The good news is that you still have time to protect your stocks from a plunge that will rival that of the Great Depression.
How so? This decade has featured record debt levels, extreme income inequality not seen since 1928 -- according to the New York Times [registration required] in 2005 the top 1% (over $348,000 in income) took home 21.8% -- their largest share of national income since 1928, and a negative savings rate of -0.7% -- last seen in 1933 -- the depths of the Great Depression.
Why does this mean that stocks will fall? Many of the top 0.01% -- those making over $25.7 million a year -- are getting that way by borrowing money. Consider Blackstone Group CEO, Steve Schwarzman, whose annual compensation is estimated at over $500 million. If banks and bondholders were not willing to lend Blackstone billions of dollars, his deals would not work. In 2006, a record $480 billion was used to finance leveraged buyouts and Moody's expects the default rate on this debt to increase to 3.07% this year. Bad buyout loans could lead to corporate bankruptcies and worker firings.
Another group in the top 0.01% are CEOs who send lower paying jobs overseas to maximize their business profits and boost their incomes. According to the Wall Street Journal [subscription required], Princeton University economist Alan Blinder estimates that 30 million to 40 million jobs could be sent overseas due to globalization. For those American workers whose jobs are offshored, it could be harder to pay their bills. But the bosses who send the jobs overseas should be just fine.
And those who are getting by despite negative savings are heavy borrowers. Those lower income people are among those taking on a record $2.4 trillion in consumer installment debt. And they are disproportionately represented among the borrowers of $1.3 trillion worth of subprime mortgages -- 47% of which got loans despite no verification of their incomes or no down payment. When low teaser rates reset, borrowers can't keep paying -- 2.2 million are expected to default.
And the problem is not limited to lending against houses. Investors are borrowing to buy stocks at levels that exceed 2000 -- right before the dot-com crash. Specifically, in 2006 stock margin debt hit a record $286 billion. If investors who borrow money to buy stocks need to pay it back due to a drop in price, the margin debt lenders will sell that stock fast -- accelerating a stock market decline.
In the 1980s and 1990s I witnessed this pattern: low interest rates encourage borrowing. Borrowing drives up asset prices. Banks loosen their lending standards to keep growing -- figuring that if a borrower defaults they can always sell the collateral at a profit. This encourages asset producers -- in this case home builders -- to increase the supply.
And when the borrowers can't pay, the supply exceeds the demand and prices tumble just as lending standards are tightened. Banks fail, borrowers default, companies fire workers, and eventually the excess supply clears and the market recovers.
With record levels of borrowing, the big unknown is when this clearing will begin to reverse economic growth and how long it will take to be completed. Money market funds would be a safe haven in the meantime.
Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter.
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Reader Comments (Page 1 of 1)
3-29-2007 @ 1:13PM
rolf schuetz said...
Subject: Depression in the Real Estate Market
Time: 12:07:27 AM EST
Author: rolfjr
Mood: Worried
Music: Boston Edit Entry Delete Entry
Having practiced in the real estate market for some 16 years, the past 5 years have concerned me. In 1991, mortgage interest rates were at about 10%. A 10% mortgage loan meant that a buyer would be paying back $3 for every $1 that was borrowed. So if a 30 year fixed loan was $300,000, a borrower could expect to pay back to a bank about $900,000 over that 30 year period. Recently, interest rates fell to an all time low, 5%. That was in 2005. 5% mortgage interest rates changed the $3 to $1 to $2 to $1. Translated that means that a borrower who would have only qualified for $300,000 in 1991 would be able to qualify for $450,000 in 2005 or a $150,000 more! It had a direct role in increase of housing cost across the country, because Sellers could get more value for their house due to the increased spending power of borrowers.
While interest rates began to fall at slow pace between 1992 and 1999 (I recall that they fell to between 7 and 8 percent). That changed suddenly between 1999 and 2000. Why? Well there were a many reasons.
