San Diego Housing Bubble News and Analysis

my guess would be 2007 Q2 at the earliest...not before that. It's prudent for them to increase rates right now but I think they will holdoff at lease 2 quarters.

My guess is that they don't raise rates. The chinese need to loosen their currency and let it rise against the dollar. Hopefully they will (continue) to do so slowly and we will have a nice gentle fall over the next decade. I agree currency shocks are bad. But, weaker dollar=good. We buy fewer imports and sell more exports. Wail about M3 (M9, whatever) and housing prices all you want, but until the CPI shows real action or there is a dam-busting currency crash, the probability for raising rates is about zero for 2007. The european central bank (alert: "rumors via bloomberg")has indicated it is not worried about a weakending dollar till it hits 1.45 (!) versus euro. So, don't expect any help in coordinating walking the dollar back up. Given the doom and gloom expectations about the housing market on this site - I would expect less worry about inflation....real-estate busts are nice inflation killers (see: Japan, the last decade or two). Sometimes too nice. I too long for an end to the free-money decade, but I worry about deflation as much as inflation in the years ahead.

I don't think they'll raise rates, since inflation goes down in a recession. According to Nouriel Roubini, the next Fed move will be a rate cut in early 2007 to stimulate the economy after it's clear we're in a recession.

I'm of the opinion it doesn't matter whether they cut or not. It only matters whether they are behind the curve of the bond market at this point in the game. Which they are and have been. Realistically the easy money regime has created so much leverage to this point I believe a cleansing is written in stone.

I don't expect much from exports as we've already sent our manufacturing base overseas.

Some of our exports go into products made by the Asian export-oriented countries, and sold to us. So our recession will first hurt the Asian export countries, and then trickle down to us by reducing our exports to them.

One thing is not yet quite clear to me is why would the Europeans support a strong Euro? Don't they have export and employment to worry about?

I agree with brian_in_la. There is a probability of deflation in future years. In grammar-speak, inflation is past tense and deflation is future tense. So, methinks, it is still safe to hoard cash in US CD's and dollars. Grocery store prices for eggs, meat, grains and milk will remain reasonable with deflation. If you normally travel abroad however, then hold your cash in foreign currencies.

My best guesstimate is that long rates aren't going to move much from here (maybe decline a bit) but that short rates will decline next year and into 2008. The high inflation we've seen over the past 10 years is in the PAST (by definition) - it's probably over for a while. So, while the government's been reporting 3% inflation, the real rate has probably been more like 5% after adjusting for hedonics, substitution effects and the use of owner-equivalent rents (instead of housing prices). But now housing prices are already high (and moving lower), oil is already high (and probably won't be increasing at the same rate it has over the last few years), commodities are already high (and not increasing at the same rate as the last few years)... you get the picture. So, the big inflation moves have probably already happened for this long cycle. My guess is that for the next 5-10 years the reported inflation figures will actually be roughly what the real inflation rate is, or 3%-ish. Housing prices will decline but it won't show up in the CPI because use of owner-equivalent rents smoothes the series on both the upside and the downside. Commodities may increase but at a decreasing rate. We'll probably get a bit of import inflation due to a declining dollar but I don't think it will offset the other stuff. So, again, it's just a guess but I think the "real" inflation rate is actually going to be reasonable over the next 5-10 years, which means short rates would decline 150-200 bps over time and long rates would stay about where they are, give or take 50 bps. The problem is for those people who have owned fixed income over the last decade, because interest rates were set by the market based on the government's reported inflation figures, which were much lower than the real inflation rate. These people have been screwed and don't fully know it (although they may sense it when they look at prices around them). But that's the past; that doesn't matter going forward.

davelj, what you say makes sense. But, what's different this time is the huge, huge stash of dollars sitting overseas, or locked up in the Treasury on behalf of folks overseas. Never has been seen before in U.S. history.

Please tell me why you don't think those dollars will come out in into circulation, giving us big time inflation.

Your analysis makes sense, and what you lay out would play out in any other downturn. But account for those excess, uncirculated dollars and tell me what you come up with.

I very much agree with davelj as well. Unfortunately I think this fact will slow down the depreciation rate of the housing market, not kill it, just slow it down.

