U.S. Bubbleocracy

By Paul Mampilly

The housing bubbleocrats are starting to feel the pain resulting from the bursting of the housing bubble. Bubbleocrats hoping for a kind word from Warren Buffett at his annual confab in the capital of capitalism in Omaha, Nebraska, were sorely disappointed. Buffett thinks that a “significant downward adjustment” – i.e. a crash – is a real possibility for real estate prices.

Housing bubbleocrats should not dismiss Buffet’s opinions without due consideration. Buffet’s Berkshire Hathaway has numerous businesses that give him a direct eye into housing markets. These businesses include manufactured home builder Clayton Homes, paint producer Benjamin Moore, roofing and insulation manufacturer Johns Manville, furniture makers Nebraska Furniture Mart, Jordan’s Furniture and crucially, real estate brokerage, mortgage, title and homeowner’s insurance firm HomeServices of America. Buffet’s companies are widely exposed to housing and the operations of these companies have benefited from the rise of housing prices and consequently will suffer as prices drop. Buffet then has no negative axe to grind in the continuing national debate regarding housing prices.

Nonetheless, we know that housing bubbleocrats are unlikely to be convinced by such arguments. Behavioral finance tells us that belief in a point of view, even if irrational, will always trump logic until it’s too late. For these true believers then, we present “Toll Brothers orders fall 32%” and “Sold – or Not: When home buyers walk,” stories from the Wall Street Journal (WSJ) and the Washington Post (WP) respectively that should shake housing bubbleocrats from their complacency about the danger in elevated housing prices.

Toll Brothers, referenced in the WSJ story is a leading builder of luxury homes and is squarely in the eye of the gathering housing storm. Robert Toll, the company’s CEO, in reporting quarterly results, said this week, “we are entering our ninth month of slower sales in most of our markets.” Nonetheless, according to the WSJ article, Toll remains sanguine and hopeful and believes that the current slowdown is temporary. He blames current market conditions on competitors who have been lowering prices to get rid of burgeoning inventories (i.e. too many homes, too few buyers) and speculators who are now exiting the markets and canceling deliveries.

The gradient of Toll’s order slowdown in 2006 suggests that the CEO’s optimism is based on the triumph of hope over reality. Toll’s second quarter order decline of 32% follows a 29% decline in first quarter orders. The first quarter order decline was thought to be temporary too and one that would be reversed shortly.

Capuchinomics thought differently and told our readers about it in our February 11, 2006 e-letter “Big Bang Theory: Housing bubble meets pin.”

Toll’s second quarter order decline is confirmation of even grimmer portents for prices and the first signs of a coming debacle in housing. The WSJ article cites Bank of America securities analyst Daniel Oppenheim who points out that Toll’s 32% decline in orders came despite a 15% increase in the number of new Toll subdivisions being built. To us Toll’s order book looks to be in a meltdown.

Toll (and presumably other home builders) continues to build at a furious pace even as prices are taking a dive. Unless demand picks up, housing prices are entering the death spiral that precedes a bust as inventories rise further even as prices decline. As Buffett noted at his Omaha confab, “When you have speculation-type holdings and Internet day traders moving into the day-trade of condos, then you get a market that can move in a big way.”

Even as prices begin to descend into their death spiral and eventual collapse, bubble prices are catalyzing demographic trends as Americans uproot their lives get at their piece of the housing bubble. The New York Times (NYT) in “Farther afield: Americans head out beyond the exurbs” cites William H. Frey, a University of Michigan demographer who says there are vast regions of the country that have been “locked off” due to high housing prices. What Frey means is that many parts of the US are now unaffordable to home buyers.

Consequently, they have now given up on these markets and have moved to areas beyond exurbs to areas that were previously too rural and distant to be considered for residential housing.

Underlying this migratory trend to the ruburbs (our term for rural suburbs) is housing ennui of Americans who have been “locked off” from the experience of being housing bubbleocrats. “For $250,000 or $300,000, you can live in a big house,” says Paul Wylie, Wichita Falls county judge in the NYT story. Wylie’s statement encapsulates the central truth of this contemporary age: delusional dreams of vast wealth through speculation in real estate. Americans having lost faith in the stock markets and experiencing stagnant wages now believe that the path to riches lies in owning a five bedroom McMansion.

Today, the greatest benefit of living in our democratic, capitalist society is not the right to vote or the right to free speech but the right to this delusional dream of vast wealth through speculation i.e. the right to be a bubbleocrat. In the U.S., speculation has replaced the once quintessential ethic of hard work, thrift, fiscal prudence and generational progress. Now all we aspire to is to get rich by being at the forefront of the next asset bubble.

The US has successfully transitioned itself to a bubbleocracy where speculation is central activity of the economy. The rich and wealthy speculate through hedge funds and private equity, the middle and upper class through real estate and stocks and the working class through lottery tickets and gambling. From the lowest to the highest economic stratas of society, speculation has become the central preoccupation of the nation. However, the most populous economic strata in society is the middle class and hence the primary path to being a bubbleocrat has been through speculation in real estate.

For those still looking for jackpots through the housing bubble, it’s dark days ahead. The window on this speculation has closed. What is left to come is the ugly political aftermath and the resulting social convulsions. Proof that the real estate window has closed can be seen in the WP article that notes that home builders “are reporting that more people are walking away from contracts and from tens of thousands of dollars in deposits,” and that “the Washington market is among those seeing the highest percentages of buyers abandoning ship – more than double last year’s rate, according to one research firm, and perhaps as high as one in three new-home buyers in some places.”

For homeowners uninterested in speculation, but accidentally caught in the cross hairs of the real estate bubble’s back draft, there’s some good news. The Los Angeles Times in “Taking stock of your property – on the financial markets” notes that the Chicago Mercantile Exchange (CME), Chicago Board Options Exchange (CBOE) and International Real Estate Exchange (INREEX) are readying products that will track home values by cities and regions. These contracts will follow in the footsteps of Hedgestreet, an online financial market that according to the Los Angeles Times,” allows anyone with a $100 deposit and an internet connection to trade in instruments called “housing price hedgelets” based on prices in Chicago, L.A., Miami, New York, San Diego and San Francisco.”

Capuchinomics knows that most homeowners will not use these financial “innovations” to protect themselves because most believe there is no bubble. However, we’re optimists and so we hope that at least a few will use these financial instruments to counter declining prices. Others unwilling to take on such financial wheeling and dealing should minimize their exposure to a housing market collapse in where they can like in their stock and bond portfolios.

[Editor’s Note: Paul Mampilly, CFA is the Editor & Publisher of Capuchinomics. Paul previously worked at Bankers Trust, Deutsche Bank and ING as portfolio manager/equity analyst between 1991 and 2003. He earned his MBA from Fordham University and his BA from Montclair State University. Paul was awarded the Chartered Financial Analyst (CFA) designation in 1997.

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