Turkeys fall back to earth: It started with real estate

[EJ]

Turkeys fall back to earth
June 7, 2007 (iTulip)

Don't forget, it started with real estate

An old expression reappeared during the 1990s stock market bubble to explain how Internet and telecommunications companies with no apparent prospects, and run by children, were able to go public and then see their stock prices shoot up: "If the wind blows hard enough, even turkeys fly." A gale force wind of money has circulated the planet for the past few years, putting everything from large public companies to large empty office buildings to flight. As inflation increases globally, the Wall Street backed American Association for the Prevention of Cruelty to Flying Turkeys has been lobbying the Fed for if not a rate cut at least forbearance on hikes. But recently the bond market started telling the Fed that time is running out, and stock market investors are taking notice.

We developed the diagram to the left for readers who desire a concise depiction of the economic order of things in our world, and where today's turkeys fit into it. You see the US "platform economy," as some of its apologists creatively label it, fulfilling its role as manufacturer of financial assets, in both paper and digital form, and as grand maker of clever ideas. These are shipped to Europe and Asia where, presumably, they don't have enough of either, where they are turned into stuff. In return, Asians and Europeans ship their hard earned savings, of which they are told they have too much–especially in the eyes of Congress–and cheap goods manufactured in Asia by workers who have had for decades less pricing power in their labor markets than a sea shell necklace vendor at a seaside tourist trap. The oil producing countries send not only oil but–pennies from heaven–the money to buy it with. When it comes to using one's perch in the global geopolitical catbird seat to extract tribute at the height of empire, it just doesn't get any better than this.

Problem is, workers in Asia are gradually gaining pricing power as the global economy surges for perfectly legitimate reasons, along side less legit ones such as crazed speculation in just about everything, resulting in turkey levitation. Future wage inflation is virtually guaranteed, for example, in China where the state in spite of a monopoly on force that accrues to dictatorship must constantly weigh the political consequences of heavy handed subjugation of angry rural workers–the Chinese equivalent of the cheap labor supply that the US government has to pretend to not want crossing its southern border–versus the negative economic consequences of unionization.

But the unionization movement in China is picking up speed, and not with little tail wind from government. Unions not only help the CCP keep out foreign companies it doesn't want there but also provides a welcome safety value for an increasingly cranky proletariat and demands for democratic reforms. Readers may recall that the major long term impact on wages in the US from draconian Fed tightening under Volcker in the 1980s was the virtual elimination of unions as force of pricing power in US labor markets. While still nascent, unionization along with limits to the rate of increase in the skilled labor pool are starting a wave of wage inflation in Asia that is closing the loop that starts with the dollar printing press and ends with rising prices of fake Fendi hand bags at Walmart. As we have warned for years, once traded-goods prices start to rise, the low US CPI inflation hoax will be at an end.

Alas, the Fed is out of time stalling on a response to the inflation threat, and the dissonance between the reality on the street and Fed jaw boning is starting to develop a Twilight Zone quality. Monday Professor Ben said the economy will pick up, presumably laying the groundwork for future rate hikes. The Whitehouse days later announced that the economy is headed into a slump, lowering its GDP forecast for the year from 2.9 to 2.3 percent. We suggest readers skim both stories while imagining them read by Rod Serling. The bond market, smelling an inflation rat, started to push up long bond yields. As mortgage rates rise in tow, the housing market, already on the ropes, may fulfill the Whitehouse wish. But the damage won't be so bad, according to the National Association of Liars: "Home sales will probably fluctuate in a narrow range in the short run, but gradually trend upward with improving activity by the end of the year," said Lawrence Yun, the group's latest economist-in-the-barrel.

We are sticking to our October 2006 prediction for a housing bubble deflation led US recession by Q4 of this year. Nonetheless representatives of the real estate industry will repeat versions of the "it's coming back" story, reminiscent of claims by Abby Joseph Cohen during the year 2000 stock market correction, even as stock markets price in a late 2007 recession. When the US Economy Quartette begins to play “Nearer my God to Thee,” expect the RE guys to talk louder and louder, and continue to do so until all you hear is "blub, blub, blub."

