FSO Editorials: "ARM Implosion Straight Ahead" by Dr. Joe Duarte 06/24/2006

FSO Editorials

ARM Implosion Straight Ahead
by Joe Duarte, MD
Joe-Duarte.com & IntelligentForecasts.com
June 24, 2006

Editor�s note: The Federal Reserve is likely to raise interest rates at its June 29, 2006 meeting. The relationship between new Fed Chairman Ben Bernanke, the Federal Reserve, interest rates, and the housing market is increasingly important for the U.S. economy, and likely the global economy. The housing market remains the major cog of the U.S. economy. As homeowners have tapped their home equity to finance their lifestyles, they have also resorted to adjustable rate mortgages that offer low monthly payments. Recent data suggests that a significant number of adjustable rate mortgages will come due by 2007, creating the potential for a major explosion in foreclosures and uncollected debt at the same time when the U.S. economy is starting to show signs of both slowing, as well as it remains under inflationary pressure, stagflation, a terrible combination reminiscent in many ways of the 1970s. In this series of analyses, originally penned between June 13 and June 20, 2006, Dr. Duarte reviews the situation and its implications for the markets.

June 20, 2006
Housing May Be Key Indicator For Direction Of Interest Rates
Housing Dilemma

The housing market has a date with destiny, as up to a trillion dollars in adjustable rate mortgages are due to reset by 2007, says the Associated Press, perhaps triggering a default and foreclosure crisis for the U.S. real estate market.

According to the wire service: "This year, more than $300 billion worth of hybrid ARMs will readjust for the first time. That number will jump to approximately $1 trillion in 2007, according to the MBA. Monthly payments will leap too, many beyond what homeowners can afford."

Recent data, including the Fed's Beige book suggest that the low end of the housing market is already starting to feel the pinch of higher rates, while the high end is mostly shrugging it off.

And the evidence is starting to build, supporting the notion that a new trend is on the way. "Last year, foreclosures hit a historical low nationwide at about 50,000. But that number has more than doubled since then, according to Foreclosure.com."

The big question then, is whether the Fed will stop raising rates when the low end completely implodes, or whether they will try to make a significant dent in the high end as well.

One housing expert told the wire service the following: ["ARMs are a ticking time bomb," said Brad Geisen, president and chief executive of property tracker Foreclosure.com. "Through 2006 and 2007, I'm pretty sure we'll see a high volume of foreclosures."]

Subdivisional Divergence

Stocks fell on 6-19, partially on the news that housing industry is expecting a weakening of the market. New housing start data, to be released at 8:30 Eastern time on 6-20, will provide further clues as to wether expectations from builders are correct or off the mark.

Nevertheless, the effect on the financial markets was swift, as the release of the National Association of Home Builders' index for sales of new, single-family homes, which hit a point not seen since 1995 was good enough to trip up any early day gains.

More interesting was the fact that the bond market actually sold off, with the U.S. Ten Year note yield again nearing the 5.2% area, its recent top.

According to the Wall Street Journal: 'The association pointed to rising mortgage rates, ["deepening affordability issues"] and the retreat of investors from the market as reasons for the increased pessimism from home builders. NAHB Chief Economist David Seiders said the decline in the index wasn't surprising, given expectations of a cooling down in the housing market. "We now expect new-home sales to be off by 13% from the record posted in 2005," Mr. Seiders said in a statement.'

Inside the report, the components were no brighter. According to the Journal:

1. "Single-family housing starts are expected to be down 9% from last year's record, Mr. Seiders said. Housing starts are expected to be supported by big builder backlogs and reconstruction for last year's hurricanes."

2. "Within the NAHB's Housing Market Index, the component for current sales of single-family homes fell to 47 in June, down from 50 in May."

3. "Expectations for sales in the next six months decreased in June by five points to 50, the NAHB said. The traffic of prospective buyers also fell, dropping four points to 29."

