The Rude Awakening
Laguna Beach, California
Friday, August 25, 2006 ------------------------- - Lending themselves into a hole – a lending trend to
keep an eye on,
- Where did all the paper money go? The word on pay-
options ARMs,
- 1.3 billion savers, investors and entrepreneurs and
more to come...
------------------------- Eric Fry, a stone's throw from the housing bust, reports... The American economy seems to have caught the housing-bust
virus. But since the virus is merely incubating, the "host"
remains largely asymptomatic. We Americans still attempt to
sell our houses at record-high prices...even though we
can't. And we still attempt to over-consume by spending the
home equity we think we still have...even though we don't. Meanwhile, most mortgage-lending stocks seem perfectly
healthy, even though they aren't. As the virulent "housing bust" virus advances from
incubation to full-blown outbreak, the host will begin to
feel a bit woozy. Symptoms may include falling home prices,
slumping consumption and widespread economic malaise. The
falling-prices stage is already beginning; but the buyers
of mortgage-lending stocks seem not to have noticed. Perhaps they will notice soon. --- The China Report ---
The Greatest Investment Opportunity The World Has Ever
Known It's Bigger than Cable Television, or the 'PC Revolution'
Yet, Not 1-In-20 Americans Has Even a Single Dollar
Invested... China has now surpassed the U.S. to become the country that
attracts the most direct foreign investment. And it's not
hard to see why. The country is rapidly becoming a nation of 1.3 billion
savers, investors and entrepreneurs. And with a blistering
recent economic growth of more than 12%, investors who act
now have an opportunity to reap tremendous short-term
gains. Find out how you can join an elite group of investors who
could take advantage of this opportunity for amazing
profits: http://www.isecureonline.com/Reports/CHN/ECHNG806/ ---------------------------- Down on Downey
By Eric J. Fry "We conclude that a decline in house prices is underway,"
Grant's Interest Rate Observer recently remarked. "If the
house market, like the stock market, were mean-reverting,
the sell-off could carry a far way. A return to the post-
1968 trend line would imply a drop of 22%. Which, of
course, for these real estate-centric United States, would
imply disaster. "We do not predict disaster," Grant continues, "but we do
expect a pullback severe enough to inhibit the leveraged
American consumer and to stunt the growth of the U.S.
economy..." Your California editor does not predict disaster either,
but he does not rule it out. Nor does he rule out the
possibility that mortgage-lending stocks like Newport
Beach-based, Downey Financial Corp. (NYSE: DSL), might fall
a lot lower...before they move higher once again. Real estate transactions – and related economic activities
– have become a disproportionably large contributor to the
overall U.S. economy. Therefore, we would miss them greatly
if they took a sabbatical. "Between 1997 and 2004," Grant relates, "the value of these
residential transactions amounted to 16.4% of GDP, almost
double the median reading from 1968 through 2005." This
monumental real estate boom fostered "echo-booms" in all
housing-related industries. Since the end of 2001,
according to Northern Trust economist, Paul Kasriel,
housing-related industries have produced a whopping 43% of
the nation's total net private sector employment growth. 
Obviously, therefore, any slackening of real estate
activity could convert the nation's largest job-creator
into a job-destroyer. "In the months ahead," says Kasriel, "Econ 101 predicts
that the prices of existing dwellings will continue to
soften. This will serve to reduce the excess supply as some
not-so-serious sellers take their homes off the market and
as those sellers who have to sell acquiesce to the reality
of lower prices. The knock-on effects of all this will be
subdued consumer discretionary spending as those 'home
ATMs' are not refilling as rapidly as before. Another
factor that will curtail consumer discretionary spending is
slower income growth in housing-related industries as
employment and sales commissions moderate further." Membership within the California Association of Realtors,
for example, might slip a bit, once home-selling becomes
more tedious – and less remunerative – than raking rock
gardens. 
"We know that the behavior of the residential real estate
sector tends to lead the behavior of the overall economy,"
Kasriel conntinues. "That's why folks at the Conference
Board stuck housing building permits into the index of
Leading Economic Indicators rather than the coincident or
lagging indices. Might it be in this cycle that the
behavior of the residential real estate sector is even more
important than other cycles?" "Yes," is the implied and worrisome answer. The casualties of a real estate-induced recession would be
many and varied. So varied, in fact, that we could not
begin to anticipate them all. But we could certainly
anticipate that those closest to the front lines – namely,
builders and lenders – would suffer first and most. Acknowledging this likelihood, the homebuilding stocks have
been falling sharply for months. But the mortgage-lending
stocks, as a group, have not...at least not in relation to
the sharp drop in mortgage-lending activity. Over the last
12 months, the shares of Kaufman and Broad, the nation's
largest homebuilder, have plummeted 50%; while the shares
of Downey Savings have not dropped at all. Probably they should have. Downey's loan origination volumes are tumbling in lock-step
with the drop in California home sales. 
