Popping the Bubble

Stop what you’re doing for a moment. Put aside other e-mails
or tasks and don’t answer phone calls. Then sit back and imagine
this scenario …

The
entire nation is swept up in a real estate frenzy.

Buyers
go berserk over choice properties. Speculators buy with money
they can’t afford and loans they could never repay. Bankers
rush in to dish out still more credit with no restraint and no
remorse. Everyone knows it’s a “bubble.”

But
no one seems worried about its consequences.

Then,
one day, banking regulators finally decide it’s time to
do something to restrain the madness. They don’t want to
end the party because they know the hangover could be traumatic.
They dare not even admit it’s a bubble, lest they create
the very panic they’re seeking to avoid. Their sole desire
is to gingerly contain it, to prevent it from growing out of control.

So
they raise interest rates a few notches. They issue some lending
guidelines. They warn banks about risky real estate lending. And
they hint — not so subtly — that violations will invite
more scrutiny.

But
they’re too late. The horse is out of the barn. The bubble
is both too big and too vulnerable. Even the most subtle change
in official policy is enough to pop it, and that’s precisely
what happens.

Banks
pull back a notch, triggering defaults by speculators who were
counting on borrowing from Peter to pay Paul. Investors recoil
in horror. Some real estate prices suffer a correction.

Soon,
nearly all real estate, whether part of the bubble or not, tumbles
out of control, dealing a series of lethal blows to the construction
industry, the banking industry, and even the insurance industry.

The
stock market takes a swan dive, losing nearly half its value within
a year. The entire economy sinks into a recession.

Five
years later, gigantic bankruptcies gut the economy. Ten years
later, chronic deflation and depression tear away at the fabric
of society.

Finding
this scenario hard to believe? If it were just a description of
the future, I could understand. Or if it were merely a figment of
my imagination, you’d also have good reason to disbelieve
me.

But
alas, it’s real. In fact, it describes precisely what happened
starting twenty years ago — in Japan.

I know
because I was there. Around the time the bubble was beginning, I
worked as a research analyst at the Tokyo office of one of Japan’s
large brokerage firms. I edited a biweekly newsletter for Japanese
institutional investors. I toured the country giving speeches about
the economy. And I saw how the bubble was forming.

From
that point forward, events unfolded according to script —
rampant real estate speculation in the 1980s … modest intervention
by regulators in late 1989 … the bubble popping in 1990 … a
ten-year depression until the early 2000s, and … continuing after-shocks
to this very day.

Back
to the Present

Japan’s
real estate bubble revolved mostly around commercial real estate,
financed by commercial banks and purchased by thousands of large
corporations. Individuals also joined the fray, but they were not
the primary drivers.

America’s
bubble is different. It centers mostly around residential real estate,
financed primarily by mortgage lenders and bought by millions of
households. Corporations have also played a role, but not at the
core of the boom.

Also,
many American’s still have substantial equity in their homes,
a cushion that may help soften the decline, at least initially.

However,
anyone who ignores the equally striking similarities does so at
great risk. Just pick up any newspaper and read the front-page headlines.
Or better yet, just go to Google and search for “housing bubble.”

One
of the first items that popped up in my search last week was this
shocking article from the San Francisco Chronicle …

Two
out of three Bay Area home buyers are choosing interest-only loans,
and some experts warn that the popularity of the controversial
form of mortgage debt is a sign that the overheated housing market
is boiling over.

These
loans, which allow borrowers to avoid paying any principal for
three years or more, have grown explosively in recent years to
become the favored mortgage for buyers in the region, replacing
the standby 30-year mortgage preferred a generation ago.

They
accounted for nearly 70 percent of home purchases in the first
two months of the year in San Francisco, Marin and San Mateo counties,
up from 18 percent in 2002 and 59 percent in 2004 …

In
San Jose, 61 percent of purchase loans in the first two months
of 2005 were interest-only, up from 9 percent three years ago.
And 78 percent of home buyers in the Vallejo metropolitan area
chose interest-only loans, up from 6 percent …

But
housing experts warn that these loans are loaded with risk. Borrowers
who put down small or no down payments and who do not elect to
pay principal rely almost exclusively on price appreciation to
build equity. If home prices flatten or fall, borrowers could
end up owing more than the home is worth.

The
Wall Street Journal, meanwhile, confirms that this is a nationwide
phenomenon …

…
adjustable-rate and interest-only mortgages accounted for nearly
two-thirds of mortgage originations in the second half of last
year. Both types of loans have helped fuel the strong housing
market since they carry lower initial monthly payments than do
fixed-rate loans, enabling borrowers to purchase more expensive
homes.

