Monday, November 10, 2008

The Bureau Of Labor Statistics Mind Trick

Just a quick note for anyone who still trusts their government/media to tell them the truth.

When you hear of the "official" unemployment rate put out by the government, you are only getting half the truth (actually, it's 55%, but who is counting?). The government wants you to believe that our unemployment rate is only 6.5%, up from 4.8% when compared to last October.

The truth is the American unemployment rate is an eye-popping 11.8%, up from 8.4% last year.

Part of the problem is how the government calculates the unemployed. If 100,000 people were canned last month, but 120,000 people were designated "not looking for work," then the government tells us that the net amount of unemployed decreased 20,000.

...and we wonder why Fannie/Freddie went kablooie. I can't wait for them to administer health care and use that for political purposes.

The Bureau of Labor Statistics (Ministry of Truth) puts out these stats on a monthly basis. Rather than listening to the dim bulbs in the mainstream media, or the various talk show hosts that are in the tank for their president, you need to download the BLS stats and refer to Table A-12. For the latest report, it is on page 18.

Line U-3 is the 'official' unemployment rate. Think of this as the dress size your wife imagines herself to be if she dropped 25 pounds.

Line U-6 is the actual unemployment rate. Think of this as the dress size she wears if it is constructed without Kevlar reinforcements.

The truth is out there. The government just assume we are too dumb and lazy to look for ourselves.

Uhhh....wait a minute...are we not the nation that thought that "real estate always goes up?" Didn't we think we could borrow our way to prosperity? Don't we all own the same 600 stocks and plan on selling them at a profit in a relatively short time frame?

Never mind. I now return you to your regularly scheduled debt-laden, socialist implosion, already in progress.

Friday, November 07, 2008

Bainbridge Island: Post Election Psychosis

Now that Bainbridge Islanders can't engage in their two favorite activities (endless yammering about home appreciation and wallpapering over the entire island with OBAMA '08 propaganda), we are going to have to brace for the next annoying, self-serving, short-sighted, hip-n-trendy corpus of mindless twaddle that they will lord over all of us in the name of neo-enlightenment.

Wednesday, October 22, 2008

Bankers, Beanie Babies, Leverage and Liars

Q: How do you know when a banker is lying?

A: He publishes his quarterly financial statements.

The Institute For Economic Reality, a think tank based in Poulsbo, Washington, has been watching the "credit crisis" unfold for a few years, and has concluded that bankers are dumber and more dishonest than airline executives - a feat that was previously thought to be unassailable.

Many have asked me if there is any way for the banks to be able to "hold" their assets and survive by getting relief from being forced to mark their assets to market. In other words, can the banks just agree to all lie on a grand scale, and pretend all is well?

No. In fact, it will make the matters worse. If they stay this course, we will have a systemic failure of the entire world-wide banking system.

Why? Because the entire credit economy is based upon this little thing called "trust."

Trust is the basis of credit, which is the basis of our monetary system. The dollars, francs, yen, rubles, euros, kroner, pesos, and rupees you hold are all based upon the belief that people will execute contracts faithfully and will transmit truthful statements when negotiating those contracts. Should people lose faith in their counter party to perform on their contracts, money will cease to flow. The less faith, the more the markets will freeze.

If you go to a farmer's market, and a farmer had several bags of produce for sale, but you couldn't examine the produce, you would need to trust that farmer in order to buy what he was selling. If the farmer tells you that there are two kilos of fresh apples in the bag, and you buy them, you expect to get two kilos of fresh apples. Should you open the bag and find two kilos of rotten, worm infested apples, are you going to buy more apples from this farmer?

Only if you are Fannie Mae or Freddie Mac.

If most of the farmers conduct their business in this manner, how much money will flow at the farmer's market? Money will flow proportionately to the amount of trust, which in this situation is zero.

What happens to the farmers that actually have fresh produce, but still sell them in the opaque bags that all the dishonest farmers use? They fail too.

You can see the problem; our politicians can not. It is costing you trillions of dollars, and it is about to cost you even more.

So, what does this have to do with mortgages, and why do the banks want to continue to lie? Because their alternative is to die, and their executives will probably get the Ken Lay treatment.

The reason the banks can't tell the truth is because of the leverage they have used to get them into this Gordian Knot. Banks like to keep things complex, because they believe we can't figure out what they are doing if they use complicated terminology and talk about really large, spooky figures. However, as we have already stated, bankers are the sleaziest animals in the business community, so they like to masquerade as High Priests of a goofy, New Age religion in hopes that we just leave our tithes and hope the God of High Finance smiles upon us.

Banking is actually pretty simple. Bankers go out into the community to borrow money from people with more money than debt at a low interest rate, repackage it, mark it up, and sell it to people with more debt than money. They pocket the difference (aka "spread"), pay their bills, and call the remainder profit. That's it. That is what they do.

So, if it is so easy, why are they in such trouble? Greed + lack of vision = bankruptcy.

Let's look at another example that we can understand without having to break out our Banking Rosetta Stone.

Back in the early days of "Operation Enduring Bubble," we had lots of speculative playthings. Yes, housing was moving right along, but the real action was in esoteric tech and Internet stocks, Pokemon cards, and Beanie Babies. Americans were simply enamoured with colored socks that were half filled with plastic beads and given a cute name. With the advent of eBay, we had people that made a living buying Beanie Babies at a high price, marking them up, and selling them to a love-starved population at an even higher price.

One such such enterprise that consulted with The Institute For Economic Reality was named "DRECK's: Purveyors of fine American schlock." Dreck's came to the IER with quite a story, and they have agreed to share their story so others don't make the same mistake, or at least if they do, they will feel really bad about it.

Dreck's started out on a limited budget and had a sales volume of $1000/yr in Beanie Babies. They would buy about $800 worth of BBs and sell them for $1000, netting themselves a sweet 25% profit. Then, as the Beanie Baby craze hit its stride, the owner of Dreck's got a bright idea. He could borrow money, expand his business, and really rake in the dough. The interest rate was fixed, Beanies were cute and would "always go up" in price, so this was a "no lose" situation. In fact, the only way to lose was not to be fully leveraged to the never ending Beanie Baby craze.

Dreck's went to a friend and borrowed $9000, combined it with his own $1000 and now had $10,000 worth of half-filled colored socks in his mother's basement. Dreck's friend, the lender of the $9000, made the loan without collateral, as he trusted Dreck's to make good on the loan.

The risk paid off, and paid off big. Beanies were up 30% in that period, which brought the entire gross sales amount to $13,000. Dreck's paid back the $9000, plus $50 in interest, got his original $1000 back, and still had $2950 left over. His return on investment (ROI) was 295%!


Now, Dreck's was a real business. The owner went out and took his sweetie to a monster truck rally, and got a lift kit for his Toyota 4x4. He also bought shares in in late 1999.

Dreck's did it again. He took $1000, and borrowed $19,000, because he calculated that he would get a 50% return on the sales, and he could then move out of his mother's basement and get real office space. He placed an order for $20,000 worth of adorable bean bags. The lender was happy with the previous investment, so he thought it would be prudent to extend the credit line.

Bubbles have a funny way of popping when the maximum damage will occur, and this would be no exception. Rather than appreciating 50%, the Beanies were now deflating 15%. Dreck's couldn't move his Beanies at the prices he used to justify the loan, and was afraid to put them on eBay at a lower price, for fear the lender would see and call his loan.

That $20,000 order now had a market value of $17,000 and the trend was for it to continue to decline even more.

Dreck's original $1000 was gone, and $2000 of the lender's money was also gone. This is where it gets bad. Dreck's decided to pay the interest and "roll" his loan. He cooked up some false financial statements stating that his Beanie Baby inventory was worth $25,000, rather than the $30,000 he had anticipated, but he was still solvent at $25,000. The lender didn't think otherwise. After all, the lender trusted Dreck's.

