The Blame Game

MarketWatch is reporting Lenders gone wild.
Here are some of highlights (in italics) followed by my comments in normal print.

Highlights

Countrywide wrote in its official comment on the proposed [lending] guidelines. Requiring lenders to qualify borrowers on the true cost of a loan, the company said, "would tend to defeat the intended function of the loan and would significantly reduce the number of borrowers that could qualify."

Countrywide missed the boat by a mile with that feeble comment. The original stated intent of products such as pay option arms and interest only loans was to balance payments for people with widely fluctuating incomes month to month not to get the most people to "qualify". Once marketing took over, however, the products eventually took on a life of their own.

In a bubble, "the financing gets progressively worse. At the end, you get nuttiness." Prices got so high that "the only way people could buy houses was by bending the rules". In the Orwellian parlance of the mortgage industry, loans that ignore the true ability of the borrower to pay for the loan are called "affordability" products.

That is one the best summations explaining the growth of toxic loans you will find anywhere. Attempts to make homes "affordable" encouraged speculation, flipping, lies, and fraud. Because of toxic loans, Fannie Mae, and 300 other programs designed to make housing affordable, home prices skyrocketed.

The amount of money to be made by appraisers, originators, real estate agents, and for a time flippers, was so staggering that nothing could stand in the way of bubble expansion. If it took liar loans and fraud to make a deal then liar loans and fraud you got. What finally burst the bubble was not an event per se but exhaustion. The pool of greater fools eventually dried up. I talked about that in The Exhaustion Process.

About one-third of the mortgages sold in the last year were devised to minimize the initial monthly payment to make it seem as if buyers could afford a more expensive home.

"Seem" is clearly the operative word.

"The guidelines will likely have a chilling effect on option ARM lending at regulated institutions," said Frederick Cannon, a banking analyst for Keefe, Bruyette & Woods. However, unregulated lenders such as investment banks and real estate investment trusts, could have a competitive advantage because they aren't covered by the new federal guidelines, he said.

I agree with the first sentence above but not the second. If the big lenders are shut out of the gravy train, they will soon find a way to stop anyone else from benefiting. That is unlikely to be necessary, however, since there is such a huge increase in defaults and foreclosures that the market was about to put an end to this nonsense anyway. In effect Congress shut the barn door after 49 of 50 cows already escaped.

The regulators face conflicting goals. They want to ensure the safety of the banking system without intervening too much in decisions about what products and services to offer. Protecting consumers from unfair and deceptive lenders is another goal that may be at odds with yet another goal: Increasing homeownership in the United States.

The dual goals of the regulators are a big part of the problem. Government has no business promoting home ownership over renting. Market forces should drive decisions. Instead we have an "Ownership Society", tax breaks, and GSEs while we also have a goal of "affordable housing". It is important to understand that the ownership society, GSEs, and tax breaks all act to drive up the price of houses. The goals are actually contradictory.

Regulators should have one goal: regulation of the industy to prevent fraud, unsound practices, and to ensure the safety of the banking system.

The Role of Government

I discused the role of government in the housing bubble on May 18, 2005 right near the peak of insanity in Should the government sell bread, orange juice, or mortgages?

What would you think if the government decided that that the price of bread was way too high and decided to open up a chain of bakeries to sell bread at the "correct" price? Here is another one: what if the government decided that Florida orange juice was priced too high and started selling orange juice by the barrel at the "correct" price? If either of those happened would you be standing on top of a mountain and screaming with all your might about the insanity of it all? I think you would and so would I. Well how come there is no screaming about this?

The Washington post reports that Housing and Urban Development Secretary Alphonso Jackson has a message to sub-prime lenders: "We need to reach out" to African-American, Hispanic and other first-time buyers with better loan concepts, more flexible guidelines and quicker service, said Jackson in an interview. "I am absolutely emphatic about winning back our share of the market" that has slipped away to subprime lenders."

Excuse me! Since when is it the business of the federal government to "win back" market share on housing loans? How is this any different that the federal government opening up bakeries to compete against the outlandish price of bread by private bakeries?

Yes Mish readers right at the tip top of the bubble the HUD was "absolutely emphatic about winning back our share of the market" that has slipped away to subprime lenders."

As of today we now have guidelines in place to prevent such nonsense. I have no doubt those guidelines will not apply to HUD. If you want a prime example of "Lenders Gone Wild" look no further than HUD.

In Lending Guidelines / Credit Squeeze I posted some comments from a friend of mine in the industry, Ramsey Su. He has some additional thoughts out this afternoon. Here goes.

Thoughts from Ramsey Su

Notes to myself, Sept 30, 2006.

The meat of the guidelines can be found in 2 paragraphs (pages 11 and 12).

For all nontraditional mortgage loan products, an institution’s analysis of a borrower’s repayment capacity should include an evaluation of their ability to repay the debt by final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule. In addition, for products that permit negative amortization, the repayment analysis should be based upon the initial loan amount plus any balance increase that may accrue from the negative amortization provision.

Furthermore, the analysis of repayment capacity should avoid over-reliance on credit scores as a substitute for income verification in the underwriting process. The higher a loan’s credit risk, either from loan features or borrower characteristics, the more important it is to verify the borrower’s income, assets, and outstanding liabilities.

Switching back from a FICO based to a ability-to-pay underwriting standard is alone a monumental change. Compounding that with using fully indexed rate and fully amortized repayment, this will close the door on the irresponsible practices of the last 3 years.

To slam the door tight:

Risk layering – lenders are free to so whatever they like as long as they use MITIGATING FACTORS such as higher FICO, lower LTV and DTI ratios.

Reduced Documentation – no more stated income loans unless there is a reason for it. “W-2, pay stubs or tax return” borrowers are going to have a tough time justifying why they need to go to low/no doc route. Lenders are going to have an equally tough time pushing these products. Is this the end of the disguised Alt-A loans?

Simultaneous Second-Lien Loans – though these 80-20s may be toxic, the new qualifying standards would pretty much remove most of the toxins. I suspect that borrowers not suitable for this loan product is not going to get pass the other guidelines to get here.

The end of the flippers:

Non-Owner-Occupied Investor Loans – this guideline limits LTV using debt service plus reserve underwriting, similar to any income property loan. I would guess that if you want to buy a house or condo as an investment, you are going to need at least 40% in down payment to qualify.

Subprime. Here is the paragraph pertaining to subprime on page 13:

Lending to Subprime Borrowers – Mortgage programs that target subprime borrowers through tailored marketing, underwriting standards, and risk selection should follow the applicable interagency guidance on subprime lending.9 Among other things, the subprime guidance discusses circumstances under which subprime lending can become predatory or abusive. Institutions designing nontraditional mortgage loans for subprime borrowers should pay particular attention to this guidance. They should also recognize that risk-layering features in loans to subprime borrowers may significantly increase risks for both the institution and the borrower.

In addition to the rest of the guidelines, subprime loans raised the issue of predatory or abusive lending practices.

How many subprime loans are “sold” to, versus “applied for” by the borrowers? In other words, had it not been that cold call, the flyer in the mail, the spam email, would some of these subprime loans ever be made?

Since many of the big subprime lenders such as Accredited, New Century and Novastar are not regulated by the 5 agencies here, it is important to see who regulates them and what they are doing. Here is the best answer I can find. Similar guidelines are likely going to be adopted by the states in the immediate future.

I saw the video of Rotellini’s presentation in front of the Senate. She appeared to be far more aggressive than the other regulators on the panel. This could be one big nightmare for the non-regulated lenders because they now have to deal with 49 different states.

In addition, under the consumer protection section of the guidelines, lenders are going to be watched more closely on Truth in Lending Art (TILA) compliance.

One final section of the guidelines that interested me was the Management Information and Reporting paragraphs. Basically, the reporting systems will bring down all the different types of loans for monitoring purposes. This could be extremely beneficial to see which lender is more at risk than others.

This report, though released in Feb, remains the best measurement for past sins. So how many of these loans originated during the last few years are no longer in compliance with the guidelines?

Going forward, how many lenders are going to underwrite new loans based on these guidelines? Are there buyers out there for loans not in compliance with the guidelines, buyers who will somehow “indemnify” the originators for being not in compliance? Who are going to take out the borrowers facing recast?

In summary, I opine that just the confusion alone is going to put a pause on all these non-traditional mortgages. This will accelerate the already rising default rates. The lenders are going to blame the regulators for too stringent guidelines while regulators are going to blame the lenders for risky underwriting practices. Aside from M&As, I simply do not see any reward in owning mortgage related stocks.