Getting back to our diagram for a moment, the making stuff, saving, and lending money trade block is not motivated to lend much to the borrowing money and consuming stuff trade block–and we use the term "trade block" to highlight the absurdity of the notion of a trade group composed of a single nation that offers the world as its primary contribution to trade a willingness to go into debt to maintain a lifestyle to which it has become accustomed–if its spendthrift people and government were to reduce their consuming, such as they may during a recession, or cannot avoid so doing except by going even further into debt. Thus, as predicted by Ka-Poom Theory, recession in the US in the absence of recession elsewhere in the world will tend to cause US inflation to rise, the dollar to decline, bond yields to rise, the US economy to slow further, and so on. Smart folks over at SmartMoney.com disagree, and we recommend frequent visits to their Yield Curve page and commentary. They view rising bond yields as a symptom of lower bond demand relative to riskier assets. But then why are stocks and commodities tanking?

In the old days, before massive US trade deficits, the Fed could count on US a slowing economy to lower inflation. Markets may be at last catching on: it ain't 1980 anymore. If Volcker were to try today what he did in 1980, inflation would not fall, it would rise. Also, while Congress has never been a group to risk the unpopularity of the economic high road, this Congress, in either Republican or Democratic flavor, has proven itself completely unwilling to go for an hour without spending or borrowing more money. There is a direct tie between turkeys in Congress and flying turkeys that will continue to play out in the markets over the summer.

From the Mail Bag

Readers sent us piles of great stories the past few days (keep 'em coming!). The first we mention delivers the shocking news–take a seat if you're standing–that during the speculative home flipping frenzy at the top of the the housing bubble... fraud happened! Not only in real life, but even on TV!

'Flip This House' Star Accused of Fraud
June 4, 2007 (DOUG GROSS - AP)

On an episode of A&E's popular reality series "Flip This House," Atlanta businessman Sam Leccima sits in front of a run-down house and calls buying and selling real estate his passion.

Now authorities and legal filings claim that Leccima's true passion was a series of scams that included faking the home renovations shown on the cable TV show and claiming to have sold houses he never owned.

"This is, indeed, a con artist," said Sonya McGee, an Atlanta pharmaceutical representative who says Leccima took $4,000 from her in an investment scheme.

McGee and others say Leccima's episodes of "Flip This House," A&E's most popular show, were elaborate hoaxes. His friends and family were presented as potential homebuyers and "sold" signs were slapped in front of unsold houses. They say the home repairs -- the lynchpin of the show -- were actually quick or temporary patch jobs designed to look good on camera.

Just as the slapped-on paint used to lure suckers into buying over-priced homes is starting to peel off houses purchased two years ago, the facade of free markets is coming off the mortgage industry. Long supported by government tax policies that cost taxpayers billions, and legal loopholes that an overweight felon can jump through, pity the poor hedge fund that bet heavily on mortgage default doom.

Subprime Fiasco Exposes Manipulation by Mortgage Brokerages
June 1, 2007 (Seth Lubove and Daniel Taub - Bloomberg)

Under U.S. law, investors who buy mortgages or securities backed by them are typically not susceptible to lawsuits alleging fraud on the part of brokers.

Such protection partly explains why the U.S. mortgage-backed- securities market has ballooned. The market more than tripled since 2000; $2.4 trillion of MBSs were issued last year, according to the Securities Industry and Financial Markets Association in New York. Last year was the first time more than half of the securities issued were backed by subprime and other nonconforming loans, according to the trade group.

Over on iTulip Select, we're working up an investment thesis predicated on the idea that there will develop a new government-protected, government-enabled asset bubble, since the housing bubble is winding down. Gotta have one, just like we had to have the housing bubble after the 1990s stock market bubble popped. The alternative is too dark to contemplate. We're just not that pessimistic.