The petty cash at Dreck's was drained to pay the $100 interest payment and then the next thing was to find new investors to keep the money coming. Occasionally, some Beanies would be sold to fund the interest payment, but they would be done discreetly, as not to alert the lenders to the crashing market.

No other investors could be found, so the owner of Dreck's hit up his mom for a loan, and she blithely obliged the request.

Eventually, the lender called up Dreck's and asked about the market for Beanie Babies. Dreck's was in debt to his mother, was behind in his UPS bills, and still had a mountain of half-stuffed socks that he couldn't move. He needed to wait until the market recovered, or he was ruined. If the existing inventory was marked-to-market, he would be instantly out of business, and so would his lender, as he couldn't take a 10% hit.

They all agreed that they would lie and say that the Beanies were priced high enough to keep them from being shut down, and hopefully, they would attract other lenders to extract their money from this brier patch.

The other lenders asked to see their books, and when Dreck's said their Beanies were at the theoretical value, the lenders looked at the market and decided that Dreck's could not be trusted, so they refused to invest.

Every Beanie Baby that was sold went to pay off the loan, and Dreck's owner realized that he could never sell enough to get out from under the debt. His stake was completely gone. What money he had to operate came from his mother that was taking Beanies as collateral against the money she loaned.

Now, the mother's rainy day money is gone, and all she has is worthless Beanie Babies. The hair salon doesn't take Beanies as payment, nor does the piano teacher or soccer coach.

No matter what happens, Dreck's can't recover his money. His investors are also in trouble, as their loan was unsecured. Nobody else wants to invest, because they don't trust the numbers that Dreck's uses. Holding the assets won't help, unless another frenzy develops that takes prices higher than what they were before, but with all the Beanies on the market, coupled with the reluctance for people to speculate in bean bags, the price outlook is grim.

Meanwhile, interest payments and overhead need to be paid.

This is why the banks can't just "wait it out." Their leverage killed them, and by lying about their assets, they have guaranteed they will not get the funding to continue. If Dreck's had marked their inventory to market, they would have been bankrupted, but their Beanies would have been sold to "Second Hand Sam's" at auction, and Sam would have marked his new assets at market, gone out for a loan, and sold them for a profit. The lenders would have been paid back with interest, and the cycle would repeat. The lenders are not afraid of Sam, as they know his assets are marked at a true value. Sam cycles loan after loan, and moves Hula Hoops, Tickle Me Elmo, Pet Rocks, Rubik's Cubes, Pokemon, Beanie Babies, and parachute pants at market prices.

The denial is killing us. Lying is for poker, not for banking. This is a multi-trillion dollar bluff that will be called.

Tuesday, October 07, 2008

Blast From The Past: Rent vs Own

Because I have been too preoccupied with the financial self-immolation of our nation, I have not been able to continue the unending string of high-quality postings that Clearcut Bainbridge readers have come to expect. So, in lieu of doing actual work, I thought I would just warm up some leftovers and throw them out for general consumption.

Hopefully, this keeps me in the good graces of all the eco-hip-n-trendy on Bainbridge that really think recycling is next to godliness.

The following is an article I wrote for a friend's blog, Seattle Bubble, back in March of 2007, which was 6 months prior to the national acceptance of a problem in our banking sphere. It is a comparison between renting and buying, and examines a common hypothetical scenario that is used by those in the REIC to justify paying above-value prices for homes.

The comments are at Seattle Bubble, should you wish to read them.

For extra credit, could someone run the numbers on what the ROI was for renting vs purchasing in this example? Use -16% as the capital appreciation for owning the home for the previous 18 months.


Buy If You Must. Why Must You Buy?

by guest poster Eleua (with contributions and spreadsheets by Tim)

Click here to download the Excel Spreadsheet that the numbers below are based on.

I need to take a step back and insert a personal note. While I disagree with the motives and actions of the faceless Real Estate Industrial Complex (REIC), there are genuine, honest, intelligent and wonderful people that work as RE agents, mortgage planners, title agents, contractors, appraisers, granite counter fabs, etc. It might be difficult to find one of these in an sub-prime boiler-room, or on a CNBC interview, but there are those out there making a living that are just as much of a victim as their customers. Please separate my disdain for the high priests and the overall entity from the honest people that believe they are trying to help someone achieve a dream. Second, difference of opinion does not constitute condemnation. I enjoy a healthy, spirited, raucous discussion more than most. At the end of the day, drinks are on me.

With that said, let’s get on with the flogging.

I will be the first to say that buying is a good idea if you intend to live in the house for the bulk of the mortgage period, you can afford it, and it is viewed as your nest, rather than your nest egg. If you are a transient, or you are trying to save for retirement by living in your 401(k), you might get lucky and you might get ruined. Houses are homes. They should not be investments.

200-7! You Crapped Out.
For the past several years, we have been living in a speculative economy. During the late ’90s, this was manifested in stocks, and now it is takes the form of residential real estate. Everyone wants in on the fun. Why not? Real estate, like stocks, always goes up in value. It is a great investment, and the way for normal people to build wealth. At least that is what the Real Estate Industrial Complex (REIC) wants you to believe. They don’t make as much money if you are skeptical.

At first glance, it sure seems like a dynamite investment. Everyone has a grandmother that bought her $600,000 home back when it was $60,000, and if you live in California or Seattle, you can’t go 15 minutes without running into someone yammering on about how much their home has gone up in value. Some idiots treat a daily visit to Zillow like they would a call from their stockbroker.

By Your Lease, My Landlord

The new homeowners are buying into the idea that America does, in fact, have a class system: the Landed Class, and the Perpetual Renters. The Landed Class have unlocked the secret to passive wealth, and the Perpetual Renters are condemned to the outer darkness of blowing their savings on their landlord’s mortgage - a double insult.

All current living generations in America have been force-fed the idea that home ownership is absolutely essential to financial freedom. It is an article of faith in the national religion. Question this and you are branded a heretic. Somehow, through an Orwellian twisting of the language and a corruption of the educational system, debt became wealth. The last two generations that would have disputed this have passed on.

Morons + Money = Lumpeninvestoriat
The REIC sells homes as investments to the Lumpeninvestoriat. Homes are more expensive if the parties attach a high speculative premium. The higher the speculative premium that accompanies a property, the higher the price will be. This reinforces the validity of the speculation. Normally, this is called a bubble. The REIC makes a lot of money fomenting a bubble.

Is a home a good investment? If by investment you mean that it throws off the dividend of a place to call home, then yes. Renting provides the same benefit. If you are seeking a “forced savings program” and capital appreciation, you might be better off with payroll deduction and a quality, value oriented, contrarian investment portfolio.

Pay No Attention To The Details Behind The Curtain
Let’s examine a common exercise that many in the REIC like to conduct to shore up their position that your home is your nest egg.

A gracious local mortgage planner responded to my stunned disbelief that someone would refer to a mortgage as a “forced savings plan” by posting a comparison between a hypothetical renting scenario and buying the same house. This is her example that shows how a house can be a great savings plan.

Owning a home is not right for everyone. There are certain benefits to not owning the home you live in. If something goes wrong with the property, you simply ring up the landlord and they get to fix it. You pretty much know what your cost are going to be month to month (unless your landlord decides to sell the property, increase rent, convert the condo, etc.). On comments from last Friday’s post on interest rates, there is a discussion debating if one could consider having a mortgage as a forced savings plan. I know I’m going to seem biased since I am a Mortgage Planner…and I fully expect all of the number-crunching-junkies out there to have a heyday with what I’m about to post…but here goes!

I found two similar homes, both in the north Seattle area. The rental property is available for $1850 per month. The home for sale, with close square footage, rooms, area, etc., is available (actually, an offer is pending) for $499,995.