JG your point is good but in reality, if all those billions and billions of debt that has been purchased by southeast asia was pulled off the table I think the effects would be somewhat catastrophic don't you? Bigtime inflation is putting it nicely.

SD Realtor

jg, the money is already in circulation. It's responsible for the big bubbles in assets, and for funding all our consumer spending. It's the money used by Visa and MasterCArd, by private equity financing, buying flaky exotic mortgages, and government debt, US equities, etc.

So the question is *not* what happens when the money goes in circulation, because it already is (in assets though) but rather what happens when the money is moved out of US assets?

Where will it go, and how much will long term interest rates climb when the demand for US Treasuries declines? Something like 50% of our US Treasuries are held by foreigners.

When the foreigners sell off dollars, the demand for dollars goes down, lowering their value. That means our exports will be cheaper and our export trade will improve, possibly. It also means our imports will be more expensive. I believe our inflation is held low by cheap imports from other countries, but with a lower dollar, that would no longer be the case.

This is a question that I wish Roubini would address, but I guess nobody really knows. If not gold, then what?

I disagree with you, ps, that dollars accumulated by the Japanese and Chinese are in circulation.

From the San Francisco Federal Reserve Bank:

http://www.frbsf.org/publications/economics/letter/2005/el2005-17.html

"...Most foreign exchange reserves (such as the dollars owned by the Japanese and Chinese) are held in the form of dollar-denominated securities (such as T-bills/notes/bonds); one reason for this is that foreign governments like the highly liquid market for U.S. Treasury securities..."

"...The sale of dollar-denominated reserves (such as T-bills/notes/bonds held by the Japanese and Chinese) could have negative effects along several dimensions of the U.S. economy. First, it would tend to depress the value of the dollar vis-à-vis other currencies (as the dollars come flooding into circulation)..."

Lastly, a quick read of Setser & Roubini reiterates the points above:

http://www.foreignaffairs.org/20050701faresponse84415/brad-setser/how-scary-is-the-deficit.html

I have no idea why you think that the dollars accumulated by the Japanese and Chinese and others are in circulation.  $2.1 trillion of those dollars are 'on ice' at the Treasury.

Remember, the entirely separate source of financing for the '90s U.S. stock market boom then subsequent '00s U.S. real estate boom was, in large part, the cheap yen printed and made available via credit by the Bank of Japan in the '90s.

jg, I'm sorry I'm having such a hard time explaining this to you.

The money that came here is invested AND SPENT. It is not sitting in a vault in China. THe money is spent on buying Treasuries, ABS, MBS, equities, and so on. So the money has been spent, and the effect was to drive up asset prices and push down yields on government bonds. The money was used to buy overpriced homes, fund your neighbor's Visa purchases, IBM's corporate bonds, derivatives, and so on.

Where do you think all that money came from to create this housing bubble? Who is lending subprime borrowers 500K on stated income? It's the FCB money!!! THere is no such thing as money on ice. This money has created the credit bubble!

Furthermore, foreign central banks (FCBs) that wish to keep their currency from appreciating against the dollar, are printing their own currency in equal amounts to what is coming into the country from their exports, so there is a double whammy of liquidity. First we send them dollars which they have to print to convert, and then they send those dollars back and create asset bubbles.

So the question is, as I said before, what will happen when those dollars are removed from Treasuries, equities, collateralized mortgage obligations, mortgage backed securities, asset backed securities, government and corporate bonds, and divested into euros, yen, gold, etc?

Nothing is "on ice". Money always has an effect, and the effect is to inflate assets and create more liquidity.

The effect of that money is already here: the long end of the yield curve is low, despite Fed attempts to raise interest rates. They cannot control the end of the yield curve because of the large sums of dollars sent here by FCBs.

You should read the Flow of FUnd reports. I think the MBS market is bigger even than the Treasury market, or right behind it. THe Chinese and Saudis have been using the money that you claim is "on ice" to buy all those exotic loans!

"THe money is spent on buying Treasuries, ABS, MBS, equities, and so on."

After the Bank of Japan buys a U.S. Treasury security from the U.S. Treasury, where does that dollar sit? At the U.S. Treasury (and out of circulation).

Money isn't 'spent;' it's exchanged for something of value. The Japanese get a U.S. Treasury security, and the U.S. Treasury gets a dollar.

