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The Best-Kept Secret

May 3, 2000

It was another volatile and tumultuous week for US financial markets. NASDAQ enjoyed a sharp rally with the NASDAQ100 jumping 8%, pushing its year-to-date gain back into positive territory and 52-week gain to 77%. The semiconductors surged 14%, increasing its 2000 gain to 66% and 52-week gain to 216%. The Morgan Stanley High Tech index rose 6%, increasing its year-to-date gain to 6% and 52-week gain to 91%. The Internet index advanced 13% and the NASDAQ Telecommunications index 8%. The small caps also had a strong showing with the Russell 2000 rising 5%. For the blue chips, after a very strong start, the week ended bearishly. For the week, the Dow declined 1%, while the S&P500 and the Transports added 1%. Year-to-date, the S&P500 has declined 1%. The Utilities gained 3% this week, while the Morgan Stanley Cyclical index rose 2%. The Morgan Stanley Consumer index ended the week unchanged. With the mighty bear market returning with a vengeance in the credit market, the week ended with the financial stocks coming under heavy selling pressure. For the week, the S&P Bank index dropped 3%, while the Bloomberg Wall Street index added about 1%.

Garnering surprisingly little attention, it was very difficult week for the credit market – one that could prove a harbinger for much greater difficulties going forward. Now fearful the Fed may be forced to move aggressively to slow the overheated economy, 2-year Treasury yields surged almost 34 basis points this week to end at 6.70%. Five and 10-year Treasury yields jumped 30 and 22 basis points, to 6.54% and 6.22%. The yield on the 30-year bond increased 13 basis points to 5.96%. Even as Treasury prices sunk, there was, ominously, very little relief to be found in spreads. Although the key 10-year dollar swap spread did narrow 3 basis points to end at a still alarming 119, mortgage-back and agency spreads actually widened 1 to 2 basis points. The yield on the current coupon Fannie Mae mortgage-back surged 23 basis points to 8.05%. As we said, it was a tough week.

During the past two years equity margin debt increased by almost $140 billion, to over $278 billion. Hardly a scintilla of attention was paid to this obvious sign of speculative excess until, of course, a spectacular drop in Internet stocks incited widespread trading losses and margin calls. After the fact, as is typically the case, the media jumped on the story, becoming quite attentive to the fact that so many were involved in what at the time was and should have been recognized as patently reckless use of credit. But why the attention only after the fact?

Presently, as ebullient American homeowners watch their equity mushroom like never before - providing certainly no “newsworthy” accounts of a rash of foreclosures - scant attention is paid to the continued egregious use of credit that has for some time fueled an historic real estate bubble. In fact, the enormous real estate bubble is today the best-kept secret in US finance and economics. Total household mortgage debt ended 1999 at more than $5 trillion. During just the past two years, household mortgage debt increased by almost $770 billion, or five and one-half times the increase in margin debt. During 1999 alone, $473 billion of new household mortgage debt was created, a 60% increase from 1998’s mortgage debt creation. 1999’s additional mortgage credit was almost double 1997’s $250 billion, and 150% greater than 1995’s $188 billion. At the same time, new housing starts during 1999 were only 3% above 1998, 13% greater than 1997 and 23% above 1995. Obviously, it is not the financing of new housing construction that is behind the unprecedented explosion in mortgage credit. Instead, this massive over-expansion of credit is feeding directly into inflated housing prices.

Despite obvious signs of imbalances and desperately overheated markets, mortgage finance appears today more out of control than ever – not an easy accomplishment considering recent historic excess! It is certainly our view that an enormous nationwide real estate bubble deserves considerable responsibility for the distorted and maladjusted white-hot economy. From yesterday’s report, we see that consumer spending surged at a rate of 8.3% during the first quarter, the strongest spending increase since coming out of the early 80’s recession. Additionally, the GDP report had growth surpassing 5% for three straight quarters, the first such occurrence since 1983/84. And with virtually no available workforce, and imbalances and bottlenecks having developed throughout, it should come as no surprise that inflationary pressures are now building rapidly. Indeed, after years of egregious credit excess and rampant asset inflation, inflation is now firmly manifesting in wages, as well as goods and services prices. Any doubt that this is the case should be laid to rest after yesterday’s first-quarter Employment Cost Index report, the largest increase in 10-years. Also yesterday, it was reported that the GDP deflator grew at the fastest pace in three years. When it comes to inflation in asset prices, and now wages, goods and services, it is certainly our belief that the current real estate bubble is grossly unappreciated in its momentous role in creating systemic money and credit excess.

