PERFORMANCE ANNOUNCEMENT

As Of: March 6, 2002

The Mark - The Con - The Sting

Setup For A Double Dip Recession

   

The Mark

    It is believed that the consumer accounts for approximately two thirds of the economic growth in the United States. When it became clear last year that business capital investment was shrinking and the economy was slowing, a concerted effort was made to target the consumer. Interest rates were lowered, tax relief was offered, and people were told it was their patriotic duty to go out to the mall and spend. In spite of a collapsing stock market, which created a negative wealth effect, the consumer continued to spend due to one special situation: real estate prices have held up. The aggressive marketing of low interest rate mortgages has encouraged people to refinance their homes and pull additional cash out at record levels. If the "mark" has any resistance to taking on additional debt, receiving a tax deduction for additional mortgage borrowing is a nice sweetener.

The Con

    Real estate has always been a cyclical business, but people have been led to believe that this time is different. (Sound familiar? Reminds me of the stock market in the late 1990's.) Three factors have helped support real estate prices:
        1) Demographics. The baby boomers have moved into their prime earning years. Population growth combined with earning power has created strong demand for housing.
        2) Consolidation of the building industry combined with anti-growth environmental policies. Residential building used to be a fragmented business of small local contractors. The small builders have been swallowed up or driven out by the large national companies such as Pulte, Lennar, and Beazer. These large companies have the financial strength and expertise to better manage their inventory of building lots. Consolidation means that during economic downturns, there should be less distress selling of inventory by home builders. In the face of anti-growth environmental policies, the supply of buildable land is shrinking. Better inventory management combined with a shrinking supply helps support prices.
        3) A tremendously more efficient mortgage market. Support from the government plus the securitization of home mortgages has created an environment of easy financing for homeowners. One could argue that because the mortgage originator does not remain liable for the risk of the loan long term, the lending criteria are not suitably rigorous.

    While these factors explain the rise in housing prices, they provide no guarantee for the future. Real estate is the single most significantly leveraged asset in the United States. High leverage means high risk. The average homeowner has been conned into believing that he has enduring value in his home. (Hasn't anyone heard of depreciation?)

The Sting

    A ten percent price drop on a house with a 95% loan to value ratio means a complete wipeout of the owner's equity plus a 5% deficiency. Even if the homeowner gives the keys to the lender and walks away without a deficiency judgement, the IRS will tax the homeowner on phantom income. Real estate prices can go down and real estate prices will go down. Because the consumer has been duped into taking on a record level of debt, the stage has been set for a catastrophe. The high leverage in real estate means a relatively small drop in price can create a downward spiral of defaults followed by lower prices followed by more defaults.
    If, as recent statistics indicate, we are climbing out of the recession, it will be classified as a very shallow and short recession. It is hard to believe that we are ending a recession with the consumer having taken on more debt instead of liquidating debt, and with housing prices and homebuilding stocks at record levels. It is more likely that we have only had the first dip, and there is another sinking spell yet to come.
    Although it would be nicer to revel in the recent uptick rather than purvey bad news, forewarned is forearmed. This isn't the first time that I have warned that it will take much more than a small dip to work off the excesses of the last decade.