Past Weekly Commentaries

Index
March 1, 2006      Prediction: Governor Mark Warner will win the 2008 U.S. Presidential Election
March 9, 2006     
Hedge Funds Still in the Dark
March 15, 2006    iTulip.com II: The Sequel
March 22, 2006    Frankenstein Economy
March 29, 2006    Housing Bubble Correction Update

 
Gov. Mark Warner March 1, 2006 - Prediction: Governor Mark Warner will win the 2008 U.S. Presidential Election                        

Last night I attended a private roundtable held at Charles River Ventures in Waltham, Massachusetts to hear ex venture capitalist Mark Warner, conservative Democrat ex-Governor of VA who's running for President in 2008, give his pitch and take questions.  Most of the audience was comprised of venture capitalists. You'd be surprised to know how many Democrats occupy the high risk, high return, low liquidity segment of the banking industry known as venture capital.  And I noticed at least one card carrying Republican in the audience. I interpret his presence as an indicator of how strongly the need for change of regime is felt, even among stalwart Republican party members.

I was skeptical going in.  I'd read what little is available online about Governor Warner's positions on foreign policy, fiscal policy, energy, education, and the Wars in Iraq and Afghanistan.  I went for three reasons.  First, because I, like most Americans, am looking for an alternative to the current administration, but one that isn't positioned primarily as a critic of the current administration -- that's too easy -- but is able and willing to honestly confront the grave problems we face as a nation and lay out a plan to address them, including a clear explanation of the kind of sacrifices each of us is going to have to make to turn America back into the kind of country we want it to be.  Second, because I was invited by someone I deeply respect.  Third, for the novelty of meeting an anti-gun control Democrat, especially given that Governor Mitt Romney of our state of Massachusetts, who is also an ex venture capitalist and also has presidential aspirations, is a pro-gun control Republican.  Clearly, this is not going to be an election in which the two major parties run candidates along traditional party platforms.

Here's what I heard.

Iraq/Afghanistan Wars:  I posed a direct question to Governor Warner on Iraq: "The Bush administration's handling of the War in Iraq has been characterized by a conflation of dishonesty and incompetence.   First we're told that all of the Iraqi people are behind us.  Any talk of any possibility of an insurgency and comparisons to Vietnam is foolish and unpatriotic.  Then, after the insurgency became too large to ignore and sectarian fighting started to become apparent, we are told that yes there is an  insurgency but it's manageable... but that any talk of any possibility of civil war is irresponsible and ill informed.  Recently Iraq's defense minister himself warned of the risk of an 'endless civil war.'  How are you going to put a stop to this and create a positive outcome in Iraq?"  In response, we got a reasoned, well informed and passionate response.  Paraphrasing, he said that the operation has been too badly planned and executed to leave any truly good options at this point.  But among the least bad options available today are to 1) bring in outside help from other countries and non-U.S. corporations to begin to rebuild basic security and infrastructure so that most Iraqi citizens experience a degree of security and quality of life that builds good will toward the U.S. and new allies, and 2) develop a plan with the Iraqi government and new allies that both prevents the country from splitting into three separate nations (that's likely to lead to a complete loss of stability in the region), and provides clear milestones for the gradual withdrawal of U.S. troops over time.

Energy: We need to reduce our dependency on foreign sources of energy.  For practical reasons, given the level of energy demand that exists in the U.S. today, that means that we need to put nuclear energy back on the table.

Foreign Policy: Rebuild relationships with allies who have been alienated by the unilateral actions of the Bush administration.

Fiscal Policy:  No free lunch.  We need spending cuts and tax increases.  The cuts and increases need to be fair, spreading the inevitable pain fairly among those who are least and best able to bear it, just as Warner did to balance the budget in VA.

Education: Prepare America's children for a future of global competition with relevant educational training and incentives, as he did in VA.

I liked what I heard and was impressed by Warner.  His message is simple: America needs an accomplished, honest, competent, effective and elect-able candidate for president.  I have the same feeling about Warner that I had about Taipei Mayor Ma Ying-jeou when I met him at another VC sponsored event in Boston in the summer of 2005.  Both are elect-able men who can bridge major political divides within their respective countries and will have to lead their respective nations out of harm's way.