Hedge Funds to Deliver Eviction Notices
June 1, 2007 (Portfolio.com)

According to a report in the Financial Times, a group of 25 hedge funds has asked the International Swaps and Derivatives Association to tell the banks to stop helping the poorest homeowners avoid foreclosure.

Of course, the hedge funds don't quite put it in those terms. Instead, they suggest that the banks are engaging in "market manipulation."

Some hedge funds invest in derivatives contracts that pay investors when bonds backed by subprime mortgage loans take a hit. Since the $1.2 trillion subprime mortgage bond market has had a rough ride of late, the hedge funds that invested in these derivatives have profited handsomely. The more defaults, the better.

The funds' beef is that the same banks that sell these derivatives can decide to give the homeowners a break on their monthly payments instead of defaulting. The funds say the banks can avoid paying out on the derivatives contracts by lending a hand to the borrowers.

One hedge fund representative told the FT they aren't out to evict people from their homes. They just want to make sure the banks are operating above board.

Had they read our interview with Michael Hudson earlier this year they'd have known what was in store and saved a bundle. He predicted banks were going to extend and restructure mortgages versus take back properties, and so they have. Here's why it works.

Say you have a 30 year mortgage at 7% on $250,000, where rates will be soon enough. That loan will net the bank about $100,000 in interest over 30 years. What if you can't pay the loan now but the bank is convinced you can pay it back later? The bank agrees to add past due monthly payments onto the end of the loan for a while until you can pay, while also restructuring the rest of the loan. Let's say the net result is that the bank extends the $250,000 loan from 30 years to 40 years, and in the process knocks the monthly payment down to $1,553. Good deal for the borrower, right?

Through the magic of compound interest, at 7% at the end of 40 years the bank nets about $250,000 in interest instead of a mere $100,000 if the loan had been paid off in 30 years. Keep in mind that the borrower didn't get another dime. The borrower will in total pay as much in interest as the original value of the house when it was purchased, a total of nearly $500,000. Beeeeeautiful! If you're the bank.

Don't be surprised to see all the bears that capitulated over the last few weeks come running back over to the bear side. A few may even take the inflation side of the bear case, as we have for years. Count Bill Gross as among the first. Now he's calling for a bear market in bonds.

Oh, speaking of Volcker, is it time to bring back usury laws? They were abolished in the early 1980s to make way for Fed rate hikes. Below are for-real interest rates on loans from cashcallcom. Who needs loan sharks?

Loan Product Interest Rate Annual Percentage Rate Number of Payments Payment Amount $5,075 Loan 59% 59.95% 84 $254.03 $2,600 Loan 96% 99.25% 42 $216.55 $1,075 Loan 89% 96.78% 42 $83.89

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[DemonD]

Re: Turkeys fall back to earth: It started with real estate

EJ, what happened to that guy you interviewed earlier in the year who was "rehabbing" MBS type securities? I remember you asking him some on-point questions, and he was so smug about how his fund company was making money off of buying those securities at so many cents on the dollar and repackaging and selling them. Any idea on how well his business is doing?

[FRED]

Re: Turkeys fall back to earth: It started with real estate

EJ, what happened to that guy you interviewed earlier in the year who was "rehabbing" MBS type securities? I remember you asking him some on-point questions, and he was so smug about how his fund company was making money off of buying those securities at so many cents on the dollar and repackaging and selling them. Any idea on how well his business is doing?

We have Jim Finkel of Dynamic Credit scheduled for a follow-up interview later this month. We'll find out soon enough!

[rzero]

Re: Turkeys fall back to earth: It started with real estate

I am too dense to understand how raising rates would increase inflation. EJ has also mentioned that if we keep rates above inflation, we will avoid a Japanese-style deflation.

Can someone out there explain these to me?

[jk]

Re: Turkeys fall back to earth: It started with real estate

I am too dense to understand how raising rates would increase inflation. EJ has also mentioned that if we keep rates above inflation, we will avoid a Japanese-style deflation.

Can someone out there explain these to me?

