Government Exacerbates the Bubble

The Daily Reckoning PRESENTS: We’ve talked a lot about the frothy real estate market and subsequent bubble in these pages – and today Strategic Investment’s Dan Amoss looks at the factors that went into the housing bubble’s formation. Read on…


Preoccupation with the housing market has become more than a national pastime in the United States. It is now vital to the continued growth of consumer spending, and by extension, growth of the economy. According to the U.S. Census Bureau’s 2004 American Community Survey, there are approximately 74 million owner-occupied housing units in the U.S. Combining this fact with the number of existing and new home sales over the past few years, this tells us that about 9-10% of the housing market turns over every year.

Compare this low turnover with volume in the stock market. The typical S&P 500 stock has about 150% turnover per year, so you can be reasonably sure that the stock sitting in your portfolio is worth within a fraction of a percent of the last tick. The low housing transaction volume makes aggregate national housing value statistics misleading. The near-term value of your house is completely dependent on what current shoppers are willing and able to pay for your house. The “willing” part is psychological, and psychology has morphed from “my house will appreciate 15-20% per year” to “my house will appreciate 8% per year.” The “able” part is dependent on global liquidity and mortgage financing aggressiveness.

When studying the housing bubble’s formation, it’s crucial to take a good look at the federal government’s historical promotion of homeownership. The first influence that comes to mind is the obvious effect that GSEs Fannie Mae and Freddie Mac have had on mortgage banking; they constantly replenish the firepower of mortgage originators, allowing originators to rake in fees for each approval. Due diligence on risk now rarely goes beyond checking off credit score and income range boxes, often over the phone or online.

As part of the New Deal, the Federal Housing Administration (FHA) was created to stoke the housing market. It accomplished this by providing default insurance for lenders leery of homebuyers without the ability to afford the high down payments required for mortgages. As with all government programs, politicians never respect the costs or consequences beyond the next election cycle. In hindsight, the consequences are clear: The artificial influence of government-subsidized housing is resulting, and ultimately will result, in a gross misallocation of resources, and usually asset bubbles.

There is an interesting parallel between the Federal Reserve and the FHA. They both interfere in the free market, and the consequences of this interference have been super-charging the business (and now housing) cycle. Just as the Fed thinks it knows better than the market what the optimal short-term interest rate should be, the FHA has developed into yet another conduit through which the federal government subsidizes the entire housing market, granting first-time buyers an artificial boost in home purchasing power.

Decades of housing market inflation attracted several private companies to enter the mortgage insurance business. They viewed it as a no-brainer investment to take on the risk of default in return for modest monthly premiums. It’s important to respect the government’s aggressive response to the private sector’s market share gains. It is one of the many threats to the company I am recommending to my Strategic Investment subscribers as a short opportunity. This excerpt from President Bush’s FY 2007 federal budget proposal includes initiatives to respond to increased competition from both “piggyback” financing and private mortgage insurance:

“The Federal Housing Administration (FHA) is currently undergoing a rapid transformation to enable it to expand homeownership opportunities for low- and moderate-income families.

“Traditionally, FHA has assisted homebuyers underserved by the conventional mortgage market to obtain mortgage credit at a reasonable cost. Since the 1930s, FHA has been a primary mortgage source for first-time and minority buyers. However, in the last three years, FHA loan volume has fallen precipitously. This is good news, in part. Lower interest rates have made unassisted mortgages affordable for more families, and the private sector has increased its use of automated underwriting, allowing it to offer loans on favorable terms to more homebuyers. This is a positive development, when the private sector is offering favorable terms to borrowers who previously would have turned to FHA. However, a small portion of borrowers may still be ill served by incurring higher costs or unfair terms as compared to a comparable FHA loan product.

