Soaring mortgage defaults and the end of easy money are creating a devastating credit crunch and sparking investor panic across the country.
The bankruptcy of companies like American Home Mortgage and subprime lender Bear Stearns … the wild, 100-400 point daily swings in the DOW (which Bear Stearns Chief Financial Officer Sam Molinaro calls “the worst he’d seen in 22 years”) … and the growing wave of home defaults and foreclosures are just the beginning.
How bad is it? Here are some examples:
- Home foreclosures are skyrocketing across the nation. In San Joaquin County, California, there were 785 foreclosures in the second quarter of 2007. That’s 12-times the number of foreclosures in the same period in 2006.
Nationwide, foreclosures were up in June 87% over the previous year. - Losses are spreading among mortgage lenders. Freddie Mac, a huge quasi-governmental lender, reported a loss of $211 million in the first quarter of 2007.
- Home prices are plummeting. In Detroit, Fannie Mae has a “charming colonial” on the market for $7,000, despite $59,000 outstanding on the loan.
In many of the most-affluent areas of California, homes are now being sold at auction for 50%-75% of the price they garnered just six months ago. Some less desirable homes are not selling at any price. - Interest costs are soaring. In early August 2007, the prime lending rate hit 7.50%. That’s up over 50% from the sub-5% rates available just a few years ago.
In addition, many would-be borrowers with even small blemishes on their credit are finding that no loans are available to them.
As we have been warning for several years (see “Surviving the Coming Real Estate Crash,” IIR, June 2005), thousands, or even millions of investors will be devastated by these dramatic events.
What’s more, the real estate crash has begun to trigger an even-more worrisome collapse of derivative investments, which could dwarf the effects of the real estate crash.
Fortunately even in these frenzied markets you can not only preserve the value of your assets, but you can actually add to them handsomely.
More on that in a moment. But first, you need to understand how the growing credit crunch is about to affect your paycheck, business, assets and investments.
A CLASSIC INFLATIONARY BUBBLE
The frenzy we are now witnessing in real estate and financial markets is nothing less than the collapse of a classic inflationary bubble.
A combination of low interest rates, easy credit, and government monetary inflation encouraged millions of Americans to finance homes they couldn’t afford, buy luxury cars and boats they didn’t need, and take expensive vacations they couldn’t pay for.
Just 12 months ago, anyone with a pulse could get hundreds of thousands of dollars in credit to buy a new home.
Indeed, at the peak of the mortgage mania, in some areas mortgage brokers were giving borrowers up to 120% of the cost of their home loan! In other words, lenders paid you to borrow money from them. Or at least, so it appeared.
Just fill out the paperwork for a “no-doc, negative amortization loan” and you could get a 40-year mortgage plus a check for $20,000 or $30,000 from some unscrupulous lenders. Then you make payments for less than your interest costs for a few years.
Lo and behold, hundreds of thousands of deadbeats who couldn’t qualify for an unsecured $1,000 credit card, suddenly became proud “homeowners.”
Of course, it was all an illusion. All these borrowers really owned was debt. As I warned in June 2005, when creative mortgages reset to higher payments, thousands of new “homeowners” would discover that they couldn’t afford the homes they were living in … and then the housing bust would begin.
The Center for Responsible Lending warns: “If foreclosures continue to rise as predicted … though some people will become first-time homeowners due to subprime loans, there will be significantly more borrowers that will lose their homes to foreclosure.”
What no one is talking about is the root cause of the easy credit and creative loans which made this insane credit bubble possible.
INCREASE IN U.S. MONEY SUPPLY (M3)
2004-2007
Source: Increase in money supply
THE FAKE OWNERSHIP SOCIETY
— 2004-2007 —
It all goes back to George Bush and former Fed Chairman Alan Greenspan, and their “ownership society” initiative launched in 2002.
A key element of that initiative was the idea was that America would be much better off if more people owned homes. To make this possible, these officials did two things that encouraged millions of low-income wage-earners who rented their residences to take out mortgages.