Thanks Ramsey! Everyone appreciates the work you do in helping to sort out these guidelines. If I can follow up, here are a few thoughts of my own to tack on.

Those new guidelines have given Wall Street what it wants and needs: a convenient scapegoat to blame for continued slowdowns in housing as well as a falling stock market once it finally tops out. If the market starts falling now, it will not be because of those guidelines, oil prices, terrorism or anything else that happens. The market, like housing, will likely die from simple exhaustion.

The "blame game" has just started, however. Sports fans might think of it as being in the bottom half of the first inning with the regulators currently at bat. By the time we get to the third or fourth inning lawyers will be having have a veritable field day as the bulk of the fraud from this boom surfaces. It will be a strange game to watch unfold. Every team will get a chance take part. Unlike a normal game of baseball, however, in the "blame game" the batting order and the team at bat can change randomly at any time. But keep your eye on the ball as Bernanke should be coming up to bat soon.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Lending Guidelines / Credit Squeeze

The Federal Reserve came out today with new 27 page PDF of Lending guidelines. Here is the gist of it.

The Agencies developed this guidance to address risks associated with the growing use of mortgage products that allow borrowers to defer payment of principal and, sometimes, interest. These products, referred to variously as “nontraditional,” “alternative,” or “exotic” mortgage loans (hereinafter referred to as nontraditional mortgage loans), include “interest-only” mortgages and “payment option” adjustable-rate mortgages. These products allow borrowers to exchange lower payments during an initial period for higher payments during a later amortization period.

While similar products have been available for many years, the number of institutions offering them has expanded rapidly. At the same time, these products are offered to a wider spectrum of borrowers who may not otherwise qualify for more traditional mortgages. The Agencies are concerned that some borrowers may not fully understand the risks of these products. While many of these risks exist in other adjustable-rate mortgage products, the Agencies’ concern is elevated with nontraditional products because of the lack of principal amortization and potential for negative amortization. In addition, institutions are increasingly combining these loans with other features that may compound risk. These features include simultaneous second-lien mortgages and the use of reduced documentation in evaluating an applicant’s creditworthiness.

The Agencies proposed that for all nontraditional mortgage products, the analysis of borrowers’ repayment capacity should include an evaluation of their ability to repay the debt by final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule. In addition, the proposed guidance stated that for products that permit negative amortization, the repayment analysis should include the initial loan amount plus any balance increase that may accrue from negative amortization. The amount of the balance increase is tied to the initial terms of the loan and estimated assuming the borrower makes only the minimum payment.

The Agencies believe that institutions should maintain qualification standards that include a credible analysis of a borrower’s capacity to repay the full amount of credit that may be extended. That analysis should consider both principal and interest at the fully indexed rate. Using discounted payments in the qualification process limits the ability of borrowers to demonstrate sufficient capacity to repay under the terms of the loan. Therefore, the proposed general guideline of qualifying borrowers at the fully indexed rate, assuming a fully amortizing payment, including potential negative amortization amounts, remains in the final guidance.

Furthermore, the analysis of repayment capacity should avoid over-reliance on credit scores as a substitute for income verification in the underwriting process. The higher a loan’s credit risk, either from loan features or borrower characteristics, the more important it is to verify the borrower’s income, assets, and outstanding liabilities.

Ramsey Su on Silicon Investor offered this analysis

Immediate Reaction:

1. If the guidelines are followed, which I don't know how they can not follow, a ton of loans in the pipeline are going to be rejected. Furthermore, the recasters are going to have hell of a time refinancing, while the existing loans are all going to be non-conforming to these guidelines.
2. The big question is applicability to the non regulated lenders such as NEW, LEND and NFI. Could they actually benefit because all the regulated lenders such as CFC, WM, WFC would all be forced out of the market. I find it hard to believe that the powerful banking lobbyist would allow that to happen so it would be only short term.
3. I think it has teeth because while they are just guidelines, the banks are going to have to explain to the examiners why they choose to ignore the guidelines if they continue to lend using old underwriting standards. They guidelines are pretty clear.

TMCnet is reporting IRS Completes System for Electronic Return of Tax Transcripts; System Increases Security, Efficiency and Usability but Brings Additional Costs.

The Fraud Prevention Coalition, a national alliance of companies formed for the advancement of tools to prevent mortgage fraud, announced the Internal Revenue Service (IRS) has completed the development of a system providing secure electronic return of tax transcripts. The new "Express Service" is expected to take effect Oct. 1, 2006, and includes electronic transcripts of personal and business tax returns that will be made available significantly faster than the current two-day program it is replacing. Additionally, W2s, 1099s and K1s will be added to the program within thirty to sixty days.

Income verification is a tool used by mortgage lenders and others within the financial community to confirm the income of a borrower at the beginning of the loan application process in an efficient and cost effective manner. Verifying income via tax transcripts provided by the IRS can detect potential fraud and reduce the risk of repurchase demands.

Fib Spotting

The Hartford Courant is reporting Lenders Will Be Spotting Income Fibs Much Faster.

October 1, 2006

Starting Monday, it's going to get much riskier to fib about your income when you apply for a home mortgage. That's because the Internal Revenue Service is overhauling a key income verification tool used by lenders - making it faster and easier to pull up electronically the confidential income tax information of borrowers.

"It could be huge" in spotting fraud upfront - before it's too late - said Mike Summers, vice president of Veri-tax.com, a Tustin, Calif.-based firm that services 3,000-plus large and small mortgage lenders nationwide. Fraud in mortgage applications is now a multibillion-dollar-a-year problem, according to the FBI, and falsified income tax filings are an important contributing factor.

Some popular mortgage products themselves open the door to bogus assertions about income. Many lenders in recent years have offered "stated income" and other limited documentation mortgages aimed especially at self-employed applicants. Dubbed "liar loans" by industry critics, stated-income mortgage programs allow applicants to bypass standard underwriting requirements for W-2s or copies of personal and corporate income tax records.

Instead, applicants simply assure the loan officer or broker that, yes indeed, we earn enough to qualify for the mortgage, and the transaction proceeds to closing.

Often lenders will ask borrowers to fill out what is known as an IRS Form 4506-T along with their other mortgage documents.

That form authorizes the lender or the investor providing the money for the mortgage to obtain transcripts from the IRS summarizing income and tax data for as many as four years. The form must be signed by the borrower and can be used only during the 60-day period after the date of signing.

Until now, the process of faxing in 4506-T requests to the IRS and obtaining transcripts has been paper-driven and non-electronic - making income verifications slow and difficult to fit into lenders' highly automated loan underwriting systems. Most lenders have used 4506-T forms as a way to perform quality-control checks on pools of closed mortgages.

The only downside from a lending industry perspective: Rather than providing transcripts at no cost, as in the past, the IRS now plans to charge a flat $4.50 for each tax year covered in a 4506-T request.

Typically lenders want to see two years of returns, so the IRS's policy change means that costs will jump by $9 per loan application.

Credit Squeeze

The Christian Science Monitor is reporting Risky mortgages threaten a squeeze

In 1990, the last time the nation was entering a real estate slowdown, less than 10 percent of home loans were ARMs, adjustable-rate mortgages. For the first half of this year, that number is 46 percent of the total, measured in dollar volume, says Richard Brown, chief economist at the Federal Deposit Insurance Corp.

Of all the adjustable-rate loans, 63 percent of them this year have been nontraditional: either "interest only" loans (it's up to the buyer whether to pay any principal to build home equity) or "option ARMs," which give borrowers a choice of several possible payments each month. Even fixed-rate loans today can be "interest only."

The biggest trouble lies with the adjustable loans that begin with artificially low interest rates. Those rates may only last for a month, a year, or two years, and then comes a "payment shock" as the rates reset in ways that can double the required payments.

Earlier this year, an analysis by First American Real Estate Solutions in Santa Ana, Calif., estimated that $368 billion in adjustable-rate mortgages originated in 2004 and 2005 are at risk of default because of this pattern. Many more borrowers with traditional ARM loans also face the prospect of rising interest rates, but of a more manageable magnitude.

"This translates into ... 1.8 million families that are at risk as a result of the possibility of default and another 500,000 that are likely to go into foreclosure," Allen Fishbein of the Consumer Federation of America said last week at a Senate hearing on nontraditional mortgages.