Warner may be labeled by many Democrats as pro-gun Republican in Democrat clothing, and by Republicans as a classic pro-tax Democrat.  If Warner and Romney turn out the be the two front runners for the Democratic and Republican parties respectively, many Americans may wish they had a chance to choose between two candidates from more respectable professions than venture capital, like peanut farming or acting.  In spite of that, I believe Warner has a chance of winning on a platform of Honesty, Competence and Passion for his country and its people. 

In keeping with iTulip.com tradition, we're not in the business of making political endorsements but of making predictions 
(see our For the Record section).  We did not wish the dot com bubble to collapse, but predicted why and when it would.  We favored gold over stocks in 2001 not because we have any special affection for gold, but because our analysis pointed to more upside for gold than for stocks when the Fed went into re-flation mode following the collapse of the inivitable stock market.  Gold was trading at 13% of its inflation adjusted peak price while stocks were trading far
above their historical mean.  Still are.  Gold was cheap and stocks, even after their so-called correction, were still expensive.  Since then, gold increased from $270 to $540 today while the stock market, adjusted for inflation, has declined.

Our prediction is that Mark Warner will win the 2008 presidential election.  Considering how early we are in the election cycle, and the fact that Governor Warner came in second behind Hillary Clinton by a two to one margin in a recent straw poll, you might find that prediction far fetched.  We'll tell you why it isn't in later commentaries.  But remember, as usual, you heard it here first.

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Hedge FundsMarch 9, 2006 - Hedge Funds Still in the Dark

This morning we're treated to yet another hedge fund blow-up story on the front page of the Wall Street Journal
Troubles at Fund Snare Doctors, Football Players (Subscription Required).  Kirk S. Wright and his firm, International Management Associates, appear to have lost the fund's 500 or so investors most if not all of the $115 million that they invested.

The failure of Wright's fund adds to a long and growing list of hedge fund meltdowns, large and small.  Usually only the larger failures make the news, such as Bailey Coates Cromwell Fund ($1.3 billion), Marin Capital ($1.7 billion), Aman Capital (est. $1 billion), Tiger Funds ($6 billion), and Long-Term Capital Management ($1 billion).  But according to Nina Mehta reporting for Financial Engineering News, failures are common and their causes are numerous:

"A March study by Capco, a financial-services consultancy and technology provider, offered some grist to those unsure how significant operational risk can be.  The firm investigated 100 hedge fund failures over the last 20 years and found that half of them failed because of operational issues rather than lousy investment decisions.  These include misrepresentations and inaccurate valuations, fraud, unauthorized trading, technology failures, bad data and so on. The evidence for change may be somewhat anecdotal, but a number of industry experts say they see increasing hedge fund attention to operational issues."

So who cares if a bunch of rich guys lose a lot of money on a few bad bets?  Three major issues. 

First, there are a lot of hedge funds with nearly $1 trillion under management.  According to the SEC report Implications of the Growth of Hedge Funds, September 2003,
"The hedge fund industry recently has experienced significant growth in both the number of hedge funds and in the amount of assets under management. Based on current estimates, 6,000 to 7,000 hedge funds operate in the United States managing approximately $600 to $650 billion in assets. In the next five to ten years, hedge fund assets are predicted to exceed $1 trillion."

Second, they are unregulated: "The Report notes that one of the staff's primary concerns is that the Commission lacks information about hedge fund advisers that are not registered under the Investment Advisers Act of 1940 (the 'Advisers Act') and the hedge funds that they manage. Although hedge fund investment advisers are subject to the antifraud provisions of the federal securities laws, they are not subject to any reporting or standardized disclosure requirements, nor are they subject to Commission examination. Consequently, the Commission has only indirect information about these entities and their trading practices, thereby hampering the Commission's ability to develop regulatory policy."