I already explained it. The effect was made when the money came here. By buying so many Treasuries, the yields went way down, and asset bubbles were created. There is a misunderstanding that the FCBs are just buying Treasuries. But in truth, their purchases of mortgages (Fannie Mae GSE kind of stuff and MBS) exceeds the Treasury purchases. The growth in the financial sector rose from 4% of GDP in 1980 to 71% by early 2002 (I don't know what it is today). The Flow of Funds report shows all this. Federally related mortgage pools have grown from $114 bil in 1980 to $3 tril in 2002. In 2002, mortgage-related securities issurance totaled $1 trillion in just the first half of the year, an increase of over 50% from the same period in 2001.

So that money is hot, hot, hot, and it alone is responsible for our big stock market gains since early 1980, and the asset bubbles fueled since then. The bonds that were purchased are used by businesses and governments to provide services, and their purchase affects the interest rate of those bonds.

As of 2002, Treasuries were the 4th largest category of total credit market debt. The 3 bigger ones are financial sector, non-financial corporate business, and the household sector. The FCB dollars are going into about 26 categories of credit markets, working to make easy money for us to buy stuff, for corporations to buy each other out. Check Flow of Funds, Table L.1.

So the question remains what happens when the FCB divests its US assets. It will have the effect of credit contraction, and devaluing the dollar and US assets. Imagine the stock market really falling when those foreigners sell their US stocks.

So when we ask who is to blame for the housing bubble, don't blame realtors or lenders. Blame the US consumer for spending more than producing, because the result is that a bunch of countries ended up with hundreds of billions of dollars that they needed to find a home for.

As far as Treasury money, I'm by no means an expert but doesn't the government spend all the money it gets from selling Treasury bills and bonds? I don't understand how any money that goes somewhere just sits idle. Banks, governments, they all spend the money they get. Banks lend it, but governments use it to run their government and pay the interest on past debt.

ps, peruse any college textbook on "Money and Banking" and you'll see that the Federal Reserve and U.S. Treasury control the number of dollars in circulation via two functions:
1. Adjusting bank reserve requirements (not applicable to this topic).
2. Buying and selling U.S. Treasuries.

The U.S. Treasury takes dollars from the Japanese or Chinese and gives the Japanese or Chinese U.S. Treasury securities in exchange. That is how the Treasury keeps excess dollars out of circulation.

Japanese purchases of MBS, stocks, and real estate are different. The Japanese or Chinese give an individual or corporation dollars, and the individual or corporation deposits those dollars in a bank. The bank then makes loans against those dollars. Thus, the originally-held-by-Japanese-or-Chinese dollars remain in circulation.

Dollars received by the U.S. Treasury (in exchange for U.S. Treasury securities) reduce dollars in circulation; dollars received by individuals (in exchange for MBS, stocks, real estate) have no effect on dollars in circulation.

Good idea or not, I agree that we're not going to see an increase by the Fed until after the coming recession, whenever it hits.

JG,

To be honest I don't know enough about the mechanics of the Treasury but wouldn't they be using those funds to pay for gov't expenditures, war, etc. Otherwise why would a treasury agree to pay interest for dollars their not using?

Also, dollars recieved by individuals, companies, etc that get deposited would have an affect in that the banks don't lend out the same as they have on deposit. We have a fractional reserve banking system so the amount lent is multiples of the deposit.

jg, your college textbook would have told you that goverments actually spend the money they get when they issue bonds.

The U.S. Treasury does not put all those dollars it gets from selling Treasuries into a big vault, out of circulation, "on ice". They spend it.

Wiley, I fully agree that, given our fractional reserve system, deposits into a bank have a multiplier effect.

Example for the U.S. Treasury:
The government wants to purchase radar technology from Japan in Nov.

In Nov., the Dept. of Defense receives the radar system and pays Mitsubishi $1B via check drawn on the U.S. Treasury.

Separately in Nov., the U.S. Treasury sells the Bank of Japan a $1B T-Bill. The BOJ receives a $1B T-Bill and the U.S. Treasury receives a $1B check drawn on the BOJ.

Net effect: the U.S. receives its $1B radar system and the BOJ holds a $1B T-Bill. Because the $1B checks originated from, and ended in, the U.S. Treasury, there is no increase in the money supply.

