This week we continue our look into the factors involved in housing prices. Specifically, we are going to look at the affect of Adjustable Rate Mortgages (ARMs) on values. Do they pose a risk for the economy at large as rates rise? Some see them as a major crisis in the making, while others see no harm. Plus, we look at just how important housing is to the US economy. It should make for interesting reading.

But before we begin, let me briefly answer a few questions I have been getting of late, as we have a large number of new readers. Basically, the questions run: Why do you write this letter? Why is it free? How do you get access to so much information and what do you really do for a living?

Each week, I read between 150-200 (at a minimum) articles, newsletters, reports, books, essays and so forth. I get a lot of free material as well as some very expensive sources. Readers send me a mountain of material as well. (Some of the best work is sent to me from readers all over the world.) I have an associate who scours several services to find important material, as well as clip articles from various publications. (I simply cannot let myself look at certain publications, because I would spend all day reading them.) And, of course, I do my own regular internet searches on topics. The reason I do all this research is quite simple - I am trying to get a sense of where the major market and economic movements will be, and invest accordingly. Sometimes I meet with modest success, and other times are not going to be in my ten most memorable moments.

Typically, on Friday (though this week it is Wednesday), I sit down to write the letter. I write about what made the biggest impression on me that week - what I found to be important. Long time readers know that means it can be on a wide range of topics. Typically, it deals with a macro-economic issue, but it can be thematic, as the housing series I am currently doing. Since no one pays for the letter, I feel free to write about what interests me. It started out as a way for me to discipline myself to think about "what's really important." In early 2000, I had launched a monthly subscription newsletter. I decided to put it on the internet for free that summer just to see what kind of response I would get. I had less than a few thousand email addresses of readers gathered from various sources (speaking at conferences, other writings, etc.) when I started. The letter has now taken a life of its own. It goes to well over 1,000,000 readers each week, sent by various publishers and is posted on dozens of web sites.

Frankly, I have been and continue to be amazed at the response, but I guess the price is right (free is always good for information) and there are those who like the style and content, and for that, I am grateful. The positive response has been quite overwhelming, and I am glad so many find my thought processes of value. I now no longer (and have not for several years) publish the letter, but simply write it. Some publishers create an advertising model around it. Others send it as a service to their readers. Anyone is generally free to post the letter on their website or send it to their lists, although I do like you to at least ask, so we can know where it is going, mostly for my own curiosity's sake.

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The ARM's Are Coming

Why, some might ask, are we spending four to five weeks looking at housing? First, home construction and housing are significant components of the US economy. In trying to get a picture of the future of the US economy, you have to have a handle upon (or at least an opinion) the US housing market.

Secondly, there is just a huge amount of data to analyze. There is no way to adequately cover the topic in one or two letters. Finally, as noted above, I am trying to summarize my own thinking and research on this important topic, as I believe it will be one of the more significant areas of concern in the future.

Let's look at Adjustable Rate Mortgages. Contraryinvestor.com tells us that as of mid-May, 34.8% of existing residential mortgage loans are some type of ARM. In 2003, the rate for ARMs was only 19% of all mortgage loans, but that has risen 35% this quarter and is projected to rise to as much as 40% next year.

If you have an ARM, the theory goes, you are vulnerable to rising rates. As rates go up, so will your home payments. Home owners are using ARMs to lower current payments and are exposed to the future.

Let's get some historical perspective. From 1981 through 1989, a table buried in a lengthy Harvard study tells us that ARMs were an average of 44% of total new mortgages, so the current ratio of 30% is not all that high. Some will note that rates were coming down over that period, but I would remind you that ARM rates also went up significantly in various periods. It has only been in the past few years that low rates have come to be seen as a fact of life.

Of course, looking at historic delinquency rates also shows us that the "highs" were during that same period of the 80's. I could not find a study relating delinquencies and high ARM rates, but there is a logical correlation. I leave the actual analysis for an academic Ph.D candidate among my readers to pursue. Please send me a copy of your paper.

While I do think that ARMs will have a slowing affect upon the economy as rising rates will reduce the amount of disposable income, I do not think they are a problem per se as far as the housing market is concerned, and here's why.

We are now a transient nation. The average homeowner stays less than seven years. Why finance a 30 year mortgage if you believe you will be moving or selling within five years? Which of the choices makes more economic sense is now easy to determine. Go to www.yahoo.com and click on finance and then to mortgages. You can do all sorts of comparisons, models and "what ifs." It is a truly impressive site.