Third, these thousands of unregulated investment pools collectively pose a systemic risk to the banking system and financial markets. A paper titled Systemic Risk and Hedge Funds by Andrew W. Lo, et al, writing for the National Bureau of Economic Research March 2005, states:

"Systemic risk is commonly used to describe the possibility of a series of correlated defaults among financial institutions---typically banks---that occur over a short period of time, often caused by a single major event. However, since the collapse of Long Term Capital Management in 1998, it has become clear that hedge funds are also involved in systemic risk exposures. The hedge-fund industry has a symbiotic relationship with the banking sector, and many banks now operate proprietary trading units that are organized much like hedge funds. As a result, the risk exposures of the hedge-fund industry may have a material impact on the banking sector, resulting in new sources of systemic risks. In this paper, we attempt to quantify the potential impact of hedge funds on systemic risk by developing a number of new risk measures for hedge funds and applying them to individual and aggregate hedge-fund returns data. These measures include: illiquidity risk exposure, nonlinear factor models for hedge-fund and banking-sector indexes, logistic regression analysis of hedge-fund liquidation probabilities, and aggregate measures of volatility and distress based on regime-switching models. Our preliminary findings suggest that the hedge-fund industry may be heading into a challenging period of lower expected returns, and that systemic risk is currently on the rise."

The hedge fund industry itself, of course, argues that hedge funds are misunderstood, that the systemic risk they pose to the financial and banking systems are overstated.  A hedge fund industry Hedge Fund Association
web site explains the various types of hedge funds and states in a side bar:

"The popular misconception is that all hedge funds are volatile -- that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or don’t use derivatives at all, and many use no leverage."

That's comforting except that on the same day that we read about Wright's hedge fund failure, and more than two years after the SEC report, we're treated to the story
SEC Rapped Over Failing To Pursue HF Fraud from the venerable Institutional Investor Daily:

"The Securities and Exchange Commission has found Michael Lauer in contempt of court for violating an asset freeze order, acting in bad faith by not participating in the discovering process involving his hedge fund Lancer Management Group. To outspoken New York Post columnist Christopher Bryon the latest action is an example of SEC ineptitude, as the agency spends its resources going after small fry while not pursuing what could have been an eye-opening enforcement case against Lancer's administrator, Citco Fund Services. Bryon says the SEC has been sitting on top of the Lancer case since the firm went belly-up in 2003, and two weeks ago, according to the Post, a court ordered the unsealing of some 40 pages of internal e-mail memos and the like from 2002.

"Pursuing a case against Citco, Bryon writes, would have sent 'an unmistakable message to the entire hedge fund industry that those who break the law will go to prison.' Instead, he says, all the SEC can expect to get at the present is an injunction barring Lauer from the industry and relatively small fines. Bryon blames 'revolving-door leadership at the top [the agency has its fourth chairman in five years of the Bush administration], staff defections in the middle ranks and bewilderment at every level' regarding what constitutes 'improper and illegal' hedge fund behavior."

Fair to say that little if any progress has been made to regulate hedge funds, to "limit misrepresentations and inaccurate valuations, fraud, unauthorized trading, technology failures, bad data, and so on."  In spite of well documented problems, systemic exposure of the banking system and financial markets to the failure of certain hedge funds has grown, and appears to have done so for the same reason that the stock market bubble of the 1990s was allowed to grow to outrages proportions: no one wants to end the party, not the politicians who need the tax revenue from hedge fund capital gains and not likely the hedge fund industry itself.  It's hard to imagine the industry imposing a rule on itself, say, to hold sufficient reserves to cover liquidity risks. Such measures reduce unapparent risks but at the cost of lowering investors' very
apparent and much touted returns.  Not only will fund management bonuses based on returns decline, lower returns will make hedge funds less enticing, thus attracting less money, thus making hedge funds smaller and carry fees paid as fixed salaries smaller.  Why would any hedge fund want that?

In our next commentary, we'll discuss the poorly understood risks posed by the over-the-counter (OTC) derivatives market.

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Gov. Mark Warner March 15, 2006 - iTulip.com II: The Sequel                       

iTulip.com was first launched in November 1998.  The stock market bubble was in full swing.  iTulip.com, and few others, were warning visitors not to put their retirement money in the speculative bubble that the U.S. stock market had become.  Cramer was ranting on CNBC about the latest dot com "can't lose" stock.  We warned that the stock market was due to crash, most likely by the first or second quarter of 2000.  It did.

