Friday, December 07, 2007

Cruisn' For an Economic Bruisin'

Because I have been swamped, I haven't had an opportunity to post to my blog lately. I arrived home early this morning from the 12th Forbes Cruise for Investors, which went through the Panama Canal. A cruise, of course, is lots of fun. But it was also work for me and the other speakers. We started in Costa Rica on Nov. 30, went through the Canal, and stopped to visit St. Lucia. I disembarked in Antigua. The cruise is still proceeding on its was to Miami where it will end in a few days.

On my half of the cruise were Steve Forbes, Gary Shilling, Bob McTeer, Pete du Pont, and John Goodman. Rich Karlgaard served as the host. Gary, who has been right about the housing market all along, is still bearish on the economy and stocks. It was good to be around someone who is more bearish than myself. It made me feel like a good guy. The other speakers were more optimistic.

While on the ship, I learned about the Bush adminstration's plans to freeze certain subprime mortgage resets. Clearly, there are obvious moral hazard problems with doing something like this. It will be seen as a bailout of those who made imprudent decisions. Even so, I don't believe that even this measure will prevent housing prices from falling further. Freezing monthly payments may slow foreclosure rates modestly, but it won't solve the problem.

Given the continuing troubles in the housing market, I am posting below my comments from the December issue of the Forbes Growth Investor. This commentary was released to our subscribers several days ago:

It is not a pleasant topic, but the time has come to talk about recession. Although the probability of recession has obviously risen by a significant amount in recent months, most economists, including those at the Federal Reserve, are still betting the U.S. will be able to avoid one. Yet almost all economists, even those at the Fed, have lowered their projections for growth.

Minutes from the Fed’s Oct. 30-31 meeting reveal the new thinking. Most notably, the Fed is now projecting that economic growth will range from 1.6% to 2.6% for 2008, down from the 2.5% to 3% projection made just four months earlier. It is important to realize that the Fed is predicting anemic growth, but not recession. This, however, does not provide much comfort.

Not long ago, the so-called real estate experts claimed that housing prices never fall on a national basis. Those who said things were different this time were ridiculed. That argument is now settled. Not only have prices fallen; they are still plunging. The quarterly S&P/Case-Shiller U.S. National Home Price Index fell 1.7% sequentially in the third quarter, the biggest drop in its 21-year history. This index is down 4.5% year-over-year, and the rate of decrease has accelerated. This means that more than $11,000 of value has been erased from a home that was worth $250,000 a year ago. Of course, in some parts of the country, the story is much worse. In Tampa, you can now fetch just $222,250 for a house that was worth $250,000 a year ago.

Given losses of this magnitude, it is no surprise that foreclosures are up. Particularly hard hit have been homes financed with subprime adjustable-rate mortgages. The Fed estimates that monthly payments on more than two million such mortgages will be reset by the end of 2008. We will see many more foreclosures between now and then.

The real estate market is in a downward spiral. Falling property values contribute to foreclosures, and rising foreclosures contribute to falling property values. When a house is foreclosed, all the houses in that neighborhood lose value. In fact, Global Insight, an economic consultancy, recently estimated that property values will fall by $1.2 trillion in 2008. Foreclosures are being blamed for about half that amount.

In recent years, local governments have reaped a windfall in revenues by taxing all those inflated properties. That game will come to an end as homeowners demand that assessments be brought down to more realistic levels. Financial institutions are just starting to write down the values of their securitized subprime mortgage portfolios. Citigroup provides just one example of how devastating this can be for stockholders. The stock started the year at $55 per share. It is currently the biggest loser in the Dow Jones Industrial Average year-to-date.

Given the extent of the housing debacle, and a stock market that could potentially go much lower, why wouldn’t the economy go into recession? The Fed’s lowered growth projections are still too rosy. Perhaps the Fed is betting that the shrinking dollar will cause a huge boost in exports. We are certainly seeing some of that already. While it is true that a weak dollar can help prop up the economy in the short run, over the long run the U.S. is better off having a currency that everyone wants to hold. It's time for Treasury officials to do more than just give lip service to a strong dollar policy.