Bubbles Burst in

Babylon-Your House!

Chapter 13

 

Let’s talk about myths that most Americans believe are self-evident.

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Welcome to Happy Town, Babylon/USA!  There is a concerted effort to make you believe all this as Lou Dobbs, Ron Insana, Mayor Bloomberg, Suze Orman and all the other pundits tell you the fundamentals are good and the market may have a few rough spots but just hang in.  The market will keep going up.  Real estate will keep going up.  Condos in New York City have topped a million dollars and people wait in line to buy a new one, sometimes bidding up the price 10 percent in a single day!  When will it stop?

 

This just doesn’t ring true with history.  The market doesn’t always go up.  It took fifty years to recover from the Great Depression and get back to comparable values.  There have been horrendous real estate busts over the years.  From 1987 to 1995, the price of real estate dropped 45 percent.  In Baltimore, Real Estate peaked in the 1920’s and it took 75 years for it to recover.  It happened to me in Hartford and again in Houston and, it even happened to friends here in Sacramento.  Now the market is going through the roof.  But, can it last?

In our last chapter, we looked at the Federal Reserve and their policy of cheap interest which went down to 1 percent – the lowest since the Great Depression and their printing of money to fund government and trade deficits.  This has led to asset bubbles in real estate, stocks, etc.  Whenever you can borrow money that has been fractionalized and multiplied at a rate that is less than inflation, it is better than free money which is exactly why you hear mortgage financing commercials all the time on television.  People say prices will never go down.  The market always goes up and so does housing.  Anyone who says that either doesn’t know the facts or has a short memory.  The experts would say it can’t happen because the central banks have controls they didn’t have seventy years ago.  So let’s look at a modern economy, the second largest in the world and see what happened.  We don’t see a sudden crash but a slow and steady fall.

A Lesson From Japan – The Bubble Fizzles 

In order to understand what is likely to happen in the United States, we will look at the parallels in what happened in Japan 10 years before our slow fall began in 2000.  In the 1980’s, Japan was the miracle economy – double digit growth, considered the world’s leading economy, efficient, productive, innovative, dynamic.  Between 1971 and 1985, their stock market had double digit growth increasing five fold.  Then it really took off tripling in the next five years until 1990. 

Ten years later, from 1981 to 1995, the American economy also increased by 500 percent and from 1995 to 2000 it also tripled.  In 1990, the Japanese market began to decline and 18 months later was down 30 percent.  The same thing happened in 2000 to the U.S. stock market along with the rallies we have experienced since.

There were some differences.  The Japanese were savers rather than spenders even though their rate of savings had dropped from 23 to 13 percent (compared to Americans less than 1 percent).  The other major difference was that Japan was the major net creditor in the world (in contrast to the U.S. which is the largest debtor nation in the world).  In spite of this, Japanese have a high standard of living, work fewer hours, pay less taxes and have better social services, better health and a longer lifespan.  One would expect that, because of these factors, that the adjustment of the imbalances in the U.S. economy may be even more profound.

In the late 1980’s when the economy began to slow down, the Bank of Japan lowered the discount rate several times dropping down to post-war lows of 2.5%.  Bubbles began to inflate.  Stocks, such as Japan Airlines, was trading at 400 times earnings and many other stocks were trading in the range of 200 to 300 times earnings (a normal trading range would be about 10-15 times earnings).  Commercial land values in major metropolitan areas tripled from 1986 to 1990.  Families took out low interest 100-year mortgages in order to buy incredibly expensive tiny little houses.  At one time, the value of Japanese property was worth four times the value of all property in the United States and the Imperial Palace and grounds equaled the worth of Canada.  Young Japanese professionals would think nothing of spending couple of hundred dollars for a drink at a nightclub or $1,000 for dinner. 

When the economy began to fail, the government cut taxes to encourage spending, printed and spent money on projects, and lowered interest rates.  This led to bubbles that made people appear fabulously wealthy.  Even though the Japanese were traditional savers, they began to spend.  Their personal debt rose to 130 percent of income.  Bank lending increased by 700 percent from 1985 to 1990. 

Shinjuku Homeless; Tokyo, Japan 02Demand created by easy credit doesn’t last.  If people borrow, they must also pay it back.  Eventually, there is a contraction of credit and debts must be paid.  Eventually things balance out.  But governments and central banks fight back. The Bank of Japan became concerned about the real estate and stock bubbles so they began to raise the discount rate, going from 2.5% all the way to 6.25% by the end of 1989.   Over the next two years, the stock market lost 38.5 percent of its value but real estate continued to rise.  Again, paralleling Japan’s experience, ten years later, the S&P 500 lost 45 percent of its value but real estate continued to rise as the Federal Reserve lowered interest rates in order to stimulate the economy.