August 2002, the stock market was in the toilet, as we predicted in 1999.  We had just gone through a short recession and the Fed and Treasury were furiously pumping up The System, cutting rates and slashing taxes as predicted in 2001We received many letters of thanks from visitors who got out in time with their retirement accounts intact.

Dear iTulip.com,

I have followed your website with religious zeal since its inception in 1998.  I ducked the NASDAQ implosion while others have suffered. I even managed to sell at the top of the market bubble in Feb 2000!  Many thanks to your prescient website!!!!

G. Marsh

December 3, 2000


More letters...

Mission accomplished, we went off the air.

Fast forward to March 2006.  The NASDAQ has mostly stayed in the dumper, with various dot com toilet fish sinking and disappearing into the history books, again, as predicted.  The DOW, by a combination of a re-constitution of the easily manipulated 50 stock index -- throwing out some losers and adding in some winners -- has fought its way back to where it was six years ago.  Flat.  Except that, adjusted for inflation, it is down at least 20%.  But that hasn't kept Cramer from returning to CNBC to rant and throw chairs around while touting the latest "can't lose" stocks.  Not coincidentally, gold has gone up, as we predicted in 2001 when gold was trading near 20 year lows.  But what really kept the U.S. out of poorhouse, if only until now, was the housing bubble.  Not only did we fail to predict the housing bubble as the Fed's answer to the stock market bubble collapse, we argued that the Fed would never allow one to develop.

Wrong.

Our thinking was that in the past the Fed has been very quick to stop speculation in real estate, much more quickly than stock market speculation.  Why?  Real estate involves the banking system much more than does the stock market and l
ooking after the banking system is Job One for the Fed.  Letting millions of homeowners buy real estate they can't afford with mortgages they can never pay back is a surefire road to mass defaults that can cripple the banking system.  When a little housing bubble declined in the early 1990s, the U.S. banking system seized up.  That response to the downside of that minor real estate cycle was a Gran Mal seizure compared to the massive stoke that the banking system is likely to suffer on the back end of this wild real estate freak show.  More importantly, the political aftermath of a real estate bubble is economic devastation of the host country's economy.  Lots of unemployment and negative wealth effects that keep consumers home sulking and saving, not out at the mall buying goods from Asia that keep Asian central banks inspired to lend, and the virtuous cycle of lending, borrowing, importing and exporting going.  Not good for recessionary, inflationary and other re-election sensitive economic matters.   So why take the chance?  Because it looked better, at the time, than the obvious alternative: massive recession and unemployment before the 2004 elections.  Never good for anyone's re-election bid.

If we'd been listening more carefully, we would have heard Greenspan noting in public hearings in 1999, when a senator wondered aloud if Big Al was worried about the inevitable collapse of the stock market bubble, and he replied: only a small percentage of U.S. households own stocks whereas 70% of household wealth is tied up in real estate. Don't worry about it.  We got a plan.  Alas, we at iTulip.com missed the cue.  What we didn't understand was that the Fed convinced themselves of at the time, and may still believe today, that by the magic of securitization, the risk of defaults on all those mortgage loans that can never be repaid with current dollars is spread so far and wide around the planet that the aftermath of a housing bubble won't be anything the Fed can't deal with.  Not so, and we'll explain over the next several months just how and why, and what that's going to mean to you.

So we got the housing bubble prediction wrong in 2000.  We didn't understand that the Fed could be so short sighted and politically motivated to make policy decisions that might doom the nation to a decade or more of bad economic times, and all that implies socially, politically, and militarily.  But the Clinton/Greenspan regime and the Bush/Greenspan regime that followed turned out in retrospect to be classic Nixon/Burns president/central banker pals.  Except that rather than inflation in goods and services as a consequence of the deal cut to maintain the economy through the next election, not to mention an unpopular war, we got inflation in assets that makes nearly everyone happy, as long as the asset prices stay that way.

But they won't.  The housing bubble will end and money will be printed to reflate the economy once again and that money will flow elsewhere.  Not to stocks or real estate or bonds or hedge funds or venture capital or private equity.  But where?