With
such loans accounting for an increasing portion of consumer borrowing,
some mortgage analysts worry that the growth of these loans could
cause problems for the housing market and broader economy. “The
situation with interest-only ARMs is just one of several very
scary things going on in the mortgage industry,” says Stu
Feldstein, president of SMR Research Corp.

The
rise of interest-only loans, combined with other factors such
as higher debt levels and changing bankruptcy laws, are likely
to cause foreclosures to rise, he says, “possibly dramatically.”

Letters
of Credit

Plus,
last week, the Wall Street Journal also highlighted an
even more dangerous form of real estate debt …

More
investors prowling some of the hottest real estate in the country
have discovered an old-fashioned financing tool — the letter
of credit — and are using it in a way that may be adding
fuel to an already overheated housing market …

A
person who obtains a letter of credit is promising to make a future
payment, or else the bank that wrote the letter of credit is on
the hook. Some letters of credit are secured by the person’s assets;
some aren’t …

Using
a letter of credit to buy a home has been rare — until now
— in beach communities in Florida, Alabama, and Texas, where
baby boomers are buying second homes …

Some
say letters of credit make it too easy for speculators. Economists
estimate about 20% of residential property sales involve investors,
not families or individuals who plan to live in the home. Such
purchasing could be artificially lifting prices and demand and
could destabilize a market should speculators start dumping homes
…

No-Doc
Loans

If
you think that’s worrisome, consider the spreading phenomenon
called “no-doc loans.”

Instead
of reviewing documentation and proof of income, bankers are dishing
out loans based almost entirely on a borrower’s say-so.

Indeed,
last year, one home buyer applied for a $900,000 interest-only loan
to buy a $1 million home. He was never required to submit any written
proof of income. He just told the lender he had a big salary, and
they took his word for it.

Problem:
He was unemployed.

And
this is not an isolated event. All over the country, borrowers can
simply walk into a lending office, overstate or fabricate their
incomes, sign on the bottom line, and walk out with fat loans.

Like
in Japan of the 1980s, most lenders have dropped all restraint and
the bubble is out of control.

And
like Japan of 1990 …

Banking
regulators are finally seeking to restrain the madness. But they
can’t do it without popping the bubble.

It
has started. Banking regulators have stepped in to issue warnings.
And these warnings are not coming from just one regulatory agency
— but FIVE:

The
Office of the Comptroller of the Currency (OCC)
The Federal Reserve Board (FRB)
The Federal Deposit Insurance Corporation (FDIC)
The Office of Thrift Supervision (OTS)
The National Credit Union Administration (NCUA)

All
five have joined to warn the world about the insane, acutely dangerous
lending practices in the housing bubble.

But
their warnings are too little, too late.

They’re
warning banks, savings banks, and credit unions that too many institutions
are loading up in high-risk loans. Huh? That’s already a fact
of life. What major institution in the country does NOT have high-risk
loans?

They’re
warning them to beware of loans originated by mortgage brokers who
are not bank employees and who are paid commissions based on quantity
— not quality. Where have they been? Mortgage brokers have
been doing business like this for years, and they already
dominate the mortgage market.

They’re
warning them to cut back on interest-only loans and no-doc loans.
But as I’ve just shown you, these are already ubiquitous —
everywhere, from coast to coast.

Real
Estate Armageddon

As
in Japan 15 years ago, the bubble is both too big and too fragile
to restrain. The horse is out of the barn.

As
in Japan, the U.S. banking regulators are raising interest rates
a few notches … issuing new guidelines … and risking a major
puncture hole in the housing bubble.

Plus,
as in Japan, they’re hinting — not so subtly —
that any lenders who refuse to show restraint could be slapped with
heightened oversight, which, for many bankers, is tantamount to
not-so-mild punishment.

This
is a major turning point not only in the housing market but the
entire economy. Homes are, by far, the biggest single asset of Americans.
If the market for homes — or even just the market for home
loans — weakens, it impacts:

Banks
and mortgage lenders
Real estate brokers
Construction companies
Manufacturers and distributors of appliances, carpets, paint,
and other materials
Real estate investment trusts (REITs)

Plus,
it throws a monkey wrench into consumer spending for virtually everything
under the sun.

Watch
out! This could be big. To protect yourself, follow the recommendations
in my Safe Money Report.

Limit
your investment in real estate to properties that you can afford
and you need for your primary residence or business.

Get
most of your money to safety. And if you must keep a substantial
portion of your net worth committed to real estate, use the hedging
strategies I recommend that can help protect your capital.

Good
luck and God bless!

Martin
D. Weiss, Ph.D.
Editor, Safe Money Report
President, Weiss Research, Inc.
eletter@weissinc.com

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