“Premiums for FHA mortgage insurance currently do not vary according to a borrower’s credit risk or the expected cost from defaults, causing better borrowers to subsidize weaker borrowers. This has driven safer borrowers to seek alternatives offered in the conventional market and pay higher prices than they would have if offered FHA risk-based pricing. The budget proposes tiered risk-based pricing to address this issue, which will decrease homebuyers’ costs, and thereby increase access to homeownership. This type of pricing will enable borrowers to know why they are paying certain costs and how to lower them…

“To remove two large barriers to homeownership – lack of savings for a down payment and impaired credit – the administration proposes two new FHA mortgage products. The Zero Down Payment mortgage will allow first-time buyers with a strong credit record to finance 100% of the home purchase price and closing costs. For borrowers with limited or weak credit histories, a second program, Payment Incentives, will initially charge a higher insurance premium and reduce premiums after a period of on-time payments. In conjunction with risk-based pricing, these products will expand homeownership opportunity on an actuarially sound basis.”

The private mortgage insurance industry was invented in 1957 by Max Karl, the founder of Mortgage Guaranty Insurance Corp., after he observed a disconnect between those who could not afford a 20% down payment on a house and lenders who, for good reason, avoided extending mortgages with greater than 80% loan-to-value ratios. The word “private” describes this industry because up until Mr. Karl’s entrepreneurial venture, the FHA had a monopoly in the mortgage insurance business.

Memories of the Great Depression were still fresh in the minds of bankers in those days. They respected the importance of avoiding overexposure to mortgage debt in a long economic downturn where job losses were involved. But Mr. Karl clearly saw an opportunity to bridge the gap between mortgage buyers and mortgage sellers by assuming a portion of default risk in return for premium payments.

This was yet another step in the evolution of the insurance industry. Now instead of assuming the risk of property destruction or auto accidents like traditional insurers, mortgage insurers would shoulder the risk of default on the part of homeowners with less than 20% equity in their homes. This has undoubtedly contributed to the nonstop buying pressure on housing over the past 50 years.

This sounds like a cash machine-type of business, provided that premiums are priced at a highly profitable level (“piggyback” loans and the FHA are a threat to this), housing prices do not decouple from income growth (they have), and the willingness of lenders to extend mortgages does not fall short of required demand (this looks like a distinct near-term possibility). Two widely respected economists assert that in order for the U.S. housing market to sustain current price levels, either household debt must continue growing exponentially or real wage growth must revive from its current doldrums.


Dan Amoss, CFA
for The Daily Reckoning
August 15, 2006

P.S. In addition, poorly written mortgages can quickly turn sour. As this unfortunate occurrence spreads more widely across the United States, mortgage insurers will transform from cash-generating businesses to cash-burning businesses in a heartbeat:

Nationally, foreclosures are up 38%, higher than in any quarter of last year, RealtyTrac said. “The increases we’ve been seeing in foreclosures don’t even reflect the worst-case scenario that could happen when the $2.7 trillion in adjustable-rate mortgages are reset over the next 18 months,” said Rick Sharga, vice president of marketing at RealtyTrac.

Editor’s Note: Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored “big picture” trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.

It was on this day, exactly 35 years ago, that the monetary system of our world came to birth.

It was an immaculate conception, free of taint from history or tradition, mid-wifed by the administration of Richard Milhous Nixon, which decided that it needed to protect the nation’s gold. Thus was renounced the solemn promises made by generations of U.S. Treasury secretaries: U.S. currency obligations would be paid off in gold. Thus ended the time-hallowed monetary tradition of gold backing. Instead, in effect, Nixon plumped for default.

But who cared? By then, the United States was calling the shots around the world – if it chose to debase its own currency, who could do anything about it?

Three and a half decades later, we raise our heads and look around in fear and trembling. What hath this goldless innovation wrought?

In the 1970s, it wrought the worst recession in 40 years, until big Paul Volcker finally got control of inflation. The stage was then set for a big boom – one that took the Dow from under 1,000 to over 11,000. But, since never are there any free lunches in the financial world, stocks did not merely become 11 times more valuable; with the dollar no longer nagged by gold, there was also a tidal wave of money and credit that muddied the whole picture. Yes, stocks were priced 11 times higher, but what were they really worth? No one really knew, because the money in which they were quoted floated at high tide along with the stocks themselves.

The boom only ended in January 2000. What would have happened next, had things been allowed to progress normally, we shall never know. Instead, after jet planes flew into the World Trade Center, the feds panicked and pumped even more credit into the financial system, creating a fresh series of global booms and bubbles…in residential real estate…in foreign markets…in gold and commodities…in derivatives.