With the comparison, I’m going to assume someone has 20% down to either invest in the stock market or to buy a home. The current rate for a 30 year fixed is 5.75% (APR 5.904%). Principal and interest is $2,334 plus taxes and insurance equals a total payment of $2623. First year monthly tax benefits are $606 (mortgage interest benefit will decrease, property tax benefit will most likely increase).

The prospects are in the 28% tax bracket; they have a gross income of roughly $8000 per month and can have $700 in monthly debts with credit scores at 680 or better. The investor will receive 11% from the stock market and the homeowner will benefit from an appreciation of 7% on their real estate.

The first five years with the mortgage provide an average monthly principal reduction of $482.47 per month. Taking out any appreciation factors, the principal paid each month is a forced savings plan. With that said, home equity does not earn interest. And I would probably encourage most clients to consider not using the entire 20% for the down payment to stay more liquid (depending on their entire financial picture).

For many Americans who do not have a savings plan (and the statistics show that many do not save), owning a home is as good as it gets for building savings…and it ain’t so bad.

Let the games begin!

This is a very common proof put out by the REIC to keep the Lumps feeding from their trough. I’ve seen it in a dozen different forms. If it was posted on a billboard, and you drove past it at 70 mph, on a crowded freeway, it would make sense. Fortunately for the REIC, the flashbulb attention span, in combination with the economic and historical illiteracy of your average homebuyer makes this work.

Is This Apples-to-Apples, or Salmon to Mullet?
Using the provided example as the basis for comparison, we will take out our pencils, calculator, green eye shade, and a case of Mountain Dew and hammer out a valid side-by-side look at renting vs. owning.

Rent is $1,850/mo. I guess if you show up looking like you just crawled out from a flophouse in Pioneer Square, you would pay full price. In this market, if you showed any semblance of responsibility and wanted to negotiate, you could knock 15% off that price. However, we will go with the $1,850 to keep as close as we can to “apples to apples.”

Our poor, pathetic loser renter is on the hook for $1,850/mo + 3% hikes per year. Over the first 5 years he lays $117,863 on the altar of his landlord’s good fortune. In 10 years it amounts to $254,498. This assumes that rent tracks at 3%, which with all the building and speculating in real estate is a pretty bold assumption.

Over the same time our budding noble is also shelling out money for his living situation. He paid $100,000 for the down payment, and (according to Rhonda) currently pays out $2,623/mo in principal / interest / taxes / insurance (PITI).

Up until now, I am in agreement with Rhonda. We now need to look deeper into the realities of home ownership to find the true value of each living situation.

Real Estate Always Goes Up - It’s In The Constitution
Perhaps the biggest flaw in the classic “Rent vs. Own” comparison, as put out by the REIC, comes in the form of assumed appreciation of the underlying asset. It is given as an absolute certainty that real estate always goes up. Yes, in the past few years that has been the case. Will it happen tomorrow? Nobody knows - nobody. To assume this is, at best, irresponsible. Capital appreciation is never assumed when assigning value to an investment. Capital appreciation may be estimated for speculative purposes, but not investment purposes.

I am not against speculation - I do it all the time. However, it is speculation; it not investing, just as meaningless sex is not love. There is a huge difference. It is very important not to have expectations of one when engaging in the other. Assigning a value based upon the dividend or benefit an asset provides is investing. Assigning a value based upon someone else’s view of the price is speculation.

It’s Clear Sailing In The Rear-View Mirror
I wonder how anyone in the REIC can so confidently forecast an appreciating market? How do we know the market will not shift into reverse? We don’t. Yes, we can guess, but we don’t know. I would submit that after the breathtaking run in real estate over the past few years, and the problems that we are facing in the mortgage finance space, a very strong argument can be made for a precipitous drop in real estate prices - even in Seattle.

If you run the appreciation at +7%, you would be well served to run it in reverse to give a range of expectations. Back in 2000, many stock bulls (especially those on Wall Street that profit from high priced stocks) believed in the “New Economy.” This New Economy was based upon the absolute fact that certain, high quality stocks will always go up in price. Microsoft, Yahoo, Intel, Cisco, Juniper, Qualcomm, eBay, Lucent, Corning, etc. were all touted as fail safes. Seven years later, these predictions look foolish and self-serving. Had speculators prepared for a significant rollback, the pain may have been alleviated to some degree. Going “all-in” at the wrong time is devastating.

Removing the miracle of perpetual appreciation, the 5 and 10-year numbers for owning would have to be reduced by $201K and $438K respectively. If we reduce the appreciation by the same amount as we assume it appreciates, the owner’s position is reduced further by $126K at 5 years, and $240K by 10.

This is a pretty wide differential for something we don’t know. A prudent analysis would be to not factor in any appreciation. Such was the example in Northern California from the late ’80s to the late ’90s.

Show Me The Money! - Well…Let’s Hold Off On That.
In addition to the folly of just assuming that an asset will appreciate, it is incumbent upon the buyer to understand why an asset appreciates. Home prices track incomes as well as the ability to find easy money. Without easy money, homes could not appreciate beyond what incomes could support. A house is not a bank account that accrues compounding interest.

Unfortunately for our prospective home buyer, both sources of rising home prices are under attack. Mortgage lending has been a festival of economic irresponsibility since 2003. Up until early 2007, anyone could qualify for just about any amount of money with absolutely no documentation or lender vetting. The finance industry made billions selling high fee mortgages and chopping them up for sale in the secondary markets. It was a fundamental blunder to build a business model (or an entire industry for that matter) on lending money to questionable borrowers with lousy collateral. That business is now disintegrating right before our eyes. Lending standards will be increasing dramatically (driven by both government and investors), and rates will certainly rise. The go-go days of insane lending are in the rear-view mirror.

Global wage arbitrage with Mexico, India, China, Russia, and Brazil are keeping a tight lid on incomes. Incomes have been stagnant over the entire duration of the housing bubble, and show no sign of any broad-based increase. Other considerations include rising taxes to pay for the increasing scope of government, immigration pressures, and the retirement of 77 million Mouseketeers.

Comparing With Four Hands Tied Behind Your Back
While Rhonda was generous with her assumptions of the ROI of the renter’s investment portfolio, I wonder why this investment wasn’t treated in the same manner as the appreciation on the house? Why can’t the investment portfolio also include 4:1 leverage? Why assume 11%? If we are in the business of forecasting good things by looking in the rear view mirror, why not use a real example from another investment that took place over the same time period as the latest housing bubble? A 4:1 leveraged investment on silver bullion would have returned $1,120,000 on a one-time buy-in of $100,000 over the past 7 years.

Tax Benefits Need A Tummy Tuck
The tax benefit is overstated. Yes, itemizing mortgage interest and property taxes is a great benefit. If you make $96K/yr, you can do quite well come tax time. The problem comes with the “standard deduction,” which is the tax deduction that you get without itemizing. The standard deduction is less for a single man, than it is for a family. Rhonda assigns $35,293 of tax benefit for 5 years and $67,893 for 10. If we correct for the standard deduction for a family, that tax benefit is reduced to $20,873 and $39,053.

Oops, Your PITI is Slipping
The PITI was probably too low. $288/mo for taxes and insurance is probably more like $550. Tax rates are considerably above ½%.

It is doubtful that the county would keep property taxes stable. Even in a period of decreasing values, it is very easy for local governments to keep their bloated budgets going on the backs of the local citizenry. Even if you assume the tax rate holds steady, if your property is increasing in value, so is your property’s government-assessed value, right? 5 to 10 % property tax increases are certainly well within normal assessments. Let’s say the assessment increases at the same rate as the assumed appreciation, but with a 5-year lag.