Thus, as predicted by Ka-Poom Theory, recession in the US in the absence of recession elsewhere in the world will tend to cause US inflation to rise, the dollar to decline, bond yields to rise, the US economy to slow further, and so on.

i do not read this as saying that keeping rates up will avoid deflation. rather that both higher rates and higher inflation will be consequences of the same cause - a us recession in the absence of a global recession.

i think the mediating variable will be the dollar. u.s. recession creates a need for the fed to keep short rates relatively lower than they would otherwise be. lower short rates tend to support lower long rates. the dollar drops from both lack of growth opportunities for investment and because rates are too low to compensate for further currency risk. the dropping dollar causes the cost of imported goods to rise, along with further cost increases for energy and food. the rise in the cost of imports cancels the effect by which lower import costs compensated for rising prices in other sectors of the economy - notably services like healthcare and education, as well as housing. thus inflation rises. the dropping dollar also undermines the value of bonds, so rates rise.

remember i said rates would be relatively lower than they would otherwise be, not that they would be low in absolute terms [especially at the long end]. that is, the rise in rates will tend to lag the drop in the dollar and the rise in inflation. that, at least, is how i understand it. i would be grateful for input from others.

[EJ]

Re: Turkeys fall back to earth: It started with real estate

I am too dense to understand how raising rates would increase inflation. EJ has also mentioned that if we keep rates above inflation, we will avoid a Japanese-style deflation.

Can someone out there explain these to me?

The process goes like this.

1. As the housing market tanks, the US economy slows even while other countries' economies keep growing.
2. As the US economy slows relative to other nations which also attract foreign investment, the relative expected future return on investment in the US falls.
3. Among other financial assets, demand for US treasuries bonds falls.
4. As demand for US treasury bonds falls, prices fall and yields rise.
5. Demand for bonars also declines because fewer are needed when converting foreign currencies to bonars to purchase bonar denominated financial assets.
6. Import prices rise.
7. In the US, where so much of the low inflation story is based on cheap imports, the impact on net inflation is significant.
8. Bond yields rise in response to increased inflation risk.
9. Mortgage rates rise.
10. Housing market tanks some more. Go to step 1.

Historical spread between 10yr treasury and 30yr mortgage is 1.5%. Bill Gross now expects 10yr Treasuries to rise to 6.5%, which means 30yr mortgages at 8%. Means a monthly payment of $1,468 vs $1,179 for a $200,000 mortgage on a median priced home (assuming 10% down on the current national median price of $227,000) in 2004. Means a median priced home will cost 20% more on a monthly basis. Hard to imagine how that will not hammer an already shaky housing market. (See Monthly Payment Consumer.)

Given recent consumer confidence and consumer credit readings, perhaps we have been too optimistic and James Scurlock and Michael Hudson were right: the US economy will not decline slowly but rapidly.

[jk]

Re: Turkeys fall back to earth: It started with real estate

another loop goes: us recession means reduced us consumption and reduced imports. [trade deficit will look better, especially if the assumed non-recession abroad means exports hold up]. reduced imports means reduced dollars flowing into foreign hands, especially into chinese and japanese hands. thus the chinese and japanese have less dollar flow to reinvest in the u.s., as well as less incentive to manage the currency since the us market for their exports is dead anyway. this reduces their demand for tbonds, causing yields to rise, further weakening the economy, etc.

this highlights a key assumption - a u.s. recession WITHOUT A GLOBAL RECESSION. if the chinese and japanese are no longer exporting [so much] to the u.s., where are their goods going?

...perhaps we have been too optimistic and James Scurlock and Michael Hudson were right: the US economy will not decline slowly but rapidly.

if the u.s economy goes rapidly there is no time for the export-dependent economies, esp china and japan, to adjust. thus if the u.s. economy goes rapidly, if is more likely that the rest of the world will join the u.s in recession.

so if we want to analyze the assumption of u.s. recession without global recession, i think we must simultaneously assume a slow deterioration in the u.s. to allow other countries time to adjust to a different pattern of trade flows.

another way of saying this, is to say that if we think the u.s. economy goes down rapidly, then we need to look at global recession.

i also think we need to look at the possibility of the u.s. maintaining growth, but at a slower pace than the rest of the world. i.e. housing's downward tug may be sufficiently offset by the effects of global growth that the u.s. avoids recession altogether. you get relatively high u.s. inflation, relatively high u.s. interest rates, and further decline in the dollar - so you get the same effects, but in attenuated form and with a still slower course.