The ARM Reality

For months, we've noted here, and on the Financial Sense Newshour with Jim Puplava that there is a problem looming in the real estate market, as the low monthly payment adjustable rates of the last few years are about to expire, forcing owners to refinance to "real world" monthly payments.

Finally, the mainstream press is catching on.

In a recent article by the Associated Press, we learned the following: "In 2003, Anita Britten refinanced her two-story brick cottage in Lithonia, Ga. using a hybrid adjustable rate mortgage, or ARM. Her lender reassured her that she could refinance out of the riskier loan into a traditional one when her interest rate started to reset. Three years later, Britten can't get a new mortgage and her monthly payment has jumped by a third in six months. She can't afford her payments and may face foreclosure if her financial situation doesn't change."

Indeed, AP puts the dots together: "As more ARMs adjust upward and housing prices begin to dip, many Americans like Britten can't refinance and are finding themselves trapped in too-high monthly payments. For those who can't make their payments, foreclosure - the legal process by which the lender reposseses the house because the owner has defaulted on payments - is the only way out."

In fact, what is happening is a double negative effect, compounding a serious situation.

According to AP: "In the last several years, millions of Americans took equity out of their houses and refinanced when interest rates were at historical lows and housing prices were at record highs. Many of them chose to refinance into hybrid ARMs that lenders were aggressively pushing. ARMs, which featured a low introductory interest rate that resets upward after a set period of time, were easier to qualify for than traditional fixed-rate loans."

So how bad is the problem likely to get? AP, continuing with the Anita Britten story notes the following: "Britten's monthly payment jumped from $1,079 to $1,340 at the beginning of this year. It rose again on June 1 by another $104 and is scheduled to increase again in December. Britten, who is also paying off student loans, went to a credit counseling service to help her avoid foreclosure."

The Geography Of It All

So far, the data suggests that problems are regional in nature, with states featuring strong economies holding up better.

According to AP: "The hardest hit states so far are those that have experienced the roughest times economically. Michigan, Texas and Georgia lead the pack, specifically around Detroit, Dallas and Atlanta, whose major employers have run into strikes, bankruptcies and industry downturns. But as the housing market slows, experts expect foreclosures to skyrocket in those areas that have experienced the highest appreciation rate - like California, Florida, Virginia and Washington, D.C."

There is also a distinction between default and foreclosure, as owners who cannot make payments, can still find buyers in active markets, and avoid foreclosure.

California is a good example of rising defaults, with buyers bailing out stressed owners. Other regions, such as Texas and Georgia, are showing rising foreclosure rates.

Perhaps, an even more daunting sign of the likelihood of a glut developing at some time in the future is this: "Even investors in foreclosures are having a harder time finding good deals, as the housing market cools. Many homes that do end up in foreclosure auctions are saddled with more than one mortgage and have little or no equity - so the investors take a pass."

Finally, the biggest horror story of them all is the actual potential for a house to fall in value. AP provided this stark example: "Falling home values are also affecting homeowners' ability to refinance into a traditional 30-year fixed rate loan to avoid foreclosure. In 2002, Christopher Jones, 32, refinanced his loan into a hybrid ARM with plans to refinance again when the rate started to readjust. At the time, his downtown Atlanta house appraised for $108,000. Now, his monthly payments have shot up, but Jones can't sell his house for more than $84,000 and he can't get an appraisal for more than $85,000."

Conclusion

The Federal Reserve is likely to continue to raise interest rates. Estimates are for at least one more hike at the June 29 meeting, taking the Fed Funds rate to 5.25%.

With energy prices still significantly higher than they were a year ago, and a trillion dollars of adjustable rate mortgages coming due by 2007, though, our bet is that Mr. Bernanke might find himself hitting the down button on the interest rate elevator, a lot sooner than he might have expected.

But first, we expect a whole lot of pain.

June 15, 2006
U.S. Economy Turns Regional
At Least One More Rate Hike Likely

The Federal Reserve, in its latest Beige Book, released on 6-14 summarized the U.S. economy as continuing to "expand," but also showing "signs of deceleration."

