Download Markets at a Glance - Sprott Asset Management

Markets at a Glance
A Housing Bubble Is Always and Everywhere a
Monetary Phenomenon
March 2006
Eric Sprott; Sasha Solunac
Milton Friedman once said that inflation is always and everywhere a monetary phenomenon. As a corollary,
one could postulate that housing bubbles are also always and everywhere a monetary phenomenon. Every
rule has its exceptions of course, so “always and everywhere” may be a bit too strong… perhaps “the vast
majority of the time” would be more appropriate. Nonetheless, the title of this article exemplifies the link
between asset prices and interest rates – a link that frequently gets forgotten amongst the frenzy of greed that
bubbles tend to generate. But all good things must come to an end. The tide of interest rates has shifted
markedly in the opposite direction. Reckless financial schemes that enticed people into the mortgage/refi/home
equity loan markets no longer work and even threaten to blow up. We believe this will have profound
implications not only for the housing market but also for the economy as a whole.
It is no coincidence that the former half of this decade saw a boom in global housing prices that coincided with
extraordinarily easy monetary conditions the world over. Nowhere was this monetary easing more prevalent
than in the United States. The Federal Reserve experimented with a heretofore unseen monetary policy that
bordered on financial recklessness. It triggered a global mania in financial speculation. Beginning in late 2001
and extending all the way to early 2005, short term interest rates approached the zero bound, going as low as
1% and staying there for a full year. Having such low interest rates over such a long period of time was
unprecedented. The Federal Reserve website has a database of historical records that dates back to 1954.
Perusing that database, one has to go back to the 1950’s for a period when the Fed fund rate dipped to 1% or
lower. But even then, rates only stayed that low for two or three months and never longer. It is therefore safe
to conclude that for the first half of this decade money was, by far, the cheapest and easiest it’s been for over
half a century. Money became essentially free. So it should come as no surprise that a housing bubble was
spawned. Unfortunately, the reverse also holds true. Tightening monetary conditions will lead to the bubble’s
demise.
Let’s not kid ourselves. Housing prices are all about interest rates. It’s not about demographics. It’s not about
people’s sudden desire for homeownership. The raison d’être of housing bubbles is a declining interest rate
environment and, by implication, easy monetary policy. Rest assured that if interest rates were infinite and
people had to pay for a house with cash, housing prices would be a fraction of what they are today. Low
interest rates mean people can “bid up” the price of housing and still keep monthly payments at a reasonable
level. Low interest rates also mean leverage can be used to augment gains for those looking to play the
market. The dynamic has a tendency to feed on itself as speculative money enters the fray and causes
demand, and thus prices, to rise even further. When there is easy money to be had, it’s human nature to try to
take advantage of it… in droves.
Sprott Asset Management Inc. Royal Bank Plaza, South Tower, Suite 2700, PO Box 27,Toronto, Ontario, M5J 2J1
T 416.943.6707 Toll Free: 866.299.9906 F 416.362.4928, www.sprott.com
1
Eric Sprott; Sasha Solunac
But like all manias, “irrational exuberance” began running rampant in the housing market. People shifted from
talking about stocks during the stock market bubble of the late 1990’s to talking about houses during the
housing bubble of the 2000’s. Not a step was missed. The signs of mania were all the same. Excess leverage
with zero downpayment mortgages. New financial schemes that promise low or no interest in the first few years
of a mortgage. The questionable accounting practices of Fannie Mae. Reports of appraisal fraud. General
recklessness, not only on the part of borrowers, but especially the lenders. The biggest risk takers (borrowers
and lenders) were the ones making all the money in an ever-escalating housing price environment. Others who
were being more prudent felt forced to join in or miss the boat. So we witnessed heavy marketing by banks and
other lenders. New fangled ‘hybrid’ mortgages were being offered left and right. The draw was based on two
hooks: “free money” (a cash out refi or home equity loan means more money in your pocket today) and
“deferred payment” (make no downpayment and/or pay a low teaser rate in the first two years of a mortgage).
During the bubble, 2/28 mortgages came into fashion where the first two years of the mortgage had a low
interest rate, and thus a low payment, with a substantial step up in the remaining 28 years of the mortgage.
Such mortgages tended to be offered to subprime borrowers, those with high credit risk, who were unlikely to
be able to afford the higher payments after the initial two-year period. However, as long as the bubble persisted
there was never a problem with foreclosures. Because the price of the house went up, those who couldn’t
make the higher payment after the first two years simply refinanced into a new 2/28 mortgage! It was a brilliant
and beautiful system. The banks made their fees, the borrowers kept the house, and all was well and good.
Nobody seemed to pay any heed to the fact that the piper will eventually have to be paid. Indeed, the housing
bubble had all the earmarks of the same psychology, and the same abuses, as any other bubble in history.
Human nature doesn’t seem to change over time.
