The Rude Awakening
Wall Street, New York
Thursday, April 14, 2005 ------------------------- The Rude Awakening PRESENTS: In California, 30-year fixed-
rate mortgages are becoming as rare as 30-year old females
with real breasts… --- Advertisement --- ------------------------- ARM WRESTLING
By Eric J. Fry In California, 30-year fixed-rate mortgages are becoming as
rare as 30-year old females with real breasts - a
phenomenon that bodes ill for consumer spending…if
interest rates continue rising. Already, consumer spending is showing signs of fatigue,
even though the rising rate cycle is barely out of diapers.
Yesterday's headlines provided a grim preview of the
spending slowdown that may lie in wait. The Commerce
Department reported that retail sales, excluding auto and
gasoline sales, FELL in March. Even more troubling, general
merchandise store sales dropped .7%, while clothing store
sales tumbled nearly 2%. Also crossing the tape yesterday came word that Harley
Davidson failed to sell as many "hogs" as anticipated last
quarter, which prompted management to lower its sales
forecast for the rest of the year…The stock plummeted
about $10 on the news. "U.S. sales have been relatively
flat with the same period last year, falling short of
expectations," lamented Chief Financial Officer Jim Ziemer,
"We feel it is prudent to limit short-term production
growth." Rising interest rates - it is no secret - often slow
economic activity, including the economic activity of
riding brand new Harley "Road Kings" off the showroom
floor. But we suspect the upcoming cycle of rising rates -
a cycle that appears to be underway already - will do more
than SLOW activity, it might halt activity as abruptly as
an oncoming tractor-trailer halts a "Road King." Thus far, the effects of rising rates during this
particular economic cycle have been more-than-offset by the
ingenuity of mortgage lenders. The proliferation of
adjustable-rate mortgages, and more recently, interest-only
mortgages, have enabled homebuyers to buy much more home
that they could otherwise afford. The resulting low
mortgage payments have enabled many folks to buy more
baubles and gadgets from American retailers than they could
otherwise afford. But this seeming prosperity is contingent upon interest
rates behaving themselves. As rates rise, our "Ownership
Society" becomes an "Income-Deficient Society" that
struggles both to meet mortgage payments and to maintain
consumer spending. "Adjustable-rate mortgages are the new thing, interest-only
hybrid ARMs, the new-new thing," observes James Grant,
editor of Grant's Interest Rate Observer. No surprise then the trend-setting state of California is
setting the mortgage trend as well. Nearly half of all
California mortgages are of the interest-only variety, up
from almost none four years ago. "Confronted with soaring
home prices," the Los Angeles Times reports, "Californians
are adopting a 'buy now, pay later' strategy on a massive
scale…When the price of houses in California soared 17%
in 2003 and 22% in 2004, a curious thing happened: Instead
of home ownership decreasing because fewer people could
afford houses, it rose to record levels. "An interest-only loan offers the ability to defer for
three, five or seven years any payment for the house
itself," the Times explains. "That allows a potential buyer
to stretch to afford a place that otherwise would be out of
reach. Of course, everyone else using an interest-only loan
can stretch too. The result is that prices keep rising." The rest of the nation is rapidly adopting California's
home-financing fashion. Adjustable-rate mortgages now
account for a record-high 36.6% of all American mortgages.
Therefore, as long as interest rates remain near 40-year
lows, adjustable-rate mortgages will continue to provide
the joy of home ownership at affordably low interest rates.
However, if interest rates continue to rise, adjustable-
rate financing will impart the misery of mortgage servicing
at unaffordably high rates.  Unfortunately, California's trend-setting mortgage industry
is setting a trend that may prove toxic for the nation's
retailers. That's because rising rates cause rising
mortgage payments, which, all else being equal, cause
falling discretionary spending. EZ credit terms only serve to increase the eventual risk to
consumer spending. In other words, money borrowed and spent
today by marginal borrowers is, at best, money that will
not be spent tomorrow. "If you can fog a mirror, you can get a home loan," a
mortgage analyst recently joked. Likewise, we presume, if
you can break a mirror with a beer bottle, you can get a
loan to buy a Harley Davidson. Unfortunately, obtaining the
loan is the easy part. Servicing the loan is more
difficult, especially when rates are rising. To illustrate the downside of ARM-financing, let's consider
the hypothetical case of Mr. and Mrs. Marginal Home-Buyer.
