We are another week closer to the day when the Empire of Bubble finally blows up.
Oh, dear reader, if we were to tell you it would ruin the suspense. Besides, it is not given to man to know his fate. And here we let you in on a little secret…when you don’t have a good answer, quote the classics.
And what do they say?
“What each man wishes, that he also believes to be true.”
People prefer deception to truth. Lies, especially flattering lies, make them feel good about themselves. They are convenient and soothing, like diet cola – sweet and empty. The truth, by contrast, is too strong. It disturbs our digestion and troubles our sleep.
No, dear reader, give us mendacity any day.
One of the comforting lies that people want to hear today is that rising asset prices are the throbbing pulse of an economy in good health. And this is just one of the many ‘fibs’ that Americans happily lap up every day.
These days, a chart of practically anything is surging. Watches, executive aircraft, stamps, stocks in Zimbabwe, stocks in India – you name it. If asset prices are a measure of health, almost all the worlds’ economies are Olympic athletes.
Leading the field, of course, are the Chinese – who really do look like Olympians. They’re out in front in every sport. Already racing ahead five times as fast as the United States, the Chinese spurted ahead even faster recently, leaving economists stunned. At the close of the merry month of May, output from Chinese factories, mines and utilities was running more than 18% ahead of the previous year. Overall, the economy grew at an 11.1% rate during the first quarter. And Honda Motor Company (NYSE:HMC) says its plant in China will boost production by 71% this year.
Chinese speculators sold off their Shanghai shares recently, but the market is still sky high and threatens to push higher in the weeks ahead. China is awash in money with more than $1 trillion in reserves. And every working day, it earns another $1 billion in trade surplus.
If you believe the press reports, the Chinese put up a new city the size of Detroit every couple of weeks and build a new factory while we are taking our afternoon nap.
And now the Indian team is coming up fast, too. According to the International Herald Tribune, the Indians are sprinting – and speeding up around the bend. The Sensei index has broken through 14,000, and industrial production rose through April at a 13.6% rate.
Meanwhile, in the West, asset prices are zipping along, but real economies – middle-aged, fat, and sclerotic with taxes and regulation – are huffing and puffing like an asthmatic who’s lost his inhaler. Detroit might like to compete with Chennai, but it is old and out-of-shape. What can it do?
The folks who used to work on the assembly lines are beginning to ask that question too. In Detroit, they’re packing up and moving out. In the rest of the country, mortgage foreclosures hit a record in the first quarter, says Bloomberg. And down in Southern California, sales fell 34% from the year before.
But what’s this? Prices actually rose overall in the Golden State. How could that be? We have a theory: Most of the slowdown is occurring in the subprime market – where prices are lowest. If most of the sales that didn’t happen had been to subprime borrowers, the average sale price would rise.
Here in Britain, meanwhile, property prices are still going up too. But is this a good thing? The Daily Mail doesn’t think so. “House price nightmare has already hit rural England,” says a headline.
In Britain, as in the United States, house prices are up, but incomes aren’t. An Englishman’s home may be his castle, but the castles now sell for 10 times the salary the average Englishman can pay in many places. Only 55% of them can afford Home Sweet Home at today’s prices; in the prosperous Southeast, the figure is only 30%.
But that’s the trouble with truth. It is full of ambiguity, irony and paradox. The Englishman or Californian who sells his house now and moves to Paraguay is definitely ahead of the game. But the one who wants to buy a house looks like a loser.
The Daily Reckoning
Friday, June 15, 2007
Addison Wiggin, reporting from Baltimore…
“30-year mortgage rates saw their biggest one-week rise in over three years. A bump of 20 basis points in less than a week brought the average U.S. 30-year to 6.74% today – a one-year high. As if the subprime sector weren’t in enough trouble already. Repo men everywhere are lacing up their boots.”
For the rest of this story, and for more insights into today’s markets, see The 5 Min. Forecast
And more thoughts…
*** Are rising asset prices really a sign of economic health? Not in Zimbabwe. That godforsaken nation has the fastest rising stock market on earth. Yet, its economy is a basket case. The only thing you can do there is speculate in stocks. Who wants to build a factory in Zimbabwe? Who wants to invest in an oil refinery? Who even wants to plant trees? No one. So everyone buys stocks.
*** In America, up until the 1970s…or 1980s…the economy was pretty healthy. Stock prices reflected, in a rough way, corporate earnings. Art, property, collectibles and other assets rose, more or less, along with the economy itself. For every dollar in goods and services Americans bought from foreigners, they sold about another dollar’s worth to them.
But what is happening now? The Dow remains near an all-time high. It rose again yesterday. Other asset markets are going wild. Is this because the underlying economy is so strong? Or is it because there is just so much money around with nowhere else to go?
