Vigilant Investor

Those folks who thought Adjustable Rate Mortgages were the best thing since sliced bread may be rethinking the idea these days.

In order to get the $800,000 house he bought early last year in California’s Silicon Valley, Joe got an “option ARM,” an adjustable-rate loan that lets him choose from a variety of payments every month. The smallest payment included no principal and less than 100 percent of the interest due. The unpaid interest was tacked onto the principal, creating “negative amortization.”

This let Joe trade lower p

ayments now for higher payments later. He initially thought his salary would rise along with his home’s value - he was a marketing executive for a small software firm he was confident would be successful. But when a lost deal closed the company and “For Sale” signs popped up - and stayed up - in his neighborhood, a now-unemployed Joe is wondering how he will afford those higher payments when his rates adjust.

That snipped is from Vanessa Richardson’s article on MSNBC.com titled ” ‘Exotic’ mortgages seen losing their allure.”

While the ARM mortgage may not be the pending economic Armageddon some suggest, there are still more than a few problems presented by the $1.25 trillion of them due to reset in the next twelve months at much higher levels absent sensible action by those capable of refinancing their mortgages. If we look at mortgage rates this year, we can see a bullet has whizzed by more than a few ears:

Hence, dipping rates present a heck of an opportunity for mortgage brokers and home owners alike to convert ARM’s to more sensible long term loans less susceptible to higher rates.

Why the urgency? Let’s look at history:

What we do know is that there are more than a few “Joe’s” like the story above, and a whole heck of a lot of speculative flippers sitting on property that could be turning upside down. Indeed, we may not be in store for a housing caused depression, but given the vast problems with many other areas in the economy (particularly the U.S. balance sheet), don’t be surprised to find the housing bubble being the lead falling domino into a severe 1970s style recession — or perhaps worse.

Readers, this investing environment is definitely not 1982 all over again. (That was the start of the great bull markets in both stocks and bonds started, during which most currently active individuals and pros earned their investment spurs.) Don’t act like it is.

Recommended reading on the current mortgage situation in relation to the housing bubble and likely economic problems:

• Many homeowners with nontraditional loans are in for a payment shock
• Danielle DiMartino: Will credit market be up in ARMs?
• Mortgage Market Begins to See Cracks As Subprime-Loan Problems Emerge
• Mortgage applications slip lower
• U.S. mortgage rates slide slightly

What does the bursting housing bubble mean to the economy? What does it mean to you, your business and your family?

Tune in to tonight’s live net-radio Vigilant Investor call-in stream-cast at 9:00 p.m. Eastern. Just click the blue TalkShoe button link!

Feel free to call in and ask questions, or download the easy to use talkshoe IM interface for group chat. (Arrive a few minutes early for instructions and download!)

Also, you can always listen to past episodes by clicking our menu link at the left.

We appreciate your patience…

In a positive affirmation to the inflation crowd, Chrysler announced Monday that it expects gas prices to remain in the $3 to $4 range for the rest of the decade, and that it’s business model is changing to accommodate this new reality. The reality of high gas prices appears to also be taking a toll on consumer confidence, which plunged in August — although consumers also have the slumping housing market and job anxiety to credit for their loss in confidence.

But as for gas prices, here’s our list of a few reasons why consumers and investors ought to continue planning on prices in the $3 to $ 4 range.

Peak Oil

For those who don’t understand the Peak Oil discussion, it should not be cast aside as a half-cocked belief that the world is running out of petroleum energy resources. Rather, it is a compelling argument that the sun is setting on the easy availability of the purest quality petroleum based energy reserves. From an economic standpoint the world has benefited dramatically by having to expend very little energy in order to extract high quality oil from the earth, which can then be refined for other purposes with very little energy input. This translated into gasoline prices that were for a nearly century cheaper than drinking water. Peak oil theory, however, suggests that oil production has recently peaked, and that as the low hanging fruit slowly vanishes over the next decades, sources harder to extract or refine will have to be tapped. These resources will require higher energy and input costs, resulting in progressively higher costs to consumers. You can read more about the pros and cons of the Peak Oil Theory here.

