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Monday, August 07, 2006

The Coming Crash

The Coming Crash

Here’s what I see happening. Can anyone tell me why we are not headed for an epic crash?

The housing market in the Baltimore/DC area (and probably in many other overly-frothy areas) is starting to come unglued. Owners of speculative, highly-leveraged mortgages are starting to miss payments (and even making “jingle payments”- sending in their keys and walking away from mortgages they can’t make on equity positions where they’ve hit zero or are upside-down), producers of housing stock are either placing their condo units up for rent or even missing payments of their own, and owners are slashing selling prices like crazy (a trend likely to accelerate, particularly when the school year starts).

The reported federal deficit is ~$318B but that is inclusive of >$400B in SS and Medicare surpluses which will disappear to zero and go negative in 8-10 years (we aren’t even mentioning the several $Trillions of additional unfunded liabilities in those programs being stacked up year after year). It seems to me that this situation will turn ugly for those in power (regardless of party) as the reported deficits can no longer be hidden.

Lots of suppliers in the defense and homeland security establishment are currently being starved as new contracts are held back both because of the cost of the silliness in the Middle East and to make the budget deficits look better going into the next election. These companies represent a huge source of employment for many classes of decently-paid technical personnel (of a sort that industry doesn’t need, instead either needing other skills or simply fewer technical employees overall).

Owing to the serious monetary and fiscal/regulatory mistakes of the past ten years (and more) there appears to be massive malinvestment overhang worldwide, but especially in places like China where the steel and cement industries among others are tremendously overbuilt. The government there recognizes the problem but has been unable to clear but a sliver of the excess capacity. That has to fall apart and be worked off at some point.

It seems to me that the house of cards has to collapse, probably within five years. It’s too big to be inflated away any longer. Whatever parties are in power are going to take it on the chin (among other places) but the current opponents will have no real answers since most parties more or less operate the same way, just waiting for the log to roll back around.

It could be fun to watch, in a morbid sort of way. Anyway, tell me why all this isn’t going to fall apart?


Blogger David Wood said...

Wow, someone more bearish than me. Amazing. So let me take the other side and make the not so bearish argument (I don't think there is a bull argument to be made here).

Housing: Yes it could get ugly. But realistically, that's only going to affect the recent buyers. For the rest of us, it might be painful to watch those 150% gains melt away, but it won't have any real effect.

In addition, interest rates have peaked for this cycle. Regardless of what the Fed does from here, long term rates are headed down, and mortgage rates with them. The days of the 3% ARM are gone, but the <6% 30 yr fixed will be back very soon. That's not a prescription for housing disaster. Historically, these are very low rates.

Inflation: Inflation is already handled. We just have to wait out the lags. This is not the '70s. Energy is currently overpriced. There are many alternate primary energy technologies that are profitable at less than the current energy price. They are capital intensive, so they will come on gradually, but, longer term, energy prices will be lower than they are today without any new technology breakthroughs. With a few key technology advances, which I fully expect, long term energy prices will be much lower.

China: I've long thought China is a banking disaster waiting to happen. I see it as a disaster for China and the Chinese people, but I just don't see that the West has a big enough stake that this will bring down the international system. If it does threaten that, however, remember that we have "Helicopter Ben" at the helm of the Fed.

Health & Pensions: We are on the cusp of a revolution in health care. See the book, The End of Medicine, for example. If we can generate the political ability to change our institutions to allow this new technology to function efficiently, it will dramatically cut health costs. So the solution is, or will be, available when needed.

The effect on pensions is negative, but easily handled by increasing age requirements and shifting to defined contribution from defined benefit plans. So this is only a political, not a real crisis.

Overall economy: Three big plusses I see which will mitigate the monetary-created downturn which is coming. One, we are still benefitting from the Bush tax rate cuts, which gives an underlying support to the economy. Two, bank and corporate balance sheets are in good shape. And while P/Es are not cheap, they are certainly a far cry from where they were at the last peak. In other words, we can go down considerably, but we're not in crash territory. Three, we are still at the beginning of a tech-led productivity boom which will also tend to dampen downside economic volatility.

8:56 AM  
Anonymous Jimi said...

Here's the positive case(though all real estate is local):

As David mentioned, 1) interest rates. The long bond is declining to the point of near inversion (ok, not so positive). The main impact will be on interest-only and ARM resets which begin in mass this October. But, affordability @ 30-year fixed rates is still reasonable.

2) Job growth - job classified pages remain fat.