During the second quarter of this year, Downey managed to
originate only $2 billion worth of mortgages. That might
sound like a lot, but it was less than half as much as the
company originated during the second quarter of last year.
Back in 2001, Downey Savings averaged about $2 billion of
originations every quarter. The mortgage lender earned
$4.25 a share that year. And now, once again, Downey is
originating about $2 billion of loans per quarter. And yet,
Wall Street analysts expect the company to earn $6.80 a
share this year...and to earn $7.50 next year! We don't believe it. And even if we did, we'd be afraid to
buy the stock. That's because most of the "earnings" that
the bank reports are not the type that someone could spend
in a grocery store. In other words, the earnings reside
only on paper, NOT in Downey's corporate bank account.
The reason for this curious condition is that Downey
Savings has issued a very large number of "Pay-option
ARMs," also known as negative-amortization (neg-am) loans.
These devilish little mortgages contributed more than half
the bank's earnings last quarter...sort of. "Pay-option ARMs, which Californias took to like
surfboards, allow the buyer to choose a form of monthly
mortgage payment," James Grant explains. "And if the choice
is 'none of the above,' the unpaid interest can be added to
the loan balance (up to a point that is)." In other words, these loans allow the homeowner to skip
monthly payments, thereby INCREASING the unpaid balance.
And when a mortgage balance increases instead of decreases,
the loan-amortization is running in reverse. Hence the
name, "negative-amortization" (Neg-am) loans. Here's how neg-am mortgages work on Wall Street: Whenever a
homeowner chooses to skip a payment, banks like Downey
Savings still behave as though they received actual money.
They treat the neg-am as if it were revenue. A little bit
of this chicanery is harmless; a lot of it is worrisome. It's bad on two fronts. First of all, when a borrower skips
a payment, he skips a payment. Call it what you will, no
check arrives in the mail. Even if Downey considers a
skipped payment to be revenue (which it does), no revenue
actually arrives at Downey HQ. Secondly, repeated skipped
payments by multiple parties builds up a liability, without
also building up any of the cash reserves required to
offset the liability. That liability ultimately belongs to
Downey In the quarter just ended, negative amortization "revenues"
accounted for a whopping 57% of Downey's total revenues,
compared to only 20% last year. "Accumulated negative
amortization stood at $229 million," Grant reports, "or 18%
of June 30 net worth, up 218% from the same quarter in
2005." None of this would be so bad if the housing market were
still booming. But that's not the case. Southern California
home sales have dropped to their lowest level in nine
years. And yet, the shares of Downey Financial have barely
slipped from their all-time highs. If California real estate is peaking, can the shares of the
Golden State's mortgage lenders be far behind?" James Grant
recently wondered aloud. "'Yes they can be," he replied to
his own question, "and – up to this moment, at least – have
been." Evidently, they can be far behind and – up to this moment,
at least – have been...but they shouldn't be. [Joel's Note: You have barely been able to turn on the news
this week without being bombarded with lamentations about
the dire state of the housing market. Some analysts even
feign shock, as if this has not been imminent for some time
now. Rude readers were not so shocked to see the massive climb
in inventories and cooling prices. Emails from all over the
nation flooded in: "Very slow here and there are buyers putting in bids below
the asking price and in some cases are getting great
deals." Writes Jon from New York "The "media" is fond of concentrating on the coasts, as if
the middle of the country was immune from the bubble.
Conventional wisdom is that Midwesterners are too
conservative and would not participate in speculative
transactions...WRONG!" Chimes Cathy from Minneappolis. Before the bubble shocked the talking heads (and before he
moved to Australia) Strategic Investments' Dan Denning
issued a report on the housing collapse and what you can do
about it. Read it here: The Hidden Drop:
http://www.agora-inc.com/reports/DRI/EDRIFB05 --- Listen to a Sample --- The Global Investment Event of the Year CD Package The 2006 Agora Financial Wealth Symposium featured the most
impressive array of analysts and commentators we've ever
assembled. These special audio presentations are the
easiest and most affordable way to hear from the likes of
Steve Forbes...Rick Rule...and Dennis Gartman. Don't miss your chance to hear what these world-renowned
experts have to say about where the economy is going - and
the specific recommendations you can use to play them. Get
your CDs today. http://www.isecureonline.com/Reports/400SVANCD2/E400G827 ---------------------------- 
| 