Now, it appears that bubble-time has finally come to an end. Loan applications are down 20% from last year. The housing market index is at its lowest level in 15 years. And the National Association of Realtors thinks sales of existing houses will be about 6.5% lower this year than the last.

“Who’s going to buy all those condos?” asks the Minneapolis paper.

Who indeed. Markets go down…and go up. But what has the goldless market really accomplished? Are people better off? Richer, freer, happier?

They are no happier, say the polls. The welter of laws, codes, and regulations tying down the nation tell us they are no freer. But are they richer? Yes…and no. The rich have gotten richer, because their assets have shot up in price. But those who are not rich? The numbers are squishy, slippery; comparisons are elusive. But in terms of disposable money, the working man has made almost no financial progress in the last 35 years.

“It bothers me,” former Federal Reserve Chairman Paul Volcker said in an interview. “I tell you, I don’t know why there hasn’t been more discussion and more unhappiness about this because it’s become quite distinct. For a long time now, if we believe the statistics, the average working guy does not have an increase in income.”

The International Herald Tribune elucidates further:

“Previously, income grew more or less in step with household wealth. From 1962 to 1966, a period of low inflation and robust economic growth, real private sector wages rose 27.5 percent while real net worth increased 23.6 percent, according to Bloomberg News calculations based on government data. In the five-year period ending in 1996, real net worth gained 15.6 percent while private wages grew 11.3 percent.

“More recently, the gap between household net worth and wage growth has widened. From 2001 to 2005, the value of household assets minus liabilities rose 16.6 percent after inflation. Private sector wages rose just 2.7 percent.”

We look around and ask ourselves what the average man has got from the new and improved monetary regime of the last 35 years. A bigger mortgage. A longer workday. More gadgets, automobiles and houses. A government far deeper in debt than any government ever was.

He has gotten more globalized commerce, too. Easy credit has bought him gadgets from Hangzhou, China, or Bangalore, India, as easily as from San Diego, California, or Gary, Indiana. He’s also discovered two billion people who want his job, his house, and his standard of living.

Too bad they can’t afford them. Too bad he can’t, either.

More news from our currency counselor…


Chuck Butler, reporting from the EverBank world-currency trading desk in St. Louis:

“OK, inflation is running at 4.2%. That’s 4% too much! And now, we’ve got an economy that’s slowing down and high inflation.” Hmmm. This is beginning to remind me of the mid-70s. Remember that?”

For the rest of this story, and for more insights into today’s currency markets, see The Daily Pfennig


And more views from France…

*** We received this note today from Addison, who’s “roughing it” in the South of France…

“You won’t find Golfe-Juan on the map. The little town we’re staying in is neatly tucked into the coastline between Cannes and Antibes. This place is famous for one thing: it’s the site where Napoleon snuck back into France after being imprisoned on the island of Elbe in 1815. The scene is famously fictionalized in the opening to Alexandre Dumas’ The Count of Monte Cristo.

“Over the weekend, we rented a car and traversed Route Napoleon – the route Napoleon took through the Alps on his way back to Paris after landing here. The high mountain ‘corniches’ are well-kept roads that wind there way through rocks and cliffs with sporadic views of the Mediterranean in the distance. It’s a stretch to imagine how the stonewalls on such tight curves were so neatly crafted on steep terrain.

“We got off the route in a little tourist trap called Castellane. Apart from a 300 meter, castle-like rock outcropping with a medieval church on the top of it, the town was, er, annoying. Italian and German tourists packed the streets, making noises like pack animals. When we were finally able to find a table at a café, the garcon who served us an assiette de fromage was patronizing…in very bad English.

“On the way back to Golfe-Juan we drove through the Gorge de Verdon. The gorge saved the trip for us; it was beautiful and dramatic. Driving through the winding roads, we began to understand why the Italians and Germans are so found of high-performance automobiles. The flora reminded us of the Western Slope of Colorado. And the river cutting through the mountains was an inviting aquamarine.