If we missed predicting the housing bubble in 2000, at least we were one of the first to write, back in 2002, that in fact a housing bubble was happening, at a time when most of the financial press was arguing immigration rates and all manner of nonsense not worth repeating to justify silly real estate price increases.  Checked housing prices around your neighborhood lately?  Here's where they're headed.

So what's next?  We have our theories, as the pictures and comments below vaguely suggest.  But rather than just say, we're going to bring the iTulip.com message forward in a new way.  No more missing central banker clues about what's next for The System, perhaps the next  bubble, as when Greenspan noted in 1999 that 70% of household wealth was tied up in real estate.

The New iTulip.com is a community of the best and the brightest who will work together figure out not only what's coming next, but what to do before, during and after the events we collectively predict.  We intend to guide a lively discussion among our prized and loyal members, especially those who contributed so much to our predictive success in the 1990s.

Change is coming.  Stay tuned.  If you're new to iTulip.com, welcome.  If you're an iTulip.com veteran,
welcome back.

We will be opening our iTulip.com Forum shortly.  In the mean time, please sign up to our mailing list for regular updates.

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March 22, 2006 - Frankenstein Economy
Made in U.S.A. 1995

What does a Mr. U.S. Economy look like?  Can’t recall, exactly.  Haven’t seen him in nearly 20 years.  As I remember, he was fit, well proportioned, muscular to the point of intimidating.  If you are under 30, you’ve never seen him.  But he was there, many years ago, providing a good example, setting the pace, spreading the wealth, kicking ass and taking names.  Evidence of his past influence on the average Joe can be seen in old movies, movies with scenes like this.

The average North American, call him Joe, living in the era of
Mr. U.S. Economy, walks into a bank to get a loan to fix up his falling apart house, rather than add another thousand square feet to make room for the Made in China, Bose branded Home Entertainment center.  A dour looking loan officer, call him Ed Noway, sits behind a laminate faux walnut desk facing the nervous applicant. Prominently displayed on the edge of Ed’s desk, a brass nameplate on a wood block that reads “Ed Noway, Loan Officer.”  While Joe fidgets, Ed pours over a pile of paperwork that Joe dutifully spent until midnight filling out with his wife the night before.  They did not cuddle afterwards.  She’s not sure Joe can close the loan with Ed.  Joe's not sure he wants the extra hours he’ll have to work to make the additional payments.

Ed finally looks up to grill Joe about his employment and credit history, his assets, his attitude about saving.  Ed wants to know if Joe is likely to pay the loan back or not.  He, Ed, the loan officer, is responsible for the decision.  He doesn’t want the bank, nor he as its representative, left holding the bag if Joe punts on the loan.  Ed will look bad.  He might even lose his job.   Ed’s ass is on the line.  So is Joe’s. 

Here we have the basis for a sound business transaction.  But those days are over.  The Frankenstein Economy is here.

Today, Joe can borrow against the theoretical future value of his home and the statistical probability that he’ll have the future income stream needed to pay it back. There is no Ed at the bank to know or care whether Joe can actually pay back a loan, or if he actually uses the money to make home repairs or buy eight tons of snow to build a ski slope in his back yard to snow board in August.  The connection between Joe and his newly minted debt today is a collateralized debt obligation, part of a securitized interest in a pool of non-mortgage assets, and Joe’s default risk is perhaps sold in a portfolio of private label subordinate pieces to a pension fund of a municipality in Germany.  Who’s the counterparty of the credit derivative that's hedging Joe's default risk, you ask?  No you didn’t.  You don’t know what the heck I’m talking about.  Don’t feel bad.  Ninety nine percent of the lenders selling these loans don’t either.  They just know the money is there to lend and they’d better lend it or their competition will.

Over the past 15 years or so, the Fed replaced Mr. U.S. Economy in a free market ideology based fit of deregulation.  Mr. U.S. Economy, whoever he was, is no more.  In his place, the Frankenstein Economy.  The Fed may have had had the best of intentions when making the Frankenstein Economy, but let’s see what he’s left behind as he’s stomped across the North American economic landscape.

