The Mortgage Finance Bubble

On my way to the office each day, I drive through an older, more modest neighborhood. I have watched as a few ‘For Sale’ and ‘For Rent’ signs last summer have turned into an alarmingly large number as we begin a new year. It is my impression that, despite low rates and ultra-easy credit availability, the local existing home market has hit the wall. Interestingly, however, only a dozen or so miles north into suburbia, the market for new homes remains quite strong. This is an unusual two-tiered marketplace worth contemplating.

In the past, a weakening housing market and rising inventory would rattle the nerves of local bankers; financing for new construction would quickly run dry. But this New Age housing cycle has evolved into something quite different. For one, it is dominated by large national builders with close ties to Wall Street and the mortgage- backed securities marketplace. Importantly, these builders today have unlimited access to cheap finance to pursue their aggressive growth strategies.

Not dissimilar to the telecom sector during 1999, The Street, bankers, and Washington are today content to cheer along the construction boom and disregard the consequences.

As we have witnessed, the weaker the economy – and the more intense the financial stress – the greater the impetus for stoking the Great Mortgage Finance Bubble.

Mortgage Finance Bubble: Easy Financing

Limitless credit availability also affords the aggressive builders the decisive advantage of providing zero or minimal down-payment mortgages, together with other inducements. Along with ultra-easy financing, new homes are also effortless to insure…an attribute that has taken on new significance with increasingly difficult-to-obtain homeowners insurance.

“Zero-down, no payments until 2004” market distortions are currently sustaining strong new car sales in the face of a ballooning inventory of used cars (who wouldn’t want to buy new instead of used?). In the same way, we see distortions emanating from mortgage finance excess increasingly coming at the expense of the “used” home market.

A recent Dallas Morning News headline reads, “Home Foreclosures are Casualties of Economy”. Writer Steve Brown comments: “A bleak economy hit home in North Texas last year, putting thousands in danger of losing their homes. The number of homeowners threatened with foreclosure in Dallas County jumped 32%. And in Collin County – which has been ravaged by layoffs in the high-tech and telecom sectors – home foreclosure postings soared by 73% in 2002…January foreclosure postings for Dallas County were up 43% from January 2002. And in Collin County, foreclosure postings for the month were up a staggering 94%.” And, yet, the building boom hardly misses a beat.

One could build a case that, basically up to this point, the Mortgage Finance Bubble has worked to the interest of buyers, typical sellers and builders, alike. Perhaps this year, gains for the builders will come out of the hides of many distressed sellers (and their lenders and mortgage insurers!). Again, reflecting back to the telecom boom: many prosper for some time even after the boom has passed its peak – although the “marginal” player can be devastated as new finance is no longer forthcoming from increasingly cautious lenders.

Mortgage Finance Bubble: Office Building Boom and Bust

It may be helpful to recall the late-eighties office building boom (and later bust). Even though vacancies began rising markedly and serious problems were appearing on the horizon – making it clear that putting a moratorium on new construction was in virtually everyone’s best-interest – finance just rolled into the sector and additional high- rises were added to the developing glut.

Many “investors” found the sector’s above-market yields too enticing; and, besides, the returns had been quite strong for a few years! As we are witnessing today, in historical proportions throughout Mortgage Finance, once the financial apparatus (and speculative infatuation) has reached a critical mass, it is nearly impossible to temper. The flow of finance invariably turns to flood, and a painful bust becomes unavoidable.

Indeed, it is the awe-inspiring nature of speculative markets to inundate a sector with destabilizing finance at the very late stages of the boom. The home-building boom is poised to run through 2003, but the cost will be high. Clearly, the entire financial sector is continuing to push consumer and mortgage finance to their absolute limits – pedal to the metal. But rampant lending excess appears to have hit the point of diminishing returns. One should find the fourth quarter of 2002’s economic performance all the more alarming after confirmation that it was another truly extraordinary quarter of lending.

The Mortgage Finance Bubble is still managing to find consumers to feed it…today. But sooner or later – and if we had to bet, our money would be on ‘sooner’ – the almighty consumer is going to run out of steam.

Doug Noland
January 30, 2003


There is something missing from the world financial picture – nerves. Nobody seems to panic when they should.

“No end in sight to defaults and downgrades,” writes the FT. But bondholders don’t panic.

“2004 likely to show record budgets deficits,” says the Washington Post. The federal deficits “could top $300 billion,” says the New York Times. But Treasury buyers are as calm as serial killers.

The economy seems dangerously close to what Stephen Roach calls “stall speed”; still, the Fed doesn’t cut rates in a panic.

Consumers are losing their jobs and going bankrupt as never before. Still, there’s little change in their desire to spend what they don’t have on what they don’t need. “Trade deficit sets record,” notes USA TODAY. Despite a 20% drop in the dollar last year, the November ’02 trade gap hit $40 billion.

Stock investors have lost money for three years in a row. Stocks are still very expensive. Why don’t the poor saps panic?

And what’s wrong with foreign investors? Don’t they have any sense of fear, either? While U.S. stockholders lost 24% in the S&P last year, European investors in the S&P lost 38%, because they also suffered a loss on the dollar.

What all these people need to do is to look around for the exit sign…and stampede towards it. A good, bone-crushing panic would drive down prices to reasonable levels.

Humpty-Dumpty can teeter on the wall for a long, long time. Let’s give the guy a shove and get it over with!



