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Posted 3/22/2004
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Low rates are the problem, not the cure
Cheap money is why the dollar is falling, precious metals are rising and homebuyers are in danger. The longer the Fed waits, the worse the damage.
By Bill Fleckenstein
As I have said for nearly two years, I think owning precious metals is a way to protect yourself from the problems the Fed has created and exacerbated. So, I was pleasantly surprised last week when I found the New York Times has come to the same conclusion. In an editorial "The Cost of Cheap Money, the Gray Lady of Times Square noted that (surprise, surprise) there is such a thing as too much of a good thing. Better, the editorial pointed out the problems that arise when the central bank wants to spike the punch bowl vs. remove it:
"Mr. Greenspan should heed the lessons of the stock market bubble of the late 1990's. In the new economy, remember, we were assured that the old speed limits needn't apply. What investors were not warned about enough was the extent to which the virtuous cycle of cheap money, low inflation and strong growth was feeding a speculative financial market bubble, which eventually popped at huge cost to those investors." -- and, I might add, to job holders and future job seekers.
The Times sees a housing bubble, too
The editorial then cites a potential bubble forming in the housing market (more about housing below), suggesting the Fed consider that wildly unpopular action I have noted for a long time, which is to raise rates: "The Fed should gradually wean the country off such extraordinarily easy money before it is forced to do so abruptly, and painfully. It cannot wait until after the election, nor until it sees inflation pick up. Rates are so low that the Fed has plenty of room to move before being accused of adopting a restrictive monetary policy. It needs to get started."
But alas, though The New York Times urged the Fed to act like an adult, it appears not to understand that such behavior is beyond the Fed, whose irresponsibility has only succeeded in postponing the pain and ensuring a much greater wipeout once these bubbles start to burst. Yes, the Fed should raise rates and get it over with. It should stop subsidizing people who spend recklessly at the expense of people willing to save. (The Feds Federal Funds rate is 1% and has been at that level since June 25, 2003. Rates on 30-year fixed mortgages are 5.5% and lower.)
Having said all that, reading the minutes from the January Federal Open Market Committee meeting released late Thursday, I was stunned to see that more than one unnamed Fed head appears to be having second thoughts about all this easy money. As the minutes state: "A number of members commented that expectations of sustained policy accommodation appeared to have contributed to valuations in financial markets that left little room for downside risks, and the change in wording might prompt those markets to adjust more appropriately to changing economic circumstances in the future." (You can read the minutes here.)
But moving rates higher now is not something Easy Al is going to do. Mr. Market will deal with the chairman and the economy in his own sweet time. Regrettably, that process will involve a tremendous amount of pain, thanks to the wanton recklessness of the Fed.
The dangerous loans being made to sell houses
The March 16 edition of The Wall Street Journal carried one of the best stories I've read there in quite some time: "Creative Mortgages Fuel Home Sales." Writer Ruth Simon did a pretty fine job of discussing many of what I deem questionable practices in real-estate lending. This is why I sold my shares in Annaly Mortgage (NLY, news, msgs), as I mentioned in last week's Contrarian. I am worried that the value of loans collateralized by real estate will become impaired going forward.
I do not want to be lending to that market in any way, shape or form. The level of transparency isn't that great, and when I look at all the things going on, coupled with the leverage at Fannie Mae (FNM, news, msgs), Freddie Mac (FRE, news, msgs) and the Federal Home Loan Banks, this looks to me to be a recipe for disaster. I fully expect that the debt backed by those three organizations will be bailed out by the federal government, but, at some point between here and there, I expect things to get messy.
Related news and commentary on MSN Money
A bevy of bait to hook the in-hock
The Journal article started off ominously: "With home prices surging, lenders are coming up with increasingly creative mortgages aimed at homeowners whose budgets are stretched thin." That is, for folks who can't afford a house, we'll get you in one, anyway. From there, the writer proceeds to count the ways. One method, discussed previously on my Web site, is the "interest-only mortgage," in which no equity is built up by the buyer (excluding price appreciation). A mortgage lender quoted in the story described this type as "second only to 30-year fixed-rate loans in popularity."