Who is most at risk? Exotic loans have been rising nationwide, but are most prevalent in states such as California, Nevada, and Florida where home prices have been rising fastest. They are far less common in the Northeast or Midwest.

"It will take more than five years to get housing valuations back to where they ought to be," Merrill Lynch economist Sheryl King writes in a recent report.

"It's a time release," says Christopher Cagan, who did the risk analysis at First American Real Estate Solutions. "It's not a single impact like Pearl Harbor."

On a national basis 46% of loans in 2006 were adjustable and of those 63% were non-traditional. In other words 29% of all loans nationally were either interest only or pay option arms. That is likely to be a huge problem as interest rates reset. The chart above shows the number of neg-am loans. It is close to a staggering 27% of all loans this year in California. If the only way people could "afford" those homes was the low teaser rate, then look for a huge drop in purchases as the lending guidelines are followed.

Summary of Effects

• Stated income loans all but vanish
• Pay option arms all but vanish
• Pool of eligible buyers shrinks
• Inventories will rise
• Increased downward pressure on prices
• California, Nevada, Florida hardest hit
• Foreclosures will continue to rise
  

Look for some small sub-prime lenders to go under as a result of the increased scrutiny in the face of already falling activity.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Outsourcing Homework

Reuters is reporting U.S. homework outsourced as "e-tutoring" grows

Private tutors are a luxury many American families cannot afford, costing anywhere between $25 to $100 an hour. But California mother Denise Robison found one online for $2.50 an hour -- in India.

"It's made the biggest difference. My daughter is literally at the top of every single one of her classes and she has never done that before," said Robison, a single mother from Modesto.

Her 13-year-old daughter, Taylor, is one of 1,100 Americans enrolled in Bangalore-based TutorVista, which launched U.S. services last November with a staff of 150 "e-tutors" mostly in India with a fee of $100 a month for unlimited hours.

Taylor took two-hour sessions each day for five days a week in math and English -- a cost that tallies to $2.50 an hour, a fraction of the $40 an hour charged by U.S.-based online tutors such as market leader Tutor.com that draw on North American teachers, or the usual $100 an hour for face-to-face sessions.

"I like to tell people I did private tutoring every day for the cost of a fast-food meal or a Starbucks' coffee," Robison said. "We did our own form of summer school all summer."

"We've changed the paradigm of tutoring," said Krishnan Ganesh, founder and chairman of TutorVista, which offers subjects ranging from grammar to geometry for children as young as 6 years old to adults in college.

A New Delhi tutoring company, Educomp Solutions Ltd., estimates the U.S. tutoring market at $8 billion and growing. Online companies, both from the United States and India, are looking to tap millions of dollars available to firms under the U.S. No Child Left Behind Act for remedial tutoring.

Teachers unions hope to stop that from happening.

"Tutoring providers must keep in frequent touch with not only parents but classroom teachers and we believe there is greater difficulty in an offshore tutor doing that," said Nancy Van Meter, a director at the American Federation of Teachers.

"Tutoring providers must keep in frequent touch" says the American Federation of Teachers.
Is the internet not an acceptable means? If not, why not? Although I am generally skeptical of proposed "paradigm changes" I am inclined to believe Krishnan Ganesh, the founder and chairman of TutorVista who said "We've changed the paradigm of tutoring".



Cartoon by Jeff Koterba, Omaha World-Herald

Please consider the Time CNN article Outsourcing Your Homework.

One problem with the No Child Left Behind Act is that 80% of the kids entitled to after-school tutoring--at taxpayers' expense--aren't getting it, according to a new government report, and some rural districts offer no tutoring at all. But extra help is on the way. And like a lot of customer service these days, it comes with a distinctly Indian accent. The Bangalore-based TutorVista, which last fall began providing online tutoring to U.S. students in everything from grammar to geometry, last week announced it will provide a year of free tutoring to kids in the 10 poorest rural counties in the U.S.

TutorVista chairman Krishnan Ganesh dismisses critics who lament the further siphoning of jobs overseas. "There is plenty of work to go around," he says. "The American educational system is pathetic."

Hmmm "The American Education system is pathetic?" Given the illiteracy in some countries that could be a very debatable statement. What is not debatable, however, is a simple modification as follows "The cost of an American Education is pathetic".

The Guardian is reporting India's e-tutors give UK children homework help.

Call centres charge £50 a month for unlimited individual help to pupils thousands of miles away.

When Kelsey Baird began worrying about the complexity of AS-level biology she got a tutor from India. It is more than 4,000 miles from her boarding school in Fife to Agra, home of the Taj Mahal, but a new e-tutoring system makes the distance irrelevant.

Across India, hundreds of teachers have been recruited to feed a growing demand for online tutors. With maths and science teaching in Britain and the US in crisis, new Indian education companies are rushing to fill the gaps.

'Education is a major preoccupation [in Britain]. There isn't the money to pay for enough teachers in schools and it's almost impossible for children to get personalised attention,' he said. 'Tony Blair might be able to afford private tuition for his children, but most people can't.'

Quite often the parents will be sitting by the computer trying to learn elementary algebra alongside their children,' said Anirudh Phadke, general manager of e-tutoring at Career Launcher, a company offering tuition for the US curriculum.

India's educational standards vary hugely but there is some fine teaching of maths and science, with a traditional and rigorous approach. 'The real advantage is that Indian teachers are cheaper,' said Shantanu Prakash, managing director of Educomp, which teaches internet maths to American pupils.

India's new online teachers have not been impressed by the standards achieved by British children. 'They are not really academically fully skilled,' said Rita Sampson, a former college principal, now teaching English language online from her Bangalore home. 'There seems to have been a deterioration in standards. Retention in Indian students is much better.'

A glossary of UK slang has been compiled to help tutors navigate the peculiarities of teenage vernacular - explaining expressions such as 'bunking off', 'dodgy' and (perhaps less helpfully) 'blimey'.

Well, I think I understand "Blimey" but because of the "Truth in Reporting" act, Mish simply must plead ignorance about "bunking off" and "dodgy".

The New York Times is reporting Latest in outsourcing: Homework

COCHIN, India A few minutes before 7 on a recent morning, Greeshma Salin swiveled her chair to face the computer, slipped on her headset and said in faintly accented English, "Hello, Daniela." Seconds later she heard the response, "Hello, Greeshma."

The two chatted excitedly before Salin said, "We'll work on pronouns today." Then she typed in, "Daniela thinks that Daniela should give Daniela's horse Scarlett to Daniela's sister."

"Is this an awkward sentence?" she asked. "How can you make it better?"

Nothing unusual about this exchange except that Salin, 22, was in Cochin, a city in coastal southern India, and her student, Daniela Marinaro, 13, was at her home in Malibu, California.

Salin is part of a new wave of outsourcing to India: the tutoring of American students. Twice a week for a month, Salin, who grew up speaking an Indian language, Malayalam, at home, has been tutoring Daniela in English grammar, comprehension and writing.

Using a simulated whiteboard on a computer connected with Daniela's by the Internet and with a copy of Daniela's textbook in front of her, she guides the teenager through the intricacies of nouns, adjectives and verbs.

Daniela said, "I get C's in English and I want to score A's." She added that she had given no thought to her tutor's being 20,000 miles, or 32,000 kilometers, away, other than that the situation had felt "a bit strange in the beginning."

She and her sister, Serena, 10, are just two of the 350 Americans enrolled in Growing Stars, an online tutoring service that is based in Fremont, California, but whose 38 teachers are all in Cochin. They offer tutoring in mathematics and science, and recently in English, to students in Grades 3 to 12.

Critics have raised concern about the quality of the instruction.

"Online tutoring is not closely regulated or monitored," said Rob Weil, deputy director of the educational issues department at the American Federation of Teachers. "There are few industry standards."

Quality becomes a trickier issue with overseas tutoring because monitoring is harder, said Boria Sax, director of research, development and training for the online offerings of Mercy College, based in Dobbs Ferry, New York.

Growing Stars is rapidly expanding to accommodate students from the East Coast of the United States, as well as Canada, Great Britain and Australia.

Its recruits, mostly with recent postgraduate and teaching degrees, already have deep subject knowledge. They must go through two weeks of training on techniques, culture and accent.

"They learn to use 'eraser' instead of its Indian equivalent, 'rubber,' and understand that 'I need a pit stop' could mean 'I need to go to the loo,"' said Saji Philip, a software entrepreneur of Indian origin and the chairman and co-founder of Growing Stars, who works in New Jersey.

