Main Street Feels the Pain

By James J Puplava CFP, October 13, 2003

It has been the best of times and the worst of times, depending on your perspective. Economists are calling the recession of 2001 the mildest downturn in recent memory. Stocks went down as company profits fell, but consumer spending remained firm putting a floor underneath the economy. Although stock prices plummeted during the last three years, the loss in equities has been made up by housing appreciation.

Your Home

A rising housing sector has acted as fuel for the economy with strong residential construction spending feeding into other sectors of the economy. It has kept raw material prices strong from cement to lumber and has spurred sales in other sectors from home appliances and furniture to gardening. More importantly, strong housing appreciation has allowed consumers to keep up their spending spree by enabling households to monetize real estate inflation through home equity loans and cash out financings. Last year cash out financing allowed consumers to pull out over $200 billion in equity from their homes which went towards consumption.

Lower interest rates are making it possible for homeowners to pile on mortgage debt at a record pace. The mortgage debt of the average homeowner is at a record level as is the delinquency rate for loans insured by FHA. Delinquency rates rose by 12.59% in the latest quarter, up sequentially from 11.65% in Q1. The rise in mortgage debt has shrunk homeowners' equity to 54.3%, a new record low. Consumers have been transferring credit card debt onto their mortgages through home equity loans. Consumer credit card debt nationwide has risen by 53% in the last decade, but has fallen from an average of $4,486 to $4,126. The drop in average credit card debt can be attributed to cash-out refinancing, home equity loans, and credit lines.

Your Neighborhood Bank

Banks have turned into aggressive lenders in the real estate market. Bank lending has moved away from business lending and commercial construction and is now heavily concentrated in residential real estate. The redirection of bank capital towards the residential market is the main factor fueling the housing boom. It has become a self feeding frenzy as rising housing prices encourages more lending in the sector, which further fuels prices. As home values rise, it creates additional collateral which can be borrowed against and redirected towards consumption. The strength in retail sales has been highly correlated to rising housing prices and mortgage refis. Without an appreciating real estate market, the consumer consumption binge would come to an abrupt end.

Nationwide housing prices just hit a post-war high rising 17.5% year-over-year. The average median home price at $182,000 is now three times the median income nationwide of $60,000. As prices continue to appreciate, banks have gotten more aggressive in their lending. Credit standards have been lowered, down payments have been minimized, and pressure is being applied to appraisers to come in with appraisals to qualify the loan. Here in San Diego, large banks will loan up to 100% of the value of a house. For refis, banks are using purchase price for the first six months and then relying on appraisals thereafter. Prices are still strong in most of metropolitan San Diego and the refi market also remains fairly strong. At one large national bank, the local home equity division is receiving over 350 loan applications a day. Business is still strong and the bank has plenty of money to lend. Most loans get repackaged into mortgage backed securities. The risk of the 100% loan to value ratio has been offloaded to the securities market. These mortgages are now part of a mortgage pool owned by some mutual fund, pension fund, or insurance portfolio. The bank makes its money on the upfront fees from processing the loan.

Your Local Businesses

If the consumer and housing sector have remained strong, prospects for business have been less than stellar. Business conditions have remained weak, profits have been hard to come by and capital spending is lethargic.

Economists and analysts are optimistic that business conditions will improve, eventually picking up the slack that could emerge from the consumer sector. What makes economists and analysts so optimistic is the run up in stock prices this year from the March lows. Stocks haven't suffered as much as a 10% decline since March. Every month the indexes go higher. As The Wall Street Journal chart below shows, earnings have risen sequentially since Q2 of last year.

The only problem with these numbers is that they aren't real. The actual earnings according to GAAP aren't doing as well. The earnings that everyone is using these days are the operating numbers which look much better.

Today's announcement by Motorola one day ahead of schedule is a good example of the spin that is being applied to earnings reports. Several weeks ago Motorola warned that sales and earnings may be lower due to manufacturing delays of their new line of phones. The earnings report comes out a day ahead of schedule. The company was anxious to get some sort of good news out following Friday's Moody's downgrade of the company's debt to one notch above junk bond status. The company reported earnings of $116 million, up from $111 million the year before. This translated into six cents a share the same as one year ago. Essentially the company's profit was flat. They have fallen from Q4 2002, and Q1 and Q2 of this year. Motorola's share of the mobile-phone market has dropped to 14.6% from 26% in 1996. Operating profits for the phone segment of the business has fallen 39% to $147 million in the latest quarter. Profit margins have been cut by a reduction in selling prices from $147.50 to $145.

The semiconductor business posted an operating loss of $76 million with sales declining 3.9%. The business will be spun off. For the moment the market was concentrating on Motorola's pro forma earnings of $0.06 a share which beat estimates. Those estimates were lowered just a few weeks ago when the company warned it was having problems. Even then we won't know what the real number is until they file their 10-Q with the SEC. What we do know is that the $0.06 share profit excludes certain items, so it isn't a complete number. The company also gave a rosy fourth quarter profit forecast of $0.15 a share. That number will also exclude certain expenses. The company hasn't detailed just what those excluded items are and how big they will be. We're still dealing with CRAP* earnings and not GAAP earnings, but this market doesn't seem to care. The markets went straight through the roof at the opening after Motorola made the surprise announcement (reporting a day early after its debt just got downgraded).

This market--like the economy--rests on a false set of assumptions and hopes. The economic numbers are getting better, but they are heavily massaged. The earnings numbers are improving, but they are also reconfigured. Stocks continue to trade up on fictional earnings and Wall Street pretends to not know the difference. Everyone is celebrating because prices are up and that is all anyone is paying attention to. The rising debt levels of the consumer, rising mortgage delinquencies and maladjusted corporate balance sheets are ignored. The focus has been on rising prices, rising home prices and rising equity prices. The bubble in housing and the return of the stock market bubble is ignoring deteriorating economic and financial fundamentals. The debt levels look good only when compared to inflated home and equity prices. All anyone cares about is that prices are rising again for stocks and housing inflation continues. The rising asset prices are simply another form of asset inflation, a product of the largest monetary inflation efforts in history. Like all inflated assets that rise parabolically, they become subject to a deflationary bust. The bigger the rise, the larger the bust when it arrives. The recent NASDAQ crash of 2000-2002 should be a subtle reminder of what can happen when prices get overextended. The next bust could very well end in a crash, and when it does this time it will involve both equity and housing prices. A bust in equities is different than a bust in real estate. Falling stock prices only impact the owners of stocks as well as a few brokerage companies. A collapse in real estate prices impacts both the borrower and the lender simultaneously. To get a glimpse at what is percolating below the surface, it might be instructive to take a walk down Main Street.

Main Street (the bodacious, the forlorn, and the surreal)

A good friend of mine is a mortgage broker here in San Diego for one of this nation's leading banks. He works in the home equity division of the company handling home equity loans from $25-100,000. Over dinner the other night I asked him about the refi market. Is it still going strong or has is slackened off? He told me that the company is getting about 350 applications a day, down from the furious pace of 500-600 applications from last May and June. Nevertheless, the 350 number was a good number which was keeping his department busy. The 500-600 a day number from last May was an aberration. It reflected the drop in bond yields to 3% on the 10-year note last May after the Fed said it was worried about deflation. Business slowed down in July and August as rates rose, but things are back to a busy pace again as rates have come down again. I asked him if homeowners were still going to the well. He said that they were and in many cases on multiple occasions. There is widespread evidence that the bubble in refis here in southern California remains in force. A few examples will illustrate the bubble-like quality of today's refi market.

Case Study: Club Med Ed

Profile: Divorced male in mid-40's
Job: Switched from selling RV's to luxury cars.
Annual income: close to $100k.

Club Med Ed is a ladies man. Ed is a swinger. He likes the high life and loves to travel to exotic places. Last year he refinanced his home three times pulling out over $50,000 in equity to pay off his credit cards. Ed lives a good life on what he makes from selling cars, but it is the credit cards that really give him the high life. Nothing impresses the women like a trip out of town to a far away resort or an exotic island.

Like last year, Ed has made three trips to the refi well. Once in January, once in March to cover the trip to Cancun, and now again in October to cover next month's fling with his latest babe to Cozumel. Ed has found that his dollars go farther in Mexico.

Lucky for Ed his house has appreciated over 20% in the last year. A home that was worth $270,000 a few years ago is now going for over $400,000 today. Ed's only real problem, if he is to continue the life of Joe Millionaire, is that his home equity--thanks to the numerous refis--is now less than 10%. It is still good enough to get a loan and additional cash. My friend tells me that the bank will go as high as 100% loan to value. Ed's future problem will come when he hits the 100% level or when housing prices start to fall. Unless he can find a steady girl that will be content with an ordinary life, his Club Med jet set life could come to an abrupt end. Ed is also in the business of selling luxury cars, one of the first discretionary items to drop off when times get tough. So in addition to hitting a brick wall on refinancing, Ed could also take a hit on income. Ed's best friend, even though he hasn't met him, is Alan Greenspan.