What you find is that you are better off for the next nine years by getting a five year ARM at current rates, even if ARM rates go to 8% and stay there at the end of the five years.

What if you plan to be in your home for 10-15 years or more? If you got your 30 year mortgage last year at 5%, then congratulations. You may have had the deal of the cycle. Rates are now on their way back up.

They are still historically low, however. You can go to www.mbaa.org and look at mortgage rates over the years and see that. If I were buying today for the long term, right now, this moment, I might be tempted to lock in today's rate.

But the economist in me would say, "Take the ARM," especially if I were buying next year, when rates will be at 7%. I believe there will be a recession within the next five years. (Is that bold or what? I actually think it could be as early as 2005 or as late as 2007.) I think rates will once more head down during that period, and home-owners will get one more grab at the low interest rate brass ring. I would then lock in my long term rates.

I think there are a lot of home-owners who think the same way. Assuming people who use ARMs have not thought through the implications, or could not deal with a rise in costs, assumes people are stupid. They are not.

My biggest personal forecasting mistake occurred in 1998 when I thought that 10% of businesses would not figure out their Y2K problems, and that would trigger a recession, which was due. We got the recession, but not for the reasons I thought. Good friend Harry Brown, libertarian economist and Libertarian Party Presidential candidate, politely chided me.

"Trust the market," he said. Business and people will act in their own best interests.

I think the ARMs issue is along the same lines. People will act in what they perceive as their own best interest.

Let's be clear. If ARMs rise to 8%, we have bigger economic fish to fry. That would imply a 6-7% Feds fund rate, 6% inflation and/or an impending Honest-to-Pete recession. The Fed would be stamping on the brakes very hard, either because of high inflation or an over-heated economy. I think neither scenario is likely. 8% ARMs would imply a total breakdown at the Fed.

But what might be economically rational on the individual level may also be a problem on national level. Think of it this way. If US consumers all decided to save an additional 5% of their income, consumer spending would decline and a recession would likely ensue, as the economy would have to adjust to lower levels of consumer spending.

What might make sense (saving more money) on an individual level becomes a problem on a national level (decreased consumer spending).

While it may make sense for some US mortgage payers to use ARMs on an individual basis, if rates were to go up by only 2% ( a fairly safe bet), that would take a real toll on available consumer spending.

The total US mortgage market is $8 trillion (see below). If 38% if that is Arm financing, then roughly $3 trillion is in ARM mortgages. If rates rise 2%, then that will be $60 billion of less disposable income per year, or somewhat more than 0.5% of GDP is significant. That is (back of the napkin calculation) about 3% of consumer spending, which would wipe out any growth in consumer spending, especially coupled with rising energy costs. And that is just the mortgage market. Add in the consumer debt, corporate short-term debt and it becomes a real economic drag.

Of course, that is offset by increased income to bond-holders and savers, but that does not offset the overall drag.

Thus, I think ARM's are a problem, just not for the reason that is generally advanced by most economic bears. As I will note below and in the coming weeks, I think there are other problems in the housing market. ARMs are on the list, but not very high.

Sidebar: Yes, during a recession, there will be increased foreclosures. There always are. But that will largely be a result of rising unemployment and other circumstances, not ARMs.

The Cost of Renting versus Owning

From a consumer spending point of view, owning is actually cheaper than renting, a study from Harvard suggests. In every year since 1975 but the three recession years of 1980-81, it has been cheaper after-tax to buy a home than to rent. In many years, and especially recently, that difference has been quite large. For the last year studied, 2002, it cost a mere 18.9% of disposable income to won a home and 26.7% to rent.

http://www.jchs.harvard.edu/publications/markets/son2004.pdf

That is why some authorities predict that within ten years, home ownership will be as high as 70% within this country. Given that huge difference in average net worth for home-owners versus renters, that is a good thing over time.

While some worry about the ability of those of lower economic status to deal with mortgage payments, I find this argument somewhat demeaning, if not elitist. If someone can figure out how to find a home and get a loan and work to keep that home, then good for them! Over time, they will build up equity. Yes, a higher percentage of those in lower economic circumstances default on loans, and have less ability to withstand "shocks," but so what? The cost of default to the lenders is built into the higher rates. The individual had a shot and bad things happened. Overall, though, 85-90% or more of lower income home buyers will do just fine, thank you very much, even in a recession.