[WDCRob]

Re: Turkeys fall back to earth: It started with real estate

Historical spread between 10yr treasury and 30yr mortgage is 1.5%. Bill Gross now expects 10yr Treasuries to rise to 6.5%, which means 30yr mortgages at 8%. Means a monthly payment of $1,468 vs $1,179 for a $200,000 mortgage on a median priced home (assuming 10% down on the current national media price of $227,000) in 2004. Means a median priced home will cost 20% more on a monthly basis. Hard to imagine how that will not hammer an already shaky housing market.

Have historic declines in housing prices tracked the increased payment due to rising interests rates 1:1?

IOW...will a 20% rise in payments subsequently result in a 20% decline in housing prices? In the example above would $200k houses become $160k houses as interest rates rise? A greater decline than that? Lesser?

[Mega]

Re: Turkeys fall back to earth: It started with real estate

Thank Yoy EJ, i enjoyed reading that...............it's funny thing but i noticed all of this happening over the last few years but thought that i was missing something or simply i was not a bright "Wall street type".

Nope, just a bloke with a bit of common sense
Cheers
Mike

[EJ]

Re: Turkeys fall back to earth: It started with real estate

Have historic declines in housing prices tracked the increased payment due to rising interests rates 1:1?

IOW...will a 20% rise in payments subsequently result in a 20% decline in housing prices? In the example above would $200k houses become $160k houses as interest rates rise? A greater decline than that? Lesser?

As we pointed out Jan. 2005, historically the bust rate of decline of a housing boom has always been more rapid that the boom rate of growth. The prediction, using home equity extraction as a measure (as home equity extraction is a function of home price increases), was as follows.

From Housing Market Correction, Jan. 2005

We predicted that starting in mid-2005, home equity extraction was due to decline from $250 billion to under $0 by mid 2008. Now at under $100 billion, we are still on track. What has actually occurred so far is:

Thanks WDCRob for sending us the chart!

Home affordability is determined first by income, second by cost of credit, third by lending standards, last by supply. The strength of the housing market is determined first by psychology and second by affordability. With all factors of affordability in reverse of conditions in a booming market (declining real incomes, rising cost of credit, tougher lending standards, increasing supply) and market psychology reversing (end of belief that prices only go up), the housing market is in full collapse mode. However, as we explained in Jan. 2004, housing prices tend not to crash due to increasing market illiquidity. Rather they go into a cycle of stall, decline, stall, decline. Typically the process takes five to seven years. Due to the extremes of this housing boom, we expect the process to last 10 years or more.

[zoog]

Re: Turkeys fall back to earth: It started with real estate

There has been some correlation, but I wouldn't say 1:1. See this somewhat crude chart I put together (hopefully the imageshack link works).



However, the current housing bubble far exceeds anything we've seen before, so I'm not sure how reliable past relationships are for predicting what might happen this time.

[GRG55]

Re: Turkeys fall back to earth: It started with real estate

EJ: Another compelling, logical dissertation. In addition to jk's observations on fast vs. slow US economy decline implications, I find myself asking what could derail the sequence or result in a material modification/extended playout. Being a newcomer to iTulip I am still trying to distill the enormous amount of historical information so perhaps these have been debated before? Nevertheless, a couple of thoughts to solicit feedback from the knowledgable iTulip community:

- Is recent US Treasury price action indicating that China and, perhaps, Japan believe potential depreciation of the US$ they hold as reserve assets now exceed the loss in income from export sales to the USA? Or is this an early warning sign that the CB's with least export exposure, or selling oil (presuming demand inelastic) are acting (e.g. recent Kuwait announcement) and the situation is likely to get worse as Asia piles on?