Last month the Seattle Times did an excellent exposition into the region’s real estate boom with a series of articles under the title, “Stock-market wealth is driving a real-estate boom filled with bidding wars and multimillion dollar sales. Is this madness, our new reality, or WILL THE BUBBLE BURST?

Pulled from this article, “The 64-year-old brick and wood house in the regal Washington Park neighborhood has views to die for…The owner put it on the market last month for $1,695,000 – more than double what the 3,080-sqaure-foot house had sold for five years earlier. But that price was way off. After a quick, intense bidding war, the owner is now waiting to close on an offer of more than $2,600,000 - $1 million over the asking price.”

The Seattle Times had a list of the 10 fastest appreciating Seattle area neighborhoods, and what a home purchased in 1984 for $75,000 would be worth today. The most appreciation was in the “Central Area” at about $305,000, followed by Wallingford and Capital Hill at just over $300,000, then Queen Anne, Green Lake and Mercer Island all above $270,000 and Ballard, Bellevue and several others at greater than $258,000. Even homes in Federal Way, with the “slowest” appreciation in the Greater Seattle Area, more than doubled in price since 1984. According to the article, upper-end neighborhoods such as Queen Anne, Capitol Hill and Montlake have appreciated 60% or more during just the past two years.

The tight link between the stock market and real estate bubble is obvious. “What we’re finding with the Microsoft buyer is if they can afford to buy (a starter home) initially, and a lot of them cannot, they buy a $250,000 house. But when they trade in that first house, it’s not for a $350,000 house as the previous move-up group might have done. The Microsoft buyer exercises stock options. ‘They go to a $900,000 house,’ she marvels.”

“Twelve of King County’s 20 most expensive neighborhoods are on the Eastside (Microsoft is located on the Eastside)…The most expensive neighborhood is Mercer Island. Last year buyers paid a median price of $560,000. Not far behind was the Bellevue-Medina Gold Coast…The 1999 median price there was $469,450. Realtors report that buyers are snapping up older homes for even-higher prices just to get the property, then leveling the houses and rebuilding to suit their dreams.”

If things are crazy in Washington, they are completely insane throughout California. From the Seattle Times, “Is there no end to amazing real-estate stories? This one’s about a 1940’s vintage house, a modest 1,500 square feet on a small city lot, offered for sale at $929,000. Within days it sold for $2 million.” Wednesday, the California Realtors Association (CAR) reported that March existing home sales were almost 7% above last year’s brisk pace. The median price for homes throughout the vast state increased to a stunning $238,870, almost $27,000 above a year ago. We have no doubt that historians will look back at the present real estate booms in California, Washington and throughout major metropolitan areas and upper-end neighborhoods across the country as one of histories great real estate bubbles; a bubble with devastating consequences for the soundness of our financial system and, hence, future economic prospects.

According to Leslie Appleton-Young, C.A.R. vice president, “Rising wages coupled with a tight labor market have helped create a tremendous demand for housing in California. In some areas of the state, an extremely low inventory of homes available for sale has created a slight decline in sales compared to a year ago, while prices have continued their upward trend.” From the CAR release, “Statewide, the 10 cities and communities with the highest median home prices in California during March 2000 were: Atherton, $3,350,000, Los Altos Hills $2,750,000; Monte Sereno $2,118,000; Hillsborough $2,000,000; Woodside $1,500,000; Los Altos $1.400,000; Saratoga $1,375,000; Belvedere/Tiburon $1,050,000; Palo Alto $851,000; Menlo Park $826,000.

The regional data is simply stunning. In Orange County, home to more than 600,000 single-family units, 12-month appreciation was 9.5% with a median price of $304,390; San Diego 16% and $256,990; Santa Barbara 38.8% and $539,870; Ventura 15.2% and $287,030. To the North, San Luis Obispo 23.4% 12-month price gains and a median price of $233,330; Monterey 36% and $408,130; Northern Wine Country 21.1% and $279,820; the greater San Francisco Bay Area 27.9% and $446,920. Or, looking at nominal dollars, in just 12-months, the median home price surged $97,500 in the expansive San Francisco Bay Area and $108,000 in Monterey. Such gains are simply amazing and should be frightening to many, certainly the Federal Reserve.