Is the U.S. economy more like the Chinese economy…or more like the Zimbabwean model?
*** In the West, even our fleetest industry seems to be running out of energy. Bear Stearns (NYSE:BSC) and Goldman (NYSE:GS) announced disappointing results – thanks to their exposure to subprime mortgages. Bear said its profits were off 10%. Goldman showed rising profits, but investors sold off the stock anyway; they expected more. Freddie Mac (NYSE:FRE) announced a $211 million loss for the first quarter.
The financial industry depends, first and foremost, on cheap and easy credit. Yet, the long bond is pushing mortgage rates up. Switzerland, a source of ultra-cheap money for many years, raised rates to a six-year high. The European Central Bank, too, made the front page of the IHT by hiking its key lending rates.
What to make of it? We don’t know, but right now, rising interest rates are like a javelin – aimed right at the biggest bubble the planet has ever seen.
*** Automobiles are much more reliable than they used to be. When we were young, there was hardly a teenage boy who didn’t know how to take a carburetor apart and clean it. We learned the basics of auto mechanics because we had to. Our first car cost us $75. It was an old ’37 Plymouth. What a beauty. What a gem. What a piece of junk! How many hours we spent trying to get that old bomb to run right. It never did. And we weren’t a good enough mechanic to fix it.
Today, on the street, we saw what looked like our old ’37 Plymouth. It was in a group of three antique cars. But unlike the other two, this black sedan had stalled in the middle of the road. The driver had gotten out of the car and opened the hood, while cars behind him honked. Maybe it was our old Plymouth – still broken down after all these years.
Eventually, the other antique car drivers came to his aid. Dressed in suits and ties, they pushed the car off to the side of the road. Then, all three looked down at the engine…wondering what to do.
*** It’s been years since we’ve even bothered to open the hood of our cars. And for the most part, we’ve had no reason to. But a few weeks ago, our Nissan Patrol – which we use to pull a horse van – slipped a disc. It wouldn’t go into fifth gear. This is the second major problem we’ve had with the car. Last year, the motor blew up, and was promptly replaced by the manufacturer. This time, we’re going to have to pay $4,000 for a new transmission.
Our children are not nearly as hip to auto-mechanics as we were. None of them would even know where to look for a carburetor, if cars still have them. When something goes wrong, “just call the garage,” they say.
But recently – in South America no less – Henry, 16, had a brush with mechanical necessity. He and his mother were driving along – in the middle of a desert. All of a sudden, a tire went flat. There were no towns…no gas stations…no houses…no telephone reception…and no other cars.
“It was touch and go there,” his mother reported. “We didn’t know where the spare was or how to change a tire. We got out the manual from the glove compartment. Naturally, it was in Spanish. Henry is pretty good in Spanish – but he didn’t know the words for ‘jack’ or ‘wrench’ and things like that. But eventually he figured it out. The hard part was getting the bolts out. He pulled on them as hard as he could, but they wouldn’t budge. We thought we’d be stuck there for hours and maybe all night. But then he jumped on the wrench somehow and broke it loose. We were saved. Henry is my hero.”
The Daily Reckoning PRESENTS: While the first major financial marriages took place at the height of the ’80s, it seems that recent big business nuptials are giving them a run for their proverbial money. But as Bill Bonner explains, these business ventures are just another aspect – and inevitable victim – of the global super bubble. Read on…
THREE WEDDINGS, ONE FUNERAL
“I believe that credit markets have been recklessly permissive to the point where instead of traditional risk-adjusted rates of return the market is dealing with what I would call risk-ignored rates of return.”
– Wilbur Ross, Private Equity Pioneer
The day that Jonathan Gray met Sam Zell, sparks flew. The two were made for each other. Gray runs Blackstone’s property arm and was looking for a big trophy deal in Manhattan’s hot commercial property market. Sam Zell, who has been around the block a few times, wanted out of his dull relationship with Equity Office Partners, the group of buildings he had lived with for many years.
The ceremony that followed was smashing, the biggest leveraged buyout ever. For $39 billion the union was consummated and Gray became master of the EOP portfolio. It was one for the history books and the newspapers. It was also one that cries out for deconstruction.
Think about it. Gray took money that cost him about 6.5% in financing expense and used it to buy properties that yielded a 3.75% “cap rate” return. Right on the surface of it, Blackstone seemed to be guaranteeing itself losses. What gives?
The burthen of today’s column is that, when it comes to credit expansions, all men are created equal – rich or poor, Japanese or American, sophisticated or just-off-the-turnip-truck. As long as the bubble is expanding, they all enjoy the same deceits and illusions. The subprime homeowner lies about his income while the big city slicker forgets to ask for protective covenants. All of them end up in deals they wish they had never heard of.
