What a Difference a Week Makes!
written Jul 27, 2007
posted Jul 30, 2007
Last week, as the Dow breached
the 14,000 mark for the first time, bullish swagger on Wall Street
went into overdrive. Some of the bulls that I'm often pitted
against on television used the occasion to specifically heap
scorn on my assessment of the U.S. economy and my investment
advice. Although the attacks on my economic views were inaccurate
on many levels, perhaps their largest oversight was that the
Dow was propelled to its milestone largely as a result of multinationals
that had seen their foreign earnings increase with the weak dollar.
While many of these stocks set new 52 week highs, stocks primarily
dependant upon the U.S. economy and American consumers were setting
fresh 52 week lows. This divergence of performance provides strong
evidence that the U.S. economy remains on track for a severe
More egregious however, was
their dismissal of my investment advice. In their ridiculous
attempt at a victory dance, they conveniently ignored the far
superior returns produced by the foreign investments that I have
consistently recommended for years. Given the unquestioned superiority
of non-dollar investments, and the accuracy of my predictions
regarding the continued weakness in the mortgage and housing
markets, you would think the permabulls would have offered some
grudging respect. But it seems their collective delusions regarding
the "goldilocks" economy prevent them from acknowledging
anything that doesn't serve to bolster their positions. So, despite
a clear, well-documented, and unarguably successful track record,
they simply assume that my clients have done poorly because I
don't share their viewpoint. Their refusal to give me the slightest
bit of credit for being right about anything might mean that
they harbor a secret fear that I might be right about everything.
This week however, the preponderance
of bad economic news on the U.S. economy finally trumped the
good news coming from abroad. Perhaps the hardest pill for the
market to swallow was Countrywide's admission that its earnings
had been negatively impacted by late payments on its PRIME loans.
This threw cold water on Wall Street's self-induced delusion
that the problems in subprime had been contained. This notion
had been so universally accepted that the very word "contained"
has been conspicuously paired with subprime with almost every
However, from the onset I have
repeatedly warned that subprime was just the tip of the iceberg.
I have been writing about the dangers of the housing bubble for
years. Here are some excerpts from my recent commentaries regarding
December 22, 2006, Subprime
Disaster in the Making
The main problem is that
the majority of these loans were made to people who really cannot
afford to repay them and were collateralized by properties whose
true values were but a fraction of the loan amounts. Once the
music stops and prices return to earth, borrowers who put little
or no money down may decide to simply mail in their house keys
rather than make additional mortgage payments.
In addition, even those
who can comfortably afford to pay may choose not too. Basically,
zero-down, non-recourse mortgages give borrowers a free put option
should real estate prices decline. The bigger the drop, the more
incentive there is to exercise. Rather than throwing good money
after bad, borrowers could simply return their over-priced houses
back to their lenders and buy one of their neighbor's deeply
discounted foreclosures instead.
Also, the idea that sub-prime
foreclosures will not affect the broader market is absurd. These
loans simply represent the weakest links in the mortgage/housing
chain. Once they break the entire chain falls apart. The added
demand from these marginal buyers helped produce and sustain
the bubble. Remove it and the bubble deflates. Also, falling
home prices and rising interest rates effect every homeowner,
and the temptation to walk away from an upside down mortgage
is not restricted to sub-prime borrowers.
March 9, 2007, The Worst
is far from over
The current train wreck
unfolding in the sub-prime lending sector provides a good preview
as to what will happen to the entire credit-financed bubble economy
when the funding dries up. Contrary to the self-serving rhetoric
of Wall Street and housing industry shills, the entire mortgage
sector is not insulated from sub- prime. In fact, sub-prime is
just the tip of the credit iceberg. Beneath the surface lie similar
problems in Alt-A and prime loans, where borrowers also relied
on adjustable rate mortgages to purchase over-priced homes that
they could not otherwise afford.
With the sub-prime market
drying up, most first-time home buyers will be unable to buy.
Without those 'starter-home" buyers, the trade-up buyers
(most of whom have the ability to make down-payments and are
therefore considered "prime borrowers") will be unable
to sell their existing homes, and hence unable to trade up. This
brings down the entire house of cards. Home prices must collapse,
affecting all homeowners, regardless of their credit ratings.
Since 70% plus of the U.S.
economy is based on consumer spending, how can we possibly avoid
a recession if the credit well funding much of it runs dry? Since
home equity has been the principal asset collateralizing that
credit, how can consumers keep borrowing and spending when housing
prices fall? I heard one commentator on CNBC claim that the U.S.
economy was in great shape except for housing. To me that's like
a doctor telling a patient that he is in great health, except
for the javelin sticking out of his chest. If housing is going
down, there is no way on earth the entire economy does not get
caught in its undertow.
