Negative Equity and the Next Crisis

Addison Wiggin – June 10, 2011

  • Jim Rogers agrees: The next crisis will be worse. We identify another potential catalyst
  • What’s next for the dollar? Abe Cofnas plugs Bernanke’s latest speech into a word cloud for clues
  • Alan Knuckman goes down on the farm for a firsthand look at why corn prices are setting records
  • America’s “fourth war” in Yemen… and the story The New York Times is overlooking
  • Bernie Madoff’s boxers… our Forbes readers getting restless… your chance to join our elite “1% club”… and more

   “It’s gonna be worse the next time around,” says commodities guru Jim Rogers of the next financial crisis — the one we’ve been trying to pinpoint here and here, among other places.

“The debts that are in this country are skyrocketing,” Rogers told CNBC yesterday. “In the last three years, the government has spent staggering amounts of money and the Federal Reserve is taking on staggering amounts of debt.

“When the problems arise next time…what are they going to do? They can’t quadruple the debt again. They cannot print that much more money.”

To our growing list of possible catalysts for a new crisis — a heavily leveraged Fed balance sheet, a revival of collateralized debt obligations, a Greek default — we add another:

   The number of homeowners willing to contemplate “strategic default” has nearly doubled in the last year.

Last year, a survey conducted for Fannie Mae found 15% of homeowners willing to walk away from an underwater mortgage even if they could keep up with the payments. This year, the number is 27%.

“People are more educated about the process,“ says Jon Maddux, CEO of a website that advises people on strategic default called Business is up 10% this year, he says. “They’re making more calculated, less emotional, decisions and are less fearful and less concerned about the stigma.”

So much for contract law, eh? Good job, Jon.

   A Federal Reserve report out yesterday says the typical homeowner has only 38% equity in their principal residence — close to a postwar low, and far below the decade-ago figure of 61%.

This puts a new spin on the vaunted “homeownership rate.” According to the Census Bureau, 66.4% of Americans “owned” their homes in the first quarter of this year — itself a 12-year low.

But look deeper…

Thus, the real “homeownership rate” — excluding people with negative equity — is 57.2%.

By contrast, two government-sponsored firms, Fannie Mae and Freddie Mac, “own” 90% of new mortgages issued in the U.S.

   “At Fannie Mae,” reads the 1999 version of Fannie Mae’s mission statement, “we are in the American Dream business. Our mission is to tear down barriers, lower costs and increase the opportunities for homeownership and affordable rental housing for all Americans. Because having a safe place to call home strengthens families, communities and our nation as a whole.”

“Thanks to Congress’ wisdom,” then CEO Franklin Raines extrapolated the firm’s vision in testimony before Congress in May of 2001, ”in understanding the power of private enterprise to meet this critical public purpose — and in crafting a compact with private investors — no single company in America is focusing more capital and commitment to closing the homeownership gap than Fannie Mae.

“We are in the American Dream business,” Raines went on to repeat, “and our mission is to ’tear down barriers, lower costs and increase the opportunities for homeownership and affordable rental housing for all Americans.’”

It’s a cruel world, isn’t it? The people Raines purportedly set out to help are the very same who’ve been hurt worst by the crisis. And those who continue to be subject to rising ’barriers’ and ’costs’ and decreasing ’opportunities.’

   “Negative equity is the most important leading indicator of default rates,” says Strategic Short Report’s Dan Amoss, “and the number of underwater homeowners’ positions will keep rising in the coming months.

“I’m convinced,” Dan continues, “that one of the big risks being completely ignored by the stock market right now is a reversal of the improving earnings trends reported by the big banks.

“If there is an obvious pickup in mortgage default rates and consistent weakness in housing prices, bank regulators will pressure bank executives to reflect the losses in their reported earnings. Rebuilding their reserves could depress bank earnings to the degree that they were depressed in 2009.

This implies solvency issues for Bank of America, Wells Fargo, J.P. Morgan Chase and Citigroup, and big losses for the U.S. government and private investors.

You want to be ready should that moment arrive. Here’s how to get started.

   Stocks are selling off hard early on a Friday, and for no obvious reason. The Dow is only 23 points from breaking below 12,000.

But volatility as measured by the VIX isn’t making a dramatic move up. At 18 on the nose, the VIX is merely at the high end of its range over the past three months.