Mortgage interest rates are effected by inflation, treasury bonds and the federal debt. How so? The federal government loans money to banks as well as it takes out loans. Much of the money that is given to banks by the federal government is given based upon the three factors above, i.e., that the government is also in the business of making money and they have to take into account the amount of money that they owe in principal on the federal debt, the inflation rate (which affects the value of currency) and the amount of interest owed by the federal government for its public debt which we all know as the Federal Debt. While I am not the biggest fan of President Clinton, during the course of his two terms, he and of course the federal government were able to lower the interest rates of numerous indentures that matured and rolled them over at a lower rate.
Ok, so what? Well since the government saved billions of dollars of repayment interest money, they also began to charge lower and lower rates to lending institutions. That meant that mortgage companies and banks could get more funds cheaper. You might think that banks only lend out the money of their account holders, but that is only a small part of their portfolio. Borrowing cash from the government at low rates and then lending it to the public at slightly higher rates meant that lending institutions would be making a margin on the borrowed money. Add in low inflation rates, annually about 1.5% to 2.2% and you had the receipt for the real estate boom from 2000 to 2006.
Recently, this has changed due to the rise in inflation and the renewal of a portion of the federal debt. Inflation devalues money and usually means that there is too much circulation or that the cost of goods and/or services has risen higher then the median income of consumers due to the over circulation of currency. Inflation has been a key part of the reason why the federal reserve has been increasing interest rates on money that it lends to lending institutions. Also, unlike the fortunate President Clinton, President Bush was unlucky enough to have a small portion of the federal debt mature during his tenure, and the interest rates on that part of the federal debt went up. That occurred in July of 2006. Both of these factors have caused interest rates to increase from 5% to about 6.25% in the past 18 months.
This is not good news for sellers in the real estate market nor is it good for purchasers over the past 3 years. It has lowered the buying power of potential buyers and given the fact that housing prices are directly linked to mortgage interest rates and buyer household incomes, median housing price have been slipping for the past 6 to 8 months. I have watched homes go from a market value of $200,000 to $500,000 during the high water mark of home prices. It was the "Roaring 7 Years", where there were no checks and balances on loans made. Banks were lending money without requiring the customary 20% down because property value were increasing are a rate that dwarfed inflation. That $500,000 home if it is located in the New York City area has lost about 5% of its value or $25,000 in the past 6 months.
To make the situation worse, most loans between 2005 and 2006 were covered with Private Mortgage Insurance because most borrowers only put 10% or less down. Also, to get the rates down many consumers took out adjustable rate mortgages for either 3, 5 or 7 year terms. Those adjustable change each month based upon that months indexed interest rate. That means that if a mortgage was taken out at 5% 18 months ago a borrower is now paying 6.25%. Its not all bad, most adjustable have a cap of 2% so the rate probable won't go over 7%! All of this has me worried.
In February or March of 2007, the federal reserve will meet to discuss raising interest rates due to the inflation rates of November and December of 2006. November's rate was 3.4% (ouch). If interest rates are raised by the federal reserve, banks will pass along the higher rates to consumers, perhaps in April of 2007 rates will be 6.75%. That should crash an already sliding real estate market. It should also increase the number of foreclosures which ironically enough have been on the increase for the past eighteen months.
If your a buyer, you have two choices. First, try to buy now and barter with the Seller to reduce the purchase price and make sure you don't take out an adjustable rate mortgage. Second, hold off and wait for the collapse which I calculate will happen by the end of the Summer of 2007. Try to put 20% down, take a fixed loan and try to buy down the rate. Just an educated guess but the rates might be at 7% by August.
For Sellers who own homes prior to 2000, the reality is you will be dropping your home prices by 10 to 20% in the next 6 months if your serious about getting it sold. If not you probably will not be selling anytime soon. For any Sellers who purchased between 2000 and 2006, well, enjoy your home, you will be there for a while. For the flippers, well your finished as that part of the market is done.