Case Study: Hopelessly in Love

Profile: Recently divorced and in love again
Job: School teacher
Annual income: $50,000

Hopelessly in Love had the misfortune of marrying an attorney. She put put him through law school. Unfortunately, after taking the bar and getting a job at one of San Diego's biggest law firms, the late nights and weekend work wreaked havoc with their marriage. Eventually, hopeless husband spent more time away at the office for good reason. He was having an affair with another attorney at work. The affair was discovered and the divorce followed. Hopeless got the house in Del Mar and Junior.

The home is a few blocks away from one of San Diego's nicest beaches. The home has appreciated well over the last three years following the divorce. Hopeless has fallen hopelessly in love again with a man we will call Bud. Bud has been married three times before. We don't know why there have been three marriages. My friend is a mortgage lender, not a marriage counselor. The fact that Bud is a traveling salesman may have a lot to do with those failures. Bud, like Club Med Ed, is also used to living the high life. He has close to $30,000 in credit card bills and almost an equal amount on a car loan. Bud thinks it is a good idea that his debts are paid off before he and Hopelessly in Love get married.

Hopelessly in Love is going to refinance her home in order to pay off Bud's bills and pay for the honeymoon to Hawaii. Let's hope that the third time works for Bud, especially since his job keeps him on the road and out of town a lot.

Case Study: Orville and Olympia Overextended

Profile: Family of four, stressed, and financially strapped
Jobs: Real estate broker and medical technician

The Overextendeds just moved into a luxury-gated community in one of San Diego's newest developing suburbs. Their new home cost them over $1 million with an additional $150,000 in home upgrades. The gated community has monthly association fees and requires that all new homeowners landscape their front yards within six months of moving in. Orville and Olympia have been sweating it. The down payment of 20% and the $150,000 in upgrades ate up all of their equity from their last home. They barely had enough money to pay for drapes and shutters for the new house. There was no money left for the pool and landscaping. For that, Orville and Olympia were depending on the refi market. When rates backed up this summer, they called off plans for a refi. The rates would have been higher than their original 5-year fixed loan. Luckily and in the nick of time, mortgage rates have fallen again and they have gone for the refi. They will pull out $100k in equity which will buy them an average size pool, a few trees, shrubs and a nice green lawn.

Orville and Olympia's real problems will begin when the real estate market slows down, which could impact Orville's income. Orville's income comes exclusively from commissions on the sale of existing homes. Another problem they will face in five years is when their 5-year fixed rate first mortgage comes due. If interest rates are higher then, or if housing prices depreciate, they will have a major financial crisis on their hands.

The one thing that Club Med Ed, Hopelessly in Love, and the Overextendeds have in common is the appreciation of southern California real estate prices. San Diego is listed as one of the top bubble cities for real estate in the country. Other metropolitan markets aren't as lucky. After a sizzling real estate market for the last three years, many homeowners are simply walking away from upside down mortgages. Many couples have borrowed more money than they can afford to buy bigger homes or fix up the homes that already own. The Seattle Times reports that delinquent mortgages rose by 50% in the last three years. Low down payments, sub-prime loans, and predatory mortgages have enabled people to buy homes they can’tafford. The Seattle Times reports that short sales and foreclosures are now running at double-digit rates as people simply walk away from homes they can no longer afford.

The paper tells the story of an Issaquah couple who didn't want their names mentioned because they were embarrassed. The couple earned more than $200,000 a year, lived in a 3,200-square-foot custom home built on acre of land. In addition to a new home they bought a new car every year. Why not if car dealers were offering incentives such a zero down and zero-percent financing?

Troubles began when the husband took a pay cut in order to save his job. The bills piled up and they no longer could afford to pay them. The couple filed for divorce as a result of financial pressure. The wife was stuck with the house and three kids. The home was sold for $30,000 less than what was owed on the mortgage.

In the same article, another story is told of an investor who bought a 3,330-square foot home in Everett from a couple that could no longer make their house payments. The former homeowners took out a second mortgage to buy a motor home. Right afterwards he lost his job at Boeing and his wife had to go back to work. They sold the house for $30,000 less than they owed.

There are other stories like these that are told in papers around the country. They represent the other side of the story of the real estate boom. One only wonders what will happen when the real downturn arrives or when homeowners like Club Med Ed and Orville and Olympia Overextended can't get financing. The bursting of the real estate bubble combined with the next leg of the bear market is going to be devastating for the country.

Speculation Hits the Stock Market

As for the other bubble in the financial markets, there are signs that the froth is back as speculation makes a comeback in the stock market. I'm talking about just hedge funds and large money center banks. The big boys are gambling with leveraged money. That isn't new. What is new is that the individual investor has returned to the markets and is speculating in a major way. Margin debt has risen substantially, day trading is back in style, and buying of bulletin board stocks has surpassed NASDAQ volume for the first time in years.

There are plenty of stories to tell and not enough time to cover the full spectrum of speculation that has enveloped the markets. A few examples illustrate the point.

Case Study: Raymond Whitwer, as told in the WSJ

Profile: Retired San Diego Contractor
Current occupation: Day Trader

Raymond Whitwer retired from the contracting business and now spends his days trading the markets. He has an Ameritrade account and trades in and out of stocks 6-10 times a day. Mr. Whitwer likes the volatile technology area, especially the high flyers such as Lucent, Research in Motion Ltd, and Adobe Systems. Mr. Whitwer likes the action of technology stocks where he can make a quick buck in as little time as a few minutes. If he can get a $1 profit on a share he is happy. "I don't hold anything", says Whitwer. "If I can make a dollar, I sell it." Mr. Whitwer is 82 years old.

Case Study: Larry the Plunger

Profile: Unemployed software engineer
Current Occupation: Day Trader
Income varies per trade

Larry had made a good deal of money in the 90's first from his salary at a high tech company, next from his stock options, and finally from investing his 401(k) money in tech stocks in which he considered himself to be an expert. During the in 90's he was a buy and hold investor as he watched his tech stocks go up double-digits every year. Larry lost more than half of his net worth during the first leg of the bear market which saw the NASDAQ lose 75% of its value.

As luck would have it, after losing his job and having a lot of free time on his hands, the stock market, especially tech stocks took off again. Larry, convinced that buy and hold was dead as an investment strategy, attended a weekend day trading course. The course changed his perspective on the markets. He is convinced that he now has the skills to speculate, take big risks and stay out of trouble. His new-found knowledge and belief in mechanical training systems has convinced him that he can’tlose money. Larry's specialty is placing his bets on just a few stocks. When he bets, his bets are big because he concentrates all of his buying power in just one or two stocks. Bulletin board stocks have become his favorite choice for speculating. They offer enormous leverage. A penny stock can double in day and when you are buying several hundred thousand shares, the winnings can be huge. So far Larry the Plunger has been lucky. He is up several hundred thousand this year. Not bad for not working. He says he can get used to this style of life which has given him freedom this year. Larry is convinced that this bull market is real and he hopes to pyramid his winnings into millions and then retire before the age of 35.

Case Study: Jerome Mahoney CEO of iVoice as told by the WSJ

Jerome Mahoney is the CEO of iVoice, a Matawan, New Jersey company that manufacturers phone and voice computer systems. The firm has 11 employees and has no earnings. The company stock has caught the attention of the likes of Larry the Plunger and others like him who hunt for new opportunities among the Bulletin Board companies. iVoice is a Bulletin Board stock. Last Wednesday iVoice was the most heavily traded Bulletin Board company on the Board. Over 178 million shares traded hands. The stock dropped 8% on the day. The stock (IVOC) is up 253% this year. Today iVoice closed down a fraction with over 241 million shares exchanging hands beating out last week's record volume. Today there were mostly losers in the stock.

The Journal asked the chief executive of the company if he could explain why the heavy trading in the firm's stock since there had been no real news. Jerome Mahoney responded by saying, "Why there is so much trading, I couldn't tell you," he said. "We don't know when we will turn a profit. We never tell anyone that the profit is around the corner."

iVoice's stock doesn't move on news or on earnings; it moves on momentum. Speculators like Larry the Plunger who can buy several hundred thousand shares at a time can drive the price of the shares up double digits in a single day. The trick is getting out before other fools head for the exit gates. It is a game for the nimble and quick of foot or key stroke as most training in these shares are done electronically.

These are the best of times or the worst of times depending on your situation and perspective. The economy may not be doing all that well, but there is plenty of money around for speculation and consumption. Some consumers like Club Med Ed have been able to monetize the value of their homes to live and supplement their lifestyle. Others like Orville and Olympia are just hanging on and making ends meet. Others like Larry the Plunger and Mr. Whitwer are happy to make a quick buck. Larry hopes the new bull market can last long enough to enable him to amass millions trading so that he can then retire at age 35.