Money Supply and Credit Inflation

When you expand the units of currency in circulation, eventually prices will adjust to the expansion. However, it should be understood that price inflation does not hit all goods and services equally. Instead, it hits hardest those goods and services highest in demand. Energy is one of those first-order, high-demand goods. The U.S. dollar is the common currency used for all global oil transactions. As such, Continue Reading »

Last Thursday’s single family home report was dismal. Here are just a few of the highlights:

• New single-family homes sold in July were down 22.2% from year-ago.
• New homes for sale in July jumped up 22.44%

With a little math, we find the gap is an astounding 44.66%, the worst since 1972. This would suggest that prices have only one way to go to restore equilibrium to the marketplace.

It will be interesting to see how the markets will digest the year over year data when, in September, the numbers hit even harder. One year ago you could read most analysts claiming the housing bubble was non existent. Lately the consensus has been that we’ll have a Fed engineered soft landing.

But the degree to which expanding credit has enabled this bubble reach such heights, combined with how dramatically bubble-created home equity — and it’s extraction via home equity loans - has buoyed the economy, should both be underestimated at your own risk.  A soft landing is something to hope for, but that, too, is facing obstacles of historic proportions.

As prices slack, home equity loans will plummet, as will consumer confidence and related consumer spending. Meanwhile, a record $ 1.25 trillion adjustable rate mortgages (ARMs) are coming due this year and next. It will be interesting to see how much discretionary spending is unsettled as ARM users are faced with the choice of rolling over into a new, higher ARM, or locking in with an even higher fixed rate mortgage.

If you’ve stumbled onto this article, we encourage you to look around since this is only the tip of the iceberg related to problems facing the U.S. economy and the changing investment dynamic. It is not 1982 all over again.

There’ve been lots of questions in the news lately about inflation, and even more about if the economy might dabble into recession.

We think this is a good time to review the economic growth indicator, GDP (gross domestic product). As with other primary indicators, such as CPI (inflation) and unemployment (among others), the 2006 way of calculating those figures is a far cry from how they were done 30 or 40 years ago.

Of course, we are told that the new formulas are more accurate than the old ways. — Or, why else would the powers that be have changed the methods?

That question belies wishful ignorance of the nature of politics and the depths to which politicians will go to in order to pawn off sows’ ears as silk. It should surprise nobody, then, that the “improvements” to GDP, CPI and unemployment all happen to present a rosier picture of the economy than each preceding method. (They done “small things” like help reduce Social Security costs by about 40% from where they would have been.)

With that in mind, let’s take a look at John Williams’ figures for real GDP vs. official GDP. For those of you who don’t know Mr. Williams, he’s been in the econometric consulting business for years. Decade’s ago, when his firm’s effectiveness at gauging the economy started to slip, he noticed that said degradation in quality coincided with an official adjustment from the government authorities in how some of the figures were calculated. After doing a good bit of research, his firm re-engineered the official figures back to their old selves pre the changes. Soon enough, his firms accuracy was restored to its prior levels. [You can read our prior posts on how and why the numbers were politically rigged .]

With that as a backdrop, I present to you Mr. Williams’ GDP figures produced for his website Shadow Government Statistics.

We encourage skeptics to visit his site to learn about his methods. In summary, however, GDP is the beneficiary of understated inflation and overstated economic activity. Looking at the graph we can see that the recession was far deeper than most analysts believe, and that what we are experiencing now is the second leg of a recession that started in 2001.

Were this just one piece of lone material out their in the wilderness, we could easily discount John William’s material. But Vigilant Investor is devoted to bringing together at one place the evidence to support that John Williams should not be dismissed out of hand.

We know in this, the era of the supposedly omnipotent efficient market, there will be many skeptics among our 25,000 monthly readers. Therefore, we encourage everyone to listen to a recent radio interview with John Williams, as well as read the interview of him done earlier this year by former Barron’s editor, Kate Welling.

From the Hearings on Monetary Policy and the State of the Economy Committee on Financial Services, the U.S. House of Representatives

July 20, 2006, Washington, D.C.

MR. PAUL: Good afternoon, Chairman Bernanke.

I have a question dealing with the Working Group on Financial Markets. I want to learn more about that group and actually what authority they have and what they do. Could you tell me, as a member of that group, how often they meet and how often they take action; and have they done something recently? And are there reports sent out by this particular group?

MR. BERNANKE: Yes, Congressman. The President’s Working Group was convened

by the President, I believe, after the 1987 stock market crash. It meets irregularly, I would guess about four or five times a year, but I am not exactly sure. And its primary function is advisory, to prepare reports. I mentioned earlier that we have been asked to prepare a report on the terrorism risk insurance. So that is what we generally do.

