What Happens When You Challenge Common Sense
by Graham Summers
August 30, 2006

What happens when an entire economy challenges one of the most basic rules of common sense?

We’re beginning to find out.

Following the tech bubble crash and the September 11th terrorist attacks, then-Federal Reserve Chairman Alan Greenspan pushed interest rates down to 1% in an effort to combat economic recession.

In dollar terms, this meant you could borrow $100,000 and only pay $1,000 in interest payments. In basic terms it meant Greenspan was urging U.S. consumers to challenge the old adage: you can’t get something for nothing. With interest rates this low, you actually could get something, a lot of something, for next to nothing.

U.S. consumers loved the idea. They refinanced their mortgages and decimated their savings, buying more and more things they didn’t need, couldn’t really afford, and probably shouldn’t have bought.

This included newer, bigger homes.

In 2004, homeownership hit an all time high of 69%. However, don’t let the word “ownership” fool you into thinking these people actually put equity into their homes. Altogether, homeowners cashed out over $139 billion in home equity in 2004. Simultaneously, second mortgage debt rose to $178 billion.

Mortgage lenders had a field day. In 2004, total mortgage debt rose to a record 7.2 trillion dollars. But this wasn’t enough… the lenders wanted more. And so, like unpopular highschoolers looking for prom dates, these companies began to lower their standards.

They began to court individuals with sub-prime credit (“sub-prime” being a fancy financial word for “bad”). And they courted these consumers with big loans at high interest rates, interest only loans, and the now dreaded option of adjustable rate mortgages: mortgages that allow you to choose to pay even less than the required interest payments… for a time. In some cases, lenders even offered mortgages that didn’t ask for verification of income or credit.

This pattern continued until June 2003, when Greenspan discovered that giving something for nothing really isn’t the best method of producing economic growth. And so, the Federal Reserve began to raise interest rates… seventeen times from June 2003-August 2006. During that time, Greenspan retired, Ben Bernanke stepped in, and reality began to kick in, first in the home sales statistics… and now in mortgage lenders’ share prices.

On August 15, 2006, the National Association of Realtors announced that 2Q06 existing home sales fell 7% from 2Q05. The supply of unsold homes rose to a record 7.3 months worth of sales. In other words, even if U.S. homebuilders stopped building homes today, there’d still be enough homes on the market to last for the next seven months.

And the sub-prime mortgage lenders are hurting the most.

Ameriquest, the privately held, largest sub-prime lender in the U.S., just axed a third of its work force and closed down 229 branches. Its publicly traded counterparts aren’t faring much better: Countrywide Financial’s (CFC) July 2006 purchase volume fell 19% to $17 billion. More telling, Countrywide’s riskiest mortgages (the adjustable rate ones) have been hit hardest, falling 27% from the year before.

Even companies that don’t rely on mortgage loans for their primary source of income are getting hit. For example, the tax preparation services company, H&R Block (HRB) whose mortgage segment only accounted for 25% of its 2005 revenues, recently took a charge of $61 million due to its sub-prime mortgage customers falling behind on loan payments.

All of these companies are now trading at 52-week lows with historically low price to earnings (P/E) multiples. Don’t let the numbers fool you: the low P/Es and low share prices here are not signs of cheapness, but serious warnings for the U.S. housing market, and economy. And these 52-week lows are still miles above where these companies traded before the housing boom.

Good trading

Graham