Next, there are "piggyback mortgages," which give a first-time borrower a home-equity loan along with their mortgage. As to the ubiquity of this type, the article stated: "At GMAC Mortgage, about 20% of borrowers who take out a fixed-rate mortgage use a piggyback loan option." And homeowners can get a "fixer-upper mortgage," based on the value after renovations (no room for make-it-up numbers there, right?). Then, there's the "miss a payment" mortgage, where folks can skip up to two mortgage payments a year and 10 payments over the life of the loan. Or, they can choose the "payment option mortgage," which offers a smorgasbord of ways to pay.
A subset not discussed by Simon is one brought to my attention by readers of my daily column who work in the mortgage business. These "seller kickback mortgages," as I call them, are attractive to home buyers who cannot afford a down payment. In this arrangement, the price of the house is bumped up so that the seller can rebate the down payment to the buyer upon closing. Recently, a computer technician in our office talked about how he had just purchased a $200,000 home while putting down just this princely sum: $34 worth of closing costs.
Wall Street and 4-wall speculation:
These novel ways to speculate on one's home strike me as a loose corollary to the stock market bubble: They just give folks another way to keep the game going. It sort of reminds me of when stocks could no longer be valued by reasonable methods (as early as the mid-1990s). People started conjuring up new reasons to buy stocks, i.e., stock splits, and of course it continued to get crazier from there.
I note that the intersection of the stock market and housing market came alive in a recent Wall Street Journal story called "Brokers Faulted for Risking Mortgage." The story reported that three stockbrokers who allegedly urged their customers to tap their home equity to invest in the stock market were accused by the National Association of Securities Dealers with making unsuitable recommendations. What was the problem? Their clients used money from mortgaging homes to buy stocks soon after the 2000 market peak.
There is a consequence to all of this creative financing, as the earlier Journal story points out -- higher prices. This, of course, is necessitated by creative financing itself. Housing prices go higher, so people can't afford them. Mortgage lenders come up with creative methods. People buy homes they can't really afford using these creative methods. Again, housing prices go up.
At the end of the day, what you have is an asset price that's been pushed beyond all reasonable bounds, supported by a debt-to-equity ratio that's too high. Then, inevitably, something goes wrong, and you have a good-sized wipeout.
This is what I expect to occur, though I obviously don't know the timing. However, I can say that eventually, the ensuing debacle will probably create very attractive investments, because when push comes to shove, the government will bail out the mess. But going through that process might be somewhat problematic for many people.
The euro correction is almost done
In my March 8 Contrarian, I updated readers on my roadmap for the euro/gold correction. With more data available since then, I'd like to freshen that update with another.
I will admit right here that this is a bit of voodoo and guesswork, necessitated by the fuzzier fundamentals inherent in these markets.
In any event, if one looks at the euro's correction last summer and reviews the squiggles on the charts, the euro correction now under way appears quite similar. If this setback follows the path from last summer -- and remember, this sentence starts with an "if" -- my guess is that the present correction could end in a couple weeks.
Whether one wants to own the euro or not, it probably will have some impact on gold. Previously in my daily column, I have noted the producer buybacks below $395, opining that the correction from here had more to do with time than price. If one looks at a chart of the gold price, one sees the potential for an inverted head-and-shoulders pattern, which we saw last July and August. Assuming, of course, that this actually is an inverted head-and-shoulders pattern (which we won't know until after the fact), it appears that this is fairly close to completion. So, from the perspective of the charts, the gold correction looks like it's further along (if it isnt already over) than the euro correction.
To repeat, this is all just supposition and conjecture, and subject to change. But I thought I'd elaborate on what I am looking at because the next couple weeks might prove opportune.
Research drivel worthy of public redress
Finally, I want to give a high-five to Robert Pozen, the chairman of MFS Investment Management. In a recent New York Times interview, he called for brokerages to break out research and distribution costs from their trading commissions.
His rationale for stripping "securities analysis" out of trading fees: "We are valuing their research at zero."
At long last, we see it in black and white: someone labeling the product of the dead-fish community for what it's really worth (though I'm not sure Mr. Pozen hasn't overestimated the price).
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckensteincapital.com site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. At the time of publication, he did not own or control any of the equities mentioned in this column. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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