune) — As the credit crunch hit hard in the third quarter, most banks were forced to cut back their lending. But one group of banks increased lending by an incredible $182 billion. Who were these deep-pocketed lenders — and are they capable of handling such a large rise in loans, especially at a time when credit markets are unsettled and mortgage defaults on the rise?

The lenders in question were the 12 Federal Home Loan Banks, set up under a government charter during the Great Depression to provide support to the housing market by advancing funds to over 8000 member banks that make mortgages. In the third quarter, loans to member banks, also called ‘advances,’ totaled $822 billion, a 28% leap from $640 billion at the end of June.

This is a staggering amount of mortgage-buying activity. Where did this $182 billion come from? Did the FHLB just happen to have nearly $200 billion lying around? If not, how was it that the FHLB was able to find buyers for mortgage paper at a time when the mortgage markets were more or less frozen? What sorts of mortgages were purchased? Were they high grade or the subbiest of the subprime? In point of fact, it is a bailout, plain and simple. It is an egregious use of public monies that was not voted on, but is guaranteed, by the public. But the FHLB fiduciary stewards did not stop there. They went further, by advancing a stunning $51 billion to Countrywide Financial Corp, recently voted as most likely to fail by its classmates. How bad does this move smell? Bad enough for a US Senator to notice.

In a letter to the regulator of the Federal Home Loan Bank system, Sen. Charles Schumer said Countrywide, the largest U.S. mortgage lender, may be abusing the program.

At the end of September, Countrywide had borrowed $51.1 billion from the Federal Home Loan Bank system — a government-sponsored program.

“Countrywide is treating the Federal Home Loan Bank system like its personal ATM,” Schumer, a New York Democrat who heads the housing panel of the Senate Banking Committee, said in the letter. “At a time when Countrywide’s mortgage portfolio is deteriorating drastically, FHLB’s exposure to Countrywide poses an unreasonable risk.”

So what we have here is a case where the fiscal and monetary authorities are desperately shoving enormous amounts of money (and new policy) into a very stressed and ultimately unsavable situation. On a personal level, this bothers me a great deal. Partly because I have been prudent and saved and rented while waiting for the silliness to end, yet the very first response of my government is to punish me and reward the imprudent. But mainly because big bailouts doubly punish us all; first, by the inevitable inflation that results, and second, because our future options will be diminished by debt.

What needs to happen is very clear. The bad debts need to be wiped out. The mal-investments need to be written off.

So now that we know this thing is going to implode, the only relevant part left is to ask the questions, ‘How am I exposed, and how can I avoid having the bag passed to me?’

Here I will revert to my past recommendations:

  • Get out of debt.
  • Be very careful about where you keep your money. Already several high profile money market funds have suffered losses and closed down, returning less than the deposit amount to their clients. Expect this to get worse.
  • The dollar is in a precarious situation, especially if the Fed begins buying up bad debt for paper money in a big way. Gold. Silver. Top off your oil tank at home.
  • Be aware that pensions, municipal investment accounts, and even your bank are all highly likely to be exposed to the leveraged losses that are now upon us. If you are exposed here, figure out how not to be.
  • If you are a citizen of a country whose central bank insists on bailing out the monied elite (big banks) with your current and/or future tax dollars, use every possible avenue available to legally apply pressure upon your political representatives to prevent this from happening.

Now, go back to the top and re-read the quote by Ludwig Von Mises. It neatly describes everything you need to know. The preceding 20 paragraphs were my way of illustrating that there will be no voluntary abandonment of credit expansion. In fact, the data shows that our fiscal and monetary authorities are fighting that possible outcome tooth and nail. That leaves the dollar exposed to the risk of losing its reserve currency status as it heads towards international pariah status. Not that there’s anything wrong with that…unless you think we might, someday, need to import oil, or something made out of plastic, or electronics, or underwear, or …

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