So, What Are You Doing This Saturday?
Houses are also maintenance intensive. Rhonda assumed that our homeowner never needed to repair his castle, nor make a visit to Home Depot. If the homeowner spends 1% of the value of his home on maintenance and improvements (what’s a trendy Seattle home without granite, stainless, and bamboo?), we need to add another $400/mo to the equation.

The Highest Fee Brokerage
Finally, the REIC never likes to bring up that a hefty fee exists for cashing out of the home ownership money machine. You need to pay them a minimum of 7% of the gross sale to get at all that wonderful equity. Assuming the home price remained constant, that is another $35,000 out of the piggy bank.

The Bottom Line
Now that we have a more complete picture of the situation, let’s take a look at the financial bottom line for rent vs. purchase in few possible scenarios. We’ll use Rhonda’s given purchase price, down payment, investment return (11%), and rental price, varying only the assumed appreciation in each case. “Home Value” refers to the total amount of money you pocket upon the sale of the house (since that is the only way you can get the money).

The Million-Dollar Taffy Pull
So, did we answer the question of it being better to rent versus own? Not really. It is all based upon how congruent your assumptions about the future are with the reality. Nobody knows what will happen next week, much less 10 years from now. I would say that wildly optimistic assumptions of owning compared to a watered down forecast of the economic flexibilities of renting is not a valid comparison.

People always forget that using borrowed money for investing (whether it is a brokerage margin account or a mortgage) is leverage. Leverage works both ways. It amplifies your success or failures. What turns 4 walls and a roof into the American Dream is the same mechanism that makes it your financial coffin.

Yes, if you get enough appreciation of a home’s value, it makes sense to buy. This is true on any investment. However, if the home stagnates in value, or falls, the damage is magnified by the mortgage, taxes, and illiquidity.

Home ownership brings certain benefits like some level of sovereignty over the use of the property and any ephemeral value from “pride of ownership.” It also brings other pitfalls, such as illiquidity, maintenance, acts-of-God, or even your overweight, aging hippie neighbors that insist on walking around naked as they oscillate between the hot tub and the “herb” garden.

Renters may need more than just the consultation of a sledgehammer and a case of Mickey’s Big Mouth to knock out a wall, but if a heavy-metal band moves into the house next door, they can give notice, pull up stakes and move into a nicer home. If a renter gets transferred, they don’t have to put up with the agonizing process of selling a home in a squishy market, and then paying 7%+ to the REIC. At worst, they lose their deposit and move on.

Lending While Intoxicated
As the mortgage finance industry scraped the bottom of the barrel to find new suckers buyers to put into homes, they swerved head-on into the world of the financially illiterate. Many of these buyers did not have sufficient savings to pay the standard first/last/deposit as required for most rental contracts. Many did not have sufficient income to qualify to rent, yet the finance industry was able to qualify them for a home. This was done under the pretense of getting them into a beneficial financial situation. Rhonda summed it up as follows:

“For many Americans who do not have a savings plan (and the statistics show that many do not save), owning a home is as good as it gets for building savings…and it ain’t so bad.”

Yes, I guess you can refer to the principal paydown on a house as a “forced savings plan.” It is true that most Americans do not have any form of savings, other than their aging Beanie Baby collections, so I guess this is better than nothing. It also presupposes that most Americans are idiots. With that, I agree, but would like to add that allowing an idiot to juggle a half-million dollar, highly leveraged, speculative savings plan is a recipe for an unmitigated disaster in their personal life. Set this against the backdrop of tens of millions of the very same, and you have the certainty of a national financial disembowelment.

Given the recent activity in the sub-prime mortgage finance companies, this hypothetical is now a reality.

Saturday, October 04, 2008

Inslee Wins Immunity!

On Friday, October 3, 2008, America was sold out to foreign bankers by the United States House of Representatives in a 263-171 vote.

There were few bright spots in this disaster, but among the brightest for people in North Kitsap, Bainbridge, Shoreline, Kirkland and Edmonds was that our Congressional Representative, Jay Inslee, kept the faith with his district and voted "NO" on both occasions. As I had pointed out in an earlier posting, Inslee displayed incredible courage as he went against the tide of the House, his party, and the Banking Lobby. For this, we should be very proud.

Also included in the Clearcut Bainbridge "Roll of Honor" are Congressmen Dave Reichert (Bellevue), Doc Hastings (Yakima/Tri Cities), and Cathy McMorris Rodgers (Spokane). Senator Maria Cantwell also voted against this act of treason in the Senate vote on Wednesday. Seattle Representative, Jim McDermott, voted against the bill on Friday largely on the tax provisions, but voted for it on Monday.

It is not the purpose of Clearcut Bainbridge to engage in partisan politics, but when someone displays unusual courage to do the honorable thing and not sell out his fellow citizens to foreign bankers (or even domestic bankers), I believe recognition is in order.

I make no apologies for being a conservative that has voted Republican my entire adult life*. This vote does not change that.

As for the other four unmentionables that voted to put our tail between our legs and lick the boots of foreign bankers, I would encourage everyone in those districts (2nd, 3rd, 6th, and 9th) to vote for the challengers (Rick Bart - 2nd (Bellingham/Skagit), Michael Delavar - 3rd (Kelso/Vancouver), and Doug Cloud - 6th (Gig Harbor/Bremerton/Olympic Peninsula). The challenger for the 9th District (Federal Way/Tacoma/Puyallup), James Postma could not be reached for comment on the Bailout Bill. His website is not clear on the matter. He is likely a better alternative to the incumbent.

In the 6th District, Doug Cloud, is challenging "Congressman For Life" Norm Dicks. I have had two separate conversations with Cloud on the issue, and he is passionately against the Bailout and advocates the banking reforms that will create a healthy, stable, and functional banking system for American commerce. I highly encourage all in the 6th District (Western Tacoma/Bremerton/Olympic Peninsula) to help get the vote out for Cloud and send Dicks to a well deserved retirement.

* I did not vote for Bush in 2004. I wrote in a candidate that actually envisions greatness for America.

Thursday, October 02, 2008

Maria Gets It Right; Patty Sells Us To China

Yesterday evening, the US Senate passed this abomination of a bill, called a "rescue package" by a 74-25 margin. Among the provisions includes a law that allows the Treasury Dept to buy foreign debt from foreign banks and stick it on the back of the US taxpayer. Both Cantwell's and Murray's office were well aware of this provision, as I, and many others, had faxed and called. Senior staffers at Murray's office were well aware of this, per a phone conversation I had with them on the day of the vote.

The fear mongering and lack of public review in these matters is simply breathtaking. We were told on September 19th that if this didn't pass by the time Asia opened on 9/22, that "our economy could end" "payroll would not be met" "and credit would freeze solid."

As of October 2, 2008, all still seems to be functioning normally. Please submit a comment if you hear of any widespread economic collapses.

The purpose of the bill is to give in to economic extortion. We are paying a ransom to keep the Chinese and Dubai money flowing to the US Treasury. Without this money, we would be paying more for credit, which reduces asset prices - the basis of the US economy since 1982. Let's see how long it is before the next ransom payment is due.

That's the trouble with bubbles - once you start blowing, you can't stop. Eventually, the bubble breaks.

Please take the time to call/fax Senator Cantwell and express your appreciation for her courageous vote in a losing cause. She deserves the backing of grateful Washingtonians for her vote.

As for Senator Murray...

Senator Cantwell: 202-224-3441

Senator Murray: 202-224-2621

[Edit: I found this YOUTUBE of someone who "gets it." I assure you this is not me. The clip is not overly profane, but is definitely rated PG]

Tuesday, September 30, 2008

Paying For Chinese Subprime

This is getting to be worse than a bad drive-in horror movie. The villain not only refuses to die, but comes back in an even more hideous form. As if $700B for American financial toxic waste (yes, that's what it is called) wasn't enough, we now are going to pay for as much Chinese, Japanese, English, and Arabian toxic waste as they can shovel at us.