Let's assume the happy couple purchased their dream house
in the early days of 2004 for $250,000. Let's further
assume that they acquired said dream house by using a one-
year, interest-only mortgage at 3.5%, and that the
resulting monthly mortgage payments consumed 35% of their
combined incomes. In other words, let's assume that they
"stretched" to buy as much home the bankers would allow
them to buy. During the first year, the happy homeowners paid $729 per
month to satisfy their mortgage. Unfortunately, because
Alan Greenspan has raised short-term interest rates SEVEN
times since the early days of 2004, the interest rate on
the Marginal Home-Buyer family's interest-only mortgage
will soon "re-set" to an interest rate around 5.5%. At that
rate, their monthly payments would jump to $1,145, or more
than 50% of their combined monthly incomes - a burden that
would be sure to make our happy homeowners very unhappy, if
not utterly insolvent. To be sure, not all holders of interest-only mortgages are
skirting the edge of solvency, but we would guess that most
are close enough to the edge that rising rates would force
them to sharply reduce their discretionary spending.  Perhaps, as the chart above suggest, rates have risen
enough already to restrain consumer spending somewhat. The
blue line depicts the price trend of the Bloomberg Leisure
Stock Index divided by the S&P 500. When the line was in an
up-trend, stocks like Harley-Davidson and snowmobile-maker
Polaris were performing better than the S&P 500. But
lately, these stocks have been under-performing the S&P.
The red line depicts the price trend of Harley-Davidson
shares, a bellwether of consumer-spending trends. The fact
that both of these price trends are sloping toward the
southeast suggests that consumer spending might continue
heading south. 30-year mortgages and natural breasts may both remain rare
sightings in California. But neither will become extinct.
Indeed, the trauma of rising interest rates in an
"adjustable-rate society" may inspire a longing for a
return to simpler times - a return to the days when
mortgage rates were fixed for 30 years…and breasts were
not. [Ed. Note: We've got a recommendation on how to profit from
falling consumer spending, below, in the Did You Notice. If
you would prefer to profit directly from a bust in the
lending industry, here's how: http://www.agora-inc.com/reports/DRI/WDRIF319 --- Advertisement ---
The $241 Million "Mutual Fund"
For only $2 a share, you can sneak into all 12 of these
undiscovered companies… stocks that the SEC ordinarily
only reserves for the mega rich.
But now YOU too can double your money as these stocks
rise…GUARANTEED or your money back!
Find out more…
|
------------------------- Did You Notice…?
By Dan Denning
RTH is a basket of the biggest retail stocks in America. In
the past, I've been partial to trading puts on it, because
it's the single best way to be "short the American
consumer." In an era of high debts and rising interest
rates, that's nearly always a good trade…over the long
term. 
But in the short term, it wouldn't be at all surprising to
see the stock snap back up to $94. The two momentum
indicators I've included on the nearby chart both show the
stock being oversold…What we're looking for soon is a way
to be "short" RTH if and when the snapback rally comes. The
best way is to place a limit order for an option that will
decline in value as the stock rises, giving us a chance to
get into a bearish trade on RTH at a good price AFTER the
snapback rally.
Obviously, there are several elements to the trade. If the
rally does not come, then you simply won't get filled on
your trade. No risk there. In that case, you can expect to
see a far larger down move in RTH, a big breakdown. A long-
term put would be in order if you simply can't wait.
[Ed. Note: For the specific trade Dan issued today, you'll
need to subscribe. We've knocked $100 of the price tag, and
if you subscribe before April 18, you get Dan's 5 best
option plays of 2005. See here for the details: http://www1.youreletters.com/t/131809/4903640/775069/0
------------------------- And the Markets…
| Wednesday | Tuesday | This week | Year-to-Date | DOW | 10,404 | 10,508 | -57 | -3.5% | S&P | 1,174 | 1,188 | -7 | -3.1% | NASDAQ | 1,974 | 2,005 | -25 | -9.2% | 10-year Treasury | 4.37% | 4.36% | -0.11 | 0.15 | 30-year Treasury | 4.68% | 4.66% | -0.08 | -0.14 | Russell 2000 | 603 | 613 | -8 | -7.5% | Gold | $429.30 | $428.80 | $2.60 | -1.9% | Silver | $7.20 | $7.18 | $0.06 | 5.7% | CRB | 300.83 | 302.63 | -3.49 | 6.0% | WTI NYMEX CRUDE | $50.22 | $51.86 | -$3.10 | 15.6% | Yen (YEN/USD) | JPY 107.38 | JPY 107.69 | 0.92 | -4.7% | Dollar (USD/EUR) | $1.2910 | $1.2920 | 18 | 4.8% | Dollar (USD/GBP) | $1.8934 | $1.8918 | -85 | 1.3% |
| 