   “As usual,” says our currency specialist Abe Cofnas, turning our attention to another ever-present threat, “Fed Chairman Ben Bernanke’s speech to the International Monetary Conference on Tuesday shook up the markets.

“On the surface, Bernanke’s message was pretty clear — the latest round of quantitative easing (QE2) will end as scheduled, but interest rates will remain low.

“But once again, we can use a word cloud to dig deeper into his remarks. Below is a graphic representation of the words he used in his speech. The result is very revealing:

“You can immediately see that the two big words are ’inflation’ and ’growth.’ Evidently, that reflects the core challenge before the Fed, which is to stimulate growth without causing inflation.

“With the Fed’s historic record of being unable to do either well, we are in for a wave of disappointment on both grounds. In the medium-to-long term, that is bearish for the dollar.”

Short term may be another story, and even Jim Rogers is looking for a rally soon. As usual, Abe is keeping an eye out for new trading possibilities come Monday morning.

   Also for no apparent reason, the world seems to have noticed the United States is waging a fourth war in the Islamic world.

“The Obama administration has intensified the American covert war in Yemen,” The New York Times reported on Wednesday, “exploiting a growing power vacuum in the country to strike at militant suspects with armed drones and fighter jets.”

As we noted last year in Apogee Advisory, Yemen’s demographics amount to gasoline waiting for a lighted match. When empty bellies launched protests in Tunisia and Egypt, Yemen quickly followed.

One week ago today, an explosion in a mosque wounded the 32-year dictator and U.S. ally Ali Abdullah Saleh. Depending on whom you want to believe, it was rocket fire or a planted bomb. Regardless, he was flown to Saudi Arabia for treatment, and he may not return for months.

Hence, the aforementioned power vacuum.

“Half the capital is controlled by a former henchman of Saleh who hates him,” says veteran foreign correspondent Eric Margolis, “and the other half is controlled by security forces run by Saleh’s eldest son.”

On that picture, we can superimpose the U.S. battle against al-Qaida sympathizers and a host of tribal conflicts and secessionist movements. Throw in the fact that Yemen is 52% Sunni and 46% Shia and you’ve got flashpoint No. 2 in Byron King’s New War scenario for $220-a-barrel oil.

If you haven’t acquainted yourself with this scenario, we urge you to do so now before the headlines overtake our forecast.

   Commodities are selling off even harder than stocks today. Gold’s been knocked down to $1,529. Silver is back below $37. A barrel of West Texas Intermediate could fetch less than $100 before the day is out.

   The grains are likewise pulling back… but only after corn hit a record yesterday. At $7.81 a bushel, the price of corn is actually higher than wheat — an extremely rare event in the last 10 years.

The immediate catalyst was the Agriculture Department trimming its forecast for this year’s crop by 2.3%. Resource Trader Alert’s Alan Knuckman isn’t surprised — not after venturing out from his home base in Chicago to a waterlogged Ottawa, Ill.

“To the untrained eye — I profess to be a trader, not a farmer — the land looked abandoned, instead of green with growth,” he remarks. “Once you actually stepped onto the ground, weakened by excessive moisture, seedlings could been seen growing in the mud cracks.

“If you’re new to the corn-planting world,” advises Alan, “simply look to one simple time-tested barometer: ’knee-high by July.’ Right now we’re toe-high,’ so we’ve got some room to make up in a few short weeks.”

Meanwhile, farmers who haven’t planted yet have a decision to make: Either “take a chance with late corn or the payoff of the crop insurance subsidy. My nonscientific land survey saw swaths of prime farmland that were unusable until an extended dry stretch makes it possible for tractors to get in.”

The decisions of those farmers in Illinois — and Indiana and Ohio — will do much to determine where corn prices go from here.

[Ed. Note: “Thank you for this new service,” writes an Agora Financial Reserve member commenting on the Executive Briefing we send to members on Fridays. “Now I don’t have to go surfing through my emails and folders to read or reread the latest.

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“At present, my investing has been limited to his work/research, but in the future, research from Byron and Chris will be used, and probably the others (Knuckman, Amoss, Coffman, Guenthner, Nelson, Elmerraji) at a later time. They all have incredible talent and dedication to their specific fields of interest.

