2006 - Prediction: Governor Mark Warner will win the 2008 U.S.
I attended a private roundtable held at Charles River Ventures in
Waltham, Massachusetts to hear ex venture capitalist Mark Warner,
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
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
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
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
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
have been alienated by the unilateral actions of the Bush
Fiscal Policy: No free lunch. We
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
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
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
trading at 13% of its inflation adjusted peak price while stocks were
above their historical mean. Still are. Gold was cheap and
even after their so-called correction, were still expensive.
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
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.
Back to Top
March 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
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
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."
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
Associationweb 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
"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
"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
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.
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
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 2001. We received many
letters of thanks from visitors who got out in time with their
retirement accounts intact.
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!!!!
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.
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 looking 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.
Back to Top
22, 2006 - Frankenstein Economy Made
in U.S.A. 1995
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
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
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.
not sure he wants the extra hours he’ll have to work to make the
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
is responsible for the decision. He doesn’t want the bank, nor he
its representative, left holding the bag if Joe punts on the
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
in his back yard to snow board in August. The connection between
Joe and his newly minted debt today is a collateralized debt
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
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.
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
lend it or their competition will.
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
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
across the North American economic landscape.
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
except during recessions, until 1990. Then they started to take
more and more liabilities. In 1995, when the Frankenstein Economy
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
Large and sudden reversals in long-term trends imply future regressions
to the mean; the Frankenstein Economy has made a mess of 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
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
(inflation adjusted) value of their homes declined, market value
skyrocketed. A few voices of reason were dismissed as egghead
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."
for the post 1995 real estate bubble shown in the chart above, again
thanks Paul Kasriel at Northern Trust, are legion. The favorite:
scarcity. Little country, the U.S.A. One of the hottest
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
Theirs, much like ours, started right after their stock market bubble
burst, but unlike ours conked out a couple years later.
Ten years of flat prices. Maybe this is the report that has given the
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
what you paid for it in 2006? Let's hope they're right and prices
to the mean.
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
previous life shows: the U.S. savings rate from 1960 to 2000.
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
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
plastic surgery after another in the hope that he can keep getting the
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
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
private and institutional investors baled years ago. The Asian
only do it to keep the U.S. consumer borrowing and their exports
until they can find a better customer.
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.
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
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.
Correction Update Geographic
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
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
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
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
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
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
of all private sector jobs created since 2001 were related to
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
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.
Correction predicts that in housing markets where bubbles
prices will go through seven stages of decline, Stage A through StageG 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
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
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.
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.
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,
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
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.
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
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
past the tipping point for those living in homes purchased in rural
areas at or near the top of rural market housing bubbles.
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
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
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:
Industries (e.g., construction, realty services, landscaping, building
(e.g., mortgage lending)
Venture Backed High
Our best estimate is
that eventual price stabilization will be transmitted from the outside
as price declines were. This does not mean that prices will
stabilize at the same levels relative to their peak prices in all
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.