Assets vc Liabilities

Since at least 1950, before Mr. U.S. Economy was put in cryogenic storage and replaced by the Frankenstein Economy, U.S. households purchased financial assets at an increasingly higher rate than they took on liabilities.  They did this, except during recessions, until 1990.  Then they started to take on more and more liabilities. In 1995, when the Frankenstein Economy appeared on the scene, a 50 year trend started to turn upside down.  Net acquisition of financial assets not only stopped growing but turned negative, as the chart above from Paul Kasriel at Northern Trust shows. 

Large and sudden reversals in long-term trends imply future regressions to the mean; the Frankenstein Economy has made a mess of the markets.  The folks at the Fed, of course, think the Frankenstein Economy is doing great!  Before we go into that, let’s view a few more pictures of the monster’s gruesome trail.

Also starting in 1995 -- not by coincidence, in our view -- under the influence of the Frankenstein Economy, North Americans developed religious expectations about the value of their homes.  While the nominal (inflation adjusted) value of their homes declined, market value skyrocketed.  A few voices of reason were dismissed as egghead mumbo jumbo, such as Yale professor Robert Shiller, whose research concludes that except for two periods — the early 1940s and the late 1990s — when adjusted for inflation, home prices in the U.S. "have been mostly flat or declining."


Rent vs Market value

Justifications for the post 1995 real estate bubble shown in the chart above, again thanks Paul Kasriel at Northern Trust, are legion.  The favorite: land scarcity.  Little country, the U.S.A.  One of the hottest real estate markets?   Las Vegas.  (Tip for Vegas real estate buyers: land scarcity and thus land value in the desert can be repealed as quickly as the zoning laws that created it.)

What about a nation that has an actual shortage of land relative to population, such as Japan.  How did the housing bubble turn out there?  Theirs, much like ours, started right after their stock market bubble burst, but unlike ours conked out a couple years later.

Japanese Condo Prices

The chart above, compliments of a San Francisco Fed's Asset Price Declines and Real Estate Market Illiquidity: Evidence from Japanese Land Values January 2005.  They found that if you bought a condo in Japan’s version of NYC in 1992, ten years later the market valued it at around 80% of what you paid.

Ten years of flat prices. Maybe this is the report that has given the Fed the confidence to issue the calming view repeatedly expressed in public that housing prices will not “collapse” after the U.S. boom ends but merely “flatten out.”

Say you're 50 years old.  Are the optimists saying that -- best case -- a house may be worth nominally (price adjusted for inflation) in 2016, when you are 60, what you paid for it in 2006?  Let's hope they're right and prices don't regress to the mean

Personal Savings

Back to our hero, the Frankenstein Economy.   Just as he's convinced North American's of the inevitability of home price appreciation, he has convinced them that they do not need to save.  He’s been highly influential on this point, as the chart above from iTulip.com’s previous life shows: the U.S. savings rate from 1960 to 2000.  Once again, we note a distinct change in trend in the year 1995.

Of all the outlandish features of the Frankenstein Economy, his most outstanding is his enormous head relative to his brain.  When he’s thinking at all, he imagines that the world outside the USA finds him as attractive as his previous incarnation, Mr. U.S. Economy.  Like an aging Hollywood actor who's suffered one plastic surgery after another in the hope that he can keep getting the star role of the 30-something action hero even though he’s pushing sixty, he expects to keep getting paid a movie star salary premium.  So far the ruse seems to be working.  He’s taking in $2 billion in foreign investments every day, enough to fund the country’s massive budget and trade deficits.  But mostly it’s Asian central banks that are paying; private and institutional investors baled years ago.  The Asian central banks only do it to keep the U.S. consumer borrowing and their exports flowing until they can find a better customer.

Merchantile Trade Balance

His trade deficits are shown in the chart above selected from the highly recommended site Grandfather Economic Report.  As you can see, Economic Frankenstein started to work his magic around 1995 as North Americans began to buy a lot more stuff from overseas than they sold.  To see exactly how North Americans paid for all this, see our Chart of the Week, Purchases of U.S. Financial Assets.