“A favorite past-time of the tourists in the gorge is a sport called canyoning: you wrap yourself in a floatable wetsuit, put your camping gear in a dry-bag, then head off down the river without a boat or paddle…hopping, diving, tumbling and floating your way to the lake some 40 kilometers away at the other end.”

More from Addison to follow…

*** Today is the Feast of the Assumption, which commemorates the day the Mother of Jesus was taken up body and soul into heaven. Even though it didn’t become a dogma until the 20th century, the Assumption was widely accepted as a fact in the Middle Ages, along with a belief in Mary’s immaculate conception. It is a public holiday in many countries, including Cameroon, France, Italy, Belgium, and Spain. We are not theologically inclined, but, unlike the Nixon administration, we see no particular reason why we should object to a tradition that has been around for centuries. In a few minutes, we too will be off to mass.

But meanwhile, as always in August, our house is open (and our liquor cabinet) to guests. Nearly every evening, we have them. Some guests visit from across the street…others from far away. But without fail, the conversation is lively, often engaging. And, though your editor is not an especially sociable fellow, he goes along with the rest of the family and keeps his ears open.

“A couple of things surprised us,” started a French naval officer just returned from a three-year stint at Virginia Beach, VA.

“Americans are very warm, nice people. But they don’t seem well traveled or well informed. We kept meeting people who didn’t have passports and had never even left the state of Virginia. Or, if they were taking a big vacation, maybe they would go to Florida. That seemed strange to us in a country where people are so rich, and so advanced technologically.

“You’d think they’d be more curious about the rest of the world. Then we read that even most members of Congress don’t have passports. It makes you wonder. After all, American foreign policy is the most active and aggressive in the world, yet, Americans themselves are not really very interested in the world outside and don’t know much about it. And then, they are very bad at languages…and bad at understanding foreign culture, which makes me think they are going to be very bad at working their way through complex international situations – such as what we have today in the Mid-East.

“It doesn’t really surprise me that they’ve made such a mess of things there. They just didn’t understand what they were getting into. And now, they don’t understand how to get out of it.

“You can certainly criticize us French on many levels, for many different things, but we do know something about dealing with Arab countries. And, we warned America’s leaders not to go into Iraq in the first place. Not because we particularly care about Iraq…we just know from experience in North Africa that you don’t go into those places, unless you know exactly what you’re doing and how you’re going to get out. Americans – and I’m talking about the people I worked with at the naval base – oversimplify the rest of the world, because they don’t really know it that well.”

“What was the other thing that you found surprising?” we asked.

“Oh…well, in France, military families tend to have a lot of children,” replied the officer. “It is just tradition. We’re usually very conservative…and Catholic.

“But in America, big families are rare. We have six children and people think we are either very rich…or very eccentric. They don’t know what to make of it. Most of the Americans in our neighborhood had two children…or maybe three at most. Six was unheard of.

“I guess these things go in fads and fashions…partly. But another reason could be that Americans have to pay for their own education, beyond a certain level. And for health care. And it gets very expensive to have families. Some people I know actually made that calculation when they decided not to have more children. They simply couldn’t afford them. So, the only people with big families are the rich…or the poor, who don’t care about higher education. It’s kind of sad, really. It’s sad when people want more children and can’t afford them.”

*** We also had another group of visitors – a family of Americans with four children. They returned to the United States during the London airport closures last Friday. We were wondering how they made it home…and then got this note:

“We returned safely to Maryland last night. Elisabeth’s advice (after we saw our train leave without us) to jump on the next train to Paris was good. From Montparnasse, we took a taxi to the airport without problem.

“In fact, we were blissfully unaware that anything was going on with air travel until we reached Iceland. Happily, the security guards there didn’t take the idiotic restrictions on carry-on baggage literally. They seemed as annoyed as we were to have to go through with the motions. After checking with a supervisor, they even let us on with sealed baby food for Jeremiah – and Bethany’s asthma inhaler, though we don’t carry the doctor’s written prescription with us. But it did delay us.

“Luckily our baggage was already checked through from Paris to Baltimore, so even though we were held up by an hour, the plane couldn’t leave, since our baggage was already in the hold. We were literally the last to board.”