“Never take financial advice from someone younger than you are,” is an old-timer’s rule. Mr. Gray is only 37 years old. He was probably still in school the last time a major season of trophy marriages took place in New York. Then, it was the late ’80s and the ardent suitors were Japanese. Americans couldn’t believe their good fortune; here was a race of the dimmest witted rich people they had ever seen.
The fairy tale financial wedding of the era took place in 1989, between the Mitsubishi Estate and America’s own darling, the Rockefeller Center. Mitsubishi spent $1.4 billion, which was still big money in those days. Then it discovered it needed to fix the roof…and went on to spend a fortune on improvements and maintenance. A trio from Columbia Business School later dubbed the Mitsubishi-Rockefeller connubial one of the “Dumbest Business Decisions of All Time.”
What was so dumb about it was that it ignored the fundamentals of property investment. Buying properties only makes sense if you can get enough out of them in rent to cover your expenses and give you a decent return on your money.
After having invested nearly $300 billion in prestige properties in the United States in the 1980s, the Japanese quickly decided they wanted out and kept selling for the next 15 years. Prices of commercial real estate in America fell as much as 50% in the early ’90s. The buyers of Rockefeller Center had counted on rising rents; instead, rents fell, vacancies rose and the poor star-crossed samurai were buried in losses. Finally, they lost control of their trophy darling altogether. R.I.P.
It is now almost 20 years later. The drama is still the same, but the dramatis personae have changed. A few days ago Morgan Stanley made the news. All Nippon Airways owned a string of 13 hotels in Japan. It wanted to unload the places for about 100 billion yen and announced it would accept bids. Thirty suitors showed up. One of them, the aforementioned Mr. Gray, offered 235 billion yen. But then, along came another hunk, Morgan Stanley, with 280 billion yen; it won ANA’s favor with a bid 2.8 times greater than the Nips had hoped to get.
Financial marriages, when they result from such fevered bidding contests, are rarely happy ones. Lovers, caught in the heat of the auction, and steamed up by free-and-easy credit conditions, get carried away. A few months later, when money is not so easy to come by, they look over at the unfamiliar head on the pillow next to them and wonder what they have gotten themselves into. Even before Morgan Stanley raised the bar, prices in Tokyo had risen substantially. Dividend yields in Japan’s property sector, compared to 10-year bond yields, have been cut in half in the last five years. Average cap rates in Japan are now only 3.5%. Vacancy rates are below 3%. At the price Morgan Stanley paid, it is likely to soon find itself in a funk, like Mitsubishi Estate 18 years ago.
While Morgan Stanley was becoming one of Japan’s biggest hotel operators, it also paused to pay court to the aforementioned Mitsubishi Estate Co. This time, it was the Japanese who were wooed into selling a stake in their own property, worth – would you believe it – $1.4 billion, the exact amount of the Rockefeller Center purchase.
At least property investors in Japan can still hope to get enough yield to cover their financing costs – thanks to mortgage rates near 2%. In London and New York, on the other hand, the spread has gone negative.
The biggest deal in British property history took place recently too. This time the suitor was the huge Spanish property giant, Metrovacesa, and the trophy was London’s HSBC headquarters on Canary Wharf. At more than $2 billion, it was a trophy price too – the highest ever paid for a British building. In London, even more than in Japan…or in New York in 1989…a man looking for bargains might as well go home. Rents are said to be up 25% over the last 12 months. Prices per square foot are twice as high as those in New York. And at the price paid by the Spanish, their new trophy building will yield no more than they could have gotten in Tokyo – 3.8%. But financing costs are a lot higher in Britain than they are in Japan. Even the prime rate in the U.K. – at 5.5% – is significantly higher than the expected yield on the HSBC building. The Spaniards could get a better return from government bonds – almost without risk or hassle.
It boils down to this. You can learn amortization schedules in school, but some things you still have to learn on the job. And every generation has to pay its own tuition.
When you approach the final stage of a credit expansion, the bubbleheads rush head first into a flurry of bad investments. And when the confetti has stopped flying and the wedding gifts have been put away, they find that the unions that they entered into in such haste may now be regretted.
The Daily Reckoning
June 15, 2007
Editor’s Note: Don’t forget – you can hear Bill (along with all of your favorite DR editors) speak at this year’s Agora Financial Investment Symposium in Vancouver, British Columbia. This year’s theme is “Rim of Fire: Crisis & Opportunity in the New Asian Era” – and it’s your first look at investment opportunities, global market concerns, and the best investment bets across the globe.
Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).
In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is – an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt at a discount – just click on the link below: