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The Day After Tomorrow, Part 2

Broken Resolutions

by James J Puplava CFP, President & CEO, PFS Group. April 22, 2005

Web Note - The following short story is hypothetical in nature, but is based on what was, what is and what will be.

The Saga of John and Terry Wheeler Continues

Things could have been better, but they could have been worse. The way John Wheeler looked at his circumstances, the Wheeler household had come out on top in 2004. John was uncomfortable with the amount of debt they had taken on in furnishing their new house with the furniture, spa and patio addition. It was hard for him to believe that their mortgage and credit card debt now amounted to over $547,000. But on the other hand, the appreciation of their new home had more than made up for it.

One of their neighbors just sold their home for $750,000. The house had been on the market for less than a month. Tom Craig told John that they had sold their house too soon. Had the Craigs waited, they may have gotten even more. At the time of sale, they had two backup offers with one buyer willing to pay more than the list price. The Craigs were trading up to a bigger home. They were buying one of the fabulous models at Big Sky Ranch, the new subdivision where John's company had been doing all of the electrical work. The Craigs' new home would cost more than $1 million dollars. Wow! A million dollars— that was hard for John to believe. But then again, it was hard for him to believe that their home was now worth more than $750,000!

The way John looked at it, the new year held lots of promise. Their Christmas credit card bills had just come in. They managed to get through Christmas with only $1,500 in credit charges. To John's relief, Terry's tips from Christmas and New Year's had been over $2,000. They paid off their Christmas bills and even managed to put a few extra bucks in the bank. John and Terry made a New Year's resolution to put their financial house in order. Work was plentiful. One of the builders at Big Sky Ranch had sold out their first seven phases and was now anxious to accelerate their construction program. John's boss had asked for volunteers to work Sundays. With pay at time-and-a-half, John took up his boss' offer. The extra pay would come in handy. John wanted to build up savings, so they could handle the furniture payments, which would kick in January 2006.

Making Ends Meet

The only worry in the Wheeler household was that no matter how hard they worked— even with the extra overtime and tips— their cost of living kept going up. John's union had negotiated a pay raise last fall. The extra pay helped. However, part of the pay increase also included an increased co-pay on medical. Medical costs had been rising more than double-digits a year and John's company was no longer willing to absorb all of the increased costs. Medical costs had been a big contention in labor negotiations. The result of those negotiations had been a pay raise, but John now had premiums deducted each month for medical benefits. On top of that, the insurance company had increased sis deductible from $250 a year to $500. Terry was also complaining that food, gas, and sundry costs kept going up almost every week. With premium unleaded now at $2.79 a gallon, it cost more than $60 a week to fill the tank of Terry's Ford Explorer. John was bringing in extra money with the overtime work on Sundays, but the extra money never seemed to be enough. It looked like living costs were rising faster than wages.

Terry had agreed with John on their New Year's resolution to get their financial house in order. But it was a hard resolution to live up to. With John working weekends, Terry missed their Sunday date nights. She missed going out to dinner and the movies. It didn't seem right that they worked so hard and had so little to show for it. The money was coming in, but it was just as quickly going out. There were the mortgage payments, the home equity line payments, the car payment, and the credit card bills. Next year the furniture payment kicked in and that would add another $350 a month. No matter how hard Terry tried to save money, there never seemed to be enough in checking at the end of the month. Living on a budget was no fun and to tell the truth, she didn't know how much longer she could hold out. Terry had her eye on the January white sales. They needed new dishware and she wanted to get linens for the master bedroom and the guest bedroom downstairs. Terry not only missed going out to dinner and the movies, but she also missed going shopping with her friends. It was about the only girl-time she got.

You might call it a temptation, but Terry could no longer resist it when her neighbor, Shelly Benson, called Saturday morning. Shelly and a few of her friends were headed to the mall to take advantage of the department store sales. Everyone was having a sale. The Saturday morning paper was full of advertisements for half-off sales on just about everything. Terry really wanted to get new linens for the bedroom. The bedroom sheets were looking worn and went back to their apartment days. Nothing lifted Terry's spirits more than a trip to the mall. She took Shelly up on her offer. Darn it, she wanted those new sheets and with luck maybe she would find the new dishes to go with the dining room furniture at a great price.

The trip to the mall was productive. Terry found the linens and dishware she was looking for, and with the sales price and her newspaper coupon, the total was only $1,200. The girls decided to do lunch before heading to Nordstrom's to get makeup and browse through the new spring fashions. Terry began to feel guilty after buying the dishware and linens. She had broken her New Year's resolution to curb spending, but they really needed new linens. She hoped John would understand. She avoided the temptation to buy a few spring outfits, having already spent $1,200. It was no fun watching Shelly and her friends spend freely after lunch. If the truth were told, Terry was a bit jealous. She couldn't understand where Shelly got the money. Shelly and her husband Jack were no different than she and John. Jack taught economics and social studies at the local high school and Shelly was a cashier at Ralph's grocery. The Bensons couldn't be making that much money— not on a teacher and a cashier's salary— yet they always seemed to have money. Since the Wheelers had moved into their house, they watched both Bensons get new cars— including a new LX 300 for Jack— furniture, and wave runners. They were also able to take nice vacations. Last year the Bensons took their wave runners to Lake Havasu and rented a houseboat for the whole month of July.

John and Terry had done a little of the same buying with a Ford Explorer for Terry, the new furniture, and the spa and patio addition. However, John and Terry were now struggling to make ends meet, whereas the Bensons seemed to be flush with cash. Maybe they had come into an inheritance or had a rich in-law? Shelly and Jack Benson seemed to lack nothing. They frequently went out to dinner and were able to take a vacation. Shelly went to the malls on weekends and they both drove new cars. Terry couldn't understand what had gone wrong with their own finances. John was bringing in extra money from overtime and her tips were still holding up, but they had resorted to penny pinching and coupon clipping. Costs were going up everywhere and on every "thing." Their weekly grocery bill had gone up considerably. Shelly began to shop at Wal-Mart and Costco, using coupons, buying in bulk and cutting back on more expensive foods. Hamburger replaced steaks, fresh vegetables replaced frozen entrees, store brands replaced national brands and they now drank beer instead of fine wine.

Unfortunately, the cost-cutting in groceries was offset by increases in gasoline prices. Terry now spent over $60 a week to fill her Explorer. John's diesel truck cost almost as much to fill. Their property tax bill had been going up right along with their mortgage payments and home equity line. It seemed no matter how hard they tried to save, their living expenses far outpaced their gains in income.

The Secret of the Suburban Lifestyle

On the ride home from the shopping mall, Terry mentioned to Shelly that she and Jack were lucky. It seemed that things were going well for them. Terry shared some of her frustration with their own financial predicament with Shelly. That is when Shelly revealed the secret behind their great finances. Her husband Jack was a genius when it came to shopping around for mortgage deals. The Bensons bought their Phase 1 home at the beginning of the development in 2000. They spent less than $400,000 to buy their home, so they had experienced much higher appreciation than the Wheelers, who had bought in 2003. The key to their financial success, Shelly explained, was managing their debt costs. They had been able to extract more equity out of their home and lower their mortgage payments by shopping the markets for the best interest rate deals. Their original purchase of their home was with a 30-year fixed rate mortgage. As interest rates came down, they switched to short-term fixed rates with interest-only loans, which were much less than the standard 30-year mortgage. Each time they refinanced, they were able to take more equity out of their home and lower their payments at the same time.

Despite rising interest rates and rising debt balances, Jack had managed to lower their payments even further by switching to a variable rate mortgage. The way Jack and Shelly viewed their finances— with their home appreciating at double-digit rates each year— it was time to take some of that equity out for a spin. Jack and Shelly didn't want to wait until they were retired to enjoy life. They were both in their late 40's. They wanted to enjoy life now— not when they were 65. Jack and Shelly had learned to turn their home into an ATM machine that kept them flush with cash.

As the car pulled into the driveway, Shelly suggested that Terry should have her husband contact Jack. Jack could show them how they too could lower their house payments, pay off their credit card bills and enjoy life by taking advantage of low interest rates and a rising real estate market. Terry felt a whole lot better and for the first time in many months, she had hope for their financial predicament. She couldn't wait until John came home to tell him the good news. Meanwhile she had to get ready for work. The restaurant was heavily booked for Saturday night, so she would have to wait until Sunday evening after John came home to approach the subject of refinancing. She was also a bit nervous about breaking the news of her spending spree at the mall. This was going to require a little TLC to finesse.

Sunday night dinner was going to be special. Terry bought t-bone steaks and a bottle of pinot noir from the restaurant. The steaks and wine had set her back $50, but it was worth it. As an employee, she got the steaks and wine at cost. When John got home, he was taken by surprise by the candlelight dinner, the steaks and the pinot. Something was up. Terry had either gotten a big tip or she had broken her pledge by going shopping for something big. John knew his wife pretty well. "All right, out with it," John said to his wife. Terry started to cry as she told John what she had done. She told John it just didn't seem fair that they both worked so hard and had to keep pinching pennies. That was when she told John how their neighbors the Bensons were living so well. They had been able to take equity out of their home and still lower their payments. Perhaps Jack could help them?

John's first response was one of anger. He was mad that Terry had broken her promise. He was aware that their sheets were looking a bit ragged, but they simply didn't have the money for non-essentials. He was also worried about their mortgage payment, which was coming up for another adjustment in March. The Fed had just raised interest rates and the papers talked about how more interest rate hikes were on the way. John was developing a big dislike for Mr. Greenspan. Why did Mr. Greenspan have to make life so difficult for everybody by going off and raising interest rates? To John, higher interest rates meant only one thing—higher mortgage payments. He wasn't looking forward to March when their monthly payments would be going up again.

His ears perked up when Terry told him how the Bensons were coping with their finances. The one consolation was that the Wheeler home kept appreciating. Perhaps they needed a financial plan? John couldn't stay angry with Terry for long. The steaks and the pinot noir had definitely soothed things over. They both agreed to talk to Jack Benson early next week. John was a little hesitant in revealing their finances to a neighbor, but if Jack could help, they definitely needed to do something. Terry wasn't the only one wanting a few things for the house. John wanted to get a Gladiator workbench for the garage, a few power tools and a new Toro lawn mower for the yard.

Taking Equity Out for a Spin

Jack Benson made things easy for the Wheelers. After his wife told him of their plight, he thought it only neighborly to lend a hand and he called the Wheelers Tuesday evening. John and Terry invited him over to discuss their finances. Jack arrived with his laptop after dinner. Terry served coffee and desert, while John told Jack their financial history. They cleared the kitchen table and Jack set up his laptop, which had his Quicken loan calculator. Jack quickly assessed the problem. The Wheeler's income wasn't rising fast enough to keep up with expenses even though their home had appreciated considerably.

Source: HSH.com

With a mortgage balance of $547,000 and a market value of $750,000, the Wheelers were sitting on too much equity. Jack suggested they consolidate their credit card loans and their furniture loan, which was due for payment next year. He suggested a negative Adjustable Rate Mortgage (ARM) with the payments fixed for three years. With a negative ARM, they could lower their payments, pay off their credit card and installment loans and take out a little equity to buy the things they wanted around the house. Jack's plan would pay off the furniture loan of $10,000 and the credit card debt of $7,000. Jack also suggested they take out an additional $11,000 to buy the Gladiator bench, power tools, and lawn mower and still have a few bucks to take a vacation or just live life a little better. Their new loan balance would be $575,000, but their payment would drop from $2,500 to $2,425 a month. By consolidating their loans into one monthly mortgage payment, they would lower their payments by close to $650 a month. This eliminated their home equity line, credit cards, and furniture loan and gave them a little cushion in the bank. The negative amortization on their loan would add another $437 to their mortgage balance each month, but that could easily be handled by their home's appreciation.

John was a little overwhelmed by it all, but it seemed to make sense. He was a little hesitant about increasing his loan balance each month. Jack reminded him that John was doing the very same thing by running up his credit card balance each month. At least this way, by consolidating the loans, all of the interest was tax deductible. It lowered his payments, freed up some of the equity in his home and took some of the financial pressure off John and Terry each month. They could go back to their date nights with dinners out and movies. Jack told him it was time they let their investment in their home do the heavy lifting instead of trying to penny pinch.

They agreed to the plan. Jack put him in touch with his mortgage company. By the end of the month, the Wheelers had their new loan. Their debts were consolidated, their payments were lowered, and they had a wad of cash in the bank. They could finally start to relax a little and enjoy life. John and Terry took the following weekend off. They both planned on going shopping. John wanted to get his Gladiator work bench ordered and pick up the lawn mower and power tools at Home Depot. Terry shopped in the Home Depot nursery for a few pots and plants for her garden. They planned on going out to dinner at their favorite restaurant to be followed afterward by a movie. Life was finally getting back to normal.

Addicted to Debt

Without ever realizing it, both John and Terry had become addicted to credit. Like a heroin addict, they eventually needed more. Living on credit was now becoming a way of life for both of them. They were hooked. They were dependent on low interest rates and concomitant refinancing and appreciation of their home to pay their monthly bills. Like many Americans, credit became the third leg of finance. To live the American dream in today's terms required more than a two-salary income. It also required monthly access to easy credit afforded by the latest housing bubble and a lax monetary system. Greenspan was more of a friend than John would ever realize. He was their drug dealer, their sugar daddy. He kept them supplied with credit. By lowering interest rates to half-century lows and flooding the economy with ample money and credit, the Greenspan Fed had created a series of bubbles that enabled couples like the Wheelers to live beyond their means.

BRAINS, BEAUTY AND AMBITION
Meet Erica Barry

Erica Barry had two things going for her— brains and beauty. Friends who knew her well would tell you she had two other attributes—a mbition and personality. Erica exuded confidence. Her likeable personality drew people to her. You felt good in her space. Her brains and personality naturally led Erica into sales. She had majored in psychology at USD. As a psyche major she wasn't sure what to do with her degree. She could get a master's or her doctorate and go into private practice, but that didn't suit her. Her father's advice made the most sense. Erica's father was a successful corporate attorney. He counseled his daughter to go on and get her MBA. It was the smartest decision she had ever made. She was a natural when it came to marketing and sales. Maybe it was her psych background that gave her a better understanding of human nature? She had a natural affinity for people and it showed.

After getting her master's degree, she went to work in the marketing department at one of the nation's largest homebuilders. The three years she spent at Pine Brothers taught her the ropes of the real estate development business. At Pine Brothers she worked in marketing research, conducting field polls and focus groups. It gave her a chance to understand what motivated buyers. She got to know their needs and wants. Within a year on the job she was able to translate that knowledge into a major marketing shift in the way Pine Brothers built and marketed homes in southern California. The 1990s ushered in a major change in home building. Maybe it was the prosperity of the era, but homebuyers were looking to trade up. Families wanted bigger homes with nicer amenities— upscale kitchens and stainless steel appliances, granite counters, media rooms, his and her studies, bigger family rooms, bonus rooms for the kids, and master bedroom retreats were now demanded by today's discerning homebuyer. It was all part of that upscale lifestyle for the twenty-first century.

Erica's career was quickly advancing at Pine Brothers. In the fall of 2003 she was put in charge of the company's Big Sky Ranch project. It would be one of the more ambitious projects to date for the company. Pine Brothers had bid on enough acreage in the new housing development to build 200 homes. This would be the first upscale project for the homebuilder. The company had been successful building small starter homes at the low end of the market. Their Big Sky Ranch project would be their first foray into the upper end of the housing market where profit margins were far richer.

Erica Inaugurates Marketing Strategies at Big Sky Ranch

Strategy #1 Lifestyle Choices

Erica worked for months with the design team making sure they would incorporate her "Lifestyle Choices" scheme into the home designs. The project would include three model homes with three elevations— Tuscan, Spanish, and Cottage. Since land was expensive and the lots were small, the model homes would pack as much square footage as possible into the design of each home. The basic models would start at 3,500 square feet and go all the way up to 4,000 square feet. Erica wanted to provide buyers with plenty of options to fit their lifestyle and family needs. The homes would all be two stories, one giant box plotted on a small piece of land. But within the giant box, there would be plenty of choices— enough to satisfy the most discriminating buyer. Each floor would incorporate her "Lifestyle Choices," giving the buyer the choice to add optional bedrooms, dens, media rooms, enlarged family rooms, or master bedroom retreats. In effect, she wanted to give the buyer the ability to customize their home and make the home buying experience a personal one.

The construction team wasn't too keen on all of the customization. They would have preferred the cookie-cutter approach, but in the end Erica got her way. It really wouldn't be all that difficult to build. Essentially all you were doing was moving or adding a few walls internally. Yet it was the customization that would allow Pine Brothers to charge a higher base price. The models would start out at $825,000 and go all the way up to $930,000 for the largest model. Besides the higher price, the "Lifestyle Choices" could be sold at a premium to homebuyers and make each home highly profitable. It was the same thing car makers learned by selling the car buyer's premium in sport or luxury packages. It was just being done on a larger scale. Homebuying options were going to be the big money-maker and Erica's research showed her buyers would be willing to pay a premium for those options.

Strategy #2 Buyer's Choice Financing Packages

The second part of Erica's marketing strategy meant lining up an attractive financing package. She had a good relationship with Danny Garcia at CityWide. Danny put together several attractive loan packages from ARMs, interest-only, and negative amortization, to traditional 30-year fixed loans. CitiWide was pushing ARMs. According to Danny, the lower rates would enable the home buyer to buy a bigger home and add a lot more options. Danny's sales literature included a buyer's choice matrix showing the buyer the difference in payments for each type of loan. Side by side, the ARM was the obvious choice. Erica loved CitiWide's loan program. The matrix of loan options that Danny put together would help her sell more of her "Lifestyle Choices," which would make each home sale that much more profitable. The adjustable loans CitiWide was pushing made financial sense to Erica. According to Danny Garcia, the average homebuyer in San Diego went through a refi cycle every 3 years. Because the economy was so cyclical, the average San Diegan kept their home only 3-5 years. People got laid off, they got transferred, or they simply traded up. Very few homeowners kept their home for a long period of time. For that matter, very few people kept the same mortgage. Homeowners were always refinancing when interest rates changed. The traditional 30-year fixed rate mortgage was becoming an anomaly. Very few home buyers chose it for obvious reasons— the rates were higher and no one planned on living in the same home for 30 years.

Strategy #3 The Turnkey Home

In addition to an attractive financing package, Erica wanted to make sure that homeowners could move into their new homes on a turnkey basis. Pine Brothers would put in the front yard landscaping. This would also make the development look more attractive with the front yard landscaping already in place. In addition, it gave Pine Brothers the ability to give the project a tasteful and uniform look. In addition to front yard landscaping, Eric arranged a designer package, which allowed buyers to add shutters and drapes onto the mortgage. They also offered a back yard landscape package, which included a built-in spa as most lots were too small for a pool and an outdoor built-in barbeque and patio. CitiWide agreed to finance it all. If it was attached to the home or the lot, it could be put on the mortgage, according to Danny.

Erica Sees Her Dream Take Shape

Erica was getting excited over the new project, which had been named Traviscio. The development would have a Mediterranean flavor in line with the largest model and the Tuscan and Spanish elevations. By September the Big Sky Ranch project manager had provided land for the ten different homebuilders to bring in their sales trailers. The trailers would serve as their sales office until their models were built. In October Erica moved out of the home office to the sales trailer at Big Sky Ranch to head up the marketing and sales effort. Erica was a little nervous, since this was a new avenue for the company. Luxury home building was a new direction for the company and she was partially responsible for the change in direction. She was going to have plenty of competition. There were ten other builders and Traviscio was going to be one of the more expensive developments within the ranch. Still, she felt confident. The least expensive homes in Big Sky Ranch would begin at around $700,000 with the average being $750,000-$800,000. Erica believed homebuyers would be willing be pay more for her "Lifestyle "options and the wider degree of customization it afforded. Erica's confidence was based on her research. The city, the state, and most of the country were undergoing a real estate boom. New homebuyers were coming into the market— thanks to the lowest interest rates in half a century and new creative financing. Those who owned homes were trading up. The American public was in love with real estate. Perhaps it was the bear market in stocks or lower interest rates that brought on the boom? Erica didn't care. Buyers felt they couldn't lose money in real estate like they did in stocks. Besides, real estate was tangible. It was something you could enjoy.

Pine Brothers began to run ads in the local paper advertising the new project and by the second week in October they would be open for business. Footings were laid for the three model homes with an expected completion date by early March. What happened next was beyond Erica's or the company's wildest dreams. Opening weekend Erica had deposits on the first five homes in Phase 1. By the end of October, the first phase had sold out. Just as Erica had imagined, buyers were enthralled with her "Lifestyle Choices" and the various option packages. Not only were buyers taking advantage of the "Lifestyle" options, but they were adding luxury options from granite counters, upgraded appliances, travertine tile and wooden floors, to built-in barbeques and spas. Her average homebuyer was spending an additional 10-15% on options. Some buyers had added as much as $200,000 in options, with one couple spending as much as $250,000 on options and upgrades.

By end of the year, the first two phases had sold out. The most expensive models were selling first with prospective buyers going on a waiting list until the next phase would come up for sale. By year-end Erica had sold twenty homes and she had a prospective buyers list of over 200 names. The company was now in crisis mode with more demand for their product than they could deliver. The problem was availability of subcontractors. Pine Brothers was one of the bigger builders, so they had better access to subcontractors. They got their subs to agree to work weekends for an extra price. Erica's frantic selling pace was one reason John Wheeler was working overtime and had been asked to work Sundays. The company didn't mind paying for overtime, because they were able to pass on the higher labor costs to the buyer. What Erica wanted most was more product. Erica had sold out the first four phases before completion of the model homes. By the time Erica moved out of the sales trailer into the model home office, she had sold seventy homes. Moreover, she still had a waiting list that numbered in the hundreds. To make it on the list, you had to fill out a one-page financial questionnaire and get pre-qualified. That put you on the list in the order of qualification.

This was unbelievable. She had sold 70 homes and she still had a list of over 150 qualified buyers. Most of her home sales had been coming in at close to $1,000,000. The "Lifestyle'' options combined with upgrades were adding an additional 10-15 percent to the price of each home. Her most expensive model with buyer options and upgrades had sold for over $1,150,000. Her "Lifestyle" choices had been a big success. Many of her buyers were opting for media rooms, second story bonus rooms for the kids, and the home office/study. One of the more expensive options was the casita option, which combined the front living room and one of the garage bays into a private and separate residence. This was popular with many of the ethnic buyers who lived with relatives or in-laws. It was a way to take care of the aging parents and give them a degree of privacy. At $30,000 it was an expensive option, but a popular one as well.

Erica's Total Success, but Financing Was the Key

The opening of Traviscio had been more successful than Erica could have dreamed. Her "Lifestyle" choices and upgrade packages had been a big hit with homebuyers. But in the final analysis, it was the financing package that had been the real key. Over 60 percent of her buyers were going with adjustable rate mortgages. Of that group, over a third had gone with negative amortization loans. Everyone wanted to add options and upgrades and it was the lower-rate adjustable loans that made it all possible. Another 25 percent of her buyers went with interest-only loans. To her amazement only about 15 percent of her buyers went with the traditional 30-year mortgage. They were mostly older and they generally put more money down. About 60 percent of her buyers were trading up from previous homes. They, along with the older buyers, were the ones with the most equity. Another 10-15 percent of her buyers were co-op. Most of them were ethnic buyers with in-laws and relatives who would live with them. The rest of her buyers were a combination of second home, transfers from out of state, and retirees. Only 5 percent of her buyers were first-time buyers. Most of those first-timers were newlyweds who were high-income-earning professionals from attorneys, mortgage brokers, doctors and engineers, to high-tech specialists. They put down the least amount of money. It was their annual income that qualified them to buy a home.

What surprised Erica the most was the way buyers were spending money. Those who were trading up used the equity of their previous home to load up on options. Her buyers wanted to purchase as many options as their equity and income could afford. If they had equity from a previous home, they spent it all on options and upgrades. Instead of the standard home and lower monthly payment, they opted for a more richly appointed home. The big enabler was the adjustable mortgage, the negative amortization ARM, or the interest only loans. Nobody was interested in building equity. They were more anxious to buy as much home as their incomes and equity would allow.

Erica believed her "Lifestyle Choices"' program, combined with upgrade packages, made her program a success. Deep down she knew it was the low interest rates and attractive financing packages that made it all possible. Her only worry now was not the homebuyer, but the Fed. If interest rates started back up any further, options and upgrades would become less affordable. If interest rates really rose, it would make it more difficult to sell homes. The last rate hike had forced a few of her prospective buyers to switch to variable rate mortgages to stay qualified. A few buyers had dropped off the list. She had been expecting higher rates and had a backup plan waiting in the wings to counter a more aggressive Fed. For now she had a long qualified buyer list, homebuyers were adding as many options and upgrades as they could afford, and Pine Brothers was selling as many homes as they could build.

GOVERNOR, WE'VE GOT A PROBLEM
Meet Phil Angelina

Phil Angelina was special assistant to Governor Arnold Schwarzenegger. Phil was a holdover from the Wilson administration. He had been a key player in helping Wilson deal with California's budget crisis in the early 90's following the 1991 recession. Both parties relied on his budget expertise, because no one understood the budget better than Angelina. After getting elected, the new governor asked the former Republican governor for help in getting a handle on California's budget mess. Gov. Schwarzenegger had inherited a $15 billion deficit that showed no sign of abating. Wilson recommended that new governor hire Angelina. Nobody knew the intricacies of California's budget better than Phil. He knew where every nickel and dime in the state's budget was spent. When approached for the job, Angelina told the new governor that he may have taken on an impossible task. The special interests were too well entrenched and they were unrelenting in their demands for more largesse. They wanted the governor to raise income taxes on individuals and businesses to pay for more benefits and new spending initiatives.


Source: Governor's Budget Summary 2005-6

Like many of its residents, California's government was living beyond its means. Between 1998 and 2004, the state budget had grown by 44 percent—from $78 billion to $108 billion. Special interest groups controlled the state legislature and wanted the governor to raise taxes to meet their growing demands. The state was hemorrhaging with red ink from heavy welfare payments and special perks, to growing salaries and retirement benefits for its public employees.

California was already one of the most highly taxed states in the nation. Income taxes were as high as 9.3 percent and the maximum rate was reached at a very low level of income. State sales taxes were as high as 8 percent in some cities. Property taxes were also high as were property fees. California was steadily losing companies as so many found the state hostile toward business. Doing business in California was getting too costly. Taxes and the cost of living were too high. Workers comp and medical costs were also high. Many companies from retailer Costco to the big defense contractors were considering exodus options. The governor knew that if taxes were raised, California would lose more of its tax base, which would only make the deficits grow even larger. Unlike the federal government, California couldn't mint money, so it tapped the bond market.

Taking It to the People

The only way to solve California's budget nightmare was to force the government to live within its means. Angelina had been the brains behind the governor's new initiative the "Live Within Our Means Initiative." Having very little success with a recalcitrant legislature, the governor was turning to the people. It was his only hope in curbing the state's runaway spending habits. The initiative would constrain state spending over time and give the governor the ability to reduce appropriations in years the state was facing major deficits.

If the initiative was passed by the people— and there was every reason to believe it would— the state had a fighting chance, if the economy held up. What worried Angelina was the state's real estate bubble. He had been following California's real estate market closely. Like the excess capital gains taxes of the late 90's, the rising value of homes— especially in California's biggest cities— was helping to close part of California's budget gap. What kept Angelina up at night were the Fed's consecutive rate hikes and the impact it would have on California's economy and its real estate market. If the economy went into recession, many workers would lose their jobs, businesses would close shop, and the real estate market could collapse in the same way it did in 1991. This time, however, it would be worse. California's real estate prices had gone through the roof. The state had experienced several back-to-back years of double-digit appreciation. The turnover of existing homes at higher prices and the escalating prices of new homes had been a tax boon to the state. The construction industry was a major employer. It was one of the few industries within California that was growing and hiring workers. That meant income tax revenues. In addition to tax revenues from workers, the rising value of homes brought more money into the state's coffers from property taxes.

California's Perfect Financial Storm Brewing

What was starting to crystallize in Angelina's mind was the growing possibility of "The Perfect Financial Storm." Phil saw three storm fronts growing simultaneously. If the three storm fronts met and formed one "Perfect Storm," it could mean bankruptcy for California. He had been working on an outline of a draft of an economic intelligence report that he would present to the governor when he met at the governor's mansion for dinner on Thursday evening. He hoped his worst fears would never materialize. Nevertheless, he needed to prepare the governor just in case.

The way Phil had analyzed the economy, there were three potential deadly financial storms fronts brewing in California. The first was the economy. If interest rates continued to rise, many businesses would cut back and start laying off workers. Fired workers would then have difficulty in making their monthly mortgage payments. Since the majority of real estate loans in California the last few years had been ARMs, payments would also rise along with higher interest rates. Fired workers and higher mortgage payments would create the first deadly economic storm— real estate foreclosures. Foreclosures and bankruptcies would then lead to the second financial storm— a banking crisis. Most of the state's banking institutions were heavy lenders in the real estate market. Some of California's banks had as much as 60 percent of their loan portfolio invested in real estate and mortgages. If enough buyers defaulted, it could create a banking crisis, forcing many banks to dump their foreclosed properties into the market at distressed prices. A distressed real estate market would lead to the third financial storm— a fiscal crisis for the state. If banks started to dump foreclosed homes at distressed prices to remove them from their portfolios, it could cause a waterfall decline in real estate. Collapsing real estate prices would mean collapsing property taxes and possible bankruptcy for the state.

This is what kept him up at night. He was sure it would also have an impact on the governor. Before making it big in Hollywood, the governor had made a fortune investing in California real estate. Phil was sure his report would command Schwarzenegger's full attention. The governor understood real estate. Angelina needed to make him understand how it would impact the state's finances. This was definitely going to be a full cigar-pondering report. Angelina was hoping the governor's spirit would be up for dinner on Thursday. Being the bearer of bad news was never pleasant.

TROUBLE IN THE TRADING PIT
Meet Tony Shapiro, Grecko's #1 Trader

Traders Are a Different Breed

Traders tend to be a highly strung group of individuals driven by the adrenalin of the markets. They spend their days shouting into phones, barking orders across the trade desk with their eyes simultaneously glued to their computer screens. Traders rely heavily on their computer systems and software packages to give them a better analytical reading of the markets. Their goal is to be the first to discover opportunities long before the herd arrives. They operate in a high stress environment, spending their days jumping in and out of markets, looking for arbitrage opportunities. At a time when arbitrage opportunities were getting harder to find, the pressure from competition was becoming more intense.

What sets the great traders apart from the rest of their breed is the ability to read the models. Anyone can buy a sophisticated software package. Advanced analytical models are ubiquitous on Wall Street. To become the best of the best, you have to read the economic tea leaves better than anyone else.

The key is reading the models and then knowing when to pull the trigger. This is where experience counts. Experience and success go hand in hand. It breeds confidence. It was that confidence and a string of successes that enabled you to borrow money and employ greater use of leverage. Getting money wasn't a problem, if you had a track record. The big money center banks were jumping through hoops in courting the hedge fund business. The bigger your fund and the more successful you were, the more the banks wanted to loan you money. Confidence and access to money is what gave you staying power in the markets. It gave you the ability to trade on a larger scale and squeeze additional pennies long after the nickel players had left the playing field.

Because arbitrage opportunities were getting harder to come by, spreads on trades had narrowed to dimes, nickels and pennies. When a nickel was all that could be had, leverage became a key factor in squeezing the last ounce of profits out of a trade. Double-digit bond yields were a thing of the past. The Fed had engineered the lowest interest rates in half a century. With low single digit yields, it became necessary for hedge fund managers to resort to leverage to inflate their returns. When it came to leverage, firms looked for the cheapest source of financing. It could be yen, it could be dollars, or it could be gold. The press had given a name to this phenomenon. It was called the "carry trade." The idea was to borrow money at the cheapest interest rate and then invest the proceeds in higher paying assets. As long as the underlying interest rate, asset value or currency didn't change, and if the spread between the cost of borrowing and the rate of return on investment was greater, money was made.

Confidence Is King at WedgeBook Partners

What set WedgeBook Partners apart from other hedge funds was not only it size, but the reputation and pedigree of its founding partner, J. Gordon Grecko. Grecko's string of successes acted as a magnet for money. Bankers wanted to lend to Grecko's fund and the rich wanted Grecko to manage their money. Grecko had been winning for so long that many on the Street began to feel he was invincible, including Grecko himself. Grecko was the king of the calculated gamble. His models had been so finely tuned through experience that they had become printing presses for making money. It was this confidence in his models and confidence in his own decision-making ability that enabled Grecko to leverage the capital of his firm.

However, WedgeBook had a weakness. Unlike investment banks, where independent risk managers watched over the traders, the only overseer at WedgeBook was Grecko himself. He was the general and his traders were the lieutenants and sergeants that carried out his orders. At WedgeBook, it was a one way street with orders coming down from the top. He expected his traders to execute his instructions. As the years went by, Grecko became more confident in himself with each successive trade. These days he seldom listened to outside counsel. Other opinions were now a distraction that he needed to blot out to keep his trading skills finely tuned. The WedgeBook trading room was built around an irrepressible faith in mathematical certainties. The closing price printed each day was the raw input to the firm's moneymaking machine. Those raw inputs were expected to be reliable predictors of the future. Over time they had proven to be moneymakers. At other times it was Grecko's instincts that prevailed. It was those instincts that gave him the edge—the ability to question the models and know when the universe sample had changed.

Tony Shapiro was a ten-cup-a-day coffee drinker and WedgeBook's head trader. He was one of the few individuals at the firm whose opinion mattered to Grecko. He and Grecko went back to their days at Solomon. Shapiro had been one of the newbies who gravitated to Wall Street right out of graduate school. Shapiro got his MBA from Columbia where he developed a gift for numbers and finance. Like his boss, he had plenty of ambition and ego. Tony wanted to climb his way to the top. The only difference between Tony and Gordon was position. Grecko had started from a higher rung on the ladder.

Shapiro had been baptized on Solomon's trading desk where he learned the catechism of bond trading. Riskier bonds carried wider spreads, and spreads widened with time. These rules of bond trading made up the vast matrix of yields and spreads on debt securities throughout the globe. Occasionally these spreads would widen during times of crisis, but eventually they would revert back to the mean. If you had the capital to ride out the storm, spreads always came back down. It was the lesson that had been learned time and again throughout the last decade. It was what had given Grecko the confidence to back up the truck and leverage the fund when Treasury yields broke out in the summer of 2003 and 2004.

Looking for a Soft Landing

The year had been going well and as usual Grecko had called the markets correctly. Rates started back up through February and March. This made a few of the fund's bankers a little nervous, but their faith in Grecko was what overcame their fears. By April rates were heading back down again as foreign money poured into the US Treasury markets. The economy showed signs of slowing down and the Fed proceeded cautiously with quarter-point rate hikes at their March, May, and June meetings. By July there was talk of the Fed's increasing rate cycle coming to an end. Housing starts had fallen for three consecutive months, industrial production was down, inventories were building, and the job picture was starting to look bleak again. The June employment report showed less than 30,000 new jobs, while the unemployment rate had inched up to 5.7%. Retail sales were weak with consumer confidence plunging as stock markets swooned back and forth between double digit losses and occasional rallies. The automobile companies were hemorrhaging in a sea of red ink. Both Ford and GM bonds were on credit watch for a downgrade to junk bond status. The talk on Wall Street had shifted away from the Goldilocks economy. All anyone talked about now was a soft landing. Fund managers had become a little fearful with money moving out of equities and into bonds on each new sign of economic weakness.

Once again Grecko had been correct. The fund had leveraged its position in junk bonds, exotic emerging markets, interest rate swaps, long and short positions in various ETFs, and several paired trades. What Tony Shapiro was beginning to feel uneasy with was the fund's gold position. In an effort to find cheap financing, Grecko had taken up Piedmont Bank's suggestion to borrow in the bullion markets. Gold lease rates had been as low as 20 basis points. The fund had sold more than 500 tons of gold short around the $420 level. Instead of going down as expected, gold had been acting strong, trading in a higher trading range than the firm's models had predicted. In addition to selling gold short, the fund had major short positions in gold and silver equities. This trade had been positive during the first half of the year. The HUI and the XAU had been down high single digits for most of the first half of the year. In addition to short positions in gold and gold mining equities, the fund had a short position in silver. In February and March the fund had sold silver short in ranges between $7-$7.50. The fund had gone short silver by 20,000 contracts or roughly short 100 million ounces.

Grecko Calls It Wrong in Metals

Instead of falling as Grecko had predicted, the metals were now starting to shows signs of developing strength. The dollar started to weaken as it became obvious the US economy was slumping. As the dollar weakened, the metals markets came back to life. The stock market had been tracing out a broadening top pattern with lower lows and higher tops. But very few sectors were participating as one sector after another peaked and rolled over. It was clear that corporate profits had also crested with each quarter showing further signs of profit deterioration. Rising energy, raw material and health care costs were taking their toll on profit margins. More companies were missing estimates and issuing warnings that the next few quarters would look even worse.

Grecko's fund had shorted the major indexes. The only trades in the red were the firm's bullion positions. Credit spreads began to widen again and the yields on 10-year T-notes were starting back up. WedgeBook's profit position in junk and emerging market debt was still large enough to absorb a temporary rise in spreads. They also had growing profits in their equity short positions. The bulk of the firm's positions were in leveraged bond trades—some of which were illiquid. This made Shapiro nervous in case other positions in the fund began to hemorrhage. He was thinking of liquidity and where he was going to get it. He was keeping a close eye on the fund's bullion and precious metal equity short positions. These trades made Tony nervous. They were too volatile in his opinion and would be difficult to cover, if the metals markets turned against them. In his opinion, the gold and silver equities market was too small for the firm to play in. WedgeBook had grown too large. Tony felt more comfortable in the larger currency, bond, and equities markets where there was plenty of liquidity for funds of WedgeBook's size to operate in.

Tony Begins to Squirm

Just after the 4th of July break, Tony Shapiro was starting to get an uneasy feeling. He almost hated to watch the news. There were days on the trading desk when he just turned off the television monitors. This was not his style and it wasn't healthy in maintaining his trading edge. This was the time he needed to keep his wits about him. It seemed that each day brought more bad news. A trade war was heating up in Washington with Congress ready to slap tariffs against China. The Chinese were threatening to retaliate. The idiots in Congress didn't realize the consequences to the bond market if the Chinese stopped buying Treasuries— or even worse—started dumping their hoard of Treasury bonds. Next to Japan, which held $702 billion in Treasuries, China's central bank owned $196.5 billion in US government debt. The Chinese were the second-largest owners of Treasuries on the planet.

To make matters worse, the Commerce Department reported record trade deficits for the months of March, April and May. The monthly trade deficit was now averaging more than $60 billion a month. Rising energy prices was part of the reason. However, the major factor behind those deficits was the plain fact that imports were growing faster than exports. The deficits had to increase in size. The US was importing more than $2 billion a day just to pay its trade bills. This was putting pressure on the dollar and bond markets, which in turn gave the gold market a lift.

By the second week in July, things were beginning to look ugly on every one of Shapiro's trade screens. Every trade monitor looked red with occasional columns of green. Tony was now starting to take Zantac every day. The acid from the coffee and weathering of his nerves was starting to take its toll. Tony didn't like what he was starting to see. The week started out with major losses for the second quarter for Ford and GM. The credit agencies responded by downgrading their bonds. Both automakers' debt had been denigrated to junk status. That downgrade rippled throughout the corporate bond markets. Spreads widened even further. Interest rates were backing up everywhere. Yields were rising in the Treasury markets, in mortgage backs, corporates, and emerging market debt. Investors were becoming risk-averse and dumping anything associated with risk. The index of financial companies broke down in the spring and by July their charts were looking ominous. Defaults were on the rise as the debt-strapped consumer showed strains from the combination of rising energy prices and interest rates. Even the Treasury market was losing ground as foreigners absented themselves from weekly Treasury auctions. Governments and large foreign investors were losing confidence in America's economy and capital markets. That loss of confidence was starting to show in the rise in long-term Treasury yields.

Global Concerns Mount

America wasn't the only country undergoing problems. Trade frictions were breaking out everywhere as developing economies came under economic duress. Canada and Europe threatened trade sanctions against the US, the US threatened trade sanctions against China, and China threatened to retaliate. Unemployment continued to grow throughout Europe, reaching 13 percent in Germany. Budget deficits were growing even larger in Europe with most of the major countries surpassing their Maastricht limitations. France, Germany, Italy and Greece were running deficits that were 4-5% of GDP. As their economies bordered on recession, politicians were looking for scapegoats. The anti-China chorus was growing louder by the day. Trade sanctions could be heard throughout Europe and all of North America.

Everywhere Shapiro looked there were developing storms. Tony laid out an outline of the problems and where the firm was most vulnerable. He planned on faxing a brief synopsis to Grecko, who was vacationing at his villa off the Amafi Coast resort of Positano in Italy. Shapiro identified seven problem areas that could affect the fund's portfolio.

  1. Rising US trade and budget deficits
  2. Deteriorating economic growth
  3. Declining corporate earnings
  4. Trade tensions
  5. Rising oil prices
  6. Rising inflation
  7. Strengthening gold markets

The relentless rise in the US trade deficits was putting greater pressure on the dollar. The US was getting to the point that it would require almost $2.5 billion of capital a day to finance its trade deficit. The only source large enough to finance that deficit was Asian central banks. The word coming out of Asia was that many of the smaller countries were cutting back on dollar purchases and diversifying their portfolios. This left only the Japanese and the Chinese, but they were also scaling back their buying of US debt. In the first quarter Japanese and Chinese buying of Treasuries had been less than $5 billion. Total central bank purchases were less than $50 billion. The US needed a minimum of $50 billion of buying each month or pressure would be put on the Treasury markets. The trade friction in the US Senate and the threat of 27.5% tariffs against the Chinese were only aggravating the situation.

The weaknesses in the dollar and its implications for the bond market were of major concern. The fund was heavily invested in junk securities and emerging market debt. The deterioration in corporate profits as a result of a weakening economy was causing credit spreads to widen. The fund still had a profit in its positions, but that profit margin was getting thinner with widening credit spreads. A falling dollar was also causing interest rates to back up which was also impacting the portfolio.

Far worse for the fund was the strengthening in the precious metals markets. Gold was now at $440, silver was close to $8, and the HUI had risen back to its March high of 224. The fund had been stealthily moving to cover its gold equity short positions. Unfortunately, the market was shaken badly with the early May lows. The trouble the fund was having buying in again was due to all of the sellers who had been shaken out of the markets. The fund couldn't buy back any size without causing gold equity prices to soar. What scared Shapiro was the plain fact that gold lease rates were backing up. He wanted to start buying back in their gold and silver short positions. WedgeBook wasn't the only hedge fund short the bullion and precious metals equity markets. Shapiro was going to suggest that they begin to cover now before the rest of the shorts started covering in a buying panic. The market was too small and illiquid for a fund of their size to be operating in. If the shorts started to cover all at the same time, it would be like a waterfall trying to work its way through a garden hose. Shapiro would put the finishing touch to his memo to Grecko this evening and then fax it to Grecko from home.

OTHER PLAYERS SEE DISTURBING SIGNS
Erica, Danny, Tony, Grecko and the Wheelers Concerned

Erica Barry had begun to notice a subtle trend that surfaced in May. More of her prospective buyers began dropping off the list as mortgage rates headed back up. With the Fed raising interest rates in May, variable rate mortgages were trending up and it was widely expected that the Fed would raise rates again in June. Her prospective buyers list had fallen to less than 100. More buyers were dropping off the qualified list as mortgage rates were consistently heading higher. Recent buyers were spending less money on options as the cost of money became more expensive.

Even more alarming was the call she received from Danny Garcia regarding the Stuart's home sale. Pine Brothers required all of their homeowners to sign an agreement to hold their homes for one year before selling. This was to discourage the flippers and speculators from coming into the development. The company allowed selling in the case of financial difficulties or job transfers. Danny called to tell her that Dan and Jenny Stuart were going to put their home on the market. They had missed their last two mortgage payments. As rates rose on their variable rate mortgage, they simply didn't have the funds to meet their monthly obligations. Dan Stuart, a bio-tech engineer, had lost his job at Envirotech. The company had laid off most of their engineering staff to save money. The papers made a big stink over the layoffs, but the company president expressed it succinctly. The venture capital market had dried up. In California a million dollars would only cover payroll for three months for his staff of technicians. In India that million dollars would cover the same salaries for a year. The company had no choice, if they wanted to remain in business.

Erica thought she could live with one For Sale sign, but Danny had other bad news. The Specks called him to find out their mortgage options. They were having difficulties making ends meet. They were looking to draw out equity from their home to pay off credit card bills and their new car loans. The Specks barely qualified for their original mortgage. They had put down over $100,000 that they had extracted from the sale of their previous home. Most of that equity had gone into options and upgrades instead of a lower mortgage. Danny wasn't sure if they would qualify for a new loan. Their credit card bills had increased substantially since their mortgage loan was approved. Dave Speck talked openly of selling, if refinancing was not an option.

Tony Shapiro arrived at work at five in the morning on Monday to get a handle on the day's trading. He came in early to get his reading done. When he read the day's headlines, he knew he would see trouble in the day's markets. The Washington Post broke a front page story that it looked like a surprise attack on Iran's nuclear and biological weapons plants was possible. The US had moved B-2 bombers to air bases in Afghanistan and Azerbaijan. The carrier battle groups, the Nimitz and the Reagan, moved out of San Diego and joined forces with the Kennedy, the Eisenhower, and the Carl Vinson. The US now had five carrier battle groups in the Persian Gulf. It was looking like more than a training exercise. The Post also reported that a Delta Force contingent recently left Fort Bragg en route to Azerbaijan. A battalion of Rangers was also on the way.

The Iranians were on TV threatening severe consequences to the US if any attack was made on its sovereign soil either by air or by land. The Iranian threat was not considered lightly. The Iranians had close connections with vicious international terrorist regimes and had used them against the US in the past. The Post article mentioned that Iran had been mining uranium deposits in Saghand and were constructing an enrichment facility at Natanz. According to the article, the Iranians were less than two years away from developing nuclear weapons. They already had missiles that could reach distances of over 1250 kilometers.

The Markets React... Badly

Oil prices gapped up $5 at the opening on the Nymex. Oil prices were now over $60 a barrel. Gold surged $20 to $460, silver gapped up $.60 to $8.40. The damage in the equity markets was attention-getting. The Dow fell 450 points in the first minute of trading, falling below 10,000 for the first time in over a year. The Nasdaq dropped 140 points, piercing the August lows of 1752. The S&P 500 gapped down 50 points at the opening bell. It was beginning to look like a real meltdown. A little after lunch the market began to breathe a sigh of relief. A large buyer stepped into the futures pit and began a massive buying program. There was also massive buying of the QQQs and Diamonds. The massive buying by a large institution had stemmed the avalanche of losses for the day. The Dow closed down 375 points at 9751, its first close below 10,000 since last October. The S&P 500 lost 40 points to close out the session at 1,105. The Nasdaq was hemorrhaging in a sea of red ink, losing over 110 points and breaking though the previous low of 1752 to 1750. The possibility of another war wreaked havoc with credit spreads. The long-bond gained two and a half percent with the 10-year note gaining 2 percent. Credit spreads widened to their largest gap since the beginning of the year. The spread on U.S. corporate junk widened to over 500 basis points over Treasuries. Emerging market spreads were back over 400 basis points.

Grecko's fund was bleeding everywhere. Tony Shapiro sent his assessment report, along with the losses of the day, by fax to Grecko's villa. Shapiro stressed it was important for J. Gordon Grecko to interrupt his vacation and return home, so the fund could begin damage assessment and work on a rehabilitation plan. Shapiro left out the part about the numerous phone calls from the fund's nervous creditors.

Grecko had just finished a late dinner after a day's sail on his 130 foot yacht, Achilles. He lit up his favorite Cuban cigar, a Cohiba Siglo III, and his man Jasper opened the second bottle of Opus One. The sun was just setting on the Amalfi coastline. The view from his villa was breathtaking. Tomorrow he was taking Achilles to Capri. His thoughts were caught up in the cloud of smoke from his cigar when his butler gave him Shapiro's fax. Grecko had been totally oblivious to the day's events in Iran, Washington, and New York. He read the report in complete calm, but deep beneath the surface, he had an uncomfortable feeling. Events could get out of hand and if they did, he would find himself in the same position as his mentor at Solomon, John Meriwether. Grecko acted decisively. He instructed his personal secretary to call his pilots, who were lodged in town, to get the G-4 ready. He wanted to leave for New York immediately.

Erica had sensed that the real estate market was beginning to slow down with each Fed rate hike, which made variable rate mortgages more expensive. ARMs represented about 60 percent of all of her customers. She spent Tuesday morning at corporate working on a marketing incentive plan to help bolster a decline in sales activity. Prices would be kept the same, but she was working on a buyer incentive package. It would give a prospective buyer a choice of free upgrades such as granite counters in the kitchen, window shutters, or upgraded appliances. If the buyer didn't want upgrades, Pine Brothers would give a $10,000 gift certificate to Bradley's furniture mart. The home study option now came with a new Dell computer. If things really got soft, she was thinking of offering a new Honda Civic. Gas prices were now over $3 a gallon and economy cars were back in fashion. Erica hoped that she wouldn't have to resort to the car option. That all depended on how well the economy held up and how soon the Fed would finish with its interest rate raising cycle. She hoped it was soon.

For a while it seemed that life had returned to normal for John and Terry Wheeler. The refinancing of their mortgage and all of their debt had made life easier. Terry once again had money to spend. She loved shopping at the malls with her friends and going out to dinner and the movies with John on Sunday evenings. However, good times never last forever. At the end of April she had a worrisome experience—business at the restaurant slowed down to a crawl that weekend. The restaurant had low turnover and her tips that weekend amounted to a little over $400. She ignored the weekend as a fluke. Since there weren't any good movies out and the weather had been especially nice, she and John stayed home that Sunday. Terry also noticed that the stores were having more sales and there was less crowding at the mall. She normally had trouble finding a parking space on Saturdays, but lately parking hadn't been a problem.

It turned out that the dip in April had indeed been a fluke. The following weekend tips went back up to nearly $500. However, by July, there had been a noticeable downtrend at the restaurant. There were less seatings on weekends and more customers were opting for the restaurant specials. Another detectable trend was customers choosing the house wine instead of their fine vintage wines. The Opus One, Caymus Select, and Joseph Phelps Insignia weren't selling like they use to. For Terry, a lower restaurant tab meant lower tips, since most customers tipped on the basis of the bill.

The Wheelers got another blow to their income in June. John's boss told him that several of the builders were holding back on their construction programs, since sales had hit a soft patch. Nobody was expecting a downturn in the industry. The builders felt activity would pick up as soon as the Fed stopped raising interest rates. The builders and lenders were hopeful and expected mortgage rates to come back down again.

By the end of June, Terry's tips had dropped to less to $400 a weekend. The elimination of John's Sunday overtime also cut into their budget. To make matters worse, their living costs kept going up every month. Their food bill kept rising even though Terry used coupons and bought store brands. In addition to price rises, she noticed that packaging had become smaller. Last weekend she bought a birthday gift for the Bensons' daughter at Mervyn's. She was startled when the sales clerk told her they no longer offered gift boxes. She could go to the gift wrapping counter at customer service and purchase a box or a gift bag instead.

The Wheeler checking account was greatly depleted at the end of June. For the first time since March, their dinner on Sunday night was paid with their MasterCard. If Terry's tips didn't improve, she didn't know what they were going to do for income. Their living costs continued to go up, but their income had been going down. First it was the drop in her weekend tips. Now it was less overtime for John. She and John and discussed their predicament. That was when John mentioned calling Jack Benson to see if he could work some of his mortgage magic with another refinancing option. John and Terry thought they still had a good deal of equity left in their home. Surely there would be some kind of mortgage plan that could save them money. As far as they knew, their house was still worth a lot of money. Several homes had gone on the market since May. None had sold, but most of their neighbors were asking close to $750,000.

Terry couldn't figure out how they had gotten themselves into this mess. She had really thought that consolidating their debt would give them breathing space. Terry wasn't aware that the US economy was now in a stagflationary environment with anemic economic growth and rising inflation. It was the reason her cost of living kept going up and why business at the restaurant was down along with her tips. When times get tough, discretionary spending gets cut first—like eating out at restaurants. Long-term interest rates were also reversing course. A two-decade cycle of lower interest rates had come to an end. Rising interest rates were having an impact on housing, which impacted John's overtime. If the real estate bubble burst, it would also affect John's job. Terry just didn't understand it. Maybe it went back to New Year's and a broken resolution.

What Terry did not know was that the situation went beyond even her own broken resolutions. The country had broken all of its fiscal discipline. Americans were living beyond their means. The government was living beyond its means. The pay-as-you-go fiscal discipline of the 90's had been abandoned. Government had broken its fiscal resolutions, broken its fiscal discipline, and monetary policy had abandoned all sensibility. Since 1994, when the credit bubble really started, the country began to live on borrowed money. Now it was living on borrowed time. The great unraveling was about to begin.

To be continued.

Coming Next "The Great Unraveling—the Return of J. Gordon Grecko"

© 2005 James J Puplava CFP, Storm Watch Update Archive

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