Central banks do have some control over the economy so rather than a massive collapse, there was a slow decline for the next 15 years.  The once booming economy stagnated.  Businesses failed.  Large banks wrote off trillions in debt.  Prices began to fall.  The government printed money and spent money financing huge construction projects.  The national debt grew from 60 percent of GDP to over 150 percent.  Unemployment, previously non-existent, grew to 5 percent.  But it didn’t happen over night.  The market fell in 1989 but the GDP continued to grow until 1992 just as the U.S. economy rebounded ten years later.

The Fed acted more quickly than Japan’s central bank, cutting the Fed rate to 1 percent in ten months while the Japanese took almost five years to lower theirs.  Congress passed three tax cuts and started two wars.  Japan also stimulated money growth resulting in excess capacity and low profits but wouldn’t let companies fail (which they probably should have).  It is akin to the continual U.S. bailout of the airline industry which has lost more money in the past three years than they ever made in the past seventy.  Over the next 14 years, Japan lost 75 percent of its stock and over 80 percent of their real estate value.  It is still stagnant and slowly recovering.

When we compare the Japanese experience with America, we see that the stock market took a huge initial hit.  It is not accurate to look at just the Dow which is thirty representative companies.  You have to look at the S&P and Nasdaq where losses were much larger and have not recovered. S&P peaked at almost 1500, dropped to 740 and is now back up to 1200.  The NASDAQ dropped from 5000 to 1200 and is now up to 2000.  Japan’s decline did not occur all at once.  It had many rallies – ups and downs, but was marked by a steady decline.

The thing to realize is that even with Fed “management”, the Stock Market has gone through 17 to 20 year cycles: down from 1929 to 1946, up from 1946 to 1965, down from 1965 to 1982, up from 1982 to 2000 and down since.  Economies adjust and any irrational exuberance leading to highs must be followed by lows.  The idea of a “consumer” economy is a myth!  Consuming without producing is not sustainable!  America has become the biggest debtor nation of the world – buoyed only because other countries still believe in the dollar so they spend more than 80 percent of their savings supporting our spending habit.

No matter what the Japanese government or their central bank did, there was nothing they could do to stop the slide – cut taxes, print money, lower tax rates, spend money on government works projects.  Their policies led to the same asset bubbles and credit debt we are experiencing but nothing could keep them from falling back to where they should be.  One significant difference between us is that Japan runs a balance of payments surplus, whereas the U.S. is running the greatest deficit in the history of the world – over $650 billion a year which leads to the weakening of the dollar against other currencies.  Both countries had huge government deficits.

American Bubbles – What Does It Mean?

The loose money policies of the Federal Reserve have resulted in growing asset bubbles here in the United States.  In spite of the fact that the discount rate has gone from 1 to 2.5 percent, real estate prices continue to soar as Americans continue to spend.  Mortgage rates are still at near record low levels.   After all, the cost of money is still below the inflation rate so Americans borrow and spend.

“But to repeat, the pivotal hallmark of a "bubble economy" is that the ballooning asset prices are widely used as collateral for a general consumer borrowing and spending binge. In the United States, mortgage borrowing by households during the first half of the 1990s increased by an annual average of $168 billion. This accelerated in the decade's second half to $296.9 billion. But after 2000, it virtually exploded to an average annual growth rate of $615 billion.

It is undisputed that the greater part of the escalating mortgage borrowing in the United States was for purposes other than house purchases. In short, it boosted consumption as a share of GDP at the expense of business investment and the trade balance. That is, it radically changed the U.S. economy's pattern of growth - actually an unsustainable pattern of growth.” (The Daily Reckoning, 2/2/05)

We have an interesting phenomena – falling incomes and increases in spending.  How can this be?

“We reported on falling incomes last week. This week we wonder, along with the Arizona Republic, how it is that people whose incomes are falling are able to pay more for their houses. "House prices are outpacing income gains," says the paper. In the Phoenix area, continues the report, existing house prices rose 22% last year. No figures are available on income gains in the area, but nationwide, real incomes fell 0.8% while nominal incomes rose only 2.5%. There is a big gap between 22% and 2.5%. How is it closed? With debt, of course. The average homebuyer must take out larger mortgages than ever before. And even at today's low interest rates, this makes it harder for him to pay for a house. The "affordability index," according to the newspaper, is now at its lowest level in 15 years. Sticking to the essentials...let's see...incomes falling, house prices rising...how long can this go on?  (Daily Reckoning 2/3/05)

The result in many markets is that first time buyers, who historically account for almost half of the buyers, can no longer afford to buy any home at any price.  Three years ago, first time buyers accounted for 60 percent, two years ago for 40 percent and today 20 percent of the buyers in the Sacramento area.  The number of buyers coming in with an Adjustable Rate Mortgage (ARM) has risen from 10 to 50 percent in some markets.  Some get into a house at very low rates, which can rise dramatically.  I once owned a house in Minneapolis and the ARM rate hit 13.5%!!!

