Housing Bubble Part II, III, IV, and so on
Thu Jun 28, 2007 at 11:05:49 AM PDT
When the Federal Reserve announces in a few minutes that there will be no change in the Prime Rate, the market will scrutinize their comments for any hint of which direction they are leaning. The market seems to be thinking that the Fed is biased toward more accomodation. Rates should head lower.
And why not? Alan Greenspan directed the FOMC, through a less than subtle statement, that he wants to see the housing market gain another 5% of value. Even a small increase in the value of existing homes would pop the subprime bubble, slow down the number of foreclosures, and keep the economy humming.
Anyone who has bought a home knows the value of housing exists in a circular logic, a) labor and materials b) interest rates, borrowing costs, and c) land. A change to any one demands a compensatory change in the value of the other two, to maintain equilibrium. When equilibrium is not the desired effect, the policy of restraining the effects of inflation on two of these, labor and materials, and land, while lowering interest rates, is the correct procedure to inflate the Housing Bubble.
Get ready for Housing Bubble, Part II
Investment Outlook
Bill Gross | July 2007
Looking for Contagion in All the Wrong Places
Because the problem lies not in a Bear Stearns hedge fund that can be papered over with 100 cents on the dollar marks. The flaw resides in the Summerlin suburbs of Las Vegas, Nevada, in the extended city limits of Chicago headed west towards Rockford, and yes, the naked (and empty) rows of multistoried condos in Miami, Florida. The flaw, dear readers, lies in the homes that were financed with cheap and in some cases gratuitous money in 2004, 2005, and 2006. Because while the Bear hedge funds are now primarily history, those millions and millions of homes are not. They’re not going anywhere...except for their mortgages that is. Mortgage payments are going up, up, and up...and so are delinquencies and defaults. A recent research piece by Bank of America estimates that approximately $500 billion of adjustable rate mortgages are scheduled to reset skyward in 2007 by an average of over 200 basis points. 2008 holds even more surprises with nearly $700 billion ARMS subject to reset, nearly ¾ of which are subprimes.
What Bill Gross won't say, is that the surest way to head off a lending crisis is to follow Greenspans advice, and inflate the housing bubble, a bit more. Lower interest rates are the surest way to make this happen. However isn't there some likelyhood that labor and material costs will rise with lower interest rates? And the immigration bill is headed for trouble, can we count on a steady supply of Hispanic construction laborers to keep a lid on wage costs? Lower interest rates also tends to accelerate commodity costs, Copper, Lumber; how can the Fed lower rates without creating wage and price inflation?
Congress, regulators, even Fed officials are stepping in and warning mortgage originators (even mortgage buyers!) that they’d better be careful and only make good loans. Those nasty capitalists! They must have gotten carried away a few years ago. Somehow all those BMWs in the New Century parking lot in Irvine, California didn’t attract much notice in 2006. Now, well, there’s nary a Prius to be found there, but lots of outraged politicians in Washington, that’s for sure.
The Fed, with the help of their pals in Congress, can stimulate the economy, without inflation, if they act to restrict credit to only those who are credit worthy. Did I say Congress? When Congress closes the door, through greater regulation of the mortgage lending business, they open the door for the Federal Reserve to lower interest rates, and inflate the housing bubble once more. To really play the game well, they should be passing this immigration bill, which would keep low wage construction workers on the job. The game is called selling out your constituents.
To death and taxes you can add this to your list of inevitabilities: the subprime crisis is not an isolated event and it won’t be contained by a few days of headlines in The New York Times. And it will not remain confined to a neat little Petri dish in some mad financial derivative scientist’s laboratory. Ultimately through capital market arbitrage it will affect risk spreads in markets completely divorced from U.S. housing. What has the Brazilian Real to do with U.S. subprimes? Nothing except many of the same bets are held in hedge funds that by prudence or necessity will reduce their risk budgets to stay afloat. And the U.S. economy? Of course it will be affected. Consumption will be reduced to say nothing of new home construction over the next 12-18 months. After all, attractive subprime pricing has been key to the housing market’s success in recent years.
Suppose you had an oil well in backyard. You know how many barrels are in the ground, and you can calculate your net worth that way. Suppose you wanted to improve the value of the oil you have in the ground, but market demand for gasoline is steady across all socio-economic classes, a true market economy. A group of oil well owners decides to raise the price of gasoline, and although they sell less of it, they make the same amount of money, but primarily they are able to improve the value of that existing oil, by selling less gasoline at a higher price. A smaller volume of sales at a higher price leverages the value of a much larger number of existing homes.
Everyone who owns a mortgage has an oil well in their back yard, and they benefit from rising home values, even if the market is slow. Why by simply selling shares in your oil well, you can afford to buy the things you need, like gasoline, which keep going up. Refinancing your home is the equivalent of selling shares in your oil well.
Housing Bubble Part II is a policy aimed at increasing housing prices, while reducing the volume of new homes, but leveraging the value of those homes, by selling new homes to more a more wealthy clientele.
As political policy this really stinks, and Congress is up to it's neck in the deception. While homeowners assets increase, their debt load increases as well. How many times can the Fed reflate the housing bubble, if each time a smaller segment of the population is allowed to leverage the existing homeowners? That's hard to say.
If not taken too far – and there is no hint yet of a true "crisis" – these developments may be just what the Fed has been looking for: easy credit becoming less easy; excessive liquidity returning to more rational levels. Still, PIMCO looks for the Fed to issue an insurance policy in the form of lower Fed Funds at some point over the next 6 months. And what happened to our glass half-full secular thesis of last month? We still believe in strong global growth, but...as we also suggested...that the U.S. housing downturn will affect growth and short-term yields over the next year or so. We remain consistent and resolute. Contagion? Maybe, but you won’t be finding it at "99.9%" pure Bear Stearns. Look for it instead, in the subprimely financed homes of Las Vegas, Rockford, Illinois, and Miami, Florida. This problem – aided and abetted by Wall Street – ultimately resides in America’s heartland, with millions and millions of overpriced homes and asset-backed collateral with a different address – Main Street.
William H. Gross
Managing Director
Anecdotally there is a housing development to the East of me here in Southern California, built during the go-go years of the 1970's. The development was built in waves, and each successive wave was valued higher, as speculators rushed to buy in early, and turn these new homes for a profit when the second wave was built. Eventually it led to a housing recession, sky high interest rates, and recession. We appear to be early in this process, of a growing number of these Housing Bubbles, and each one drives the lower income homeowner into more difficult circumstances.
And the Democratic Congress is actively accomodating the destruction of the American home owner, and the economy. Their concern for mortgage regulation will never work unless they take control of the budget (Iraq) and they wrestle Montary Policy away from the Federal Reserve, which is a vestige of the Bush incumbency.
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