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We have been hearing reports for some time now - that there is an inflationary bubble in the US and European real estate markets. Some people that perhaps do have an interest in seeing this continue might tell you - Keep Buying and Do Not Worry. Others, like us, know that if any commodity or investment has already run up thirty, forty, fifty percent or more in a very short period of time is probably ripe for a correction. This is especially true if the run up was a result of some other phenomenon, such as cheap money (artificially low interest rates) or no money down financing.  However, this is not just about the fact that prices have gone up. Which is to say, it is helpful to see the larger picture and other issues at work, so you can make an informed decision as to how to handle your personal investments going forward.

The US National Association of Realtors had the following to say back in November 2004:

The association's First-Time Homebuyer Affordability Index shows a typical first-time buyer household, aged 25 to 44, with an income of $31,225, had 74.7 percent of the income needed to purchase a typical starter home with a 10 percent down payment. The median starter home price was $160,200 during the third quarter. The index shows the typical first-time buyer could afford a home costing $119,700. However, many buyers are making smaller down payments than assumed by the index, and are using loans that give them more buying power. (For further reading see links below - number 1)

According to information for 2005 on the FDIC website: 

As for personal income, it grew 5.8 percent in 2004 and 4.2 percent in 2003. While stronger than the pace of rent growth, this was still far less than the pace of home price gains during the past two years. This gap between growth in home prices and incomes has been widening since the decade began. Moreover, the price-income gap has become especially pronounced in high-cost metro areas. The housing affordability index for first-time homebuyers of the National Association of Realtors, which takes into account home prices, incomes and interest rates, slipped 3.8 points in 2004 to 77. This marks the second-lowest annual level for the affordability index since the recession year of 1991. The lowest reading during this interval was 75.9 in 2000, when 30-year mortgage rates were over 8 percent. If this decline in affordability continues, it might eventually weigh on home sales and price appreciation as first-time buyers are priced out of the market.
In addition to increased leverage and sub-prime lending activity, use of adjustable-rate mortgages, or ARMs, remains high. According to the Mortgage Bankers Association, ARMs accounted for almost 46 percent of the value of new mortgages in 2004 and 32 percent of all applications. Both figures were up sharply from their 2003 levels of 29 percent and 19 percent, respectively. It is noteworthy that this development occurred despite the fact that the average annual fixed rate for a 30-year mortgage remained virtually unchanged from 2003. Furthermore, data from the Federal Housing Finance Board indicate that the ARM share is high and rising in several of our boom markets. Taken together, these trends suggest that highly leveraged borrowers are increasingly taking on interest-rate risk as they stretch to afford high-cost housing. Although homeowners taking out ARMs may be more exposed to payment shock when their monthly payments adjust upward with rising interest rates, for many, this event is some years off. A large share of ARMs originated in recent years featured initial fixed-rate periods that could last up to ten years. The FDIC and other analysts have previously explored the growing role of ARMs in financing home purchases.

Another evolving trend that has not been tested in a housing market downturn is the increasing market penetration of innovative mortgage products, such as interest-only (I/O) and option ARMs. These mortgages are specifically designed to minimize initial mortgage payments by eliminating principal repayment; but these also can increase leverage and expose owners to large jumps in monthly payments as interest rates rise. According to Inside MBS and ABS, interest-only mortgages accounted for 23 percent of the value of non-agency mortgages in 2004. Some market participants estimate that these higher risk ARMs are increasingly being offered to borrowers seeking low- or no-documentation loans and to those with blemished credit histories. While financially savvy borrowers using these products are more likely to be prepared for the possibility that their monthly payments may jump sharply, marginal borrowers may face greater difficulties adjusting as their monthly payments inevitably rise.

