Monday, August 22, 2005


Bubbles and Canaries

The search for a harbinger of doom in the stock and real estate markets

I am sure you have heard of Google. I am sure you know that Google went public in August of last year and proceeded to triple. If you did not know this factoid, that is ok, most people are not giving the stock market anywhere near as much attention as they did five years ago. GOOG has been the cat's meow since its launch giving investors not an ounce of angst. That has changed over the past month. GOOG topped out on July 21st with an interday high of 317.80 and it is currently 275.10 (-4.90 on the day). I think GOOG is an excellent candidate for the stock that will signal the end of this rally. The canary in the coalmine.

Bill Fleckenstein in his most recent column for MSN Moneycentral has a different candidate for the canary in the real estate bubble coalmine.

Up until very recently, finance companies were able to come up with more and more imaginative products and expand the pool of potential speculators in the real-estate market -- thereby making it possible for prices to hold steady or be driven higher.

But a contact in the subprime-lending arena (lenders who specialize in making loans to borrowers with less-than-stellar credit records) suggests to me that it's becoming increasingly difficult for originators of subprime mortgages to sell them at a profit. Unless all of these are booked on the originator's own balance sheet, we'll start to see credit being cut off to the more marginal real-estate speculators -- the driving force, at the margin, behind the real-estate market.

Meanwhile, subprime-mortgage company New Century Financial (NEW, news, msgs) recently lowered its earnings projections, even though its loan volume is supposed to be rising. What that means, among other things, is that the company is facing margin pressure, which jibes with my contact's information. (I added to my New Century short position last Wednesday. I'm trying to be alert to additional problems, as it's beginning to feel to me like the short side of the entire housing ATM is slowly becoming an investible idea, not that I've done much about it just yet.)

In any case, I believe what's now changed is that, with the advent of problems in the subprime arena, the pool of potential buyers will begin to shrink. That will be a very big development, as it is a significant change at the margin. All important change tends to begin at the margin, and I think this is a perfect example.

Thus, the macro winds have shifted, I believe, and none of those shifts has occurred in a way that is bullish for U.S. assets. Bottom line: It's my opinion that a top is being formed (or is already in place), both in the housing market and the stock market. That spells trouble for an economy built on the unsustainable strategy of trying to speculate our way to prosperity.

So keep an eye on GOOG and NEW. I agree with Mr. Fleckenstein that real estate is in a bubble and the hardest thing to do is predict an end to a bubble. (Saying you are in one is actually extremely easy, just say it and wait for people to vehemently disagree with you) It is helpful to look at what is the fundamental mechanism that is fueling the borrowing and the availability of credit for subprime lenders facilitated with imaginative financing schemes is the number one candidate/culprit. Remember, 2000 to 2003 was phase one in the bear market. Phase two was the rally and phase three will be much worse because of this simple reason: all hope is abandoned as memory of the bull market is erased from the collective consciousness.

Have a nice day!


In repsonse to Diego's and Bill O's comments here are a couple links to articles about how new types of mortgages are driving housing prices.

Stop for a minute and consider that interest-only and adjustable-rate mortgages now comprise roughly 60% of all home loans (with "interest-only" contributing one-half to two-thirds of that). Just about four years ago, they may have accounted for less than 20%. That's not to say these two flavors of mortgages couldn't become even more popular -- because they could -- but to illustrate the magnitude of the potential problem we could ultimately face.

For those who think that real estate can never go down, I should note, as I did in my May 5 column, a like-minded belief among Japanese property owners in the late 1980s, where values have subsequently declined for the last 14 years. That decline, however, may finally be in the process of changing.

Another prevailing myth in the real estate market: We can always ride out any bumps in the road. While that may have been partially true in the past (assuming you didn't lose your job), it may be less likely in the future, given the huge percentage of people taking out interest-only and adjustable-rate mortgages.

For instance, if you had a 30-year $300,000 mortgage at 5.5%, it would cost roughly $1,700 per month (before taxes and insurance). If you took out an interest-only mortgage, your payments would start out at $1,375 but would rise in a few years to between $1,800 and $2,200, depending on how rates fluctuated in the future, assuming they went up. (Of course, rates could be higher or lower, depending on the prevailing policy.)

If you pick one of the super-duper interest-only mortgages that permit borrowers to basically choose their payment, you could shoehorn into the same $300,000 loan with a monthly payment of about $965. But a few years down the road, that would rise to around $2,200. That's a mighty hefty jump. (These numbers are meant as approximations, just to give you some feeling for the size of the jump that's staring lots of folks in the face.)

The housing affordability lesson I was taught is that your cost of housing should not exceed 35% of your net income. So if you have a married couple that take home $100,000/year they can afford a mortgage+taxes = $35,000; let's say $30,000 after property taxes. If you can structure an interest only loan allowing you to borrow $300,000 for $965/month then that couple can afford to pay $777,202. [=({30,000/12}/965)*300,000] Suddenly paying $500,000 looks prudent. But then you get into the interest rate game and the you must hope that real estate at least stays the same and that there is no loss of income. Bubbles are built on easy credit. I know this will end badly because of all the economic variables that have to remain ideal for the people who have borrowed beyond their means.


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