March 14, 2007, From
the subprime to the Ridiculous
With the meltdown in the
subprime mortgage sector now laid bare, many on Wall Street desperately
cling to the notion that the pain will be localized. The prevalent
delusion is that the overall mortgage, housing and stock markets
will be little impacted by the carnage ravaging the subprime
Those who think that the
subprime market is unrelated to the broader economy do not understand
that the problem is not just the fiscal responsibility of marginal
borrowers, but the inherent weakness of the entire U.S. economy.
It's just that the sub-prime sector, being one of the most vulnerable
spots, is where the problems are first surfacing.
The bottom line is that
far too many Americas, not simply those with low credit scores,
have borrowed more money then they are realistically capable
of repaying. The credit boom was created by initially low adjustable
rate mortgages, interest only, or negative amortization loans,
and an appreciating real estate market that allowed homeowners
to extract equity to help make mortgage payments. Now that real
estate prices have stopped rising, and mortgage payments are
resetting higher, borrowers can no longer "afford"
to make these payments.
Significantly, most sub-prime
loans involved low "teaser" rates that lasted for only
two years. In contrast, teaser rates for most prime ARMs typically
last for five years. This difference, rather than any inherent
distinction in the fiscal health or credit worthiness of the
borrowers, explains why the delinquencies are so much higher
in the sub-prime sector.
In reality, the problem
goes way beyond housing. Nearly every big ticket item that Americans
consume is paid for with borrowed money, with foreign lenders
supplying the credit. Without access to low cost credit, the
spending stops. When the spending stops the service sector jobs
associated with robust spending will disappear as well. Without
paychecks, even those with low fixed-rate mortgages and high
credit scores will not make their payments.
March 22, 2007, Don't
Uncork the Champagne Just Yet
One of the biggest
bones the Fed threw to the markets in its last statement was
its failure to directly mention the problems developing in the
mortgage market. This omission suggests that the Fed is not overly
concerned with the subprime crisis, or the possibility of that
weakness spreading into the broader mortgage market or the economy
in general. In other words, a problem isn't a problem until the
Fed says it is. This ignores the fact that the Fed is reluctant
to actually identify a problem, no matter how severe; for fear
that such recognition alone might spark an even greater panic.
So with the apparent blessing
of the Fed, Wall Street can now borrow a page from the Las Vegas
promotional playbook and claim that "what happens in sub-prime
stays in sub-prime." Unfortunately, like an out of work
showgirl with a folder full of embarrassing photos, the problems
with subprime will soon show up on everyone's doorstep.
June 28, 2007, Subprime
Shoes Continue to Drop
The meltdown in the subprime
mortgage market is inexorably spreading throughout the U.S. economy.
Bear Stearns' reluctance to mark down the value of their overpriced
CDOs is mirrored by an equal desire among homeowners to hold
tight to their fantasies of real estate riches. Just as CDOs
are not worth the "marked to market" value conveniently
assigned by Wall Street, homes throughout the country are not
worth anything near the asking prices listed on "For Sale"
signs. Wall Street may be able to buy some time by bailing out
troubled hedge funds to keep their worthless subprime mortgage
investments off the market, but no such safety nets exist for
strapped consumers looking down the barrel of resetting adjustable
rate mortgages. Inventories will continue to balloon until reluctant
home owners come to their senses and slash prices.
However, as I have been
writing for years, the biggest losers in the real estate bubble
will not be the borrowers who took advantage of easy credit,
but the lenders who foolishly underwrote the loans. Some will
lose 100% of what they invested, and those who used margin may
lose even more.
The main problem was that
Wall Street, hungry to feed the profit-rich CDO market, convinced
the mortgage industry to abandon all traditional lending standards.
In prior years, when borrowers were required to make sizeable
down-payments, lenders were assured that borrowers would not
knowingly commit themselves to mortgages that they could not
afford, and that sufficient collateral would exist were defaults
to occur. In addition, by verifying incomes and assets, lenders
gained further assurance that loans would actually be repaid.
Once lenders dropped down
payment requirements, the stage was set for the unfolding disaster.
The advent of no-documentation loans, especially ARMs with teasers
rates, interest-only payments and negative amortizations, further
allowed risk free speculation to run rampant. Is it any wonder
house prices rose so high when Wall Street allowed so many people
to gamble with other people's money?
If borrowers actually had
to put their own hard-earned money down, they would have thought
twice before committing themselves to mortgages they could not
afford. But once Wall Street took all of the risk out of real
estate speculation, there was no reason not to roll the dice.