MR. PAUL: In the media you will find articles that will claim that it is a lot more than an advisory group you know, if there is a stock market crash, that you literally have a lot of authority, you know, to impose restrictions on the market. And we are talking about many trillions of dollars slushing around in all the financial markets, and this involves Treasury and, of course, the Fed, as well as the SEC and the CFTC. So there is a lot of potential there.

And the reason this came to my attention was just recently there was an article that actually made a charge that out of this group came actions to interfere with the prices of General Motors stock. Have you read that, or do you know anything about that?

MR. BERNANKE: No, sir, I don’t.

MR. PAUL: Because they were charging that there was a problem with General Motors, and then there was a spike in GM’s stock prices.

But back to the issue of the meeting. You tell me it meets irregularly, but there are minutes kept, or are there reports made on this group? Continue Reading »

1. We’re coming up on the five-year anniversary of the 9/11 attacks. Is the country safer or more vulnerable to terrorism?


On balance, more vulnerable. We’re safer in terms of aircraft travel. We’re safer from being attacked by some dumbhead who tries to come into the country through an official checkpoint; we’ve spent billions on that. But for the most part our victories have been tactical and not strategic. There have been important successes by the intelligence services and Special Forces in capturing and killing Al Qaeda militants, but in the long run that’s just a body count, not progress. We can’t capture them one by one and bring them to justice. There are too many of them, and more now than before September 11. In official Western rhetoric these are finite organizations, but every time we interfere in Muslim countries they get more support.

In the long run, we’re not safer because we’re still operating on the assumption that we’re hated because of our freedoms, when in fact we’re hated because of our actions in the Islamic world.
Continue Reading »

“Greenspan was in the limelight for the wrong reason: He participated in the U.S.’s boom — some might even say he acted as cheerleader — as opposed to regulating it. His easy-money policies brought the party to new heights, fueling asset bubbles in the U.S. and, more recently, China. Lots of cheap, U.S.- provided money flowed into already overheated Chinese assets.”

That’s from William Pesek Jr. in his “Central Bankers More Like Santa than Scrooge” piece, today in Bloomberg.

We think it’s a good read for understanding some of the problems facing investors going forward. The better you understand, the better you’ll be in a position to adjust.

That’s a question I often get about our ongoing commentary on the busting of the housing bubble.

Let’s see what one of the nation’s largest home related retailers has to say about the situation:

Stalled housing market clouds Lowe’s outlook

The real problem, you see, isn’t the housing market directly — it is the credit bubble that created a bubble in all things housing, and then by inference, most things in the economy servicing those folks. And this is no small issue: It is said that half of all jobs created since the recession of 2001 were housing related. Consider these graphs:

[click charts for full sized]

There’s no doubt that the Fed will work feverishly to engineer a soft landing for the economy as a consequence. But given the many structural headwinds we speak of here on a daily basis — and we truly encourage you to flip through our past for material that will help you understand the severity of the situation — Ben Bernanke and crew have their hands full. At the moment we can only hope that many folks lured into Adjustable Rate Mortgages over the past few years are taking advantage of the opportunity locking in lower fixed rates given the bond market’s current cooperation.

A big concern of ours, however, is that many ARM users were unable to accept 30-year fixed mortgages and needed the ARM to make it in the door. With $1.2 and $1.5 trillion of these resetting in 2006 and 2007, it is impossible to not expect that a large percentage of those homeowners will find higher fixed mortgage payments, leaving those individuals with dramatically less disposable income. Those who manage to refi into a new ARM in our current window… well… interest rate roulette comes to mind.

With that in mind, the fact that officially reported (and fudged) inflation is on the rise, and that wages are stagnating by comparison, only adds insult to injury. The thought of the fed attempting to pump more liquidity into an already saturated environment only begs the questions of “how?”, and “at what cost to prices?” The only problem is, what alternative do they have in their bag of tricks?

Can you say recession? You should contemplate the possibility of a bad one with inflation, too.

“The fabled engine of our economy is clearly unwinding. The sobering implications, however, were lost on the stock market last Tuesday. That’s when a weaker-than-expected PPI number incited the umpteenth Fed-is-done rally. What folks ignored that day: News from the National Association of Homebuilders that its Housing Confidence Index fell to the lowest level since early 1991.”