First, they created the money needed to finance all of these new loans. How? By inflating the U.S. money supply at the fastest rate we have seen for decades.
Between 2004 and 2007, the Federal Reserve doubled the rate of increase of the money supply (M3) from 6% to over 13% a year, as shown by the chart.
Awash in new currency, banks had to put the money somewhere. That turned out to be real estate.
No one asked, “How could low-income workers who could barely afford rent, make house payments?”
In 2002, President Bush launched his “Ownership Society” initiative, including programs to greatly increase the ownership of homes by low-income Americans. Here’s how the White House web site describes this initiative:
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“Expanding Homeownership. The President believes that homeownership is the cornerstone of America’s vibrant communities and benefits individual families by building stability and long-term financial security. In June 2002, President Bush issued America’s Homeownership Challenge to the real estate and mortgage finance industries to encourage them to join the effort to close the gap that exists between the homeownership rates of minorities and non-minorities. The President also announced the goal of increasing the number of minority homeowners by at least 5.5 million families before the end of the decade. Under his leadership, the overall U.S. homeownership rate in the second quarter of 2004 was at an all time high of 69.2 percent. Minority homeownership set a new record of 51 percent in the second quarter, up 0.2 percentage point from the first quarter and up 2.1 percentage points from a year ago.President Bush’s initiative to dismantle the barriers to homeownership includes: American Dream Downpayment Initiative, which provides down payment assistance to approximately 40,000 low-income families; Affordable Housing. The President has proposed the Single-Family Affordable Housing Tax Credit, which would increase the supply of affordable homes; Helping Families Help Themselves. The President has proposed increasing support for the Self-Help Homeownership Opportunities Program; and Simplifying Homebuying and Increasing Education. The President and HUD want to empower homebuyers by simplifying the home buying process so consumers can better understand and benefit from cost savings. The President also wants to expand financial education efforts so that families can understand what they need to do to become homeowners. |
A key mechanism to expand homeownership was liberalizing mortgage qualification rules, making it possible for millions of previously unqualified low-income people to finance homes.
What no one asked was: “How could low-income workers, who could barely afford rent on a small apartment, suddenly afford much larger mortgage payments on a house?”
As recently as the fall of 2006, as home inventories were soaring, former Fed Chairman Alan Greenspan was still strongly recommending “creative mortgages.” The money was provided by the Federal Reserve, and much of it was disbursed through the two 600 pound gorillas of the lending industry, the quasi-federal agencies Fannie Mae and Freddie Mac.
These creative mortgages included . . .
- Interest-only loans, in which no principal on the property was initially paid.
- “No-doc” loans, in which the borrower’s word was accepted without documentation regarding his or her income.
These loans are an invitation to commit perjury. A study by Mortgage Asset Research found that 90% of borrowers with no-doc loans grossly inflated their income, often by 50% or more. - Negative amortization loans, in which the borrower could – for the first few years – pay less than his interest on the loan; meaning he or she owed more every month on “their” property.
- Subprime loans, in which people with bad credit could (initially) get low-interest loans with little or no downpayment … only to much higher payments a few years down the road.
What many borrowers who never read the fine print in their mortgage agreement failed to realize was that the low payments on these loans were only good for a few years.
After that, their payments would go up and their interest rates could skyrocket, adding hundreds, even thousands of dollars a month to their payments.
For many subprime borrowers who could barely make minimal payments, the financial effects of mortgage resets have been devastating. In some cases, the re-set payment is higher than their entire take-home pay!
The result was inevitable: Skyrocketing mortgage defaults and home foreclosures.
Nationwide, mortgage defaults (borrowers 3 months or more behind in their payments) were up over 83% in March 2007 compared to March 2006.
In many areas, foreclosures – lender repossession of homes – are up 5-to-10-fold over the previous year!
In addition, foreclosures and defaults are now spilling over into the primary lending market, and more and more borrowers with good credit and traditional loans are going into default and facing foreclosure.