- China (Japan too?) would not appear predisposed to readily give up traded goods market share (I agree that if they do, that will be inflationary). Might they respond by "helping" debt strapped US consumers by going on an asset acquisition binge with their sovereign-wealth funds thereby continuing to recycle US$? Admittedly this is not going to be enough to offset the enormous size of the US Treasury market, but perhaps a new equilibrium scaling back one and increasing the other, could keep the game going a good while longer (or at least till they buy Pebble Beach and Rockefeller Center)? Could this be a coordinated way that the Chinese, Paulson and the Fed can lower rates and try to reflate without completely tanking the US$?

[jk]

Re: Turkeys fall back to earth: It started with real estate

- Is recent US Treasury price action indicating that China and, perhaps, Japan believe potential depreciation of the US$ they hold as reserve assets now exceed the loss in income from export sales to the USA? Or is this an early warning sign that the CB's with least export exposure, or selling oil (presuming demand inelastic) are acting (e.g. recent Kuwait announcement) and the situation is likely to get worse as Asia piles on?

i think that for the chinese, the issue around chinese export sales has much more to do with employment and social/political stability than with mere profit and loss. i'm sure they notice the profit and loss, but their real problem is how to manage the economy so that it supports the longevity of their current political system. they will need to wean themselves substantially from the u.s. market while maintaining employment and employment growth. they will not deliberately destroy their export market, except, i suppose, if the us presents a more direct threat to their polity.

last week saw not only kuwait uncouple from the dollar, but that bastion of financial strength, syria, did the same. i think cb's around the world, including the pboc, are tiptoeing away from the dollar as best they can, given their varied circumstances. kuwait and syria did no more than china did a while back - announce that instead of using a direct dollar peg, they would tie their currencies to a basket of other currencies. so china won't dump currently held dollars, i think, but try to steer new income in other directions.

- China (Japan too?) would not appear predisposed to readily give up traded goods market share (I agree that if they do, that will be inflationary). Might they respond by "helping" debt strapped US consumers by going on an asset acquisition binge with their sovereign-wealth funds thereby continuing to recycle US$? Admittedly this is not going to be enough to offset the enormous size of the US Treasury market, but perhaps a new equilibrium scaling back one and increasing the other, could keep the game going a good while longer (or at least till they buy Pebble Beach and Rockefeller Center)? Could this be a coordinated way that the Chinese, Paulson and the Fed can lower rates and try to reflate without completely tanking the US$?

i think it likely that they will increasingly buy real assets, including companies, in preference to financial claims like bonds. when they buy pebble beach and rockefeller center we will know that the top is in, again, in u.s. commercial real estate. the dollars-coming-home is part of poom.

i would like to add that i find it startling that the us is experiencing a phenomenon i associate with weak latin american countries -- capital flight. for some time domestic equity flows have been directed overwhelmingly to overseas investments. in this week's squall, asia, interestingly, has sold off less than the u.s. and europe.

[bart]

Re: Turkeys fall back to earth: It started with real estate

...
i think cb's around the world, including the pboc, are tiptoeing away from the dollar as best they can, given their varied circumstances.
...

Yes, certainly - and even "fer shure".

The key in my opinion is that this is not some new thing. The move away from the dollar has been going on for years. A trend in motion tends to stay in motion, as the old saw goes.

Here's a portion of data from the IMF about CB reserves (and note that the PBoC is not included - they do not report to the IMF):

[dbarberic]

Re: Turkeys fall back to earth: It started with real estate

The process goes like this.

3. Among other financial assets, demand for US treasuries bonds falls.
4. As demand for US treasury bonds falls, prices fall and yields rise.

As it has been discussed before in iTulip, central banks often act in the name of politics and not self best economic interest.

What makes you so sure that foreign central banks will allow the demand for T-Bills to fall? So far, as investor demand has fallen for T-Bills, foreign central banks have been jumping in to compensate.

Your theory is spot on, if you assume that everyone in the market place acts rationally. But, we have seen many times that central banks often do not act rationally. They act for political reasons, which may not be rational at all.