Describing a regional pattern of variable activity, the Fed explained: "Activity moderated in four Districts--Atlanta, Kansas City, Richmond, and San Francisco--and the New York District noted increased concern about the outlook for the second half. Seven Districts--Boston, Chicago, Cleveland, Dallas, Minneapolis, New York, and St. Louis--said growth was similar to the pace reported in the last Beige Book. The Philadelphia District, however, reported an improvement in overall economic conditions."

The data was good enough to allow a relief rally in an oversold stock market, but not enough to wipe out the expectations for more interest rate increases from the central bank.

Overnight, the Swiss central bank increased its own set of interest rates, maintaining the global trend toward higher rates intact, although Japan's central bank, fearful of increasing global market volatility, left its rates unchanged at zero.

Less Strength Than Expected

The Fed described an economy that is starting to grow at a slower pace, likely due to its already robust interest rate increase cycle.

According to the Beige Book both consumer spending and manufacturing grew at a slower pace than before the month of May, the prior report.

Real estate was mixed: "Residential real estate markets continued to cool across the country, with slower homebuilding and sales of existing homes. In contrast, commercial real estate activity strengthened, and a few reports expressed concern about too much building in some portions of the real estate market."

There was also strength in the service area, while "The financial sector continues to report good credit quality. Commercial lending picked up, but there was some slowing in loans to consumers, particularly for mortgages and home equity loans."

But there were two pockets of potential problems, energy and the labor sector, two areas that have been of concern to the central bank for some time.

Still, this is the area that is likely to keep the central bank raising rates: "Labor markets continued to tighten, with more Districts reporting employers having difficulty finding skilled workers. Wage pressures remained moderate overall, with the exception being workers with hotly demanded skills. High energy costs were fueling price increases in manufacturing and, to a much lesser extent, retail. Reports of costs being passed forward varied considerably but were more prevalent than in the last Beige Book."

Market Sectors To Watch

The Beige Book can be a prelude to significant gains in key market sectors, if the central bank considers growth to be significant in these areas.

This book lists three areas of interest to traders: "Strong activity was noted in the production of goods to supply the energy, semiconductor, and aerospace industries. Areas of weakness included production of agricultural equipment and autos. Slower demand for goods to supply residential building, most notably lumber, was mentioned by a few Districts, although the Atlanta and Dallas Districts reported demand for construction-related materials still remained strong overall."

Most interesting was the mention of aerospace and semiconductors: "The San Francisco District reported that activity expanded overall, with production of commercial aircraft near full capacity and capacity utilization of semiconductor manufacturers at or above 90 percent."

On 6-14, shares of Boeing rallied, as its rival Airbus is having problems with manufacturing delays on its latest jet model.

Real Estate Blues

The one area of significant concern on the weak side of the ledge continues to be housing, with the Fed delivering sobering remarks about the low end of housing in the Dallas area. We have reported on this in the last few days, citing rising foreclosure rates in the area.

According to the Beige Book: "Some softening of the market for existing homes was reported by ten Districts--Chicago, Cleveland, Dallas, Kansas City, Philadelphia, Minneapolis, New York, Richmond, St. Louis, and San Francisco. Dallas and Richmond noted that activity remained quite strong, and Chicago reported slowing from high levels. San Francisco reports hot housing markets in Utah and parts of the Pacific Northwest. Several Districts said sales had weakened for some of the most expensive homes, except in the Dallas District where demand for lower-priced homes "had dipped noticeably."

There were also signs of weakness in the New York suburbs while the Manhattan market showed some "tightening."

There was more bad news buried in the summary, including sobering news about home building activity in areas of the Northeast: "Homebuilding slowed in most Districts--Chicago, Cleveland, Dallas, Kansas City, New York, Philadelphia, St. Louis, and San Francisco. The New York District reported that some homebuilders in New Jersey are withdrawing from the authorization process and allowing their options to build to expire, noting that increases in fuel and materials costs are pinching profits. Homebuilders in the Atlanta District reported that single-family home construction was near year-ago levels in most parts of the District, except in Florida, where sales slowed. The Atlanta District also reported that Florida condominium sales continued to weaken and several projects were cancelled."