In the near future, the U.S. may have no choice but to look to countries like India and China to buy our assets, to avoid a continuing implosion of real estate
But the worst is yet to come. BusinessWeek says that the increase in home foreclosures won’t peak and begin to fall until at least March of 2008. However by then, foreclosures are expected to be several times higher than they are today.
As home inventories increase, credit becomes much harder to get, and real estate prices fall, problems are spilling over into the primary mortgage loan market. More and more would-be home buyers with good credit are finding it difficult or impossible to sell their old home or finance a new one. It could be years before real estate prices again experience sustained increases.
Another huge wild-card is the retirement of millions of Baby Boomers in the next ten years, many of whom will be selling their large homes, and moving to smaller houses or apartments.
According to Yale economist Robert Schiller (interviewed in the July 2006 issue of IIR), the only way we can prevent a continuing implosion in U.S. real estate prices is by selling assets to countries like China, India, and Brazil, which have large, emerging middle-class citizens with more and more cash to spend.
THE HIDDEN DERIVATIVES CRISIS
— 2004-2007 —
Subprime borrowers unable to make re-set monthly payments are only one of many groups affected by the growing mortgage credit crunch.
What most people don’t realize is most lenders no longer retain ownership of their mortgages, but rather bundle them together and then resell to other investors — such as pension funds, insurance companies, private equity companies, and foreign banks. Many major investors are foreign companies and banks.
Worldwide there are now over $365 trillion in derivatives. That’s an incredible 12-times the GDP of the entire world.
Large banks in China and Japan have been two of the biggest purchasers of U.S. mortgages – so a bank in China or Japan may already own your home if you have taken out a mortgage any time in the past ten years.
Once mortgages are bundled and resold they morph into securities such as Residential Mortgage-Backed Securities (RMBs). Such securities are just one example of derivatives – debt or investment derived from other debt and investments.
In addition to mortgage derivatives there are also insurance derivatives, pension fund derivatives, stock derivatives, and futures derivatives.
The important thing to understand about derivatives is that they create an enormous, inverted pyramid of debt and financial obligations based on comparatively small real assets.
According to the Economist, credit derivative product companies (CDPCs) can leverage their capital up to 30-times. Thus $1 trillion in mortgage debt can turn into $30 trillion in derivatives.
Derivatives themselves are also bundled together and resold, creating debt upon debt.
Because they have been so profitable, in the last few decades hundreds of trillions of dollars in derivatives have been created.
Derivatives are now owned by many of the world’s largest and most trusted financial institutions, such as Bear Stearns, Citibank, and the Bank of China.
Worldwide, Agora Research estimates there are now some $365 trillion in derivatives.
That’s an almost unimaginable sum, amounting to over twelve times the gross domestic product of the entire world!
Today many banks, hedge funds, pension plans and corporations that have invested in these derivatives are in a very precarious position. According to NewsMax.com, many derivatives are so highly-leveraged that “a fall of a mere 2 percent in the value of the underlying assets could wipe out the entire portfolio.”
The recent bankruptcy of American Home Mortgage and several divisions of Bear Stearns is just the beginning of the effects of the real estate meltdown and derivative crisis.
Most at risk are funds and institutions which are heavily invested in derivatives, including many banks, pension funds, insurance companies and large companies. Indeed our entire economy is now at risk of recession.
10 WAYS TO PROTECT YOURSELF
- Recommendation #1:
Find out if your bank and the other institutions you depend upon for financial security are safe. If you don’t like what you learn, switch.You can do this by getting an objective, independent safety rating on your bank, insurance company, pension plan, Medigap insurer, and stocks from Weiss Ratings, 15430 Endeavour Dr., Jupiter, FL 33478, 1-800-289-9222.
Some of the country’s largest banks, insurance companies and pension plans are most at risk from bad real estate investments and derivative debt.
On the other hand, many well-capitalized smaller banks, insurance companies, etc. are much safer.