Biju Mathew, an Indian-born software engineer, set up Growing Stars after moving to Silicon Valley five years ago to work for a technology start-up company. In India, he had been paying $10 a month for twice-a-week tutoring sessions for his children.

In the United States, he found, a similar service could cost $50 or more per hour. The idea of homework outsourcing was born, and the company began offering its services in January 2004.

It's good to see that the India tutors are "culturally educated". Imagine the brewhaha that might erupt if a tutor told a 13 year old student to "Please use the rubber" instead of “Please use the eraser”. If you think I am joking, please consider Teacher: Reprisals began after field trip

FRISCO – A veteran Frisco art teacher says school administrators have retaliated against her because a student reportedly saw a nude sculpture during a field trip to the Dallas Museum of Art. District officials say they are supporting a principal who reprimanded Sydney McGee over the field trip and other performance issues.

At Ms. McGee's request, the situation was aired in public during a school board meeting Monday. The school board rejected a request that would have allowed Ms. McGee to transfer to another school.

Ms. McGee, who has taught in various Texas districts for 28 years, said she visited the museum and spoke with museum staffers before the trip to ensure that it was appropriate for the fifth-grade class. Ms. McGee said she does not know which piece of art offended the parent, and the district did not identify it.

That's pretty amazing isn't it? A teacher was fired because she took her 5th grade students to an art museum where the kids saw a nude statue. Note that this happened after the principal gave permission to the teacher. Also note that no one would even say what the offending statue was.

Hmm, I think I was wrong earlier. This type of nonsense as well as bickering over evolution and the desire to teach creationism is exactly why many consider the US education system to be pathetic. In light of the above, can you really blame them?

So here is what it comes down to: The US system is enormously costly for mediocre results. In fact that is an unsustainable trend. The market is always willing to fill such vacuums and if permitted usually does so at bargain basement prices. That is exactly what we are seeing in these articles. There is free tutoring in some cases. But for the masses the cost of tutoring ranges from less than the price of a cup of Starbucks coffee all the way to $10.00 an hour. This is in contrast to $40 an hour for US tutors.

The market has spoken. Education costs are going to come down. That is a good thing. Outsourcing homework is just the start. Eventually the cost structure will be outsourcing entire classes or perhaps offshoring entire classes.

Previously we discussed Medical Tourism, the Healthcare Fiasco, and the Healthcare Fiasco Continued. If you have not read those articles, please do so. The market is bound and determined to find ways to avoid the high cost of US healthcare and education.

Left unhampered by governmental regulation, it will do just that. US educational costs have peaked. There is only way to go from here and that is down.

There was an interesting debate about inflation on Silicon Investor week. Heck, there is a debate about that practically every day. The general viewpoint is that the US$ is toast, commodity prices are going higher, and costs will follow. Even if the first two are true (and given one's timeframe that is very debatable), one of the biggest reasons for high prices in the US is labor costs. With the internet and global wage arbitrage, there is continued price pressure on that cost.

The cost of education is hugely one of labor and bureaucratic costs. In that regard we are headed straight for huge cost reductions when it comes to internet education. $2.50-$10 an hour for an Indian tutor, vs. $40-50 for a US tutor. The former will win over the latter any time (except for those rich enough that prestige is more important than money). Let's do the math. Assume on average $5/hr vs. $40/hr. That is an 87.5% cost reduction.

Deflationary pressures are sneaking up on everyone on account of globalization. Oddly enough someone was recently telling me that globalization would increase inflationary pressures. As long as wages comprise a higher percentage of costs than raw materials, that person is just plain wrong.

Medical tourism, outsourcing homework, falling prices of goods produced overseas, falling restaurant prices as discussed in The Psychology of Deflation, unrelenting outsourcing of all kinds of goods and services, the inability to pass on costs as evidenced by Intermediate vs. Finished PPI, and a strongly inverted yield curve all tell me that deflationary pressures are strong and growing. The only question anyone should have at this point is to wonder if these are cyclical or secular changes. I strongly suggest the latter.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Cautious on P&G skin-care

Mish note: This post is somewhat delayed as the news broke on this story a few days ago. But I have a couple of interesting pictures to share, one just translated from Chinese with thanks to a good friend. It is also possible that repercussions to this incident will have a long term impact on the Chinese market for US cosmetics.

Reuters is reporting China consumers turn cautious on P&G skin-care row.

SHANGHAI (Reuters) - Public anger in China over a popular skin-care line has become a public relations headache for Procter & Gamble, underlining the challenges foreign firms face as they contend with increasingly discriminating consumers.

The U.S. company suspended sales of its SK-II cosmetics line in China last Friday after the country's quality watchdog said it found traces of potentially harmful chemicals in the products.

Windows have been smashed at the company's Shanghai office and one of its Web sites have been hacked at the weekend after the firm went back on an undertaking to give customers their money back pending further word from the watchdog, said a P&G spokesman, Charles Zhang.

"In Wuhan and Harbin, there were incidents where there was some physical contact between our beauty consultants and consumers," Zhang said, adding no one had been hurt.

In another incident reported by Chinese media last week, counters in Shanghai selling the Japan-made products were forced to close after police broke up an angry crowd demanding refunds.

CBS News is reporting Irritating skin whiteners pulled from shelves in China

Sales of an expensive line of skin whiteners, concealers and other skin care products have been stopped at cosmetic counters across China after inspectors found two ingredients that are banned under Chinese regulations.

Customers in China and South Korea have complained of rashes, and sales have been stopped in mainland China. However, Procter & Gamble's line of cosmetic creams, called SK-II, remains on sale in 14 countries, including Canada.

Chinese health regulators found trace amounts of the two heavy metals in the products, which are made in Japan. Chromium is used in stainless steel and to prevent corrosion; neodymium is used for colouring glass and whitening.

At first, a spokesman in Tokyo said the company was investigating how the metals could have gotten into the creams. A statement issued in Canada said the metal content was natural and harmless in small quantities.

But a chemical pathology expert was quoted in China as saying use of contaminated cosmetics could cause skin irritations and, very rarely, skin cancer.

Procter & Gamble initially said it would not stop selling the product, but it would give people refunds, if they signed forms saying there was nothing wrong with their creams.

Lovely. We will give you a refund if you sign a form that says there was no reason to give you a refund. Who was the genius at P&G that dreamt up this solution? Hopefully he (or she) was fired.

A good friend sent me a couple of pictures with a comment about the title of the first article above. "Cautious?", she quipped, "Does this look like cautious to you?"

Smashed windows at P&G Shanghai office



Warning about various Cosmetics



My friend was also gracious to provide a formal translation of the above.
Here goes:

The first line on the forehead translated into:
Cosmetics contains banned chemicals: Cr and Nd

The English and Chinese on the eye cover were the names of the cosmetic products in English and Chinese.

The Chinese characters on the left corner translated:
Cr can cause skin rash, severe allergies, and make long even permanent damage to the skin.

The Chinese characters on the right corner translated:
Nd can cause bad reactions to the eye and mucosa. If inhaled, it can cause pulmonary embolism in the lungs and damage the liver.

My friend asked me to mention that China uses the EU standard for cosmetics, so these chemicals are banned.

Here are the reported health effects of neodymium.
Here are the reported health effects of chromium.

The question of the day is "How long will it be before Chinese companies come out with their own brands competing against Clinique, Estee Lauder, SK-II, Dior, etc?" Based on the "cautious reaction" displayed above, I have a feeling it might be faster than some might think.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

The Exhaustion Process

Before we discuss exhaustion, let's take a quick look at some of the best and worst reports on the August New Home Sales figures released today. Following are two brutally slanted headlines.

Bloomberg is reporting New Home Sales in U.S. Rise in August to 1.05 Million Pace

Sept. 27 (Bloomberg) -- New home sales in the U.S. unexpectedly rose in August from a three-year low the month before, signaling a possible pause in the housing slowdown. The median price of new homes fell for the first time since 2003.

Purchases of new homes, which account for about 15 percent of the market, rose 4.1 percent to an annual pace of 1.05 million from a 1.009 million pace in July that was less than previously reported, the Commerce Department said in Washington. Inventories slipped 0.4 percent.

Declining mortgage rates and incentives offered by builders helped spur purchases last month, economists say. The Federal Reserve, after raising its key lending rate 17 times in the two years through June, is seeking to engineer a soft landing for the housing market and the broader economy.