Eric Fry, reporting from New York…

– The stock market reversed an early morning sell-off yesterday to eke out a slim gain. The Dow ended the day at 8,110, as an early 136-point deficit turned into a 21-point advance by the closing bell. The Nasdaq added about 1% to 1,358. The commodity markets were equally volatile, as crude oil jumped nearly one dollar to $33.63. Gold headed in the opposite direction, falling $3.70 to $366.30 an ounce.

– The stock market’s mid-day recovery and the gold market’s sell-off resulted, in part, from rumors that the U.S. government might be getting into the dictator-relocation business. The U.S. might avoid war, or so the rumor goes, if Saddam Hussein were to pack up his things and move out of Iraq to a country-to-be-named-later.

– Colin Powell gave some credence to the idea yesterday at a State Department news conference, when he said, “If [Saddam] were to leave the country and take some of his family members with him and others in the leading elite that have been responsible for so much trouble during the course of his regime, we would, I am sure, try to help find a place for them to go.”

– Shortly after Powell’s remarks, however, State Department spokesman, Richard Boucher, pooh-poohed the Saddam- relocation theory as simply, “an idea floating out there”.

– Another idea floating out there these days is that the economy is stabilizing and will mount a recovery later in the year. But as President Bush admitted in his State of the Union, “Our economy is recovering. Yet it is not growing fast enough, or strongly enough”. In short, the Union is in a pretty sorry state these days.

– The CEO of one large S&P 500 company told your co-editor Tuesday, “This economy is far worse than the official numbers indicate.” Given the rough conditions on Main Street, the CEO was justifiably proud of having produced modest earnings growth last year. Unfortunately, the path to that modest growth was littered with the pink slips of more than 1,000 of his employees…Therein lies a HUGE problem for the U.S. economy.

– Since final demand for goods and services is tepid at best, achieving “growth” necessitates cost-cutting, and cost-cutting often means job-cutting. Despite a theoretically recovering economy – based on the latest GDP numbers – the labor market keeps grinding lower.

– “The labor market downturn is far from behind us,” the Economic Policy Institute (EPI) reports. “Today’s labor market is much weaker than it was one or even two years ago, and the ‘jobless recovery’ grinds on.”

– The EPI, citing a few of the most troubling labor market trends, observes: “Payrolls contracted not only over the recessionary year of 2001, but also over the alleged recovery year of 2002. Unemployment rose throughout 2002, ending the year at 6.0% in December. Since the most recent economic peak, the jobless rolls have expanded by 2.8 million.”

– Jobs are continuing to disappear, no matter how much economic growth Wall Street strategists think they see and no matter how many positive GDP numbers Washington’s bean- counters produce…There simply is no recovering evident in the labor market.

– “Employment losses in the most recent recession and subsequent jobless recovery have been greater than in any of the other three [prior] recessions and recoveries,” says the EPI. “Other recessions may have led to greater losses initially, but by this point in those recoveries, the economy had bounced back and payrolls were again expanding.” That’s not happening this time…A bona fide “jobless recovery” is underway…

– The only feat harder to achieve than accumulating $100 billion is losing it. Not just anyone can lose $100 billion. First, you have to get that huge pile of money from somewhere. Next, you’ve got to figure out enough idiotic ways to throw money around that you lose $100 billion-worth of the stuff. Somehow, AOL Time Warner managed to achieve this epic feat in 2002.

– Yesterday, the struggling media-company-cum-Internet- icon-cum-basket-case announced that it would take a $45.5 billion charge to account for the declining value of its America Online flagship property. Earlier in the year, AOL took a much-publicized $54 billion charge. Add it all up, and before you know it, $100 billion has ascended into money heaven.

– Three years ago, when AOL and Time Warner consummated their union, your co-editor predicted that the merged entity would display the agility of “an elephant on Quaaludes.” But a drugged-up pachyderm never could have burned through $100 billion. Only delusional CEOs – flanked by armies of MBAs and investment bankers – could successfully plot the complete destruction of so vast a sum of money.


Back in Paris…

*** If all these investors panic…what will they panic towards? Our guess is that the exit sign has GOLD written all over it. In dollar terms, the price of gold has gone up 31% in the last 12 months. In the near term, it may well go down (we hope it does…we’re buying)…but there are not many other places for panicky investors to go.

*** The Europeans can retreat to euros, of course. The dollar lost 26% against the euro in the last 12 months. Deutsche Bank says that if the dollar were to follow its cyclical pattern of the last 20 years, we should expect it to drop to $1.25 to the euro 12 months from now. It’s currently at about $1.08.

*** The surprise may be that the dollar drops far more than that – against euros as well as gold. Never before has the U.S. has such a large trade deficit. Never before have there been so many people with so many dollars outsize the U.S. When these people panic, the pile up at the exits might be much worse than anything in the last 20 years.

*** War, war…war. The word is on every pair of lips…and every editorial page. We don’t know whether the war against Iraq will turn out well or badly, but colleague Dan Denning thinks he’s found a way to make a buck off of it.

“One way or another, Iraq is going to pump more oil,” he says. “Oil may not go up in price, but a few companies – the oil service businesses – are going to go up in price.”

“These companies went between 15% and 40% during the last war against Iraq,” Dan tells us. “They’ll do the same this time.”

[Editor’s note: we’ll here more from Dan tomorrow about the real ‘smoking gun’ behind the war with Iraq…stay tuned.]