Over time, home ownership will lower their costs of living and increase not only their net worth, but there is a very real psychological effect to home ownership which is part of our human DNA. Worrying about higher foreclosure rates that are already built into the cost models is not fruitful. We have other, more relevant things to worry about, as we will see in the next few weeks.

Housing's Virtuous Cycle

Let's look at some overall statistics as regard to the housing market. Mark Zandi, chief economist at Economy.com wrote a report last August called "Housing's Virtuous Cycle." He noted a couple of very intriguing points. First, even though housing represented just 5% of GDP (gross domestic product), it was responsible for roughly two-thirds of inflation-adjusted GDP growth since the start of 2000.

As I noted many times in those years, housing (along with consumer spending) kept the economy going during the slowdown, and helped cushion what should have been a major recession after the bursting of the stock market bubble.

In an update to the report, he notes that even as the economy has recovered, housing has still accounted for over 25% of real GDP growth in the last 12 months. "Roughly speaking," said Zandi, "the housing industry has added almost 750,000 jobs over the past 5 years, which accounts for nearly 30% of all jobs created during that period." That number includes not only construction but mortgage financing and real estate as well. (Dallas Morning News 6-21-04)

"What a lot of people don't understand, though, is that if housing just goes flat, its contribution to GDP growth will go to zero."

Some see no problem. Amy Cutts, deputy chief economist at Freddie Mac tells us, "It's our view, and has been our view, that in 2005 it doesn't matter to housing what interest rates do, as long as they stay below 6.5%. Given how low inflation is, there is no reason for rates to rise above this level." (again, DMN)

She notes that it may be that housing will set another new record high this cycle. Housing permits, a leading indicator, are sitting at their highest level in more than 30 years.

But new home sales are not at record highs. They were off some 12% in April, the sharpest decline in a decade. They were up again in May by 15%. The theory that many suggest is that people are trying to beat the rate rise. To see if that is valid, we will need the luxury of six months of data to see which month is indicative of the future.

According to one industry group, things might not be as rosy. The mortgage Bankers Association released it Mortgage Finance Forecast June 11. While not ugly, it does not suggest the new home market will be growing. Remember, it is Zandi's contention that if new housing construction is merely flat, it will add nothing to real GDP growth. But the MBA group suggests it will recede as interest rates rise. That means housing will be a drag on real GDP growth. (It also does not portend well for employment.)

How much? From 2,035,000 housing starts (annualized) in the 4th quarter of 2003, they expect starts to slow to 1,583,000 in the third quarter of 2005. They project that housing starts will drop a little more than 13% for the entire year of 2005. They also expect 30-year mortgage rates to rise to 7.1% and to average 7% in 2005. ARMs will go from 3.5% to almost 5% (or a projected 4.9%). (Note: 5% ARMs are not an economy killer.)

Even though the projected drop is "only" 13% in 2005, this represents a drop of over 20% from the peak production of the last quarter of 2003, which is a large drop. If Zandi is right, not only will that mean housing is not contributing to GDP growth in 2005, it suggests housing will be a drag to growth.

Another few thoughts can be gleamed from this forecast. The MBA thinks the sale of existing homes will drop almost 15% as well. But not to worry. Home prices are projected to rise about 4% per year for 2004 and 2005.

Interestingly, they project that mortgage originations for home purchases will rise over the next few years, even as refinancing is simply going to collapse. From 2,530,000 refinancing loans in 2003, we will see a drop to just over 1,000,000 this year and 421,000 in 2005. They see refinancing dropping from an overall share of 66% in 2003 to 24% in 2005.

(You can see this report and a host of others at http://www.mortgagebankers.org/marketdata/forecasts/index.html. MBA is rather bullish on its economic forecasts.)

Think the MBA are just a bunch of optimists? Then look at the forecasts made by a group of housing market insiders to find true optimism. The National Association of Realtors, the Independent Community Bankers of America, mortgage-market makers Fannie Mae and Freddie Mac and the National Association of Home Builders issued a joint study which is a ten-year forecast of the housing market.

