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October 23, 2008

Unintended Consequences
by David Galland

As you may know, here at Casey Research we are not optimistic about the outlook for real estate, that lynchpin of the U.S. economy. This pessimism is evoked by a number of factors, starting with the simple fact that residential housing increased by about 50% between 1992 and 2007, massively outpacing population and income growth over the period. As you absolutely know, much of that excess inventory is in the hands of individuals who simply can't afford to pay the freight.

Then there is our hardened belief that the equivalent of an express train wreck is about to happen in the 4 - 6 trillion dollar U.S. commercial real estate market. There will be a lot less in the way of Ho! Ho! Ho! this holiday shopping season, and a lot more Oh... Oh... Oh's.

And none of it is helped by the inevitable rise in interest rates, which are today at near 50-year lows. While we might not be quite at the bottom, we're close... after which we expect a persistent rise as the government bailouts flow through the inflationary pipeline. Of course, wounded housing markets react about as well to rising interest rates as I do to the prospect of my taxes going up in the next administration.

Unfortunately for the housing market and by extension the U.S. economy, we are already seeing the ghosts of what's to come. This just in from Bud Conrad...

"The U.S. government's conservator status of Fannie and Freddie was supposed to lower mortgage rates, which it did for a few weeks. But we have now started to see the unintended consequences of guaranteeing the banks - namely that investors are moving away from housing-related debt and investing it in bank debt instead, pushing mortgage rates up. My sense is that movement by foreigners away from agency (Fannie Freddie) debt contributed to the half-point rise in mortgage rate, too. The TIC data confirm that shift.

The result is that housing will be further hurt with the higher rates and will continue to fall in price."

On the same topic, the news is out this morning that in September, single-family home starts in the U.S. fell to the lowest level in 26 years. Just 544,000 new homes would be built over the next 12 months (if the trend were to stabilize here, which it won't).

Just so you have the right perspective, at the peak of the bubble, annualized housing starts in the U.S. were running at 2,265,000 units, so we're seeing about a 75% decrease.

By the time this is over, it wouldn't surprise me to see housing starts fall to 10% of the peak.

Of course, housing is far more than just "another" economic stat. In addition to the tragic financial and emotional implications of coming up short on the mortgage on a personal and even societal basis, there are the direct consequences to the broader economy. No more excess equity to borrow against to fund shopping sprees, and none to allow for a comfortable retirement for far too many.

This is, and will continue to be, a big problem for the economy. While there is no soft solution at this point, the best we could hope for is that the damage will be quick to come and quick to pass. But the only real way for that to happen is for house prices to fall to the point where ready buyers are available. And that entails workouts between lenders and borrowers, or outright foreclosures, to clean up the mess and allow the market to function as it certainly can, and will again... if left to its own devices.

Unfortunately, the plans now being bandied about by the government envision pretty much the polar opposite of letting the market clean itself up. Rather, they involve taxpayers buying defaulting mortgages and even the imposition of a moratorium of some duration on foreclosures. Most people read news such as that and shrug it off. It may help to view these ideas through a narrower spectrum.

For example, imagine you are the president of a small bank and you had lent money in good faith to someone in the neighborhood. We'll call him Joe as that seems to be a popular name for these sorts of examples these days.

For reasons only known to him, Joe has stopped paying on his mortgage, leaving your little bank on the hook for $200,000. Following procedure, you have Mrs. Smith down in the lending department send Joe a nice letter asking him what's up, to which she receives no response. So you personally send him another letter, this one offering to have him down to the bank to have a chat and see if you can work things out.

No response, no money.

So, uncomfortable at having to perform the duty, you give Joe a call and he admits he is in over his head. When you offer to help him work out a payment plan, he calls you a blood sucker and hangs up on you.

Pained by the outcome of your loan, because you'd rather be getting paid back on the agreed-upon terms, you call up your lawyer and reluctantly authorize the expense of beginning the foreclosure proceeding. At that point, you know you will likely spend thousands and the better part of a year trying to get back your property (and it is your property). But what choice are you left with?

And then you hear - as does Joe - that Congress is seriously considering passing a moratorium on foreclosures, and you reach into the locked drawer of your desk for the flask you keep there for such occasions. Joe, meantime, heads down to the local deli for a six pack to celebrate free rent for the foreseeable future, perhaps paying for his purchase by selling off the copper pipes he's ripped out of the guest bathroom.

This exercise is, of course, little more than the morning musings of a sleep-deprived mind, and I am well aware that the circumstances surrounding the defaulting on loans are as varied as humanity itself. Even so, the underlying principles are the same. There is a contractual agreement between a lender and a borrower that no one had to be waterboarded to sign. In the event of a failure to perform on the part of either party, it is up to the two parties alone to resolve -- with the help of an impartial judiciary if an impasse occurs.

Interjecting an overreaching government run by perfect-worlders into the process can only gum up the works. And, I would contend, result in just the sort of unintended consequences now being reflected in jumping mortgage rates. Or, for that matter, the entire housing mess in the first place... much of which is the unintended consequence of Greenspan ratcheting down interest rates instead of pouring himself a nice cup of tea and watching as the participants in the dot-com mania received their just desserts.

Personally, I am shocked by the rising cacophony of calls for more, not less, government regulation. Given the widespread chanting now going on in favor of elevated levels of oversight, retribution, taxation, meddling, and outright nationalization, it is clearer than ever that the laissez faire view I just expressed is in a minority. And the situation is only going to get worse as the next wave of well-intentioned government operators step up to the controls... controls that are being firmly bolted onto the machinery of markets.

We are about to enter a dark period for the free markets. That's the bad news.

The very good news is that, seeing it coming, you can anticipate where the next unintended consequences will occur and position yourself to profit.

David Galland is the managing editor of The Casey Report, the flagship publication of Casey Research, LLC., which for over 26 years has been providing independent minded investors with unbiased recommendations on big trends they can profit from. From as long ago as August 2005, in a lead article entitled "Profit from the Collapse of Western Civilization" Casey Research was alerting subscribers to the crash now unfolding and recommending specific steps to profit. What's next for the U.S. and global economy? How long will the crisis last? How can you profit? Find out for yourself with a no-risk, fully guaranteed three-month trial subscription. Learn more now.

David Galland
Big Gold

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