“And this new service will help me and others to become more organized when we’re deciding which companies to invest in or trade. It will help me in particular to become grounded with the services and research from Agora Financial Reserve.”

The most remarkable thing is that entry to the Reserve comes with a one-time fee that gives you access to all our research for as long as you live — and beyond. You can designate a beneficiary to continue to receive the research.

Given the limited liquidity of some of the plays, we always cap our membership drives to 1% of our current readership. But if you’re ready to step up to our highest level of VIP service, the door is now open. Please review your invitation, here.]

   The U.S. Marshals Service rose to its level of maximum competency yesterday as it auctioned off the few possessions of Bernie Madoff’s they’ve yet to ditch:

The auctioneers paid to smile in this circumstance… we think.

Last fall, Ruth Madoff’s 10.5-carat diamond ring, a Steinway piano and even Bernie’s black velveteen slippers drew heavy interest.

Eight months later, however, it’s come to this: Fourteen pairs of the convicted swindler’s boxer shorts were among the items auctioned off this week in Miami Beach. Together they fetched $200, which works out to a little over $14 each.

Pricey if you consider Madoff could have been wearing those when he learned the Feds were on his tail.

Proceeds will be used to help compensate Madoff’s victims. (After the U.S. Department of Justice Assets Forfeiture Fund takes its vig, no doubt.)

   “I don’t know why all Americans aren’t livid,” writes another reader of our Forbes post earlier this week. “In a perfect world, all of the miscreants at the Fed would be hanging in a tree right along with the majority of Congress, who are the single-largest collection of morons ever assembled in one place in the entire history of mankind. Too bad this isn’t a perfect world.”

The 5: Apparently, the natives are getting restless.

   “The coming economic collapse will be global and severe,” writes yet another reader at our Forbes blog. “Representatives from the world’s largest economies (G-8 or G-20 or similar) will gather to analyze the crisis. They will conclude that global financial regulation was nonexistent or insufficient to control the bubbles in sovereign debt, electronic trading, derivatives, etc. Sovereign nations will concede financial regulation to a global governing body (IMF?) and the world will have a global financial regulatory authority in a very short time: a world Fed.

“Fear of a global economic collapse is insufficient motivation for sovereign nations to concede their financial regulatory authority to a world Fed. Creation of a global financial regulatory authority will be possible only after a global economic collapse. Your Social Security or tax ID number will be your account number. Every transaction will include this number. Ours is the first generation to see computer technology sufficient to track 7 billion global account numbers.

“All this could start in motion any day now. Not to worry, there will be sufficient food, water and clothing. Anything more than that is a luxury anyway. Just ask the poorest 1 billion people among us.”

The 5: Over 128,000 readers have logged into that post alone. Crazytown.

   “I read your article about the amount of money used transporting and protecting our presidents,” comments another, “A long time ago when the government remained within the confines of the Constitution, presidents would walk down the street unattended.

“Secret Service was unnecessary, and everyday citizens could knock on the front door of the White House. It’s true. James Polk was known as the ’most accessible’ president. Ordinary citizens could make an appointment with his secretary, and he would honor it.

“I doubt the Polk presidency contributed much to the national debt. I guess when the Constitution is followed, there’s not much incentive for people to hassle a president when he travels.”

The 5: Sorry, Polk launched the Mexican-American War — quadrupling the national debt from $15 million to $63 million during his single term.

Still, you remind us of the story that the British ambassador to the U.S. knocked on the door of the White House one day in the early 1800s. President Jefferson answered it himself — in his house slippers.

The ambassador was certain the sage of Monticello was a servant.

   “Do you have the ’5 Min.’ term copyrighted?” our last reader today inquires randomly. “The Equitymaster site has a ‘5 Min. WrapUp’ daily commentary. It looks so much like your stuff I thought I would mention it.

“Maybe you can sue them.”

The 5: Heh… that’d be counterproductive. Rahul and Ajit are our partners in India. The copyright at the bottom says: © Equitymaster Agora Research Private Limited. They provide research for Indian investors who buy Indian stocks. As of yet, we can’t get access to them. But we’ll be ready when the time comes…

Have a good weekend,

Addison Wiggin
The 5 Min. Forecast


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