"New home sales were surprisingly stable last month given that homebuilders say the outlook continues to worsen," Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd in New York, said. "This is likely to be just a one- month respite as inventories remain at high levels and affordability remains a key issue."

Purchases rose in all regions except the West. They rose 21.7 percent in the Northeast to 84,000, 12.2 percent in the Midwest to 156,000 and 11.1 percent in the South to 582,000. Purchases fell 17.7 percent in the West to 228,000.

Economists' surveyed by Bloomberg News forecast sales would decline to 1.04 million from an originally reported 1.072 million pace. Forecasts ranged between 990,000 to 1.1 million.

The Chicago tribune is also touting New home sales rise in August

New home sales in the U.S. unexpectedly rose in August from a three-year low the month before, signaling a possible pause in the housing slowdown. The median price of new homes fell for the first time since 2003.

Purchases of new homes, which account for about 15 percent of the market, rose 4.1 percent to an annual pace of 1.05 million from a 1.009 million pace in July that was less than previously reported, the Commerce Department said in Washington. Inventories slipped 0.4 percent.

About 44 percent of U.S. homebuilders have reduced prices, says Gopal Ahluwalia, director of research at the National Association of Home Builders in Washington, citing a survey he conducted this month.

Net home equity extraction fell to an annualized $141 billion in the second quarter from a $196 billion pace a year earlier, according to Federal Reserve research undertaken by former Fed Chairman Alan Greenspan and senior economist James Kennedy.

Residential construction is also falling as sales slow and inventories accumulate. Home construction detracted 0.6 percentage point from growth in the second quarter, at a time when the economy slowed to a 2.9 percent pace of growth from 5.6 percent in the first three months of the year.

Scrutiny

• June sales were revised lower to 1.091 million units from 1.120 million units.
• To get a month to month "increase" of 4.1% it was necessary to revise the prior month lower to -7.5% from -4.3%
• Year over year sales are 17.3% lower than the August 2005

More Scrutiny



Revisions

New home sales have been revised lower what seems to be about 10 months straight now and every month but 2 since Feb 2005. For all this brewhahha over rising sales, let's see what the numbers look like after next month's revisions.

Jan Initial - 1,233 Revised - 1,173 (Down 4.9%)
Feb Initial - 1,080 Revised - 1,038 (Down 3.9%)
Mar Initial - 1,213 Revised - 1,121 (Down 7.6%)
Apr Initial - 1,198 Revised - 1,121 (Down 6.4%)
May Initial - 1,234 Revised - 1,101 (Down 10.8%)
Jun Initial - 1,131 Revised - 1,091 (Down 3.5%)
Jul Initial - 1,072 Revised - 1,009 (Down 5.8%)

The above data is thanks to James Bedna and the New Jersey Real Estate Report

CalculatedRisk

Some of the best over all reporting on housing, month in and month out, is done by CalculatedRisk.

Here is just one of the many charts in the above link:



Looking at the above chart I see that 2006 sales are below 2003 sales for three months running now. How long will it be before we are bumping up against 2002 numbers? I expect CalculatedRisk to add 2002 levels to his charts any time now.

Build or Bust

In the meantime note that Lennar CEO keeps building despite cooling housing market.

Standing in a hallway at Lennar's offices, chief executive Stuart Miller clears his throat. He then proceeds to recite the entire seven stanzas of Scratchings From The Little Red Hen by heart.

These days, the poem is taking on a whole new significance. After a housing boom of more than a decade, the long-awaited downturn has finally hit with a speed and force few anticipated. Home-builder confidence has dropped to its lowest in 15 years. Cancellations are up. And new construction is down to a level not seen in three years.

Perhaps worst of all, it's hard to tell when things will get better.

"It doesn't feel like we can identify a bottoming yet," said Miller, who recently downgraded Lennar's earnings estimates for the year. "It happened very quickly, very suddenly. I can't identify the trigger."

Or put in the words of The Little Red Hen: "What's become of all those fat ones is a mystery to me; There were thousands through the rainy spell, but now where could they be?"

This month three stock analysts downgraded Lennar's stock -- two from buy to hold and one from hold to sell. Bank of America analyst Daniel Oppenheim cautioned that a record number of homes on the market for sale coupled with overbuilding will result in "sharply lower margins" in the next two years for Lennar.

Lennar's response: Keep building.

Miller plans to "keep the conveyor belt running" and finish building new homes in projects already underway. He also plans to offer sales incentives and slash prices to get the homes sold.

It's an approach shared by several home builders, such as Centex in Dallas and D.R. Horton in Fort Worth. Others, such as Pulte Homes in Michigan and KB Homes in Los Angeles, have taken a different tack. These builders are scaling back production but holding firm on prices until buyers return -- a strategy some have called quality over quantity.

However, the pressure is on. KB Homes chief executive Bruce Karatz said Thursday price concessions and incentives by other builders have "required us to do the same in some cases."

Notice how Lennar and others keep building with the expectation of being able to "offer sales incentives and slash prices to get the homes sold." Obviously that is going to continue to put pressure on prices. I have no doubt that shrinking margins coupled with continued overbuilding while holding rising amounts of inventory is going to bankrupt some national homebuilders. The forementioned plan of Lennar to slash and burn is likely to (or at least should) put share buybacks on hold, as well as accelerate the typical bust cycle.

Builders build until they go bust (or as long as they get financing whichever comes first). That is the pattern in every downturn.

One thing that could prolong the life of some homebuilders is a combination of falling lumber prices, copper prices, and perhaps roofing products. However, carrying costs with rising inventory have to be skyrocketing. The builders holding the most inventory with the least amount of cash reserves are likely to be those in the most trouble.

Triggers

I would have thought that by now Miller would have figured out what the "trigger" was to this downturn. Perhaps the answer is just too simple for many to understand. The trigger (or lack thereof really) is called exhaustion.

The short version of the process is simple: "The pool of greater fools dries up".
The long version of the process is as follows:

The Exhaustion Process

• After years of price runups, people started buying homes not to live in but for investment purposes. In 2004 and 2005 a whopping 40% of all homes sold were for second homes or for investment purposes.
  
• The above happened in spite of the fact that home prices to wages relationships, and home prices to rental prices had both risen 4 standard deviations above norm.
• Credit standards steadily declined to rock bottom levels such that anyone who could fog a mirror could get a loan
• Lenders passed on risk to hedge funds, pension plans, etc who could not get enough of what eventually will become toxic waste, but at the time seemed like a good idea. Risk yield spreads collapsed as people started assuming prices of houses would never decline.
• Fannie Mae lost billions in derivative hedging as interest rates gyrated but no one really cared.
  
• Homebuilders provided down payments via charities to those who could not afford to buy a house. The IRS has been looking into this practice and it may be illegal.
• Magazine covers, books, and financial wizards of all sort were touting "Buy now before prices rise further".
  
• All sorts of creative financial products were unleashed on the unwary.
• As the pool of eligible and willing buyers shrank, subprime loans, pay option arms, and stated income loans soared as a percentage of all loans. Anything and everything was done to keep the bubble expanding.
  
• The masses embraced the trend just as it was ending.
• Panic buying reached a peak in the Summer of 2005 with people camping out overnight in Florida to buy condos for ridiculous prices hoping to flip them. No one bothered to figure out there was no one to flip them to.
  
• David Lereah, chief propagandist for the National Association of Realtors, published the same book twice. His book "Are You Missing the Real Estate Boom?" was published in February 2005 about 6 months before the peak. One year later in February 2006 (about 6 months after the peak) Lereah retitled his book "Why the Real Estate Boom Will Not Bust—And How You Can Profit from It."
  
• Pent up demand collapsed and home sales plunged. The pool of greater fools, reached its pinnacle, depending on location, somewhere between Summer of 2005 and Winter of 2005.
  
• The unwinding process has really just started.
  
• Given that the housing boom lasted for close to 20 years and sustained panic buying happened over a 3-5 year period, selling capitulation and inventory work off can easily take 7 years or more. We are nowhere close to selling exhaustion.
• Global wage arbitrage, outsourcing, rising bankruptcies, and rising unemployment will ensure this process will take a long time to fully unwind.
• Prices will continue to fall until bankruptcies and selling exhaustion are in.