The crux of our investigation here at iTulip.com going forward is to understand what led to an apparent abrupt change in many long-term economic trends that coincided with the creation of the Frankenstein Economy around 1995.  We expect that if we understand that, we’ll understand how, why and when these trends are likely to reverse and the impact that will have on our readers.  Actually, we believe we already know, but learned from our previous 1998 iTulip.com experience that you can’t just give up the answer -- no one will believe us.  Readers have to develop an understanding on their own.

In the end, Dr. Frankenstein's monster does not find peace until his creator dies. The monster then departs for the northernmost ice to die. 

In the case of the
Frankenstein Economy, the sooner the better.

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Ercon Frank


Housing Bubble Cascade Housing Bubbles Correction Update
Geographic Regions Cascade

We’ve written three articles on the housing bubble since 2002.  In Yes. It’s a Housing Bubble in August 2002, we made the case that the U.S. housing market was comprised of a number of regional real estate market bubbles. At the time, there was still controversy on the topic of whether or not a bubble existed.  Now that many housing bubble markets around the country are in decline and are getting covered on NPR and the front page of the business section of your local newspaper, only the most dedicated mortgage or real estate broker still claims that no bubbles existed.

The Fed took the strictly accurate but misleading position at the time that no national housing bubble existed.  True, real estate bubbles occur within regions – areas of concentration of jobs or especially desirable areas where land is scarce, such as water-front property -- not across the nation as a whole.  Housing bubbles happen wherever there are good paying jobs and monthly mortgage payments are declining, not just low.  With mortgage rates at 40 year lows, housing bubbles were happening in nearly every populated area of the nation that had not experienced unusual sudden job losses, as occurred for example in manufacturing industry regions of Ohio.   

Housing bubbles may not be “national” but that doesn’t make them any less dangerous for the national economy.  Contrary to the Fed’s predictions, we expected that the decline of these regional real estate bubbles was going to put a significant hurt on the U.S. economy, especially at the point many regional bubbles decline simultaneously.

We argued that a housing bubble creates its own fuel: employment within the housing industry itself.   Many high tech workers left unemployed by the collapse of the technology stock bubble, for example, moved into the real estate or financial services industries.  In fact, 43% of all private sector jobs created since 2001 were related to real estate.
In an update Housing Bubbles are not like Stock Bubbles in 2004, we explained that when a regional real estate bubble ends, it does not “pop” the way stock market bubble does, with a sudden collapse in prices.  Instead, the region experiences a collapse in real estate transactions.  The reason is that stock markets are very liquid.  When investors head for the exits, transaction volumes rise and prices can fall rapidly.  Bubbles in housing markets, on the other hand, become illiquid when they correct.  For a town or other region that experienced significant real estate price inflation, long periods can pass when there are no transactions at all.  The more time that elapses between transactions, the more uncertainty buyers feel about the “market” price for comparable properties.  

Certainty about price gains is replaced by uncertainty.  This motivates further delays in buying decisions.  Market psychology shifts to the classic deflationary “I’ll wait to buy because the price is likely to fall” decision process, the reverse of the inflation cycle psychology of “I’d better buy it now before the price gets further out of reach.”  Deflationary psychology is especially self-reinforcing in declining property markets because a home usually represents the largest purchase a household will make and involves the greatest leverage as well.  The stakes are high.

Our last piece on the housing bubble Housing Bubble Correction January 2005, we projected the trajectory of a price decline in U.S. real estate markets.  Using historical rates of home equity extraction as a yardstick, we projected a ten to 15 year reversion to the mean for housing prices, using the rate of equity extraction as our guide.

Home Equity Extraction

Housing Bubble Correction predicts that in housing markets where bubbles occurred, prices will go through seven stages of decline, Stage A through Stage G as shown above, over a ten to fifteen year period.  So far, anecdotal evidence indicates that this prediction may have been optimistic with respect to the rate of change, and we will not know for many years if our estimate of the duration of the correction is accurate.  Today, certain markets are at the latter part of Stage A of bubble growth while others are at Stage B of decline and yet others are at Stage C or further. 

Here we offer a theory that explains the variations in regional housing bubble declines and how they are likely to unfold geographically over the projected ten to fifteen year period.  This applies the housing bubbles centered in metropolitan areas versus resort areas.  Bubble pricing in the latter is largely driven by money generated by participants in the U.S. Speculative Financial System (see The Big Bet) and will decline in line with the decline of The System, of which, adding to the complexity of an analysis, real estate is itself a part.  Here we will focus on housing bubble markets tied to metropolitan areas.