3) Vacancy rates - Rental vacancies are extremely low. Landlords are getting their first major rent increases in years.(watch for its unexpectedly high impact on Core CPI)

4) Builder land inventory - uncomfortable but not unbearable. Buiders have structured acquisitions with less risk(optionality) - leaving much of the downside to the land bankers.

5) Builder pipeline - same as #4 but yes, there are pigs to be slaughtered.

6) Due Diligence projections - Other than absorption rates, the bulk of investor/developer/builder "going-in" deal assumptions remain intact.

The bull case is that real estate prices merely flatten for a while, buyer/seller negotions return for real, available inventory rises slightly, and time on market grows to about 90-120 days.

Biggest Bear indicator - Senate Bill #3535, "Expanding American Homeownership Act". Broad bi-partisan support, passed the House, Bush will sign. Introduces zero percent down mortgages to a housing agency that is totally inept. It also brings government competition to private mortgage insurers. Strike another victory for big government Republicans!

9:49 AM  
Blogger Dick Fox said...


Since David and Jimi jumped on the other side let me give your argument a little support. The Republicans are fighting against their base and economically yielding to the Democrats. Why vote for Democrat lite when you can have the real thing?

If the Democrats take the House and Senate they will reverse all of the small economic changes that have sustained us so far. Elections are the key. It appears that there is a good chance that there will not be one Republican Senator in the Northeast after the mid-terms.

10:51 AM  
Blogger David Wood said...

Now you're scaring me, Dick. If the Democrats do take over the House and Senate, we will definitely be in deep trouble. Is the American electorate really that stupid?

11:43 AM  
Blogger Henry Meers said...


The stock market may be discounting just such a change of power; that, after all, is the conventional wisdom (which usually means it will not come to pass). The Republican "base" is the worry, because it increasingly believes the party hasn't delivered after all its time in power. Should that group stay home, there could be trouble. I doubt there will be a change of power (actually have a small bet on a pick-up of seats), so we might see a rally at some point.

Dick does point to small gains. By now, after 12 years in the House and ten in the Senate, we should have had a lot more legislative progress. When Reagan left there were only two personal income tax brackets, 15% and 28%, for example. Why aren't we back there and below by now? Other goofy big-spending programs have appeared due to faulty market research.

This is being offset by the Democrats moving further and futher left, as in the Lieberman fiasco. The public has a real choice.

Bob Churchill does unfortunately make some points worth considering. My guess things won't be disasterous, if the the economy is left alone. The obvious weakness with that thought is the Fed caused the problem in the first place.

Should Bernanke and Co. pause tomorrow, there will be a race between the lagging effects of their tightening and the free market's ability to straighten things out at a reasonable price. We can only hope that "investors" have enough staying power; but the big changes do happen at the margin.

12:45 PM  
Blogger Robert P. Churchill said...

Yeah, a bit of retrenchment in the housing sector isn't going to bring the whole house of cards down, but what of the rapidly-approaching demographically inevitable and utterly unsupportable transfer payment explosion?

9:34 PM  
Anonymous Jimi said...

nice shoes Robert.

If the current path manages to cure "inflation" by killing growth the Dems can pull out the ol' "It's the economy Stupid" slogan for the 08' elections.

3:59 AM  
Blogger David Wood said...

No, I'd say they've timed it pretty well. Economy still good for this year's elections. Slowdown in '07 giving them an excuse to juice the money supply going into '08, making things rosy again in time for the elections.

6:58 AM  
Blogger David Wood said...


The entitlements are a problem, but we will muddle through. For one, we are lucking out on technology, which is providing a productivity boom just when we need it. The govt is overcommitted, for sure, but the beauty of government is that they can change the rules as they go. It's not a contract, like in the private sector, where you're committed to an agreement. So they will figure out the most politically expedient group to screw and take that route out. As I said above, I'm guessing a combination of age extensions and shift to defined contribution plans.

7:03 AM  
Anonymous judith said...

From my personal perspective, the greatest risk involves some 'surprise' increases in the inflation indices - which 'force' the Fed to resume hiking rates.
I don't think the market would like too much of a surprise.
The mid-term elections also add a bit of uncertainty.
Other than the above, I would be cautiously optimistic. As it is, I am basically 'playing it safe' for the time being....

8:04 AM  
Anonymous Jimi said...

Judith wrote:
"From my personal perspective, the greatest risk involves some 'surprise' increases in the inflation indices"

I hereby nominate the Housing component of CPI. My understanding is that this indice tracks rental rates, not home prices. Over the past several years rental rates have been relatively flat while home prices have soared. The tables have turned and will be reflected in the CPI.

9:53 AM  

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