Yes that is a long process, but the duration and magnitude of the housing bubble (really a credit bubble) is unlike anything the world has ever seen before, and thus very hard to overstate.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Updating the Arrow after Home Prices Drop

The NY Times is reporting Home Prices Drop After 11-Year Ascent

The median price in August fell to $225,000, down 1.7 percent from August 2005. That was the first time since April 1995 that the national median price was lower than the same month a year before.

On that news I thought it was time to update my comparison of the US housing bubble with that of Japan's in the 80's and 90's. The current picture looks like this.



A discussion on where previous arrows were put and why can be found in US vs. Japan Land Prices Pictorial Update.

I had a much harder time figuring out where to put the arrow for this pictorial update. The reason is because home prices nationally have actually been declining for some time. I have commented on this many times before, but for new readers, home builders have been reporting "full price sales" while giving hundreds of thousands of dollars in incentives, new cars, vacations, upgrades, reduced interest rates, etc and chalking those expenses up as "advertising costs". Mammoth price reductions from every national builder have been going on since the beginning of the year.

Palm Coast Florida

Here is a typical example from Horton.



The above ad came out on September 23 for the Daytona Beach / Palm Coast Area.
Price on the Grand Teton model was $282,445 and is now $197,445. That is a 30% haircut. Not only is that a 30% haircut but it is important that the entire subdivision was just repriced 30% (plus appliances) lower. Any flipper who paid full price is now 30% underwater (not counting interest expenses, insurance, property taxes, etc. Can that flipper sell for $197,445? Of course not. A realistic price IF one could find a buyer might be $185,000. After all who wants to by a used house when a new one is about the same price, has "free appliances" and comes with a warranty? Add in real estate commissions and that flipper may be down by as much as 50% or more. Rent it out? Supply of rentals (especially on condos) is exploding. Meanwhile prices continue to drop.

Realtors Warmly Welcomed

This kind of action has been going on for over 6 months in most of the country to varying degrees. In addition to the enormous price reductions, there is a more subtle portion of the ad that shows stress on homebuilders and prices. Right at the bottom of the ad in large type is the message “Realtors Warmly Welcomed”. A year ago builders refused to split commissions with realtors. Now builders are offering triple commissions to realtors. That is a dramatic change and right off the bottom line of builders.

More NAR Cheerleading

Let's tune back into more nonsense from our favorite cheerleader at the National Association of Realtors. From the NY Times article:

David Lereah, chief economist of the association, said he expects prices to continue to fall. “We do expect an adjustment in home prices to last several months, as we work through a buildup in the inventory of homes on the market,” he said in a written statement. “This is the price correction we’ve been expecting — with sales stabilizing, we should go back to positive price growth early next year.”

There is absolutely no indication of working through any housing inventory. In fact inventory is now up to 7.5 months as compared to 7.3 months a month earlier. Those numbers are from the NAR so it appears Lereah is not even following his own reports. Furthermore, builders keep on building faster than home sales are rising. Thus home building continues to add to supply. REOs (real estate owned by banks due to foreclosures) is also rising. That adds to supply. Massive rises in bankruptcies in the rust belt and Colorado is adding to supply. The demographics of boomers retiring will add to supply for years to come. There is simply no reason to expect either stable prices or inventory to be worked off in this situation.

A more realistic opinion was offered by Ian Shepherdson, chief United States economist with High Frequency Economics: “With inventory still rising, there is no chance of any short-term relief” for sellers. “Prices and volumes have a long way to fall yet.”

Dow Jones offers this commentary by Lereah:

NAR chief economist David Lereah said an anticipated decline in prices compared with a year earlier has begun and is likely to continue until the end of the year, helping to support sales.

"With sales stabilizing, we should go back to positive price growth early next year," Lereah said.

Lereah "anticipated a decline in prices"? When?
What amazing spin from someone buying and recommending Florida condos right before the crash, and who has argued that fundamentals would never let a year over year decline happen.

Yeah right. That is why Horton is offering 30% discounts and still has no buyers and various markets like Florida, Boston, Detroit, and now places in California have come to a standstill.

MarketWatch

MarketWatch is reporting Existing-home prices fall for 1st time in 11 years

The collapsing U.S. housing market crossed another milestone in August, as the median sales price of existing homes fell for the first time in 11 years and for just the sixth time in the past 38 years, the National Association of Realtors said Monday.

Sales of existing homes fell 0.5% in August to a seasonally adjusted annual rate of 6.3 million, the industry group said. It was the lowest sales pace since January 2004. Sales have fallen five months in a row. Sales are down 12.6% in the past year.

"Sellers are finally getting it," said David Lereah, chief economist for the real estate group. "The price drop has stopped the bleeding. Sales have hit bottom."

Let me see if I've got this straight:

1. Existing homes fell for the first time in 11 years
   
2. Inventories are still rising
3. Sales have fallen five months in a row
   
4. Sales are down 12.6% in the past year
   
5. "The price drop has stopped the bleeding"

Does Lereah have an ounce of credibility left?

Northern Virginia

In Northern Virginia MarketWatch - September/October 2006 McEnearney Associates posted Top Ten Reasons To Be Optimistic About Northern Virginia's Housing Market.
Let's look at reasons 8-10:

10. The softening of the market. Believe it or not, that's a good thing. There is no doubt that the market is slower and softer in every respect when compared to the last several years. The 20%-25% appreciation rates were not sustainable. And the longer they continued, the harder the fall would be.

9. The media. OK, this may seem a bit tongue-in-cheek, but area homeowners should rejoice every time the national media and even local media predict doom and gloom for area housing - because they have so often been wrong. The relentless drumbeat of negativity seems almost totally disconnected from reality. Our current favorite: Forbes predicts that the median price of a home in metro DC will increase only 3% over the next ten years. Not 3% annually, mind you. A total of 3%. In the best regional economy in the country.

8. History. The compounded average annual increase in the average sales price of a home in the metro DC area over the last 30 years is 7%. (Forbes, are you paying attention?) 7% is normal; 7% is sustainable. We won't see that in 2006, but an individual's housing decision should be a long-term decision. Feel good about owning a home here - unless you have to sell right now.

Reason number 10 seems to suggest that home prices are going to go up because they are now going down. Obviously that is silly.

Reason number 9 ignores the fact that the Media did nothing but report good news for years, topped by the Cover of Time in Summer of 2005 "Why We're Going Gaga Over Real Estate". As bad as sentiment has gotten, it is nowhere near the extreme we saw at the top. That cover marked the secular peak in housing. Besides, places like McEnearney Associates were bullish when sentiment was bullish and are now supposedly bullish because sentiment is bearish.

Reason number 8 proves that the writer of the article does not understand basic math. I agree with McEnearney Associates about there being a “disconnect from reality”. The first disconnect is on an unsupported rise up in home prices, where it was considered “normal” for home prices to rise 4 standard deviations above rental prices and wage growth. Home prices in many places (Florida, California, DC, etc) are up 100% or more in 4-5 years. That obviously is not sustainable even though flippers bought into the concept big time and are now being toasted over it. A second disconnect is failure to understand reversion to the mean. To average 7% we will need to see many years of zero to negative growth. A third disconnect is that 7% will NOT be sustainable in a secular downtrend. A fourth disconnect is that prices tend to overshoot in both directions. The implication of that statement on the way down should be obvious to even the math challenged. (McEnearney, are you paying attention?)

More than likely we will see prices drop 30-50% over 2-4 years depending on the bubbliness of the area, then chop sideways or down (again depending on the market), for between 6-10 years. That is what it will take to average 7% a year given the unprecedented four standard deviations above the mean rise in home prices compared to both wages and rent since 2000. That may also be the best case scenario.

When the attempt is so blatantly obvious to spin every piece of news positive by Lereah and others why should anyone pay attention to them? I have news for all the real estate wizards, flippers, and cheerleaders. Sustainable positive price growth is years away. We are closer to the peak (heading down) than the trough (about to head back up).