When you look at the house you are in as I do and realize it has literally tripled in price in the past four years, you think, isn’t that great? (except for the fact that I’m renting)  I’m rich!  But what makes it worth that much?  The danger is when the home owner sees that cash and says, “I think I’ll take it out and pay off bills, buy a new car or buy a bigger home.”  What would happen to the typical home owner if their house suddenly lost half its value?  The average American moves every four years.  They get transferred or grow out of a house.  What happens to them?  They are “upside down”, owing more than the house is worth.  They either just walk away from it as many did in Houston (and hope they don’t come after them) or they settle.  I bought a house in Connecticut valued originally at $450,000, bought it for $262,000 and, when I sold it for $160,000, I settled with the mortgage company and agreed to pay them the $100,000 I owed over the next 10 years or so.  I bought my $400,000 3500 square foot house in Houston for $132,000 in 1991 and sold it five years later for $117,000!  So much for markets always going up!

Over the past 40 years, we have had “rolling recessions” that affected certain areas of the country and not others.  Since the Fed began lowering interest rates in 2000, the asset bubble has been building.  Dr. Kurt Richebächer tells us that

“All asset bubbles and bubble economies have their highly visible and also compelling trademark in exploding credit. The distinction between the two is important. An asset bubble simply reflects a rise in asset prices out of proportion to underlying yields. A bubble economy is an economy where soaring asset prices fuel a borrowing/spending binge that may be concentrated in real estate, business fixed investment or consumption.”

All of these things are interrelated – the deficits, the falling dollar, interest rates, housing prices, stocks, bonds, etc.  The process is inexorable.  As the dollar decreases in value, our creditors are going to insist on a higher interest rate (or they stop buying and supporting the dollar) to increase their return.  This will cause long term rates to increase (bonds) and the Fed will have to follow with rate increases and both of these factors will cause mortgage and credit card rates to increase which will put homes out of the reach of new buyers, and lead to more foreclosures and bankruptcies (which are already at record levels).  Once interest rates rise, housing prices collapse and the rest of the system starts to come down with it.

Here is where the economy is headed:

“Over $5 trillion in corporate assets now depends on the ability of American homeowners to pay the monthly mortgage.  Just one small crack in the system - such as the now unavoidable rise in interest rates - and the whole thing will go up in flames.

The U.S. government has pinned the hopes of the nation's financial system on the American homeowner...at the worst possible time.  Because when those homeowners are suddenly unable to make their payments - something that will soon become unavoidable -- the bottom will fall out of not just the housing market...but the entire U.S. financial system.”

Foreclosures will increase.  Credit will tighten.  Interest rates will go up and Americans will no longer be able to get credit.  Corporate profits will fall, the Stock Market will plummet, unemployment will increase, along with foreclosures and bankruptcies and retirements and savings will be wiped out.  Speculative manias and panics are a part of history and there is much to be learned from bubbles and busts.  Panics have their beginnings in the boom which is spawned by money supply growth, debt and speculation.  But the bust always comes.

Analysis

What does this mean to Christians?  It means that you need to be prepared.  Don’t get caught up in it.  The goal is to drag you deeper into debt, make you poor and eventually completely dependent on the State.  I’m not going to give investment advice.  You need to go to the Lord and find out what He wants you to do.  You need to be prepared.

 

One thing we know for sure is this.  Don’t get caught up in debt.  Do whatever you can to keep your expenses down and live within your means.  If the Lord tells you to sell your house (while the market is high) do so.  If He says to stay, do so.  There are no right or wrongs here, no universal action plan.  You need to learn to listen to His voice and do what He says.

 

The preparation of our hearts is the most important thing in terms getting to know the Lord and letting go the things of the world.  Revelation 12:11 is our hope, “And they overcame by the blood of the Lamb, by the word of their testimony and they loved not their lives unto death.”  We want to be able to stand and testify as long as possible so the less dependent and entangled with the system, the better.  Practical preparations are an important part for all “end times” Christians but you don’t get the answers from a book.  No one can tell you what to do.  You get answers from spending time in His presence, fellowshipping with Him, listening to His still small voice and doing what He tells you to do.


 

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