That’s Bill Fleckenstein in his latest commentary, “Face it: The Housing Bust is Here“.

Fleck has been among us as one of the few sober voices out there questioning the post 2000 bust reality. You should give him a read because he has his arms around the housing bubble. It’s hard to believe that not long ago there was a tremendous amount of denial that the housing market was even bubbling. In the last year, most pundits talk of soft landings and few worries. But the details we’ve been chronicling here at Vigilant Investor (and its previous hard-copy incarnations) seem to be gaining a more popular audience, to the point where a steady and ever growing chorus appears to be coming to terms with the nature of the housing bubble problem — and what could surface in its wake.

For those interested, give these other more mainstream pieces a read — just from today’s news.

• WSJ: Consumers Curb Upscale Buying As Gasoline Prices, Housing Bite
• Foreclosures up in California By 67 percent in the second quarter
• Housing bubble peaks as 28 states see decline in home sales
• AP: Lenders Cut Riskier Mortgages Due to Wall Street Pressure
• LA Times: Millions of homeowners could soon see their adjustable rate mortgage payments skyrocket
• NYT: Rents Are Rising Rapidly After Long Lull
• Barron’s: The No-Money-Down Disaster
• Bloomberg News: No housing for working class in Florida’s ‘bubble city’

Giving every man a vote has no more made men wise and free than Christianity has made them good.

H. L. Mencken
(1880 - 1956)

• Cost of Living Gets Costlier
• WSJ: Economists Paint Gloomier Picture
• Economy Often Defies Soft Landing
• Taxable profits ‘heading down till 2010’
• Federal deficit predicted to hit $1.76 trillion in next decade
• Bush huddles with economic team as growth slows
• Energy Costs Top Small Biz Worries
• Adjustable loan resets to impact mortgage bonds
• Insurers Urge Action On Risky Mortgages
• Option ARMs still favored by lenders amid scrutiny
• Hard landing predicted for U.S. housing market
• Ford Motor to Cut 6,000 Salaried Jobs
• Ford cutting North American production by 21%

On the other hand, this summer brought a dramatic — and frankly, surprising improvement for the formerly suffering residents of Pennsylvania thanks to an initiative from State House Representative Mike Turzai. (R. Bradford Woods), PA residents can now deduct up to $12,000 in 529 contributions to a 529 college savings program. Moreover, the bill also eliminated the draconian rule that would have prevented PA income tax advantages for 529s sponsored by other states. That means contributors get the state deduction, and beneficiaries may make both federal and state tax-free withdrawals from any program, not just the PA sponsored program from Lincoln Financial out of Philadelphia.

There are still severe restrictive deficiencies in 529s. Why investors can’t simply be allowed the same, entire universe of investment options open to them ordinarily in any run of the mill account is beyond me. Instead, investors are shoeboxed and prevented from accessing alternative investments and management styles. With that in mind, there’s still a lot of reform and simplification due for 529s.

But PA resident’s options are now greatly expanded. No longer are they held hostage by PA tax considerations.

Incidentally, those of you looking for a comprehensive book on how to afford paying the ever mounting costs of college — consider Paying for College without going broke, linked to the image above in this post. Having read more than my share, it is IMO the best and most comprehensive starting point.

We often point out that, because economic changes tend to happen at a glacial pace, most folks have a tendency to allow dislocations - like bubbles - to go unnoticed, or even embraced. In fact, there is a tendency to believe that if a dislocation goes on long enough that the new environment has somehow neutralized it.

Well, regular readers are aware of the slow deterioration that has taken place in the U.S. balance sheet over the last 30 years. We came across this chart today and thought it was worth posting. It shows in bold numbers how far we’ve come (or degraded) in the last 12 years.

Give it a look (click on the graph for a full screen image), and feel free to post a comment. We’d love to hear your thoughts.

As for ours, we can’t help but notice the collapse in consumer credit growth - which has been the key driver of economic activity in the past five years. We also note the personal savings rate going negative as well as the massive plunge in household cash-liabilities. Note also how the financial sector has doubled its representation in the S&P - thanks largely to the massive injection in money supply flooding through the investment and banking communities.

We could go on, but we’d love to hear your thoughts.

In the meantime, we are still amazed that few pundits seem to think this is a serious problem, or that it is anything that ivestors ought to concern themselves with. It harkens us back to Stephan Roach’s Layford Cay comments of late last year about intra industry complacency.