Repeat the above transaction in Dec., Jan., etc. and you soon have $2.1T in Treasury bills/notes/bonds outstanding.

Should the BOJ ever choose to liquidate its $1B T-Bill, it will receive $1B via check drawn on the U.S. Treasury and the U.S. Treasury will receive its $1B T-Bill.

Net effect: reduction in the U.S. debt of $1B and increase in the U.S. money supply of $1B.

Up to this point, the $1B is strictly accounting entries between the U.S. Treasury and the BOJ. The key is not what happens to the 'dollars' returned to the U.S. Treasury (the U.S. Treasury keeps the $1B 'on hand' via accounting entry to serve as a 'reserve' against the $1B outstanding T-Bill, as the Japanese will redeem the T-Bill sometime in the future, and the U.S. Treasury must have the $1B 'on hand' to fund such).

The real key is whether the U.S. Treasury is able to sell T-Bills to sop up the 'printed' money (the original $1B check issued by the Dept. of Defense and drawn on the U.S. Treasury). The biggest way the U.S. Treasury 'prints money' is to issue checks drawn on its own account.

If the U.S. Treasury can't sell T-Bills, those $1B checks to Mitsubishi, General Dynamics, United Nations, etc. remain in circulation, get deposited in banks (and get multiplied, as you point out), and cause inflation. That's why, to-date, inflation has been mild, as the U.S. Treasury has been able to continuously sell those $1B T-Bills, sopping up the money that it has 'printed.'

Wiley, please tell me if I have been unclear on a point.

I won't interfere with your conversation with Wiley. But I'd like to elaborate on my points made earlier.

The Federal Flow of Funds Credit Market Debt chart shows that US Treasury debt has risen steadily, but it is not the largest source of credit market debt.

As of Q2 2006, Table L.1 shows these are the largest categories of debt outstanding.

Household sector $ 12,310 trillion
Non-fin. corporate 6,600 tril
Federal government $ 4,700 Trillion
mortgage pools 3,813 trillion
ABS issuers 3,228 trillion
GSE 2,686 tril

The household sector's credit market debt is the 2nd heaviest borrower in the credit markets after the financial sector (which includes mortgage pools, ABS, GSEs, and other categories).

Mortgage pools are pools of mortgage securities issued by one of the GSEs, and have brought a lot of money into our housing market, thus pushing up prices. They've grown from 4% of GDP in 1980 to 29% of GDP in early 2002.

ABS issuers have seen the greatest explosion of debt. 12 years after their introduction, their debt is 4x greater than that of commercial banks. That category includes credit cards, auto loans, equipment leases, corporate loans, mortgages (esp. sub-prime home equity loans), and trade receivables.

Pension funds and retirement accounts, which hold a lot of the ABS debt, have taken on the risk of default by borrowers of this debt. Expect to see a lot of pension and retirement account mutual funds take big losses when this credit bubble implodes, further burdening corporations and governments, and reshaping retirements for millions of Americans.

If the US budget deficit or credit demand is reduced, where will the foreigners put their dollars? The foreigners need a sufficient amount of US debt issue to recycle their dollars.

There is acually now dominating view that interest rates will be cut by March 2007 because the housing downturn is taking the whole conomy down with it. However, with the dollar decline, you have a corresponding increase in oil prices. And I think oil prices, not the housing market or recession, is what is going to drive the interest rate outlook for the US. It is simple that the Fed can afford to have a housing recession but it cannot afford $100 per barrel oil in this country. So my prediction for rates is that they will depend on oil prices.

Ok I think I agree if the Treasury is able to sell its notes to someone else (in this case BOJ), and we we have no trade deficit, then its just a trading of assets and liabilities on eathothers books. However I think the chink in the armor here is your assuming the BOJ's money was not created into existence and also that treasuries sold on the open market can and are purchased by our Fed (money creation).

Tell me if I'm wrong here (as per my initial disclosure that I'm no expert on this)

There is also this non-traditional method which has been reportedly used recently...