This item just came in:
Massachusetts foreclosure filings jump 72% in August

September 26, 2006
Foreclosure filings in Massachusetts rose 72 percent last month as a growing number of homeowners were put in financial distress by the housing market's sharp downturn. ForeclosuresMass.com, which tracks Land Court foreclosure filings against homeowners by mortgage lenders, said there were 1,812 filings last month against borrowers who were past due, up from 1,055 filings in August 2005. Foreclosures ``continue to escalate at levels we haven't seen since the housing crash of the early 1990s," said ForeclosureMass.com's president, Jeremy Shapiro. The August filings bring the total for the year to 11,214, just 279 filings short of the filings made in all of 2005, ForeclosuresMass said. (Kimberly Blanton)

Important Points to Realize

1. These are still historically low foreclosure rates
2. Trillions in ARMs have not yet reset
3. States like California have just joined the "foreclosure party"
4. The number of defaults and foreclosures is going to get massively worse before it gets any better

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Credit Bubble Conversations

Following is a set of posts from Valueguy on the Motley Fool, various posters on Silicon Investor, and me. The topic at hand is Noland's latest Credit Bubble Bulletin. Here is the discussion chain.

Valueguy
Mish I know you've addressed Noland's views in the past. Since you enjoy doing so and since many of us are reading him, I think it's worth thinking about what he's saying. I for one am starting to be convinced, even though I can see commodity and house (and other) prices going down.

Noland writes:

As is reflected in the Q2 2006 Flow of Funds, there remains an overwhelming bias within the financial sector to leveraged existing assets (chiefly government, agency, and mortgage-related securities). This bias has intensified greatly during the third quarter. Ironically, the housing and economic decelerations are to this point engendering only a moderate slowdown in Non-Financial debt growth, while Financial Sector Expansion Goes into Overdrive. The system's liquidity mechanism has not only become detached from the actual financing needs of the real economy, there is today a Powerful Propensity for Financial Excess to Accelerate Rapidly as the Economy Decelerates Only Moderately (too many waiting patiently to profit from another round of Fed largesse). This is a very important development.

To be sure, speculative leveraging these days in the fixed-income markets has an unparalleled capability of creating abundant liquidity for the markets and system generally. And as bond prices inflate in response to heightened speculative leveraging and resulting liquidity creation, those that had been positioned for higher rates (both speculations and hedges) are forced to unwind these trades – in the process creating only more price inflation and liquidity over-abundance. Meanwhile, the yield curve gyrates and causes bloody havoc for myriad curve and rate speculations.

I will be quite surprised if the Financial Sphere Horse does not once again pull the Economic Sphere Cart. Benchmark Fannie Mae MBS yields have now dropped 65 basis points from June highs. To what extent lower mortgage rates reignite housing markets will likely vary significantly by market. But they will surely incite an increase in transactions and, most likely, acceleration in already strong refinancings and equity extractions. Total Mortgage Debt growth can be expected to quicken from the first half’s 10.1% pace.

There is certainly nothing like a concurrent descent in energy prices and bond yields to get the inflation doves chirping rather maniacally. Yet, the reality of the situation is that sinking bond yields and attendant gross liquidity excess are poised to stoke fires for sectors already demonstrating flaming inflationary biases. Sitting near the top of the list, you should assume Mr. Income Inflation is salivating from recent market trading dynamics.

And, yes, Income Inflation is supporting inflated home prices that sustain the Mortgage Finance Bubble - that maintain over-consumption - that assures endless massive Current Account Deficits - that guarantee massive foreign buying of U.S. securities while writing yet another chapter in History’s Greatest Bond Market Bubble.

Valueguy Continues
What he's saying is that all the assumptions that markets will crash because of an economic downturn may be false. Most of us see that we are having a slowdown, maybe margin compression, and as always Wall Street reacts violently. Well, he's saying it's just not true, he's arguing that the fundamentals are detached from the market. Well, usually such views are wrong, and Noland himself (I think) believes that eventually stocks will crash. But why are people not scared?

Mish
Interestingly enough similar discussions were taking place on Silicon Investor.
Following is a chain of posts on SI

Jimmg
There is a good interview on financialsense.com with my old friend Doug Noland this week. He thinks the economy will surprise on the upside for the short/intermediate term.

Orkrious
Another bear capitulates.

Jimmg
Doug is very bearish longer term but thinks the strong credit growth is leading to wage inflation which will support the economy and housing much better than most think. He might be right but I tend to think we are much closer to the bust.

Rarebird
This year has been remarkably similar to 1994 with a time lag of about a month. If the same pattern holds, I'd expect a very nice correction in mid October. I want to see Volkmar Hable capitulate and see OEX Option Traders buy tons of calls on the initial leg down. That is likely after the next fling to the upside. Currently I'm modestly long. But I'll be short when it matters most.

Mish
Money supply as measured by M1 has been contracting.
Housing prices and sales are dropping fast in spite of whatever else is happening.
If there is extra liquidity, how much actual GDP is produced by it? Any?
It seems to me that it is taking enormous expansion of credit right now just to keep the ship from sinking.
The stock market may be acting well but the junk bond market and treasury markets are telling another story.
My conclusion is that "financial sector overdrive" is unsustainable in the current environment. Still that does not put a timeline on sustainability so let's look at a few indicators to see what they are saying.

Here is a chart of junk bonds spreads vs. treasuries produced by Orkrious on Silicon Investor.



Orkrious maintains that chart daily and posts updates frequently on Silicon Investor. You can follow along here.

Notice how stocks topped in May when the spreads narrowed. That was a perfectly normal action. Right now we have a huge divergence (the divergence can always get bigger of course), but I am inclined to believe the bond market.

Here is the yield curve as of 2006-09-25



The treasury market and credit spreads both seem to be saying one thing while the stock market is pricing in a soft landing or better. One of them is wrong. A similar situation took place in 2000.

Bart at NowAndFutures disputes Noland's idea of wage inflation.
Here are a couple of charts produced by Bart in cooperation with from John Williams at Shadowstats.

Employment Cost Index



Average Hourly Earnings

Bart explains his version of the CPI in The Consumer Price Index, A Big Lie.

Regardless of whether or not one believes the "lie figures" as produced by Bart, there is no doubt the CPI has been manipulated for political purposes, just as the unemployment rates is manipulated for political purposes. The only real question is on the extent of the lies.

At any rate, the above charts show a decreasing employment cost index and modestly increasing hourly wages. I have several comments on wages.

1. Averages are misleading.
2. The biggest raises went to a small percentage of workers.
3. Wages are a lagging indicator.

In addition, wages tell one story but job growth tells another. We have now had five consecutive months of subpar job growth including four consecutive misses prior to the latest month.

Wages and jobs are both important, not just wages. The only real bright spots in this recovery as far as job growth is concerned are medical related jobs and housing. There is no candidate to take up the slack for declining housing related jobs.

Note that cash out refis are drying up. The implications of that are pretty substantial. CalculatedRisk addresses mortgage extraction in GDP Growth: With and Without Mortgage Extraction and Mortgage Extraction and the Trade Deficit.

There are many stock market divergences as well including herding into winners, advance decline ratios, stock market breath, and an enormous divergence between the DOW and DOW Transports. For now the market seems fixated on a pause, sinking commodities (as if that will save consumer spending), as well as various improbable "Goldilocks" theories.

Reading Noland's post in entirety I am not sure if this is exactly capitulation by another bear or not. That said, I obviously have a vastly different opinion from Noland on the yield curve, wages, commodities, inflation expectations, and a host of other issues.

I disagree with Noland's proposal that the bond market will cause an "acceleration in already strong refinancings and equity extractions". For starters, refinancings are not "strong" at least compared to previous peaks, and equity extraction is not likely to be "strong" in a now rapidly sinking housing environment. CalculatedRisk's charts would seem to agree. Secondly, it appears that lenders are finally ready to address credit lending standards. A tightening of credit standards is likely to negate any effect of lowered interest rates. Finally the idea that "Income Inflation is supporting inflated home prices that sustain the Mortgage Finance Bubble" is simply fallacious. Home prices and transactions have crashed since June of 2005 even as wages have risen modestly. It seems Noland is forgetting about affordability, the shrinking pool of eligible buyers, and lack of pent up demand. After all, who doesn't have a house that wants one and can afford one? Noland's capitulation may be debatable but he sure is missing the boat on many key issues.

Mike Shedlock /Mish
http://globaleconomicanalysis.blogspot.com/

The Doctor is Calling

Copper is often referred to as "Dr. Copper" because of its unique ability to forecast economic trends. On September 15th I sent the following chart on copper to a friend.



I proposed copper was about to break down. Technically that near perfect symetrical triangle is a continuation pattern which in this case would be a bullish formation.