But all good things come to an end. The tide of low interest rates has shifted. The most predominant change
has been at the short end of the curve, but longer rates have been creeping up as well. 10-year yields are now
4.7%, approximately 50 basis points higher than the average for 2004 and 2005. 2-year interest rates have
seen a substantial upturn, leading to a slightly inverted yield curve. At 4.73% currently, the 2-year yield is 173
basis points higher than it was at the beginning of 2005, and over 300 basis points higher than it was in March
of 2004. As a result, 1-year adjustable rate mortgages currently have a rate of 5.4%, 200 basis points higher
than two years ago. The general consensus now seems to be that the Fed will keep raising interest rates, more
so than was initially expected. Thus, the prospect for even higher rates going forward is very probable. It goes
without saying that higher interest rates aren’t good for housing prices.
We’ve discussed the housing bubble before and the risks that it poses for the economy. (“Throwing Stones
From Glass Houses” in July 2005, “Another One Bites the Dust” in September 2005, and “The Housing
Boom Is Dead. Long Live the Housing Boom!” in November 2005.) We’ll reiterate these risks later. But the
point we want to make in this article is that, due to rising interest rates, the housing bubble is over and the
aftermath has begun (albeit we are still in the nascent stages with the worst yet to come). We would like to
draw our readers’ attention to two articles that appeared in the weekend edition of the Wall Street Journal dated
March 11. One is titled “Millions Are Facing Monthly Squeeze On House Payments”, and the other is titled
“Home-Equity Loans Level Off”.
The former article alludes to a study conducted by the research firm Moody’s Economy.com. According to this
study, a quarter of all mortgage loans outstanding, equating to more than $2 trillion of debt, is due for an
interest rate reset this year and next. The study claims that one in eight households with adjustable rate
mortgages that originated in the past two years will default on those loans! Why? Because “1.4 million of those
households face a jump of 50% or more [our emphasis] in their monthly payments once their initial lowpayment periods run out” and “an additional 1.6 million face smaller increases that are still likely to strain their
Sprott Asset Management Inc. Royal Bank Plaza, South Tower, Suite 2700, PO Box 27,Toronto, Ontario, M5J 2J1
T 416.943.6707 Toll Free: 866.299.9906 F 416.362.4928, www.sprott.com
2
Eric Sprott; Sasha Solunac
finances.” Running the numbers, this puts $800 billion of mortgage debt (or 10% of all mortgage debt
outstanding in the US) at risk of default, of which $250 billion will default according to this study. These are
staggering numbers, especially when compared to total foreclosures (at all stages) of approximately 850,000
nationally last year. Not only would defaults of this magnitude put a considerable stain on the financial system,
but when one compares the number of potential foreclosures to annual existing home sales of 6.5 million, then
interest rate resets threaten to flood the housing market with new inventory and crash housing prices.
Furthermore, the authors of the study claim that if interest rates continue to move upward and housing prices
fall, the number of foreclosures could be much higher than the above scenario foresees. [As an addendum,
there is another housing study mentioned in today’s Investor’s Business Daily dated March 23 which estimates
that almost 10% of all homeowners (if we can call them that) have zero or negative equity in their homes!]
The latter WSJ article mentions how, after growing 30-40% per year for the past three years, home equity credit
lines are now leveling off. Home equity loans have been a major boon, not only for the lending industry, but
also for consumer spending. According to a study by the Federal Reserve authored by Alan Greenspan, all
forms of home equity borrowing amounted to 7% of disposable income in 2004 (versus 3% in 2000 and 1% in
1994). People have been literally using their houses as ATM machines. To quote from the article: “Americans
have used rising home values as a piggy bank to finance spending on everything from renovations to vacations.
Home-equity credit lines, heavily marketed by banks and other lenders, were among the most popular, often
allowing homeowners to tap the value of their homes by writing checks or even using debit cards.” According to
an ISI economist, home-equity borrowing may fall 30% by year end. Needless to say, this will have significant
economic ramifications especially considering the rather abrupt reversal from 30-40% growth rates.
The household net worth data from the Federal Reserve further exemplifies the risks to the economy of a
housing bust. The good news is, as at the end of 2005 household net worth has risen by $10 trillion since
1999. The bad news is, all of this increase (and then some) came from the (supposed) rise in home values.
Whereas the value of stocks and mutual funds has declined over that time (from $12.8 trillion in 1999 to $10.3
trillion currently), the value of homes has more than doubled (from $10.4 trillion to $21.6 trillion). As a result,
mortgage debt has also almost doubled (from $4.8 trillion to $8.7 trillion). It is worth noting that if housing prices
should fall the debts will remain the same, and be that much more onerous. But perhaps even more
importantly, the loss in wealth that people experienced from the bursting of the stock market bubble ($2.5
trillion) pales in comparison with what was gained in housing! ($11.2 trillion.) Which seems to imply that the
effects of a housing crash will be of far greater consequence than the stock market crash was earlier this
decade.
We are unconvinced that household net worth has actually increased in real terms, given that the money supply
as measured by M3 has increased by an almost commensurate amount with housing prices (from $6.1 trillion at
the beginning of 1999 to $10.3 trillion currently). In short, we believe the increase in housing prices has been
more of an inflationary effect as a result of easy monetary policy rather than a bona fide increase in real asset
values. There are those who may claim that we are going out on a limb by equating housing bubbles with
inflation. After all, a house is an “asset” and therefore the inflation of assets is a “good” thing (although a first
time homebuyer may beg to differ). Furthermore, it is claimed, because housing prices have increased at a rate
substantially higher than reported inflation, housing prices are going up in real terms making people wealthier.