Monday’s San Francisco Chronicle carried a story written by Carolyne Zinko titled, Home Buying in Bay Area a Crying Game. The article began, “Real estate agent Pam Hammer knows that when she shows Silicon Valley homes to clients, it pays to have a box of tissues nearby.” No doubt, as the Greater San Francisco Bay Area now ranks as the most expensive housing market in the country, with all nine counties posting at least double-digit housing price gains over the past year. The median home price in Santa Clara County jumped 26% to $391,000. Palo Alto, a favorite of technology executives, saw the median price surge 43% to $685,000. In Los Altos, 31% inflation fueled the median price to $950,000. From the article, “Many of these homes are not mansions but rather one-story ranch homes with three bedrooms and one bathroom, sometimes two. Broker Chris McDonnell at Coldwell Banker in Menlo Park recalls trying to help a couple from Austin, Texas – the husband was being recruited by Sun Microsystems. Their large house with a pool cost $385,000 in Austin. ‘I couldn’t duplicate that here for $3.8 million,’ she said.”

We apologize for data overload but we believe it is insightful to view data from at all nine Bay Area counties to understand the enormity of this historic real estate bubble. Alameda County posted 23.5% 12-month inflation for a median price of $284,000; Contra Costa 13.3% to $230,000; Marin 33.9% to $529,00; Napa 11.5% to $219,000; San Francisco 24.6% to $420,000; San Mateo 18.6% to $415,750; Santa Cruz 36.1% to $339,250; Santa Clara 26.1% to $391,000; Solano 14.2% to $165,000; Sonoma 23.2% to $244,000. And keep in mind that these are enormous counties. There are almost 380,000 single-family homes in Santa Clara County, 250,000 in Contra Costa, and 320,000 in Alameda County.

And while the most spectacular excess is likely found in Washington, California, Massachusetts and New York, housing prices have skyrocketed throughout the country including important markets like Minneapolis-St. Paul, Miami, Chicago, Charleston, Dallas, Boise, and Denver, to name just a few. It is our view that a massive real estate bubble has in fact developed into a major systemic issue for the US financial system; one, however, easily ignored during the present real estate euphoria. And, distressingly, we see every indication that the financial sector is hard-set determined to perpetuate this fateful bubble. Last week, Fannie Mae chairman Franklin Raines answered questions posed to him by analysts from Prudential Securities. We thought the following comment was worth sharing.

“In terms of the debt and whether or not we are aiding or impeding the management of the economy, there is a simple fact that is missed in this discussion that has to be kept in the forefront of people’s minds: we only buy mortgages that have already been originated. So when Fannie Mae buys a mortgage it’s not creating new debt. We are simply substituting our debt for whatever debt the other holder of the mortgage would have had. So there is no additional debt created by the act of our buying a mortgage. The vast majority of mortgages in the United States are held by leveraged investors. So, who’s ever holding it has issued some debt in the first place, and when we buy it we issue debt and they pay off their debt. So there is no additional debt created. Now on the margin we hope there’s some additional (debt) because we are trying to expand home ownership. But not in the terms that people are saying when they assume that our issuing debt is somehow added to the amount of the mortgages outstanding. Our debt is financing the mortgage that’s outstanding. So once you cut through that, you see that we are not a source for expanding leverage in the economy. We simply try to make whatever leverage in the economy exists more affordable for homeowners. And there is no evidence that our activities are impeding the activities of the Fed. Indeed, we act as a shock absorber for the Fed in the housing area and insure that whatever signals they are sending into the economy are efficiently spread throughout our sector as a result of our activities.”