The following is what the Electronic Money Printing Press is:

Japan experiences a demand for the yen which is not welcomed by the Bank of Japan.
In order to stave off an appreciation in the yen, the Bank of Japan needs to create yen in order to sell it to buyers who offer US dollars in return.
The Bank of Japan borrows yen in the same manner as the example below, whereby the US or any other nation can create money in their insular systems.
The difference here is there is no time for a natural creation of money via the many steps. The Bank of Japan needs dollars and they need them now.
The Bank of Japan enters the yen/dollar 24 hour market selling the borrowed yen, receiving dollars in return.
The bank of Japan is now drowning in US dollars, but only for a very short time.
The Bank of Japan electronically transmits dollar money wires to the Federal Reserve Bank of New York.
The Federal Reserve Bank of New York many times with a 24 hour day receives these wires and deposits them in the Japanese Float Account at that bank.
The Federal Reserve Bank of New York is the investment manager of the Japanese Float Account.
With the knowledge of the Bank of Japan, the Federal Reserve Bank of New York utilizes 100% of each bank wire as it arrives to enter into the international market for US Treasury instruments, buying US Treasury bonds all across the maturity curve from the shortest out to 30 years.
This fuels a bull market in the US Treasury market.
This bloats the US TIC report on inflows of capital into the US.
The New York Federal Reserve Bank, by buying the bonds for the Japanese Float Account at that bank in the open market, places dollars in the hands of worldwide sellers of Treasury instruments.
Because the international US Treasury market is a private market the increase in liquidity is huge, quiet and everywhere.
The reason this transaction cannot be unwound is because the method would be selling all those bonds that have been accumulated for the Japanese Float Account at the Federal Reserve Bank of New York into the open market. That is a practical impossibility as even the huge international market in US Treasury items cannot absorb such a supply.

This transaction is totally different in its manner and impact than subscribing to an issue of US Treasuries at auction on behalf of a non US buyer, which is customary.

This is the non-traditional method Professor Bernanke utilized that liquefied the world in a short period of time. This attempt to support an international economic recovery is now hitting home with its inflationary impact. This is beyond huge and happened over a short period of time compared to traditional methods. The results cannot be stopped because the liquidity cannot be drained. Regardless of the games played to break the psychology of inflation, real inflation will be delivered in an unprecedented proportion and non traditional manner.

jg, here's a quote from The Dollar Crisis, which explains that all the money created by the FCBs entered the US as high powered money into our banking system, multiplying many times over, and creating the .com and housing bubbles.

"...regardless of what type of asset was initially purchased with these funds [inflows into the US], eventually, most of that capital worked its way into American banks. For example, if the capital inflows were used to buy government bonds, the government spent the proceeds on goods and services, and the providers of those services deposited the payments they received from the government into their bank accounts. The same is true regardless of whether the funds coming into the country were used to buy corporate bonds, stocks, or any other kind of asset. Unless the money was hidden under a mattress or destroyed, most of it would have entered the banking system as deposts; and deposits make up most of the money supply.

....When funds from abroad enter a banking system as deposts, they are not re-lent only once. The original amount that is lent will be redeposited and then re-lent and redeposited numerous times. ...Therefore, the $3 tril in capital inflows after 1983 did much more than finance an additional $3 tril worth of debt. Those inflows were deposited, lent out, redeposited, and re-lent mulitple times. In that way, they caused the U.s. money supply to expand, fueling the bubble economy that emerged in the the U.S in the 2nd half of the 1990s'."

That money created the Nasdaq bubble, too. What happened is that the gov't ran a surplus, so the FCBs couldn't buy enough Treasuries with their dollars, and had to buy other assets instead. In hindsight, we would not have had the .com or housing bubbles if the government would have continued running a deficit and issuing sufficient Treasuries to absorb all those dollars. Another solution would be to stop printing so goddamn much money!

Duncan continues, "The investments in corporate bonds facilitated the misallocation of capital that is now laying low the dot.coms and the telecommunication companies, among others. And the investments in agency debt have helped fuel the boom in U.S. property prices, that has allowed the U.S. consumer to extract additional equity through refinancing his home in order to keep spending more than he earns".

French economist Jacques Rueff explained our dollar recycling program back in 1961, before it even existed, as he saw what would happen once we went off the gold standard:

" The functioning of the international monetary system was thus reduced to a childish game in which, after each round, the winners return their marbles to the losers". - Rueff

In other words, the producer countries of Asia sell us their stuff, and then return to us the money we pay them. It's a ridiculous sytem!