Don't believe me? Here is a copy of the bill that will be attached in the Senate on Wednesday. [Edit: The Senate Bill is here.]

Go to page 33 and read Section 112

The Secretary shall coordinate, as appropriate, with foreign financial authorities and central banks to work toward the establishment of similar programs by such authorities and central banks. To the extent that such foreign financial authorities or banks hold troubled assets as a result of extending financing to financial institutions that have failed or defaulted on such financing, such troubled assets qualify for purchase under section 101.
Is this a great country, or what? We are going to buy all the US toxic debt and as much toxic debt the world's bankers can throw at a US subsidiary of their bank. We are going to fund the Communists and terrorists with AAA rated, US taxpayer backed governement bonds.

I would like to thank Congressman Brad Sherman (D-San Bernardino) for getting this into the public dialogue. You can see the YOUTUBE of his time on CNBC where he discussed the matter.

Normally, foreign leaders don't take much interest in US spending legislation. I don't recall any foreign leader panting at the prospect of each of us getting a stimulus check, but they certainly have come out and supported this.

Now we know why. They want a huge slice of free government cheese.

If the Chinese sent their revenue collection agents to the US to shake you down for tens of thousands of dollars, we would shoot them where they stand. Thousands of Chinese tax agents would be lying in a pool of their own blood on American doorsteps. However, under this plan, US IRS agents would be shaking you down on behalf of the Chinese bankers that wrote bad loans on Chinese real estate.

You read that correctly.


The bought and paid for lapdogs in the US Senate will likely pass this because only 1/3 will have to face the voters this fall. Expect most of that 1/3 to vote against this and the bulk of the 2/3 that is not up for reelection to vote in favor.

Our battle is in the House - OUR HOUSE!

When the word gets out that Main Street America has to bailout Chinese high-finance, the US will be shaken to its core. The stock market is going to lose value, and it will happen with vigor once the rush has worn off of dim-bulb US equity investors. I fear for any politician that votes for this.

Bush and Paulson have sold us out. No matter how you slice this, it comes up rancid. The Administration was either asleep at the switch, intentionally lied to us, or holds us in such contempt as to enslave our children to Chinese bankers.

When asked by Congress if the Administration would accept a bill without the foreign toxic waste purchases, Paulson told the leaders of Congress that the bill would be vetoed if such a provision were not present.


So, we now know what happened in the past few weeks. Paulson got a margin call from China and Dubai. They waited until the elections were drawing near and held out their money from the US markets. The credit market froze and China said that we have to take their bad bets, or they quit funding our deficit ($2B/day - $200/mo for every man, woman, child). China's stock market has lost 2/3 of its value in the past year, and they need money. They sold us cheap plastic crap, and we sold them toxic mortgage paper. They want a refund.

They did this during the Fannie/Freddie bailout. Paulson said that foreign interests needed this bailout, as the NON GUARANTEED Fannie/Freddie bonds started dropping in value. That's why THE US TAXPAYER had to make good on NON GUARANTEED bonds purchased by China. Now you know why these bailouts never include you.

Economic terrorism - and we are not only negotiating with these terrorists, but giving in to their every demand.

Why? So Wal-Mart wil continue to "roll back prices?"

This has the potential to get extremely ugly. Call your Congressman and call him now. Explain section 112 and how you will not stand for US taxpayers paying for Chinese and Arabian high-finance gambits gone bad. You stood firm against bailing out American bankers. Now is the time to tell them that you will not stand for this treasonous bill that is before the Congress.

This will not help you get a mortgage, auto loan, college loan, or even help your paycheck clear. This will make all of those things harder to obtain. You are being asked to float the bill for the entire world's spending orgy.

Oppose this. Pray for your country. Call for impeachment. Pull the plug on China while we still can.

The following is a more detailed explanation by a friend of mine. Please take the time to learn more.

Monday, September 29, 2008

Thanks To Jay Inslee

Here is a letter that I just faxed to Congressman Inslee's office. I would encourage all in the First District to do likewise.

For those of you in the Sixth District, you may want to get out your pitchforks and torches.

What Inslee did today took guts - LOTS OF GUTS! When the biggest, most powerful lobbying force in world history pushed all its chips to the center of the table and said "all-in," Inslee called. He went against the banking lobby (which runs the DNC), The Speaker of the House (whom he voted for), the leadership of his party (which is his lifeline), the President of the US (OK, no big deal there. Bush is radioactive), the Treasury Secretary, and the Chair of the Federal Reserve. He sided with the American People, and for that I am extremely proud to be an American and a resident of the Washington First District.

Jay, you did the right thing. The problem with the credit markets does not go back weeks or months. It goes back decades, and $700B was going to vaporize on contact. The FED shot $630B into the markets today, and look what happened. Had this passed, and the markets sold off before election day, every "yes" vote would have been running for cover.

To all the members of the First District that wrote in to OUR CONGRESSMAN and gave him the courage to do the right thing, you should hold your heads high. What you did was keeping with the greatest traditions of American citizenship. You gave your Congress a way out of Paulson's Hobson's Choice.

This is still our country. Be proud.

September 29, 2008

The Honorable Jay Inslee:

I understand that you have voted against the Wall Street Bailout. As someone that has been in close contact with your various offices and has been actively lobbying against this bill, I would like to say one thing:



Sunday, September 28, 2008

What's The Big Bad Secret?

One theory that I have held for several months is that the US banking system has been insolvent since the Dec07/Jan08 time period. Since then, the US Federal Reserve has been keeping these rancid banks on life support by loaning good money (US Treasury instruments) for bad money (various flavors of Mortgage Backed Securities). Back in the spring of this year, I noticed that the "burn rate" of the FED's reserves would put them in the red by September 2008.

Note that the crisis was brought to the Congress on September 18, 2008.

Here is a chart to illustrate what I am talking about.

If the mortgages are bad (and we know they are), then the FED is out of money. This would certainly get the Congress' attention, and explain all the panic and hush-hush over the specific problems.

Again, Paulson and Bernanke had to have known about this months ago.

If this theory is true, then giving $700B isn't going to solve the problem. It just rolls back the Day of Reckoning to March, if that. It would likely come sooner because the problem with the US banking system is one of confidence.

Panic, hush-hush, fictional accounting, infinite leverage (yes, that is part of the new bill), and Banana Republic dark-of-night rule changes do not inspire confidence.

Friday, September 26, 2008

Welcome Kitsap Sun Readers

Thanks for taking the time to stop by. The purpose of this is to discuss the rise, fall and consequences of the property bubble, or more accurately how the underlying credit bubble caused the property bubble and how it will play out in the coming years.

My basic thesis is that the US economy was underpinned on the false premise that "real estate always goes up," and since that is economically and mathematically impossible, the US economy is going to suffer for that mistake.

If you disagree, I want to hear from you. I don't offend easily, so don't be shy.

All I ask is that you stay on topic and not be excessively profane.

Tuesday, September 23, 2008

A Way Out Of This Mess

The following is a letter that I have given to Inslee, Cantwell, and Murray. I have also put this to every member of the House Financial Services Committee and the Senate Banking Committee.

If you agree with this, please visit:

Please take this letter, put it under your name and send it to your representitives. I have been working with Inslee's staff in DC to get this into the hands of someone that can get this moving. If you would like to help, please do so. Call Inslee's office at 202-225-6311 and tell them you like the proposal and want to see it implemented. It gives Congress a "way out" of the current mess that Paulson and Bernanke have trapped them.

If you are in Norm Dicks' district, I encourage you to press his office. He is one of the most powerful members of Congress and he can get things done.

Please leave a comment if you have any questions. Due to the serious nature of this matter, I will have to pass on my normal snarky tone. I hope you understand.