OK Mish, so why the "?" assuming down?
That’s a good question and enquiring minds deserve answers. Here goes:

1. One of the biggest uses of copper is housing and housing has clearly fallen off a cliff
2. Copper went into contango

In a previous conversation with this friend from a few months back we discussed the idea that the bull in copper would end as soon as copper went into contango. Although I was very aware that much (but not all) of the backwardation had worn off, I did not have a graphical presentation of it.

It seems I am not the only person watching copper. Greg Weldon at Weldon Financial posted the following charts on Minyanville on September 21.



In reference to the above chart Greg Weldon wrote:

I still believe that Copper simply cannot ‘escape’ the horror-show that has become the US Housing market, particularly as defined by an expected deepening contraction in new home building. Observe the teetering price as relates to the underlying support offered by the most recent double low ($3.265-3.275) and the med-term 100-Day EXP-MA.

It was the following chart that really caught my attention.



Boom! 2 1/2 years of backwardation in copper is now officially over.

Greg Weldon went on to say:

"The chart above plots the 100-Day Exponential Moving Average of the Cash-to-Three Month Spread for Copper, traded on the London Metal Exchange. Copper’s spreads are in free fall, and this spread has completely wiped out all of its HUGE $200+ per tonne backwardation and has collapsed into contango, indicating an amply supplied market for the first time since the 4Q of 2003.

A breakdown in Copper would be a confirming signal, and ‘should’ provide the proverbial ‘next shoe to drop,’ in terms of a broadening disinflation becoming increasingly dominant in the entire commodities sector."

Flashback December 2005

Back in December of 2005 Sterling's World Report asked the question Will Dr. Bernanke Get Along with Dr. Copper?

Many traders have affectionately referred to copper as “Dr. Copper” because it is considered to be “the only metal with a PhD in economics.” That is, copper historically has been considered to be an excellent barometer of the overall state of global economic activity because of its widespread use in industrial applications.

What Dr. Copper is saying right now is that the world economy is booming. As can be seen in Chart 1, the price of copper has nearly tripled since 2001 and is approaching $2.00 a pound. Much of that is attributable to the growth in China, which has created nearly insatiable demand for copper as it upgrades its electric power grid. But a booming housing market in the U.S. and strong growth throughout much of the developed and developing world are also part of the story.

Although copper went on to soar way past $2.00 lb all the way to well over $4.00 lb in May of 2006, the message from Dr. Copper seems quite different today.

A technical Break

We now officially have a break in that symmetrical triangle.
Let's take a look at a chart of copper as of September 22, 2006.



The interesting thing to me is that hardly anyone is taking these trendline breaks seriously even though there are breaks practically everywhere you look: oil, natural gas, sugar, the $CRB itself, and now a technical failure in copper. Yet posts of charts like these on Silicon Investor and other places just bring a big yawn. In fact, in a response to one of my blogs from just a day or so ago, someone used commodity charts to show "current inflation".

Has everyone really forgotten about the lagging effect of 17 consecutive rate hikes? No, not everyone. Brian and I at the Survival Report along with Greg Weldon and many of the professors on Minyanville are taking these breaks very seriously. Are the technical breaks in various commodities we see now akin to the technical breaks in JDSU, LU, CSCO, and INTC in 2000 that most disregarded? Right now it is hard to say, but the complacency and buy the dip mentality sure seems similar.

Perhaps this is nothing more than a head fake lower on gold, silver, natural gas, crude, gasoline, sugar, and copper. Then again perhaps the good doctor (along with confirming indicators such as M1 money supply, the inverted yield curve, and housing) is telling us that this patient (the US economy) is very ill. I think you know which way I am betting: The weakness in Housing is about ready to spill over into other areas. A consumer led recession is on its way.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Discussion on Zeros

Bloomberg is reporting EU Renews WTO Complaint Over U.S. `Zeroing' Practice.

The European Union wants World Trade Organization judges to prohibit U.S. customs-duty calculations that the 25-nation bloc says illegally inflate import tariffs.

The calculation, called "zeroing," enables the U.S. to maximize import duties by selectively excluding some market price data. The U.S. used the methodology to work out whether imports of chemicals, steel and pasta from the EU were sold below cost, or dumped, on the domestic market. The WTO ruled in favor of Japan in a similar complaint in February 2005.

Today's filing renews previous complaints because while WTO arbitrators in the past have faulted the U.S.'s use of the zeroing methodology in specific instances, they haven't outlawed the practice in principle. The complaint may further sour relations between the U.S. and EU that were strained by finger- pointing after the collapse of the Doha trade talks round.

"Zeroing ignores negative margins of dumping and therefore results in an unfair increase of the dumping liability of EU exporters," the EU said in a statement today. While the WTO has ruled against the use of zeroing by the U.S. at least three times, ``these previous rulings left open a number of issues which are now covered by the new request for consultations.''

Eliminating the zeroing practice would mean makers of hot- rolled steel, stainless steel bar, ball bearings, chemical and pasta products would pay minimal import duties, or none at all, according to the EU. Most U.S. tariffs on European companies including ThyssenKrupp AG, Corus Group Plc and BASF AG are based in part on zeroing calculations, the bloc says.

Protectionist trade policies are one of the hallmarks of deflationary times so it is should be no surprise that two zeros (Senators Charles Schumer, a New York Democrat, and Lindsey Graham, a South Carolina Republican) are once again threatening to impose 27.5% tariffs on China.

The Boston Globe is reporting Senate likely to pass China tariff bill.

The Senate is likely to pass a bill aimed at forcing China to change its currency policies by threatening a 27.5 percent tariff on its exports to the United States, a top Republican senator said on Thursday.

"I would expect it to pass and I'm sorry for that," said Senate Finance Committee Chairman Charles Grassley of Iowa.

Senate leaders have promised Sens. Charles Schumer, a New York Democrat, and Lindsey Graham, a South Carolina Republican, a vote next week on their bill threatening China with punitive tariffs.

Grassley, whose committee has jurisdiction over trade legislation, said he expected the vote to occur even though it could herald a return to the Smoot-Hawley tariff policies of the 1930s that are blamed by many economists for starting or at least protracting the Great Depression.

There is currently no similar bill in the House and the Bush administration strongly opposes the legislation.

However, many business groups and trade experts warn that even a Senate vote in favor of the bill could hurt trade relations with China.

"Senate passage ... alone will have negative repercussions for U.S. farmers, manufacturers, service providers and others, while undercutting, rather than promoting, the objectives it seeks to achieve," the Emergency Committee for American Trade, which is comprised of leading U.S. exporters and importers, said in a letter to all 100 members of the Senate.

U.S. manufacturers say China's currency is undervalued by 15 percent to 40 percent against the U.S. dollar, giving Chinese competitors an unfair advantage.

The Graham-Schumer bill directs the White House to impose a 27.5 percent tariff on goods from China if Beijing does not significantly raise the value of its currency within six months. That punishment could be delayed for 12 more months if China has begun implementing a plan to revalue its currency.

I called the last two attempts to bring such legislation to the floor for a vote "big bluffs" and in both cases although China did nothing the US Senate backed down. Is the third time the charm? Does the Senate finally have the nerve (and the stupidity) to pass something as ill conceived as this? It almost seems like it. Given that there is no pending House bill it is not likely to go anywhere but if someone wanted to engineer a stock market crash this surely would be the way to do it.

By the way Smoot-Hawley did not cause the Great Depression. It did however make it worse. The cause of the Great Depression was a reckless and prolonged expansion of money and credit leading up to the 1929 crash. Yes, it really is as simple as that although the explanation as to how and why and in what timeframe that occurred is a much longer story for perhaps another time.

Bernanke for all of his supposed depression expertise does not understand that simple statement. If he did, he never would have issued his infamous "Helicopter Drop" speech, Deflation: Making Sure "It" Doesn't Happen Here.

As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.

The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.

The important point to understand is that if reckless monetary expansion was the cause of the Great Depression (and it was) then it is impossible for reckless monetary expansion to be the cure. At best, such persistent recklessness would prolong the problem making the inevitable bust all the more severe. Furthermore there is theory and there is practice. One of the consequences to purposely causing hyperinflation is that it would destroy the US$, it would destroy the banking system, and it would destroy the Fed and all their wealth and power. For practical reasons there simply will be no "helicopter drop".

As I pointed out in Inflation: What the heck is it? Ludwig von Mises understands the endgame brought on by reckless expansion of credit: "There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved."

This leads us to our final zero for the day. If one was grading the understanding of credit expansions and depressions, the result would be Ludwig von Mises:100 Bernanke:0.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/