In contrast, though, commercial markets have remained steady, and some are actually improving. According to the Fed, though, improvement in one segment is coming at the expense of another: "Boston reported that downtown office real estate markets were improving but mostly at the expense of suburban markets."

There were also reports of rising rents in some areas, but decreasing construction in other areas of the country with projects being postponed and delayed due to high material prices.

Perhaps the most alarming passage in the summary is this: Contacts in the Boston, Chicago, and Dallas Districts expressed concern about the level of investment in some portions of the real estate market. The Boston District reported that New England--and Boston in particular--continues to attract large volumes of commercial real estate investment, resulting in price increases that require "ambitious assumptions" to justify the transaction. The Dallas District noted growing concern about overbuilding of condominiums and town homes in Dallas, and contacts "fear that it will end badly." A contact in the Chicago District expressed concern about the potential for overbuilding of large distribution centers in Indiana.

Conclusion

We may be looking at the first set of signs that the U.S. economy is starting to slow in response to rising interest rates and persistently high commodity and energy prices.

The most vulnerable sector of the economy seems to be real estate with home building and home sales starting to buckle.

The Fed seems most concerned about the low end of the market in the Dallas area, as well as the rising level of building in both commercial as well as high rise "condominium" building.

Despite this increasingly sober analysis, though, it's unlikely that the Fed won't raise rates in June.

Also important is the fact that if the activity level in the next Beige Book is not much different, we'll get more rate increases in August, and perhaps even later in the year.

June 13, 2006
Housing, Banking, And The Financial Markets
Bernanke Warns Banking System

Federal Reserve Chief Ben Bernanke warned the banking industry in a speech overnight about raising their reserve levels in order to cover potential future liabilities. The speech coincided with the release of a report on the status of the U.S. housing market that described the housing sector as "overvalued."

There was no connection made by Bernanke to the report, but the timing of his speech raises questions about whether the Fed has even more fear about the economy than it's letting on.

According to Marketwatch, Bernanke told a gathering of bankers that "U.S. banks' capital levels should match up to the risks they're taking to avoid endangering the American banking system."

The Fed Chief also cryptically "said the Federal Reserve would offer guidance ["in the not-too-far-distant future"] about nontraditional mortgages."

Bernanke was speaking to the Stonier Graduate School of Banking at Georgetown University, and had some somber comments.

Most interesting was the Marketwatch report noting Bernanke's comments about how "some big banks have moved beyond an earlier accord governing risk management and said they shouldn't engage in risky transactions without money to back them up."

Housing Dangers Rise

The U.S. housing market could be the next shoe to drop, even as the stock market is teetering and commodity prices are pulling back.

According to Marketwatch: "A growing percentage of U.S. housing markets are "extremely overvalued" and are at risk of falling prices, according to a study based on government data released Monday by Global Insight and National City."

Marketwatch added the following startling statistics: "In the first quarter, 71 housing markets, representing 39% of all U.S. housing, were deemed to be "extremely overvalued" based on median sales prices, median income, population and historic values. That's up from 64 markets accounting for 36% of housing in the fourth quarter. In the first quarter of 2004, just 1% of housing was considered overvalued. To be "extremely overvalued," homes had to be valued at least 34% more than "normal."]

With the Fed due to meet and likely raise interest rates again on June 28-29, every breath uttered by Bernanke and his newly raised "Nazgul" presidents is being highly scrutinized by the markets.

And given the overall state of the financial markets, their remarks are carrying significant amounts of weight, bringing us back to Bernanke's comments about "nontraditional mortgages" and banks needing to make sure that they have enough money to cover risky transactions.