A Solution That Works

The Honorable Jay Inslee:

By now, you have been thoroughly deluged by angry phone calls and letters from your constituents. They do not wish to pay Wall Street bankers trillions of dollars of their hard earned money for putting our financial system at this level of peril. You should respect their wishes.

However, you can’t leave without doing “something,” and that “something” always seems to come with a hefty price tag and an uncomfortable level of trust given to those, who for the last 18 months, have told us not to panic and that all is well. There is a solution that costs the government nothing, eliminates “moral hazard,” and ensures we never have to do this again. Any variation of the current proposal lacks all these features.

The solution is to fix the problem, not paper it over.

For the past 13 months, every “crisis” in the banking sphere has descended from three basic flaws in the current regulatory structure:

- Over leverage. The failures of the Bear Stearns, Lehman Bros., Merrill Lynch and various hedge funds descend directly from their level of financial leverage. At the present levels of leverage, one mistake and you are dead. Back when these financial institutions were regulated to carry no more than 12:1 leverage, we didn’t have banks blowing up every 13 weeks.

- Unregulated derivatives. This is what caused the trillion dollar insurance company, AIG, to be taken under by the Treasury Department. Financial service providers made billions writing insurance policies that were unregulated and carried no regulatory oversight that ensured they would be paid in the event they were triggered. No other category of insurance policies is unregulated in this manner. Warren Buffet refers to these instruments as “financial weapons of mass destruction.” The notional value of these numbers in the tens of trillions.

- Fictional Accounting. This is the precise reason that “short sellers” have pounced on the various financial institutions. The current accounting allows banks to intentionally produce fraudulent financial statements, regarding the value of various assets they claim as part of their net worth. The short sellers understand that the value of these stocks are grossly under their current price and act accordingly. Banning short selling does not change the fact that these companies are priced well above their value. You NEVER see short sellers attempt this with healthy, truthful companies.

The solution is to pass a comprehensive regulatory reform bill that:

- Reduces leverage to safe levels. This needs to happen over the next two quarters. Company reports shall be required to show that financial leverage is within statutory limitations, or enforcement action will follow.

- Put Credit Default Swaps on a regulated exchange. This ensures the insured party can be paid and prevents the nightmare scenario of a chain-reaction of defaults across the system. The equity options markets are a good example of how this needs to be structured. No company may be allowed to write these derivatives without the capital backing necessary for performance.

- End fictitious accounting practices. Every company must mark all of their assets to current market value on their quarterly and annual statements. Each asset must have its own accounting as to its value. This way, full transparency is brought to the marketplace and investors know exactly what they are buying. This will end the practice of hiding unhealthy companies within the larger herd of structurally sound companies, as is the current practice in the US banking system. Capital will immediately flow to the healthy companies and the assets of the unhealthy companies will be taken into the market and deployed to their most efficient use. The current practice only serves to cast a pall of doubt over the entire sector until it fails en masse.

Note that these proposals end the current “crisis” within two quarters. These proposals do not cost the taxpayer one dime. They fix the problem, and most importantly, they eliminate the enormous moral hazard that is present in any derivation of the current Paulson/Bernanke proposal. They establish the framework for building a healthy, stable, and useful financial system in the United States. “Bailouts” and dark-of-night enforcement changes are obviated.

The Congress retains all of its financial oversight and regulatory powers. The Administration is consigned to its enforcement role, as the Founders had set forth.

For more information, please go to:

We are a non-partisan organization dedicated to banking transparency and regulatory reform. Our proposal is simple, effective, permanent, and cost neutral. We are not coming to you at the last minute with some hideous scenario that we denied for 18 months.

We are giving you a way out of the present mess in a manner that the taxpayers you have been hearing on your telephones will cheer.

Please do the right thing. Do not give our money to Wall Street. Force them to take their marks like the rest of America.

Very truly yours,

Sunday, September 21, 2008

Enabling Act of 2008: The Rise of The Fourth Reich

The following is a letter that I have sent to Senators Murray and Cantwell, as well as Congressman Inslee. Please feel free to copy this and send it to anyone you believe will benefit from the content.

Enabling Act of 2008

Dear Member of Congress:

You are being asked to assign unprecedented powers to an unelected, and unaccountable former Wall Street banker, under the guise of bringing stability to the markets and solvency to our banking system. With one hastily thrown together vote, you are going to create the most powerful human being in world history – Henry Paulson.

This is being done for the purposes of fixing a “crisis” that has suddenly, in the last hour, been presented to Congressional leaders. This act would remove the constitutionally mandated powers of regulation of the money supply, and the value thereof, from Congress and give it to an unelected member of the President’s cabinet. According to the act, this person would be above judicial review, and be allowed a $700,000,000,000 revolving line of credit to print money on behalf of the United States government. That is more power than anyone has ever had – anyone. Caesar did not have this power.

This should sound eerily familiar.

In March of 1933, after the “crisis” of the Reichstag Fire, newly named Chancellor of Germany, Adolf Hitler, petitioned the German Reichstag to give him plenary powers over the affairs of German government. The Reichstag transferred its power, on an emergency basis, to the Cabinet of Germany for a period of four years, and this was called “The Enabling Act”. This was to deal with the perceived “crisis” of Communists within the German government, when the “crisis” was never fully substantiated. It is believed by most historians that the Reichstag Fire was a deliberate act to coax the Reichstag into giving up its power.

That history did not end well.

You are being goaded into giving Henry Paulson plenary powers over the economy and government spending, money supply, and value of that money. Those powers belong to you, held in trust for the citizens of the United States. Our Founders gave you those powers TO PREVENT THE VERY SCENARIO THAT SECRETARY PAULSON HAS PRESENTED TO YOU.

You are being manipulated.

For the past 13 months, Paulson, and Federal Reserve Chairman, Bernanke have repeatedly given public statements through the various media, and have testified to Congress on the soundess of our banking system. As that time has worn on, they have repeatedly come to Congress for various bailouts (Bear Stearns, AIG, Fannie/Freddie), as well as acted to install confidence through the manipulation of the Federal Reserve Monetary Policy, and announcing various liquidity programs to keep money in the banking system (TAF, TSLF). While they have been taking extraordinary measures to shore-up the banking system, they have always maintained that the system is sound and just needs a little time to get through a “soft spot,” or a “contained” problem (Subprime).

You now know that they were lying the entire time. There is no way to sugar coat this. They have been lying to you since March of 2007. They are lying now. This was plainly known to many in the professional and amateur investment community, recently smeared as “short sellers.” It turns out that the cynics were right all along.

Ask yourself, why didn’t they come to you for this unprecedented bailout last October, when Paulson attempted the same thing with various Wall Street banks? Surely, the problem was known last fall when Paulson attempted to create his “super SIV.”

Had he come to you at that time, there would have been at least 11 months to debate the issue, open it for public review, and deal with it while the stock market was trading at an all-time high. Why did he wait until the weekend before the Congressional recess for the bi-annual election cycle, and present the plan over a weekend where the public could not comment? Why did he have to wait until the stock market teetered on collapse, and the credit markets were frozen solid?

He needs a “crisis” so you will not oppose him.

Ask yourself, why did the Senate Majority Leader and Speaker of the House, as late as September 16, attempt to leave the issue in Washington and head back to their districts, leaving the Administration to clean up the mess, then suddenly have a change of heart less than 36 hours later? What was said? Why are the details of the briefing given to Congressional leaders not available for public review? Why are you being asked to vote for something so hastily and without proper briefing or public review? Does Democracy flourish in the dark, or does tyranny and fraud?

We know the following:

-Paulson and Bernanke have lied for the duration of the credit crisis.
-Every bailout has been bigger, more frequent, and has resulted in a much bigger “crisis.”