Finally, although this factor is not directly related to credit conditions, heightened investor purchases of homes could also be signaling a higher degree of speculative activity in housing markets during 2004. Data from Loan Performance indicate that 9-percent of U.S. mortgages in 2004 were taken out by investors, up from just under 6-percent in 2000. Furthermore, this share is significantly higher in local markets that are experiencing the strongest home price appreciation. In some of these markets, it is estimated that the investor share of new mortgage originations is as high as 19 percent. Academic studies show that residential property investors are less loss-averse than owner-occupants and thus more likely to sell precipitously in a declining market, thereby aggravating any existing downtrend in home prices. (For further reading see links below - number 2)

Also, information from the above link also talks about 1998, which was the last time a severe boom or housing price increase took place whereby 24 markets were considered to be involved in an inflationary boom. Today in 2005, that number is 55 markets, or more than double than the last time this kind of boom took place. What does all this mean?

Well, let us think about this for just one moment. If housing prices are moving out of reach for many new home buyers, and these very same new home buyers have to take on riskier kinds of mortgages in order to qualify (riskier for the banks mainly) - then what will be the US Federal Reserves attitude about inflation going forward? We think they opt for inflation as a policy, or at least the banks making these kinds of new mortgages want this to be the case. Why? Let us suppose for one moment the economy slips into a recession. Let us also think about the idea that if you can barely can afford to buy a house now, with no money down and an interest only or currently low adjustable rate mortgage - what are you going to do IF you loose your job or IF interest rates start going up (and you mortgage payments jump higher in the future)? Chances are, such people will probably file for bankruptcy or walk away. Now, if you are bank and get stuck with a whole lot of homes due to foreclosure - would you favor even higher prices for these homes or lower? You, as a bank, certainly would not want to be a situation whereby you loaned someone US$250,000 for a property that is now worth US$195,000. Instead, you want to be able to sell off the property and recover your money - would you not? We think the US banking industry is scared stiff about this kind of scenario and WHY there has been a push for bankruptcy filing rule changes guaranteeing by law that borrowers remain on the hook for any negative equity. So, one principal idea to consider is that the US Banking Industry will push for any economic scenario whereby inflation rather than deflation is the order of business going forward. This is a very important point because the US Federal Reserve is really a private corporation, whose stock is owned by private banking interests (so who are they really going to protect?). Also, the role of the US Federal Reserve is supposedly to try and manage economic stability policies, or better said - those policies, which best serve the overall economic interest for the country. In terms of the banking sector especially, this means inflation is the preferred modus operandi.

This is not to say that the government of the Central Bank (Federal Reserve) wants to see inflation. However, at the same time, they are more concerned about possibly having a scenario that mimics the Japanese economy over the last ten years or so, which has been deflationary. The last time the US economy witnessed this kind of event was during the so-called great depression of the 1930s - whereby many banks were stuck with loans for stock investments, and other things, that became increasingly worth less as months went by. We believe the artificially low interest rates for the past few years have been put in place to combat the prospect of deflation in the US economy. If we look back at the period 2001 - 2003, we see this as a very real fear, and we can try and understand what the US Federal Reserve was doing (right, wrong or otherwise). Now of course we have the opposite - too much inflation.

NOTED ECONOMIST PAUL KRUGMAN SAID THE FOLLOWING:

This week's cover story in The Economist makes it more or less official. Deflation, not inflation, is now the greatest concern for the world economy. Over the past year, producer prices have fallen throughout the advanced world; consumer prices have been falling for the last 6 months in France and Germany; in Japan wages have actually fallen 4 percent over the past year. Until the recent crisis prices were falling in Brazil; they continue to fall in China and Hong Kong; they will probably soon be falling in a number of other developing countries.

So far, none of these price declines looks anything like the massive deflation that accompanied the Great Depression. But the appearance of deflation as a widespread problem is disturbing, not only because of its immediate economic implications, but because until recently most economists - myself included - regarded sustained deflation as a fundamentally implausible prospect, something that should not be a concern.