They see U.S. homeownership topping 70% over the next decade as rising demand and short supplies keep prices increasing at a 5% annual pace. Among other things, they predict that:

Home sales will average over 8.5 million for the next ten years, which is a far cry from the 5,436,000 of the MBA forecast. Mortgage originations will average $3 trillion a year, 60% new home loans and 40% refinancing. (Contrast that with an MBA projected refi percentage of 24% in 2005.) $8 trillion in mortgage debt today will grow to $17 trillion by 2013. (www.rockymountainnews.com June 1, 2004)

The Consumer Values His Housing

Let's go to two studies by the National Center for Real Estate Research. The first is called "Housing: An Investment And A Piggybank For Spending" by John D. Benjamin and Peter Chinloy (American University) and the second is "Real Estate versus Financial Wealth in Consumption" by Benjamin, Chinloy and G. Donald Jud (University of North Carolina, Greensboro). I will quote directly from their works and comment afterward.

"Empirical results show that households increase spending when their housing assets rise, when their mortgage liabilities rise, and when their financial wealth rises. Increased spending over one year is 15 cents per dollar of assets held in housing, 6 cents per dollar of mortgage liability, and 2 cents per dollar of financial assets. These results indicate that households are consuming based on their total balance sheet and not on net wealth. ("Piggybank")

"A household may own a house worth $100,000 with no mortgage debt, and $100,000 in stocks, bonds and other financial assets. Even if both increased by 10% in value during one year, the amount of wealth-induced spending might differ.... The results indicate housing has a substantial impact on economic activity. For each dollar increase in real estate wealth less mortgage debt, consumers spend 8 cents in that year. By comparison, a one dollar increase in financial assets from stock and bond markets increases spending by 2 cents in the current year. The impact of housing is four times as large....

"The results are applied to two empirical observations: 1) the decline in the savings rate during the 1990s and 2) the robustness of the economy to the sharp drop in stock returns after 2000. About half the decline in the fraction of income that Americans save, from 6.5% in 1995 to 1% by 2001, is attributable to increases in real estate and financial wealth. Virtually all the decline in consumption occurring from the stock market decline of 2000-2001 is offset by rising consumption from real estate wealth. Real estate smoothes and stabilizes consumption when other assets are performing poorly.

"...A dollar decrease in housing wealth leads to a decline in consumption of as much as 30 cents.

"...The decline in the stock market during 2000 and 2001 had a limited impact on aggregate demand because of an offsetting real estate wealth effect. It appears that another reason for holding real estate is to smooth consumption and reduce its volatility. There are several possible explanations as to why consumption is so limited from financial wealth. Financial wealth is concentrated in restricted accounts such as pension accounts and insurance. Households cannot easily withdraw funds from these accounts that contain 75% of their financial wealth, and they cannot borrow against the collateral. Among lower-income families, unrestricted financial wealth to fund consumption is virtually nonexistent. Financial assets are concentrated among high-income families. These holdings may be restricted because they are held as controlling or dominant interests.

"...Conversely, tax policy favors households concentrating their debt and assets in housing. The ability to deduct mortgage interest from taxable income and the lower rates associated with a national and securitized market lead households to increase debt to fund consumption." ("Financial Wealth")

Are HELs Ringing a Bell?

Even as mortgage refinancing is on the decline, other forms of mortgage related debt is rising. We are now seeing a huge surge is Home Equity Loans as rates rise causing refinancing to slow. In a very fascinating report by the normally bullish Dr. Ed Yardeni of Prudential Equity Group, he ponders if Home Equity Loans may be the real Financial Weapons of Mass Destruction (as opposed to Buffett suggesting the FWMD are derivatives.)

"Could it be," Yardeni asks, "that home equity loans (HELs) are potentially a much more dangerous FWMD, and are more likely to detonate than some of the other ticking time bombs in the financial markets? In my opinion, as they are becoming more popular, they are helping to power the economic expansion. However, if home equity loans continue to grow rapidly, they could reach enough critical mass in a few years to set off a dangerous financial chain reaction. In other words, they are currently like a nuclear power plant. In the future, they could be more like a nuclear bomb."

"...Now that mortgage rates are rising again, refinancing activity is falling, and so are cash-outs. Nevertheless, Americans are still tapping their home equity. They are doing it with HELs and undoubtedly spending the proceeds. Home equity loans outstanding at all U.S. commercial banks soared to a record $324 billion in early May, up 36% from a year ago. They are the fastest-growing asset class in commercial bank balance sheets. A home equity loan is really money borrowed from a line of credit secured by the value of the home. Typically, the borrower pays the prime rate. The rate is usually lower when more is borrowed, according to the terms set by the lender. It can be an alternative to a mortgage or a supplemental source of credit.