The report cited both highly overvalued and undervalued markets: "Homes in Naples, Fla., were deemed to be 102% overvalued, the economists said. Other highly overvalued markets included Salinas, Calif.; Port St. Lucie, Fla.; Merced, Calif.; Bend, Ore.; Stockton, Calif.; Punta Gorda, Fla.; Santa Barbara, Calif.; Madera, Calif.; and Riverside, Calif. Among other big cities, Miami was overvalued by 64%, Los Angeles by 61%, Oakland by 47%, San Jose by 44%, Nassau and Suffolk counties in New York by 44%, and Phoenix by 43%."

Undervalued markets were also listed: "College Station, Texas, was undervalued by about 24%. Among big cities, Dallas and Fort Worth were undervalued by 19%, Houston by 16%, New Orleans by 12% and San Antonio by 11%."

The mention of Dallas as undervalued was interesting since there is increasing anecdotal evidence in the Dallas area about rising foreclosure rates, as a May 31, 2006 report in the Dallas Morning News quoted a market expert on foreclosures as seeing foreclosure rates reaching levels not seen since the 1980s real estate bust.

The report quoted George Roddy, president of Addison, Texas based Foreclosure Listing Service Inc.: "foreclosures really began to hit in 1985. But unlike today, the first impact was on the commercial side, which had been hurt by massive overbuilding. The same thing that happened in the early 1980s is happening today, but on the residential side."

Roddy offered some interesting wisdom: "you have to remember foreclosures are a lagging indicator. The unemployment rate started to drop off in 1987, but by that point too many people had gotten into homes artificially inflated by the availability of too much money. By the late 1980s people were having trouble selling their homes for what they paid for them. Consequently, foreclosures peaked in 1989, when they were running at a record 2,000 postings a month in Dallas County alone."

The remarks are rather daunting, given the fact that the latest employment report showed a major slowing in job growth, and raises the question of whether the situation for the U.S. economy is worse than the statistics are showing.

In other words, at least in the Dallas area, the foreclosure rate, at last according to Roddy's data may be telling us that the job market is already much worse off than it appears on the surface.

And Dallas is not alone. According to the Sacramento Bee: "A new survey released Tuesday confirms what steadily has become more obvious to local real estate experts: More homeowners in the four-county Sacramento region are drifting toward foreclosure. According to Irvine-based RealtyTrac Inc., the Sacramento area ranks second in the state for percentage of households in some stage of foreclosure activity."

According to the report, consumer debt, which was recently reported by the U.S. government as being at record levels is finally taking its toll on the public.

The Bee noted: ["We're not seeing a lot of people at that foreclosure stage yet, but we're sure seeing a lot of people who are headed that way," said Jeff Tarbell, president of Sacramento-based ATM Mortgage. Tarbell said that many people can't afford both rising mortgage payments and their cars, credit cards and other amenities. "We're starting to see the beginning stages of a little panic about not controlling your spending," he said.]

Conclusion

The odds are in favor of the fact that Federal Reserve is going to continue to raise interest rates. Mr. Bernanke and his governors are on tour telling the markets that much.

There are now emerging pockets of warning signs in the housing market, even as job growth is starting to slow, and debt levels are at record heights.

Mr. Bernanke has essentially told the banking system to get its act together, one week after Mr. Greenpsan told Congress that he was concerned about derivative risk.

Gold broke below $600 an ounce overnight, while oil prices were drifting below $70.

Asian and European markets were melting down, as investors start heading for the exits.

If the producer and consumer price indexes show any nasty surprises, this options expiration week could be one to remember.

Joe Duarte, M.D.

Joe Duarte M.D. is founder and Editor in Chief of Joe-Duarte.com. Dr. Joe Duarte's Daily Market I.Q. is a premium service that provides daily intelligence, trading strategies, and technical analysis at www.joe-duarte.com. Duarte offers free analysis and news coverage at www.intelligentforecasts.com . Dr. Duarte is a board certified anesthesiologist, a registered investment advisor, and President of River Willow Capital Management. He is author of "Successful Energy Sector Investing" and "Successful Biotech Investing" (Prima/Random House). Duarte's analysis appears regularly in major outlets including CBS MarketWatch and Investor's Business Daily.