- Recommendation #2:
If you are having difficulty making your mortgage payments, take action immediately. Cut your spending, get a second job, take in a roommate, do whatever you have to do to preserve your property.
If you have already received a default notice, contact your lender immediately. You may be able to get them to let you skip a payment or two, reduce your payments temporarily, or get a lower-interest loan from a local savings and loan. Perhaps you can borrow money from a friend or relative. There are also some new federal and state government programs to help. The worst thing you can do is to do nothing. By the time you receive a foreclosure notice, it will be too late.
Be very cautious about any company that offers to “save” your home for you. It could be a scam in which they strip your home of equity, sell it out from under you, and then saddle you with even larger debt. Have an attorney go over the paperwork for any such deal. If the company refuses or pressures you to sign up immediately, say thanks but no thanks.
If you are deeply “underwater” on your property (i.e., you owe more than the property is now worth), your only option may be to sell your home for as much as you can, work out a deal with your lender, and move.
- Recommendation #3:
Make sure your job or business is safe. Most at risk in a recession are businesses that depend upon good financial times, low interest rates, and free spending by consumers – such as new cars, boats, vacation condos, expensive vacations, music lessons, etc.
Funding for anything to do with the arts is also likely to plummet. If your job is at risk, do everything you can to make yourself irreplaceable at work, including taking classes to upgrade your skills, working free overtime and initiating projects to cut costs or bring in more revenue. If your business is at risk, think of how you can modify your products and advertising to bring in more revenue during a recession.
- Recommendation #4:
Consider businesses and careers that prosper during a recession. These include auto repair (people fix up rather than replace cars in a recession) … discount grocery stores (people still need to eat) … a bar or liquor store (liquor sales go way up in a recession) … gun repair and other basic skills.
- Recommendation #5:
Sell any stocks you have in at-risk companies such as home builders like Lennar (LEN), Ryland Group (RYL), and Hovnanian Enterprises (HOV). According to
BusinessWeek, lenders particularly at risk include ECC Capital Corp. (ECR), New Century Financial Corp. (NEW), Long Beach Mortgage Corp. (a unit of Washington Mutual), NovaStar Financial Inc. (NFI), and Fieldstone Investment Corp. (FICC). - Recommendation #6:
Keep lots of money in cash or cash-equivalents, such as gold, silver and strong foreign currencies. Consider getting an account with EverBank, www.everbank.com which enables you to keep your money in savings accounts and CDs denominated in gold, silver and any of several strong, foreign currencies.
If you prefer to keep your funds in a local bank, be sure to shop around for the best CD rates.
Remember: With the U.S. dollar now depreciating at over 13% a year, even if you get 6% interest, you are still losing 7% a year in purchasing power. - Recommendation #7:
Invest in strong foreign corporations. Economies of many foreign companies are now largely independent of the U.S. And nations like China, India, Indonesia and Brazil are experiencing tremendous growth, even as the U.S. falters. You will find many recommendations for foreign stocks in our current portfolio and future newsletters.
- Recommendation #8:
Seriously consider opening a commodity and currency options account. Even if stocks tank you can do great investing in these options which profit from a falling dollar and rising commodity prices.
My Intelligent Option Service recommendations, for example, have been going up 100% about every six weeks in 2007. Of course, there are no guarantees. But at that rate, $5,000 grows to $80,000 within six months. For more information, call 707-746-8796 - Recommendation #9:
Prepare now for a major downturn in the U.S. economy. Pay off high-interest credit cards, cut your expenses, move to an area with a low-cost of living, but good jobs. There are many such medium-sized towns in the Midwest and Southern U.S.
- Recommendation 10:
Be kind to yourself. Use a tightening economy as an opportunity to strengthen your connections with family and friends, and take joy in life’s everyday pleasures. Weekly family dinners and recreation don’t have to cost a lot. Take walks in a park, volunteer to help out in your community and relax.
Even if we hit a rough patch, the economy will eventually recover.
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