Now, Paulson and Bernanke are telling you that they really are telling you the truth and this bailout will work.

You are being played.

They are framing the issue in terms of Congress voting to rescue the banks and the markets. Let me be clear on this point: YOU ARE NOT VOTING ON THE HEALTH OF THE BANKS OR THE MARKETS. YOU ARE DECIDING WHO GETS WHAT MONEY IS LEFT OVER AFTER THEY FAIL. The markets (equity and credit) are going to experience a large dislocation, or in the common lexicon, “a crash.” That is an absolute certainty. You are merely deciding if the US citizens are going to keep their money, or give it to Wall Street bankers. You are deciding if the US government is going to survive or collapse. Giving Paulson unlimited spending powers will ensure that the government collapses. That is a certainty.

Paulson and Bernanke need to be removed from office for malfeasance. For 18 months, the health of the banking system has been very suspect. They have known all along what is happening and have failed to act. Their actions have been limited to lying to Congress and the American people and manipulating the accounting to cover the insolvency of the US banking system.

You are being asked to abdicate. The American people want their Constitution and their government to survive. We will rebuild what Wall Street has destroyed, but we need to keep our money in order to do it.

Vote against this unprecedented power grab. History shows the folly of such endeavors.

Very truly yours,

Sunday, August 10, 2008

When Is The Bottom? - IER House Valuation Workshop

At the Institute For Economic Reality, we are always trying to help people out of their self-imposed, colo-cranial economic impairments. Judging by the volume of chatter on how the real estate market is suddenly "affordable," it would appear that we have our work cut out for us.

When home prices have gone up 150-200% in a decade, a 15% rollback isn't exactly a buying opportunity. Keep in mind that during the run up, the "experts" all predicted that prices would not decline, but would level-off and allow incomes to catch up. When confronted with a slowdown, these same experts said that a 10-15% rollback would represent the "worst-case" scenario.

The delusion is understandable. Bainbridge Island is populated with Babyboomers, and Boomers have seen property prices increase for the bulk of their life. In fact, real estate is the one "investment" that Mouseketeers think they know well. The prospectus for a Boomer's investment in real estate goes something like this:

Property prices have gone up, so they will continue. My real estate agent said this is the "bottom," and I had better buy now or be priced out forever (they would never tell me something that is self-serving and against my interests).
Is there an objective metric to value a home? Should you jump all over a home that has been reduced in price $10,000, or wait for a better value?

As we like to say at the Institute For Economic Reality, the difference between a good home and a good investment is the price you pay for it. There are many good houses on the market, but we have yet to find a good investment.

For example, if we have a home that is located in a neighborhood where the median household income is around $75K (the Bainbridge median), and the home represents the median home, what would the value be? Let's say that it rents for $2100/mo, with property taxes of $3600/yr.

Why is the rental rate important? Given that all but the truly clueless believe we have been in a credit bubble, and that bubble distorted the prices of things purchased with credit (homes), we should expect to see a difference between the bubble value (price), and the non-bubble value (rental value). This is because rents do not move up and down in a credit bubble, as easy credit terms are not available to renters like they are to home owners. Put in another way, you never heard advertisements on the radio, or TV that told renters that they could reduce their payments and get more house, with cash back, and no credit checks. These programs were only available to people that were buying or refinancing homes. Renters had to rely on good, old-fashioned income ratios to qualify for their leases, and the rates they pay reflect the true value of the property.

After all, the only "dividend" the mortgage throws off is not having to "throw your money away on rent."

The difference between the rental value and the price is the speculative premium. That is the amount of money that you are committing to attempt to capture a rising sales price of the home. Given the recent national obsession with the concept, it should be no wonder to people that people have committed lots and lots of money to chasing higher resale values.

$2100/mo equates to $25,200/yr in gross income. That's all you get. That is the absolute maximum amount of cash the home can generate. That also presumes that you keep all of it.

The county assessor still gets her chunk.

The property manager gets her chunk (unless you do you own management).

The property still needs maintenance, and that comes out of the owner's pocket.

The house will likely be vacant from time to time.

If this is your biggest "investment," then you need insurance.

If taxes consume $3600/yr, and property managers get 10% (likely 15%), and the house is vacant 10% of the time, while you are dumping $500/yr into maintenance (optimistic), then your net cash generation, before income taxes, is $ 15,160/yr. This presumes you paid cash for your house and there is no mortgage. Your insurance is $900/yr.

That is your return on investment. What yield are you seeking? Are you going to accept a yield that is below that of US Treasury debt? If so, why are you risking so much for an investment that yields less than the safest investment on earth? You have to command a higher interest rate than that of a T-Bill, or CD at your local bank.

How much of a premium do you need? That varies by individual, but given that real estate is actually somewhat risky (vacancy rates, tax hikes, bad tenants, unforeseen maintenance expenses), you should ask for a few hundred basis points above Treasury debt. If the 10 year T-Bill is yielding 4%, and a bank CD is yielding 5%, one would think that an 8% ROI would not be unreasonable. If I am only going to get 5%, why would I even bother with all the fuss and hassle of putting up with renters and a home that needs maintenance, when I can take my money to the bank and spend my time golfing?

At 8%, your yield goal multiplies your net cash by 12.5 to arrive at the value of your "investment." $15,160 / .08 = $189,500.

YIKES! Can anyone find a Bainbridge home for this price? If so, does it rent for $2100/mo?

If we raised the rent to $2200/mo, did our own property management, and lowered our yield to 6%, we still arrive at $312,667. This presumes that with the orgy of building that has taken place, the amount of rentals on the market would command such a price. Keep in mind that $2200/mo is 35% of the median income for Bainbridge Island. Home costs have historically capped-out around 28%, and the renter will normally carry his own insurance.

If that house has a current market value of $650,000, then the speculative premium is $460,500 (or 71% of the price) for the realistic example, and $337,333 (or 52% of the price) for the delusional "investor" that is content to take large risks and expend a lot of effort to barely beat the local bank's CD.

In order for the rental value to equal the speculative/market value of the property, the "investor" would have to be content with a 2.3% ROI in the managed property, or 2.9% ROI in the unmanaged property. Just for perspective, a 120 day CD at American Marine Bank goes out at 2.45%, and I'm guessing you don't have to worry about fixing a roof, replacing a water heater, or scramble to find tenants when September comes around.

The above example is EBIT (earnings before income taxes and interest), but the overwhelming majority of "investors" will carry a mortgage. This begs the question, "Does it cash flow?"

Let's see. If we have a 6.5% mortgage and a 15% down payment, then our payments on a 30 year-fixed run $41,944/yr. That's an annual cash-flow loss of $26,784, assuming there are no further hikes in taxes, maintenance, or any prolonged vacancy period. Remember, our rental assumptions were fairly optimistic.

At the end of 10 years, the total cash outlay was $267,840 in direct cash-flow losses, plus the original 15% down payment of $97,500 for a grand total of $365,340, or $3,044/mo (average).

You should have $182,144 in equity, but you still have to pay approximately 7% in closing costs and real estate fees to get at that money, which reduces your equity to $136,644, assuming you broke even on your house price (sold it for what you paid). Remember, we are not calculating speculative premium, but are merely looking at the value of the investment without the idea that home prices will perpetually escalate. Prices can go either way.

So....our "investment" cost us $228,696 over 10 years. That is money that we flushed away. It would be more if that original $365,340 was earning 5% in a CD, but for our comparison, we assumed the "investor" kept his cash in his mattress.

In order to beat the 5%, our home price would have to appreciate to offset the amount our negative cash-flow would have grown to at 5%, which is $508,619. That is the amount the owner would pocket at the closing. If the "investor" owes the bank $467,856 at the 10 year mark, then the property needs to sell for $976,474 AFTER REAL ESTATE FEES AND CLOSING COSTS! In order to pay Cookie and Candi, we need to sell our "investment" for $1,049,972.