During the early growth stage of various regional housing bubbles, housing prices increased first in metropolitan areas, then in the suburbs and finally in rural areas.  (These are admittedly crude geographic designations designed to simplify the explanation of the theory without invalidating it.)  Prices cascaded geographically outwards from areas of high employment (income) and population density (housing demand) in metro areas to areas of lower employment and population density in the suburbs surrounding metro areas and finally, once demand pushed housing affordability to extremes there, to areas of low employment and low population density beyond the suburbs.  This process of geographic price cascading took approximately ten years, from around 1995 to 2005. 

The dynamic that drove prices outward was the need for workers in the cities and later the suburbs to escape high real estate prices, to move to where real estate was relatively cheaper and the cost of living lower, but still within an “affordable” commute.  As homebuyers traveled farther from metro areas, they encountered lower real estate prices.  At the extreme top of the market in late 2004 and early 2005, some home owners who bought property in the mid 1990s in market bubble areas before a housing bubble reached their region, sold their property at a huge profit, purchased equivalent property in size and quality in a rural area, and retired on the profit with perhaps a low wage retirement job.  For example, home owners from Boston and nearby suburban towns, as well as from new York and Connecticut, sold their homes and purchased homes in Amherst and surrounding towns, 90 minutes from Boston and have retired using the profit on the transaction.  However, most rural homebuyers who purchased at the top of the rural market in mid 2005 did so to have a chance to buy an affordable home.  Of course, as more and more homebuyers searched farther away from metropolitan areas, prices increased in outlying areas as well until property values in rural areas reached historical peaks and experienced bubbles of their own. 

Living in rural areas and working either in the suburbs or metropolitan areas increased commute time and expense, but this was affordable with gasoline under $1.50 per gallon as it was before hurricane Katrina.  But combined increases in gasoline, heating oil, natural gas and propane prices plus higher interest payment on ARMs combined in mid 2005 to pushed many household budgets past the tipping point for those living in homes purchased in rural areas at or near the top of rural market housing bubbles.

Housing bubbles are driven by the same psychological factors that drive all late stage asset bubbles, the popular assumption that prices only rise.  A steady drumbeat of negative press today, as evidence mounts that the boom is over, reinforces the negative price expectations, but nothing gets the fear juices flowing like watching home prices collapse in a neighboring town, or  watching one’s neighbor lose his or her home. 

This change in psychology will start to cause housing bubbles around suburban then metro areas to decline in a reversal of the process that drove prices from metropolitan markets outward to suburban and rural markets.   The trigger, it should be remembered, was rising gasoline and energy prices and their impact on rural homeowners who purchased at the top of the market.


After a year or so, broad regions covering metropolitan areas out to rural areas that experienced real estate bubbles will experience simultaneous price declines.  The extent of price decline in any area will depend on several factors, but most importantly the diversity of the local economy.  A local economy that is dependent on one or two industries, and especially one or two employers, is vulnerable to significant housing price declines.  An unusual characteristic of this housing boom is the extent to which it was self-reinforcing by producing jobs that in turn drove up prices.  Declining demand for housing related employment will further add to the self-reinforcing housing price deflation dynamic. 

On the top of our list are areas at risk are those that depend heavily on employment from:
  • Housing Related Industries (e.g., construction, realty services, landscaping, building supplies, etc.)
  • Financial Services (e.g., mortgage lending)
  • Venture Backed High Technology
  • Venture Backed Biotechnology
Our best estimate is that eventual price stabilization will be transmitted from the outside in, just as price declines were.  This does not mean that prices will stabilize at the same levels relative to their peak prices in all areas, however.  Prices will tend to fall dramatically from their peaks in rural areas, less so in suburban areas, and even less so in metropolitan areas, largely as a result of the relative lack of employment opportunities in rural versus metro areas and relatively high commuting and energy costs. 

Over time, prices will, or course, stabilize and recover to their mean rate of growth, at more or less the same rate as the rate of inflation.

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