The point is that deflation should - or so we thought - be easy to prevent: just print more money. And printing money is normally a pleasant experience for governments. In fact, the idea that governments have a hard time keeping their hands off the printing press has long been a staple of political economy; dozens of theoretical papers have argued that the temptation to engage in excessive money creation causes an inherent inflationary bias in fiat-money economies. It is largely to combat that presumed bias that most of the world has accepted the notion that monetary policy should be conducted by an independent central bank, insulated from political influence - and has written into the charters of those central banks that they should seek price stability as their main, often only, goal. (For further reading see links below - number 3)

BACK IN JULY OF 2003 - WILLIAM GREIDER SAID:

At the risk of sounding like Chicken Little, I am going to describe the economic situation in plain English. The United States is flirting with a low-grade depression, one that may last for years unless the government takes decisive action to overcome it. This would most likely be depression with a small d, not the financial collapse and grapes of wrath devastation Americans experienced during the Great Depression of the 1930s. But the potential consequences, especially for the less affluent and the young, would be severe enough--a long interlude of sputtering stagnation, years of tepid growth and stubbornly high unemployment, punctuated occasionally with a renewed recession. Depression means an economy that is stuck in a ditch and cannot get out, unable to regain its normal energies for expansion. Japan, second-largest economy in the world, has been in this condition for roughly twelve years, following the collapse of its own financial bubble. If the same fate has befallen the United States, the globalized economy is imperiled, too, since America's market for imports and its huge trade deficits keep the global trading system afloat.

Most authorities, I should add, do not regard any of this as likely. The great difficulty for policy-makers is that this doesn't much feel like a crisis--not yet anyway, for most Americans. So where's the urgency to undertake radical remedies? Some of Wall Street's best forecasters, for instance, are predicting 4 percent US growth in the second half of 2003. But Japan experienced false recoveries, too. Nobody knows what will unfold if nothing is done, but the consequences of waiting to find out could be horrendous for the broad ranks of Americans. When the US economy corrects for its excesses, it is always the innocents who are led to the slaughter first. Even if the odds are only one in four that the worst will happen (as the Dallas Federal Reserve Bank president recently estimated), it seems reckless to gamble. Taking strong measures now would be messy and disruptive to regular order (maybe wasteful if they aren't needed), but in the present circumstances that would seem more prudent than a false optimism that lamely repeats that the "good times" are right around the corner.

A depression can be read as a market signal of a dysfunctional economy that requires fundamental restructuring. Japan learned this the hard way. In this case, such a signal may be flashing the need for deep changes both in the American economic system and the worlds. Surely it is not too soon for Americans to ask themselves what might be out of whack and how to correct things--starting with their own much-celebrated economy.

I asked a financial economist at a major US hedge fund where the United States appears to be at this point. We are in the second or third year of what Japan has gone through, he surmised. How much longer might this go on? Another ten years, he said, if you think about Japan, another ten years.

The good news, so to speak, is that the Federal Reserve is on the case. At least Fed Chairman Alan Greenspan and colleagues now acknowledge that the gravest danger lurking in this situation is a general deflation of prices, and they promise to make sure that doesn't happen. For many months, Greenspan and other governors dismissed the growing anxieties expressed in financial circles by describing the chances of deflation as extremely small and quite unlikely. After the indexes for wholesale and consumer prices both fell in April, the Fed dropped those reassuring phrases. The chairman instead announced that pre-emptive actions may be needed to head off the threat. Declining prices, if they persist generally, create a vicious spiral of negatives--falling profits, more closed factories, shrinking employment and incomes, accompanied by waves of failing debtors, both corporations and families. In short, a far larger calamity than stagnation.

Though Greenspan doesn't say so in plain English, Fed governors recognize the corrective action that may be required of monetary policy: Pump up the money supply and deliberately induce rising prices--that is, foster a renewal of inflation, their old scourge. Rising prices provide an essential lubricant for any sustained recovery because a dose of inflation helps businesses get well and takes some of the depressive pressures off wages and debtors of every kind. The central bankers, however, are facing a very awkward moment. After twenty years of relentlessly reducing the inflation rate to near zero and winning great praise for their triumph, the governors are naturally reluctant to announce that the disease they conquered has become the cure. (For further reading see links below - number 4)

Who cares what economists and the Federal Reserve thought back in 2003? You certainly should, because the tinkering they have done to address one problem has now created another. Which is to say as well, we can somewhat predict the next level of tinkering to some extent, and how they can effect the value of your home and other assets. However, now that we have taken a look at what happened before, let us now explore the present day (2005).

The Following Article is a Very Interesting Commentary: - Continues on the next page .....
 

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