Good luck with that.

Is this scenario reasonable? Look at the price/income ratio.

Currently, the median household income for Bainbridge Island is $75K/yr, which puts our $650K median house at 8.67X income. If we assume an above-trend line income growth for Bainbridge of 3%, then in 10 years the median income will be $100,700, which puts our price/income ratio at 10.4X income. You would have to assume that we would get an above-average income growth (after a spectacular 25 year bull market), and that future buyers would wish to buy your tired rental for an 10.4X ratio, when you only paid 8.67X.

Keep in mind that prior to the credit bubble, a 4X income ratio was considered very exotic and the normal range is from 2.5-4X income. Sub-2X incomes are not unheard of in some parts of the country with high incomes.

What would the value of the median Bainbridge home be if ratios were in historic norms?

$187,500 to $300,000. (Didn't we see $189K earlier in this example?)

What if we overshoot in the correction to 1.75X? After all, we have lots of new inventory with a population that can't even keep schools open. If a major Seattle employer gets wiped-out in the credit crunch for writing zany loans and playing fast-and-loose with their accounting, that will be a gut-punch for Bainbridge incomes. What Might that business be called? (Edit: On 9/25/08, WaMu was seized by the FDIC)

Also, how many new Bainbridge residents have been selling real estate for a living? How many write loans, do appraisals, home repairs, additions, and speculative building?

Had enough? I have not. Let's look at sustainable lending, as the unsustainable lending is what got us in trouble in the first place.

If we assume that the only debt our prospective home buyer has is the mortgage on his house, and that historical, sustainable mortgage debt loads have topped-out at 28% of gross income, then how much house can we buy at 6.5% and $75K/yr gross income? They can afford $21,000 for principal, interest, taxes, and insurance (we will assume no HOA), which equates to $217,343 if we still have the taxes and insurance listed above. If we drop the taxes to 1.5% of purchase price, then the house value goes up to $221,136.

Remember, other debt (student, plastic, auto, personal) will start to weigh on a bank's ability to fund your mortgage. Our example was a "debt-free" person seeking a mortgage. How many of those people in the median income range do you know?

All the above examples presumed that we are not in a massive economic downturn and that interest rates remained at 6.5%. Both of these assumptions are not realistic. Run the numbers with mortgage rates at 9% to 14% and you will likely get a feel for what the next 10 years will look like.

I hope you enjoyed our workshop. The Institute For Economic Reality seeks to push back the frontiers of economic cluelessness. By now, you should be familiar with the amount of speculative premium that exists in Bainbridge Island real estate. Your homework assignment is to calculate the value of a second/third/vacation home with people laboring to make their payments under the above mentioned conditions. Remember, the latest "bailout" from Hank Paulson removes the tax write off for the "2 in the last 5" provision of a secondary home.

Stay solvent.

Ernst Stavro Bloviator
Senior Fellow, IER.

Tuesday, July 29, 2008

Is Bainbridge A Bargain? No, But It Will Be.

You know it's bad when the "Open House" signs outnumber the "Obama '08" signs by 2:1.

This is Bainbridge Island, Washington - the "Martha's Vineyard of the West" (yes, they really say that, and it is embarassing)- a place where smug, liberal dreamers come and bask in everlasting home appreciation.

One are not appreciating. It turns out that Bainbridge Island is in the same credit pool as the rest of the nation. Believe it or not, Bainbridge Island has to borrow money from the same places that troglodytes in Nevada, Florida, Indiana, Texas, and Kentucky borrow money. For some odd reason, there isn't a boutique lending facility with special rates and conditions for the anointed in 98110 (or 98061 if you are really hip-n-trendy).

Could it be that people on Bainbridge are being confronted with the economic reality that there is a finite amount of money suitable to be set against a 30 year old, drafty home? I guess the idea that we are "special" isn't moving homes as it once did. Perhaps we were never "special," but just a convenient place for Californians to sell out of mediocrity and go slumming up north with all their hard-won home equity. Now that Californians are likely to be facing foreclosure, they don't have all those Bongo-bucks to throw around anymore.

My sources tell me that an abrupt change happened in October '07, with regard to the X-Cal market. It confirmed my hunch and the most recent numbers certainly solidify that assumption.

If the median house on Bainbridge Island is somewhere between $625-$850K (let's call it $750K for good measure), and the median household income is a hair over $75K, that might have quite a bit to do with the rollback in prices.

$75K/yr = $6250/mo. That's the income without all the zany home appreciation money that people were sucking out of WaMu refis and HELOCs by the boatload. In other words, if we don't count new debt as income, the median household on Bainbridge has to get by on less than $6500/mo.

Subtract $700 in federal taxes (it is likely higher)
Food - $500
Gasoline - $150 (assuming a Prius with an "OBAMA '08" sticker)
Insurance - $100
Utilities - $300
MC/Visa - $1000
Health - $500
Prop tax - $300
Prop insurance - $75
Auto debt - $400
Ferry - $150
Home maintenance - $200

That's a pretty spartan Bainbridge lifestyle. That presumes no annual trips to the Himalayas, Botox/Viagra, private schools, college debt, professional fees, B&B trips to Napa, Burning Man, visits to the shrink, bail money for "Paint Night," dinner parties with the Hip and Trendys, orthodontia, Eurail passes for the kiddies, 401(k) contributions, life insurance, pet day spa, and trimming down to the NYT Sunday Edition.

Assuming this is the median Bainbridge lifestyle and income, that leaves $1875/mo for the house payment. At 6.5%, 30 years, and 20% down, that's a $370,471 house. This presumes that every last dime went to the house and the median person has $75K in liquid cash to throw at the mortgage. At 7%, the house price drops to $352K, and at 8% the median Bainbridge household can afford $319,200.

Although it is fair to note that by using canvas shopping bags, you can save a nickel at Central Market for every plastic bag you don't use. While that $1.50 can get you a cheap cup of coffee once per month, the smugness of knowing that you single-handedly saved the planet can not be measured in dollars. Drive up in your Toyota Pious, complete with "OBAMA '08" bumpersticker, and you have just exercised the "nuclear option" of eco-smugness.

Let's look at it from a debt to income perspective. With a house payment of $1875 + $75 + $300, that makes the home DTI of 36%, which is too high by normal underwriting standards. Given the unrealistic budget outlined above, the high ratio makes sense. The price still has to come down.

Before the lending madness of the past decade, it was considered to be prudent to establish a 28% cap on home costs (not including maintenance) versus gross income.

$6250 x 28% = $1750, which makes us $125 overbudget. Take out that $125, and your home prices at 6.5%, 7%, and 8% drop to $345,700, $328,500, and $297,900 respectfully.

We won't consider further debt encumbrances like college loans, payments on the snazzy new Prius, or any lingering damage on the plastic.

Keep in mind that the person in the above scenario needed to save somewhere between $60K and $75K to drop 20% for the down payment. The budget does not have any savings of any kind.
If I recall correctly, the median price for Bainbridge Island during the years prior to the housing bubble was right in the mid-$300K range. Coincidence?

Studies of the value of a home, as measured by EBIT, cash flow, and rental substitution also peg the median value in the low to mid $300K range. Assuming that we don't get a rollback in income and that we don't overshoot in the correction (both wildly optimistic assumptions), we are looking at a substantial correction in Bainbridge Island real estate of 2/3 off the peak price. Supply has shifted dramatically upward, and when the speculative premium becomes a discount, 75-80% off the peak valuation will certainly be common.

When I ride on the ferry, I never hear anyone bragging about how expensive their homes are. Back in 2005, that's all I would hear. I don't see as many California license plates as I once did.

The tide is going out.

Ernst Stavro Bloviator,
Senior Fellow - Institute For Economic Reality