The American Dream

April 1, 2007

Last year, we wrote on MAXfunds.com, “Now that home price appreciation is leveling off, the ugly side from the growth of no-and low-money-down lending should rear its head.”

The main concern in the stock market today is just how far the current sub-prime loan fallout will spread into the economy. Our opinion? Pretty darn far.

Predicting trouble in the recently hot real estate market is hardly an original idea (certainly less original than predicting trouble in tech and telecom stocks back in 1999), but most bubble watchers said it would take higher interest rates, rising unemployment, falling incomes, or a decreased demand for U.S debt by other countries to kill the housing bubble.

In just a few months, we’ve watched home builders' stock fall 50% or more. Mortgage lenders (generally REITs) are down an incredible  90%, and any company with significant ties to the housing market, including mortgage-heavy banks, has suffered significant declines. Home prices just suffered their biggest year-over-year drop in over a decade, and home sales are at multiyear lows. REITs that collect rent by managing buildings and offices have fared somewhat better, but they may very well be the next shoe to drop.

We're experiencing rock-bottom 30-year mortgage rates, high employment levels, and – for the first time in several years – rising wages. These fundamental economic indicators should have been the recipe for even higher home prices and robust sales, not diminishing returns.

Unfortunately, the trouble with looking at fundamentals is that a bubble just leaves fundamentals in the dust. Since nothing fundamental caused home prices to surge in just a couple of years, nothing fundamental is required for a correction. That observation was the premise of our article pointing out that home prices can fall without any increase in interest rates.

Low rates certainly added fuel to the fire, but the real culprit was a general misconception that a house is a “can’t lose” investment, when in fact 98% of all houses are mere commodities, just collections of land, lumber, and labor. Nothing is guaranteed.

For all the media coverage about subprime lending problems, few note that the rates these subprime borrowers were paying were not much more than their prime-paying neighbors'. A first-time homebuyer with spotty credit history and limited ability to pay back a loan that represents perhaps 5 times (or more) their yearly, often unverified, household income, could still get a rate of possibly 7% or even less on a mortgage. That's lower than the rate many U.S corporations borrow. In fact, the prime rate, the rate banks supposedly charge their most creditworthy customers, is higher.

Why would a creditor lend money to this type of borrower at such a low rate? Credit card companies loan money to much better credit risks and charge 10%-20%. The answer is that the loan is backed by the magic home. Homes, as we were all told (literally, told by the head of the Association of Realtors) rise in price every year. 

Even in a worst-case scenario, the lender is  going to get back something that can be sold to pay back the balance of the loan, even if the borrower misses the very first payment as some are now doing. Such rock solid asset-backing is why no-or-low-money-down payments are (or rather were…) required to borrow.

Many lenders are now inheriting houses that they're going to have to sell at prices somewhere between today’s price and their prices from  just a couple of years ago – some for as much as 50% less.

Even if such a dire situation doesn’t materialize, the impact on the economy and stocks probably will; only the extent of the damage remains in question. Rising home equity rationalized trillions in lending and spending - an economic boost that has largely evaporated.

Such a backdrop means a mild recession is likely, as is a 10%-20% pullback from peak levels in stocks globally. And that’s the good scenario.

The Federal Reserve knows this, and will not raise rates any time in the next two years, even with inflation picking up slightly. On the flipside, until we get a recession, much lower rates are unlikely. The Federal Reserve wants an inverted yield curve – lower long-term rates than short term rates. Keeping short rates high removes speculation from the economy (low rate adjustable loans) and keeps a firm stand against inflation, driving longer term rates down, while still maintaining 30-year mortgage rates that can support a falling housing market. The real estate market needs to be brought down slowly. Just look at the current damage with low rates. Imagine a 7% mortgage for prime borrowers and rising unemployment? Scary stuff.

Stick with short-term investment-grade bonds, avoid large stakes in financial stocks, maintain a slightly lower than normal equity stake, and cut down on alternative asset classes and emerging markets. At least until the pendulum starts to swings the other way and investors (and lenders) fear risk once again. 

There has to be a reward for taking on risk.