The U.S. economy and the financial markets are made up of a series of bubbles that are dependent on Fed liquidity to stay inflated. The Greenspan Fed is doing its best to make sure that there is plenty of money and credit going around to feed what is now multiple asset bubbles in mortgages, real estate, bonds and stocks. When the Fed talks about deflation it is referring to asset deflations as seen in stocks over the last three years. In the real economy prices of real goods are going up from raw materials to services. The Fed has vowed to make sure that interest rates stay low for as long as is necessary to get the economy on an even keel. So far all it has managed to do is create a series of bubbles. Things will be much worse when they finally unravel. And when they do, it may be due to reasons beyond the Fed's ability to control. Almost half of America's debt is now in the hands of foreigners. What they think and do will be equally if not more important than what the Fed thinks, says and does.

Americans are Drowning in Debt

As long as investors, both domestic and foreign, continue to buy the recovery story without looking below the surface, things may continue a while longer. From listening to my mortgage broker friend, the financial situation of many Americans is much more perilous than what appears on the surface. According to a recent study done on debt in America, most American's are borrowing to make ends meet. According to a new study done by Demos, a non-partisan, non-profit public policy research organization in New York, Americans are drowning in debt. Between 1989 and 2001, credit card debt in America tripled from $238 billion to $692 billion. [1] According to the new study the average credit card balance for American families rose 53% from $2,687 to $4,126 by 2001.

Demos asserts that contrary to popular belief most of this debt has gone to take care of housing costs, pay for health care and other basic essentials of life. The increase in debt is a result of structural and economic trends during the 90's of stagnant or declining real wages, job displacement, and rising housing and health care costs.[2] Credit card debt simply became a convenient and necessary financial expedient that helped to fill the gap between household income and essential costs of goods and services.

According to the survey 76% of American families hold credit cards. Of this group 55% of those cards carry debt balances that average $4,126. The greatest increase in debt has occurred in lower income groups as shown in the table below. Demos believes that these figure are understated. Aggregate data reported by the Federal Reserve puts the average credit card debt per household around $12,000. My mortgage broker friend believes that even these figures are understated since most loan applicants that he reviews have much higher credit card balances. Politicians and economists point to the fall in credit card debt over the last three years as a sign that things are improving. The improvement is not what it appears. Credit card debt has fallen, but only because homeowners have transferred that debt on to their mortgage through refis.

Average Debt of American Families, by Income Range
Family Income Group	Families Holding Credit Cards in 2001	Cardholding Families Reporting Debt in 2001	Average Household Credit Card Debt in 2001	Percent Increase 1989-2001
All Families	76%	55%	$4,126	53%
< $10,000	35	67	1,837	184
$10,000-$24,000	59	59	2,245	42
$25,000-$49,999	80	62	3,565	46
$50,000-$99,999	90	56	5,031	75
$100,000 or more	98	37	7,136	28
Demos' calculations from the Survey of Consumer Finances, 1989, 1992, 1995, 1998 and 2001. Source: Borrowing to Make Ends Meet, Demos

These are good times if you're like Club Med Ed, Larry the Plunger, or Mr. Whitwer. However, if you are like Orville and Olympia, these are times of stress where hanging on depends on the availability of cheap credit and a rising housing market to help make ends meet. At some point borrowers are going to hit a brick wall and the Fed will be forced to raise interest rates against its own wishes. Rates will have to be raised in order to defend the dollar. One can only imagine what that day will look like given the enormous sums of debt that have been taken on by the companies, households, municipalities, states and the Federal government. The amount of debt is so large that the only way out will be for policymakers to inflate their way out of history's largest debt bubble. It is one reason why the Perfect Financial Storm will become a reality. When it unfolds, hyperinflation Argentina style is the more likely outcome, not deflation.

Today's Market

Markets got a lift today after Motorola surprised the markets by reporting pro forma numbers that were better-than-expected. This week will be a busy week on the earnings front as nearly one-third of all S&P 500 companies report Q3 earnings. The experts are anticipating that things will go well as pro forma profits are expected to be up 16 percent this quarter. Real earnings aren't doing as well. But nobody pays attention to those numbers. The preference is to focus on operating earnings which always exclude major items of expense as Motorola's report did today. In a market where everything is based on hope and hype you always need a story to focus on. The markets need to turn lemons into lemonade.

Trading was light due to the Columbus Day holiday. The bond markets were closed for trading. Volume came in on the low side at 1.06 billion on the Big Board and 1.48 billion on the NASDAQ. Market breadth was positive by 23-9 on the NYSE and 22-10 on the NASDAQ.

1 Demos, September 2003, "Borrowing to Make Ends Meet," p. 9
2 ibid, p.9

* CRAP = Cloudy Reporting Accounting Principles
Charts courtesy of: Wall Street Journal, www.stockcharts.com

James Puplava

Contact Information

James J. Puplava CFP
PFS Group
PO Box 503147
San Diego, CA 92150-3147
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