Mr. Raines, not surprisingly, does not want to take responsibility for the unprecedented growth in mortgage debt, or the sky-high prices that have made housing unaffordable for so many. It is, however, a weak argument to claim that just because Fannie Mae is not originating mortgage loans that it not creating additional debt. The GSE’s, through creating mountains of additional liabilities to finance their ballooning balance sheets, have undeniably created enormous credit. Especially now, within the contemporary financial landscape, the actual origination of the mortgage is largely irrelevant. The “originator” could be a person with little more than a telephone “dialing for dollars” encouraging homeowners to refinance. Or, the “originator” could be one of many new companies. Commonly, a mortgage company such as Countrywide Credit acts as the facilitator of new mortgage loans, for refinancings and purchases. In fact, Countrywide originated $160 billion of mortgage loans during 1998 and 1999, and now has a servicing portfolio of $253 billion. Yet, Countrywide, with shareholder’s equity of about $3 billion and total assets of less than $16 billion, certainly does not have the wherewithal to finance $160 billion of new mortgage loans. Instead, virtually all conventional mortgages originated by Countrywide are sold directly to Fannie Mae and Freddie Mac. So to argue that the “originator” is behind the massive increase in mortgage lending, and that Fannie Mae is “not a source for expanding leverage in the economy” is simply inaccurate. Or, taking another angle, Mr. Raines’ claim that since Fannie doesn’t originate mortgages, it does not create additional debt, is akin to a credit card company saying “don’t blame us for the increase in credit card debt outstanding, blame the merchant who swipes the card through the Visa machine!”

This may sound like an academic exercise; it is certainly anything but. If Mr. Raines doesn’t believe Fannie and the GSE’s create credit - and the American economic community mindlessly goes along - then these quasi-government institutions that largely operate without the constraint of market discipline will only continue to perpetuate this dangerous bubble. Certainly, Mr. Raines has made it clear that Fannie has no intention to show restraint, apparently unconcerned by the explosion in mortgage borrowing and major housing inflation. Recently, according to Mr. Raines, “(Fannie Mae) did establish a goal of doubling EPS over five years that would require a 14.9% growth rate each year, which was higher than the 13.6% that we had had over the prior five years.” For perspective, Fannie Mae more than doubled the size of its balance sheet (largely mortgage holdings) over the past five years to $557 billion, increasing EPS by 90%. How enormous does Mr. Raines plan to expand Fannie Mae’s balance sheet over the next five years? Are Fannie’s plans consistent with the stability of the US financial system and economy? And are these plans consistent with the Fed’s goal of slowing the overheated US economy? And, importantly, who is going to buy the flood of new agency debt created?

This commentary was written specifically because we see the over-zealous mortgage finance sector running out of control and on course for a “train wreck.” As Mr. Raines himself admits, “the vast majority of mortgages in the United States are held by leveraged investors.” Well, we see the financial sector continuing to fuel a dangerous real estate bubble, thus creating enormous volumes of new mortgages. At the same time, the leveraged speculating community, the key buyers and huge holders of mortgage and mortgage-related securities, are finding themselves under increasing stress. And while attention is focused on the daily fluctuation of NASDAQ, a very problematic situation continues to quietly unfold in the credit market.

Today there was further news of difficulties within the leveraged speculating community. This time it was the Soros group and Conseco. We view both as very important players. Conseco, in particular, ended the year with $52 billion in assets and more than $40 billion of balance sheet liabilities. Conseco has also been a major player in mortgages and mortgage-related securities. They also have off-balance sheet derivative positions, and are a major player in the securitization marketplace. As we have written previously, it is our view that the historic US credit bubble has been pierced. Now, the “dominos” are beginning to fall and the list of casualties is destined to lengthen. The key point to recognize presently is that when the speculating community suffers significant losses, the dynamics for the credit system tend to deteriorate rapidly, as it does for the financial markets generally. The fact is that highly leveraged financial systems with endemic speculation are acutely unstable. As leveraged players become impaired, they are no longer in a position to continue to acquire the securities created by Wall Street. Moreover, as losses mount these players are forced to retrench and liquidate positions. As this liquidation only works to weaken prices of these financial assets - the collateral for the leveraged speculating community - there exists today very significant potential for “debt deflation” type dynamics. Liquidation by the leveraged players begets credit contraction and financial asset deflation. The likelihood of this process developing into a very serious financial crisis is now rising by the week. At the minimum, the consequence is faltering financial market liquidity and an acutely vulnerable stock market and credit system. The fact that a dangerous real estate bubble runs simultaneously makes this both an extraordinary period and one unfortunately quite vulnerable to a financial accident.

According to the Talmud you should keep one-third of your assets each in land, business interests, and gold.
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