We do not conform to this rather narrow view of inflation, and certainly don’t consider that government reported
inflation numbers represent anything remotely tied to reality when it comes to the purchasing power of currency.
We believe that, under a fiat currency system, when central banks go on a money printing binge as they have
done for the past several years, then that newly printed money needs to find a home somewhere and “inflate”
the price of something. To date that something has been financial assets, especially housing. It has also done
Sprott Asset Management Inc. Royal Bank Plaza, South Tower, Suite 2700, PO Box 27,Toronto, Ontario, M5J 2J1
T 416.943.6707 Toll Free: 866.299.9906 F 416.362.4928, www.sprott.com
3
Eric Sprott; Sasha Solunac
a fine job inflating the price of commodities, many of which have tripled in price over the past few years.
Miraculously, this is not showing up in the reported inflation numbers… yet. In any event, we are reticent to
equate wealth effects and fiat currency printing. Be that as it may, a drop in housing prices (real or nominal)
promises to severely constrain people’s perceived wealth, and by implication their spending habits.
Another factor often overlooked is the effect that the housing bubble has had on employment, wages, and
productivity in the US – effects that will reverse themselves in a crash. Housing and real estate finance have
become mega growth industries. The spin off effects for the economy have been enormous. Just think of all
the hands that end up in your pocket when you buy (or build) a house, do a mortgage refi, or a home equity
loan. Banks, real estate agents, lawyers, notaries, insurance companies, various levels of government, even
media advertisers. Not to mention homebuilders, renovators, the Home Depots, tradesmen, etc. They have all
prospered. So many new jobs have been created in housing and real estate finance. One may ask how has
the unemployment rate managed to stay so low with so much of the manufacturing sector (and increasingly, the
services sector) being gutted and moving overseas to China and India? The answer has been the housing
bubble. In a housing crash many of these jobs will perish. This factor is often overlooked by those who believe
the end of the housing bubble is nothing to worry about.
The housing bubble was a cure for many ills. Rising housing prices masked a lot of problems at the consumer
level such as excessive credit card debts, stagnant real wages, rising energy costs, and negative savings rates.
A cash out refi here, a home equity loan there, and Presto! Financial disaster averted. With such an easy
source of cash now off the table, we wonder how people will manage to swing the higher payments when
interest rates reset. We fear that many won’t, putting the economy and the financial system under considerable
strain.
A good source of anecdotal information is thehousingbubbleblog.com. These days there is much discussion
about appraisal fraud. Appraisers are being frequently asked to ‘hit the number’ on a home’s value to ensure
that a loan goes through – otherwise they won’t get paid. There are likely several other abuses of the system
taking place as we speak. Unfortunately, they will probably only come to the fore after the housing crash, not
before. We believe the aftermath of the housing bubble will lead to an overhaul of the system similar to what
happened after the stock market crash. Lending practices will be reexamined. Accounting standards of the
GSE’s (like Fannie Mae) will be reworked to be more transparent. The risks of the derivatives market will be
questioned. All of this will likely lead to major changes. But for many it will be too late.
In conclusion, the housing bubble was a monetary phenomenon that is now in reversal. How this will play into
Alan Greenspan’s legacy remains to be seen, but we don’t believe the post mortem analysis will be favourable.
The information contained herein may not be reproduced, quoted, published, displayed or transmitted without the prior
written consent of Sprott Asset Management Inc. (‘SAM’). The opinions expressed are solely those of the author. They
are based on information obtained from sources believed to be reliable, but it is not guaranteed as being accurate. The
report should not be regarded by recipients as a substitute for the exercise of their own judgment. Any opinions
expressed in this report are subject to change without any notice and SAM is not under any obligation to update or
keep current the information contained herein. SAM accepts no liability whatsoever for any loss or damage of any kind
arising out of the use of all or any part of this report. SAM is the investment manager to the Sprott Canadian Equity
Fund, Sprott Gold and Precious Minerals Fund, Sprott Energy Fund, Sprott Hedge Fund L.P., Sprott Hedge Fund LP II,
Sprott Bull/Bear RSP Fund, Sprott Opportunities Hedge Fund L.P, Sprott Opportunities RSP Fund, Sprott Offshore
Fund, Ltd., Sprott Strategic Offshore Gold Fund, Ltd. Important information about these funds, including management
fees, other charges and expenses is contained in its simplified prospectus and/or offering memorandum. Please read
them carefully before investing. Mutual funds are not guaranteed; their unit values and investment returns will fluctuate.
Performance data represents past performance and is not indicative of future performance. Performance comparisons
are drawn from sources believed to be accurate. This is not a solicitation.vvvvvvvvvvvvvvvvvvvvvvvvvvvvvvv
Sprott Asset Management Inc. Royal Bank Plaza, South Tower, Suite 2700, PO Box 27,Toronto, Ontario, M5J 2J1
T 416.943.6707 Toll Free: 866.299.9906 F 416.362.4928, www.sprott.com
4