Wiley, I followed and agreed with your example down to near the end. If you say that the Fed Reserve Bank of NY buys bonds on behalf of the Japanese, I defer to you, because I don't know of such a mechanism. Sounds interesting and scary!

I just know of the risk posed for huge inflation from sudden selling of Treasuries held by the Japanese, Chinese, et al.

I am not a financial or economic pro, but I just can't understand how everything can keep going up in value, and how inflation isn't a problem, when it seems like the only thing thats keeping our economy going is a crap load of loans and financing.

Everyone (wall street) acts like the economy is just fine, there will be a soft landing, and the fact that personal and national debts are at an all time high and growing is no big deal. Is anyone expected to pay off their debt, or is debt a new "concept" that goes like, "if you can afford it now, thats all that matters, perpetual debt is now OK".

Incomes are not going up, but houses in socal are 3-4 times more expensive than they were just 10 years ago. Health care is up. Fuel is way up.(temporarily down, but you are kidding yourself if you believe the worst is over). Rents are going up. People are driving nicer cars, buying nicer LCD TV's, and now we have cell phone bills/HDTV Sat bills, etc that we really didn't have 10 years ago. Theres the illegal immigration costs. Where is this money coming from? How can we say inflation isn't here?

How can the Jones' buy a $600k home in Temecula(at 2%tax too), a new Suburban or two, commute to SD, furnish their home with granite, plasma, and stamped concrete, and actually pay off ANY debt? I know I currently make a lot less than you all, but who else plans on OWNING(not owing any $$ to anyone else) their car or home? How can all these mortgage brokers survive? There like a dime a dozen, how many are actually needed? I am confused.

I know a couple who makes what my wife and I do(just about $75k per year). They just bought a first home in Menifee for $385k. They feel like they got a steal because the price was reduced $20k. They did 100% financing. Now that they are struggling to make the payment, they have decided to move to Oregon. But their plan is to wait a year, so that they can make a $100k profit on their house, "like their neighbor did". They said this so matter of fact, like everyone who owns a home just makes $100k per year, just like the past few years. They are not the only ones. There are tons of people doing this like its no big deal.

If they would make a 20% cash down mandatory, we wouldn't have any of this bs. I am just confused, and disappointed in our countries lack of financial responsibility. I wonder when its all gonna hit the fan, and wonder what I can do to make it through. So far, I sold my home last summer, invested in some Gold, Oil, and CDs, thats about it. I haven't made a whole lot yet, but I would have lost about $20k on the house if I stayed. I am happy with my decision, but I wonder whats best to do in the future.
Matt

Nice, clear read of the situation, Matt; I could not agree with you more.

Great job getting out of your house.

In my opinion, it's going to be an ugly run of years, and you're now in a better position to survive, then thrive.

I recommend gold, or better yet, gold mining mutual funds.

P.S. -- some well-heeled folks are attuned to the devaluation of the dollar and the attractiveness of gold: a guy who lives in (per my wife) the best looking house in La Jolla and I were chatting on Saturday. He found the recent article in The Economist on the fall of the dollar convincing. For folks interested in a local source for gold, he recommends Joel Perlin:

http://www.goldendures.com/about_us.html

If the Treasuries are sold off or not renewed when they expire, then the interest rates on Treasuries will go higher. What else? Where will all those dollars go? The export countries won't convert them into their own currencies. They could buy other currencies or gold or hard assets. oil is sold in dollars, so they could buy lots of it. Unless of course they think the price will come down, or they lack a large storage facility.

Imagine the worse problem when we actually pay down our debt, and there aren't enough treasuries to absorb all the dollars. Then the FCBs have to buy ever more MBS and equities, and create bigger and bigger bubble! Now, isn't that a conundrum? Paying down the national debt creates asset bubbles!

My brother thinks that China has a long term plan to attain all the US manufacturing and high tech industry knowledge, so they can learn it and copy it. Once they have what they want, they'll discard their dollars and use their money to buy natural resources.

Hipmatt your right on the money. Crowds have throughout history shown a high propensity to delude themselves.

We are witnessing a massive amount of money in circulation running around looking for yield. All else is noise. It's an illusion of wealth.