"In other words, the actual aggregate line of credit undoubtedly exceeds the amount of HELs outstanding. I wouldn't be surprised if the sum of all the lines is twice or even three times as large as total HELs, i.e., $649 billion to $973 billion in early May. By comparison, the total of mortgages held by all commercial banks was $2.4 trillion in early May. Anyway you slice it or dice it, banks already have a very large exposure to HELs borrowing, and the exposure appears to be heading higher fast.

"For now, the surge in home equity loans is providing extra spending money for homeowners. Over the past year, these loans are up 36%, or $86 billion. By comparison consumer credit is up $99 billion over the past 12 months through March. Together, consumer credit and home equity loans are up $178 billion over the past year. Together, they totaled $2,330 billion during March, or 27% of disposable personal income. This is historically high, and somewhat worrisome. On the other hand, the ratio of savings deposits plus retail money market funds to disposable personal income is also historically high at 47.3%. Consumers have the equivalent of almost a half year of income in "mattress money".

"The close correlation between the Refinancing Index compiled weekly by the Mortgage Bankers Association and the three-month annualized change in savings deposits supports my view that a significant portion of cash-outs during mortgage refinancing may have been saved as the liquidity preference has increased in recent years because of job insecurity as well as the turmoil in financial markets and the geopolitical arena. Unlike cash-outs, proceeds from home equity loans are undoubtedly completely spent on goods and services."

Let's look at the implications of the above studies, when taken together. First, if the growth in housing values is going to slow, then that means that the portion of consumer spending attributable to the "Wealth Effect" is also likely to slow.

We know that mortgage refinancings were a large part of the growth in consumer spending over the past years. That stimulus is going to recede as interest rates increase. Taken together with the drag of the increase in cost of ARMs and other debt, as well as energy costs, and it suggest a slowing economy over the next year. The stimulus from the growth in Home Equity Loans is ultimately limited, and can be counter-productive over time.

As we will see next week, mortgage and consumer debt is exploding. The growth in the last five years is simply breath-taking. That is not all bad, as debt to finance a home which replaces rent costs is not all that troublesome from one macro perspective. If you cannot make your house payment, then how would you make your rent payment? Out on the street is out on the street. As we will see, mortgage delinquencies are declining, as we would suspect as employment increases. But we will also note that we are not yet out of the woods.

These are just more economic headwinds which will all tie in with my contention that we are in for a decade long Muddle Through Economy (below long term GDP growth of 3%). Even though we are in a period of powerhouse real GDP growth, I think the current period will not be the norm for the decade.

Fabian, Bull's Eye Investing, Quebec and more

It is getting late and I need to close. I have been distracted this evening, and it is past midnight as I finish, as the Texas Rangers were playing Seattle tonight as I was writing, and I will admit to going out on my office balcony to watch from time to time. I mean, you gotta leave the computer when bases are loaded and there are no outs. And I got to see that rarity in modern major league baseball, the suicide squeeze, played to perfection. It is old fashioned baseball like that that is the reason the Rangers are in first place, even as we sent the highest paid player in baseball to the Yankees.

For those in the industry, hedge fund guru Mark Yusko, who runs the University of North Carolina Endowment Fund will be in town Friday with his friends from Salient in Houston. It seems most of their office is coming up to watch their Astros out pitch my Rangers. Now if only we can find some hitting, and if the rain will stop.

The next morning I fly to LA to be on Doug Fabian's radio show. Most of you on the west coast will be able to hear Doug and I talk investing from 1 to 2 PM.

It looks like my bride and I will be going to Quebec on vacation in late July. Thanks for all the suggestions. This fall I will be speaking at conferences in San Francisco (the MoneyShow) and Bermuda (The MAR hedge fund conference) in September. I have been invited to speak at a conference on the future at Stanford called Accelerating Change 2004 the second weekend of September with a rather distinguished group of futurists. I will be way out of my league, but it should be fun being around some very interesting thinkers. I will be speaking at the George Gilder/Forbes Telecosm conference in October in Tahoe. Talk about throwing a bear into a den of lions. More details and dates on all the above events in later issues.

Oh, yeah. My book, Bull's Investing is still doing quite well. If you have somehow managed to not buy the book after all my blatant promoting, I invite you to go to Amazon.com and read the reader reviews and then stop procrastinating and get the book!

Have a great weekend, and take some friends to dinner. Michael Roizen, author of RealAge, says being with friends (and family) adds years to your life, and it certainly makes the year more enjoyable.

Your having more fun than the law allows analyst,