Shiller Sends Shivers into Real Estate

Last week I was interviewed, together with the housing expert Robert Shiller, a Yale professor, on CNBC's Larry Kudlow show.
Shiller showed how home prices in 10 major metropolitan areas were down by 6.7 percent, year-on-year, in October (more than experts' estimates and down by 1.4 percent compared to September).

The shrill cries of Wall Street "cheerleaders" floundered to a whimper as they tried vainly to degrade Shiller's findings and find evidence against a real estate collapse that is becoming increasingly obvious.

Contrary to the claims of the "cheerleaders," the broader index of 20 metropolitan areas was just as bad, with a fall of 6.1 percent.

Professor Shiller also commented ominously that, "to see as bad a fall as this, you would have to go back to 1940!"

The Wall Street Journal ran this headline, "Pace of Decline in Home Prices Sets a Record." The article cited Michele Meyer, chief economist of Lehman Brothers, saying that "the housing shock is only about halfway over, and housing prices will continue to fall well into 2009." In general, I agree with her.

In more detail, I believe that the fall in real estate has only just started and will soon run fast and long — well into 2010, and even beyond!

Why am I so bearish? Simply because we are now coming off a period of greed, fraud and speculation of a degree seldom seen in recorded history.

Furthermore, the subprime problem is big — very big. It is widely estimated that U.S. subprime mortgages amount to $1.3 trillion, involving more than 7.5 million mortgages.

In addition, one should realize that, as The Economist reported earlier this year, the value of residential property in just the developed world rose by some $25 trillion (yes, trillion!) in just five years, from 2001 to 2006, more than the total combined GDP of the developed nations.

And where did that vast amount of money come from? Good question!

Most of it came from massive injections of low cost liquidity by central banks, particularly by our own Federal Reserve, and leverage piled upon leverage upon leverage.

So, you can see that there is a lot of liquidity, a lot of "funny money" to be wrung out before we reach the reality of fair value.

But it was not just the amount of money available; it was how it was spent — often imprudently and sometimes as a result of what, in my book, amounts to fraud.

This latter point means that there is likely to be a vast amount of contingent litigation involved in the unwinding of what has become an international financial mess, often with unclear and disputed ultimate title to the underlying real assets.

Let me explain what I mean.

Firstly, we know that "teaser" loans and adjustable rate mortgages (ARM) encouraged a large number of people to undertake mortgage obligations they could ill afford.

Furthermore, there is growing evidence that brokers and initial, so-called "lenders" required little if any real proof that the loans could be serviced. These unviable loans became known as "subprime." Perhaps they should more correctly have been termed fraudulent, or simply "toxic waste."

These loans were then sliced, diced and re-packaged into highly complex derivatives by Wall Street investment bankers. The "toxic waste" was effectively hidden within secure-sounding bundles, known as collateralized debt obligations (CDO).

These same investment bankers then obtained "triple-A" ratings from their (tame) rating agencies and sold their packaged derivatives on to unsuspecting investors all over the world including: banks, insurance companies, pension funds — even to towns within the Arctic Circle, in northern Norway, earning huge commissions. Wall Street bonuses were in the billions of dollars in those heady days.

Incidentally, a recent cover headline of Barron's gives the rating agencies — which use letter grades to assign risk — a "failing grade" for missing the fraud.

Far more importantly, Wall Street enabled the so-called mortgage lenders to pass horrendous subprime risks, which mortgage brokers had accepted, on to unsuspecting investors. This distancing of primary lender and borrower has made remedial action, such as that currently proposed by the government, extremely difficult to achieve.

Due to past abuses, in the 1920s, finance became an extremely regulated industry.

One can readily understand how an inherent conflict of interest led the rating agencies to award "triple-A" ratings to packages containing "toxic waste."

But it is somewhat harder to see why the powerful financial regulating bodies turned a blind eye to what has become a financial con game, one that now threatens our entire economy and those of other nations, risking great suffering for millions of people.

Could it be that politicians leaned on the government regulators, asking them to "go easy" so that increased home ownership both created more contented voters and provided a new source of apparent wealth for consumers, who finance 72 percent of our national GDP?

Whatever the reasons, both the rating agencies and regulators were clearly asleep at the switch — big time!

One might then wonder why such sophisticated financial investors, the banks, insurance companies and pension funds, could also be "conned" into investing in CDOs and other derivatives.

Well, there were three primary reasons.

Firstly, derivatives are complex. Few senior people in financial institutions truly understood the risk involved in a CDO package. Furthermore, it is increasingly apparent that investment banks were slow to explain the true risks hidden within the complexity of their innovative products.

Secondly, amazing accounting rules allow so-called "off-balance sheet" (talk about full and open disclosure!) investments to be excluded from the published accounts of the institution.

Finally, following years of economic pump-priming by the likes of our former Fed Chairman Alan "It wasn't me" Greenspan, the world was awash in low-cost cash.

[Editor's Note: Bernanke Punishing the Dollar. More Profits Ahead.]



Faced by historically high economic growth opportunity costs, financial institutions were increasingly anxious to find a profitable home for their huge piles of that cash.

Tempted by greed for a high yield, the ability to "camouflage" investments off balance sheets, and dulled by ignorance, investors were "persuaded" to invest not just hundreds of millions but hundreds of billions of dollars in CDOs.

All looked fine, for a time.

Then, low and behold, reality dawned. Teaser rates expired and ARMs began to reset at far higher rates. The inability to finance the "true" mortgage costs became clear. The specter of a massive subprime meltdown loomed.

Soon the presence of toxic waste hit the masters of leverage: Hedge funds (some of which, according to The Economist, has been able to leverage their capital 52 times) sought to sell some of their CDOs. But word of the inherent risks of CDOs reach the financial world and the secondary market did not just plummet. It evaporated.

The implications for other investors has been serious. The "fair judgment" valuation of hundreds of billions of dollars' worth of these non-market securities has proved difficult, to say the very least!

I understand that the major banks and investment banks still have many billions of latent write-downs in the pipe.

All this makes Professor Shiller's findings more threatening, not just to the real property markets but to our entire economy and, through it, to the world economy.

Added to this apparent problem should be added the vast contingent issue of fraud.

It is greatly concerning to realize that, as Christopher Story of International Currency Review points out, the underlying contracts could be null and void.

If the initial subprime mortgage transactions are deemed by our courts to have arisen either from fraudulent sales inducements or to have involved fraudulent banking transactions at or prior to closing, the vast bulk of sub-prime mortgages could be rendered not merely discounted but utterly worthless!

When the true nature of the entire subprime problem dawns fully upon the already nervous American consumer (who, remember, accounts for 72 percent of our GDP), I believe the odds of a recession tend towards 100 percent.

http://moneynews.newsmax.com/money/arch ... 142344.cfm