So borrowers lied about their incomes and stretched to meet payments
because if home prices kept rising all the profits would belong
to them. For years it was a stunningly successful bet that minted
real estate tycoons by the hundreds of thousands. And, if prices
reversed course, they had nothing to lose, as they put nothing
down. Buyers could walk away from their bad bets none the worse
for wear, leaving lenders to cover their losses.
However, amidst the hysteria
and oblivious to their own roles in perpetuating the bubble,
lenders also believed that real estate prices could only go up.
With such assumptions, defaults seemed unlikely and ultimately
riskless (a foreclosed property worth more than the underlying
mortgage is a boon). Also, in many cases, as hedge fund managers
made huge profits by risking their client's money, both the borrowers
and the lenders had no skin in the game. All the risks were transferred
to those who purchased the re-packaged loans, and who are now
left holding the bag.
All of the pundits and so
called "experts" who did not see this coming still
do not appreciate the magnitude of the mortgage disaster and
how it will impact the housing market in general, the economy,
the stock market, the dollar, interest rates, inflation, and
the price of gold. They are content to believe government hype
about the resilience of the American economy.
The curtain has yet to close,
but if you listen closely you can hear the fat lady warming up
in the wings. It has been one hell of a show, but there will
be no encore. For those holding toxic mortgage paper there is
nothing left to do but sue. However, even those who do not own
this stuff are not in the clear. A much larger disaster looms
for holders of U.S. dollar denominated assets in general. It
will not be long before our foreign creditors realize that Uncle
Sam is the biggest subprime borrower of them all and will similarly
mark down the value of its debts as well.
More proof that the problems
that initially surfaced in "subprime" are now emerging
in other areas was evidenced by the horrendous losses being reported
from home builders Beazer and Pulte and several more high profile
companies blaming earnings shortfalls on weakness in the housing
market. Still more evidence that the credit problems are anything
but contained is Wall Street's failure to arrange for the sale
of 12 billion in loans necessary to finance the Chrysler buyout.
This calls into question the whole private equity buy-out craze,
which had been a major driver of recent stock market gains.
Finally, today's GDP numbers
revealed very slow growth in consumer spending. As ARM payments
reset higher, home equity continues to vanish, and consumer prices
continue to rise, actual declines in consumer spending are also
likely in future quarters. In fact, to produce a 3.5% annualize
gain in 2nd quarter GDP, the government assumes an annualized
inflation rate of only 2.7%. My guess is that were a
more accurate inflation measure used, the result would reveal
what millions of ordinary Americans are actually experiencing
-- that the recession has already begun.
Even with all of this irrefutable
evidence that the credit rug is being pulled out from under the
feet of American consumers, Wall Street's permabulls nevertheless
remain undaunted in their blind optimism. Their one-way
views are so myopic that they are blinded by their own arrogance.
They are completely clueless regarding the fragility of America's
bubble economy or the phony nature of a prosperity based on low
cost, no questions asked consumer credit. Now that those doing
the lending are rethinking the wisdom of doing so, the party
is coming to an end. However, the permabulls have barely noticed
that the music has stop playing and will likely be among the
last to leave. Unfortunately for them, or anyone foolish enough
to have confused their mindless cheerleading with legitimate
investment advice, they will be broke by the time they finally
For a more in depth analysis
of the tenuous position of the Americana economy and U.S. dollar
denominated investments, read my new book "Crash Proof: How to Profit from
the Coming Economic Collapse." Click here
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C.E.O. and Chief Global Strategist
Euro Pacific Capital, Inc.
Mr. Schiff is one of
the few non-biased investment advisors (not committed solely to
the short side of the market) to have correctly called the current
bear market before it began and to have positioned his clients
accordingly. As a result of his accurate forecasts on the U.S.
stock market, commodities, gold and the dollar, he is becoming
increasingly more renowned. He has been quoted in many of the
nation's leading newspapers, including The Wall Street Journal,
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San Francisco Chronicle, The Atlanta Journal-Constitution, The
Arizona Republic, The Philadelphia Inquirer, and the Christian
Science Monitor, and has appeared on CNBC, CNNfn., and Bloomberg.
In addition, his views are frequently quoted locally in the Orange
Mr. Schiff began his investment career as a financial consultant
with Shearson Lehman Brothers, after having earned a degree in
finance and accounting from U.C. Berkley in 1987. A financial
professional for seventeen years he joined Euro Pacific
in 1996 and has served as its President since January 2000. An
expert on money, economic theory, and international investing,
he is a highly recommended broker by many of the nation's financial
newsletters and advisory services.