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<p class=MsoNormal align=center style='text-align:center'><b><font size=4
color="#ff6600" face="Times New Roman"><span style='font-size:13.5pt;
color:#FF6600;font-weight:bold'>MARCS NOTES:<br>
This article is well written and describes the bubble and aftermath very accurately<o:p></o:p></span></font></b></p>
<p class=MsoNormal align=center style='text-align:center'><b><font size=4
color="#ff6600" face="Times New Roman"><span style='font-size:13.5pt;
color:#FF6600;font-weight:bold'>This is a MUST READ <o:p></o:p></span></font></b></p>
<p class=MsoNormal align=center style='text-align:center'><b><font size=4
color=black face="Times New Roman"><span style='font-size:13.5pt;color:black;
font-weight:bold'><o:p> </o:p></span></font></b></p>
<p class=MsoNormal align=center style='text-align:center'><b><font size=4
color=black face="Times New Roman"><span style='font-size:13.5pt;color:black;
font-weight:bold'><o:p> </o:p></span></font></b></p>
<p class=MsoNormal align=center style='text-align:center'><b><font size=4
color=black face="Times New Roman"><span style='font-size:13.5pt;color:black;
font-weight:bold'>Futile Attempts <span class=GramE>To</span> <span
class=SpellE>Reflate</span> The Housing Bubble & The Deadly Cost</span></font></b><o:p></o:p></p>
<p class=MsoNormal align=center style='text-align:center'><font size=3
face="Times New Roman"><span style='font-size:12.0pt'><img width=1 height=12
id="_x0000_i1025" src="cid:image001.gif@01CACE74.9E0B7680" border=0><o:p></o:p></span></font></p>
<p class=MsoNormal align=center style='text-align:center'><b><font size=3
face="Times New Roman"><span style='font-size:12.0pt;font-weight:bold'>Daniel
R. <span class=SpellE>Amerman</span>, CFA, DanielAmerman.com</span></font></b><o:p></o:p></p>
<p class=MsoNormal align=center style='text-align:center'><font size=3
face="Times New Roman"><span style='font-size:12.0pt'><img width=1 height=12
id="_x0000_i1026" src="cid:image001.gif@01CACE74.9E0B7680" border=0><o:p></o:p></span></font></p>
<p class=MsoNormal><b><font size=3 color=black face="Times New Roman"><span
style='font-size:12.0pt;color:black;font-weight:bold'>Overview</span></font></b><o:p></o:p></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>When a
financial bubble bursts - can it be <span class=SpellE>reflated</span>? And
what are the risks for all of us the <span class=SpellE>reflation</span>
attempt fails? <o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>In this
article we will briefly review the six factors that came together to create the
real estate bubble in the <st1:country-region w:st="on"><st1:place w:st="on">United
States</st1:place></st1:country-region>. As we will cover, the government has
deemed a return to a normal housing market - one which is governed by market
forces - to be politically unacceptable. Instead, an artificial mortgage market
has been created with massive interventions in three different categories as
the government attempts to <span class=SpellE>reflate</span> the housing
bubble. Quite a risky undertaking, but the politicians have decided they are
willing to risk everything the taxpayers and savers have, in an attempt to
remain in office. These interventions include the Federal Reserve effectively
creating money out of thin air to fund almost the entire mortgage market at
below market rates. We will explore why the three interventions will not
succeed in replacing the six sources of the bubble, and the severe risks for
all of us when attempting the economically impossible becomes politically
mandatory. We will close with a discussion of the likely implications for the
housing market and the value of the dollar, as well as a brief discussion of
alternative solutions for protecting your net worth. <b><font color=black><span
style='color:black;font-weight:bold'>How <span class=GramE>To</span> Create A
Housing Price Bubble In Six Steps</span></font></b><o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>A number
of factors came together to create the housing price bubble that was
experienced in the <st1:country-region w:st="on"><st1:place w:st="on">United
States</st1:place></st1:country-region> during the early to mid 2000s.
Perhaps the central element was a quite deliberate Federal Reserve easy credit
policy that led to the lowest mortgage rates that had been seen since the
1970s, which made purchasing houses the most affordable that they had been in a
generation. <o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Qualifying
for mortgage loans is not so much dependent on home prices, but rather the
ability to afford mortgage payments. As an example, let's consider a family
with the median household income for the <st1:country-region w:st="on"><st1:place
w:st="on">United States</st1:place></st1:country-region> in 2009 of about
$50,000 per year (Census Bureau estimates). Pre-bubble underwriting standards
were that mortgage payments should take no more than 28% of household income,
which meant $1,167 a month would have been the maximum available for mortgage
principal and interest payments. According to Freddie Mac statistics, the
average 30 year fixed mortgage rate between 1972 and 2006 was 9.31%. If we take
the median $50,000 per year income and an average 9.31% mortgage rate, that
means that the exactly median household in the US qualified for a $141,000
mortgage, and assuming 20% equity, a $176,000 house.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>During
the rapid growth of the housing bubble, fixed mortgage rates spent much of
their time in about the 5.50% to 6.00% range. When we change our mortgage rate
to 5.75%, then a family with that same median income of $50,000 per year can
now qualify for a $200,000 mortgage, an increase of about $60,000, or almost
half again as much mortgage (and home price).<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>During
the peak insanity of the housing bubble <span class=GramE>- an insanity</span>
in plain view that was enabled by the federal government as well as Wall Street
and the rating agencies - subprime mortgages were being underwritten at one
year teaser rates such as 3.5%. At such rates a family with an income of
$50,000 a year could "afford" a $260,000 mortgage, or almost twice
the mortgage of a decade before, which enabled a near doubling of real estate
prices. At least until the interest rate contractually reset, at which time the
family would have no known means of making the payments, but Wall Street and the
rating agencies providing investment grade ratings were far beyond being
concerned with such trivialities by this point. <o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>However,
the plunge in mortgage interest rates was not enough to create the full housing
bubble. Even a $260,000 mortgage wasn't sufficient to buy a new home in many
desirable markets where prices were surging; the income simply wasn't there to
sell the average home to the average worker. Many people also lacked the large
down payments, the equity component of home purchases. So the solution was to
simply allow people to borrow their down payments in the form of 2nd and 3rd
mortgages that closed simultaneously with the 1st mortgage. <o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>An
additional hurdle was that the historical standard of 28% or 30% of income was
insufficient to make payments on the new, larger loans. Now, those standards
were far from arbitrary - many decades of mortgage underwriting history had
shown that most people could handle housing payment burdens of that size
relative to their income, but things got "iffy" above those levels.
However, in the early years of the new millennium, accepting those traditional
limitations was unacceptable, as not enough people could buy homes at ever
rising prices. So the standards were changed. People were now allowed to borrow
a total of 35%, or 40% or even 45% of their annual income in total required
mortgage payments (including 2nd and 3rd mortgages). <o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>With this
combination, we were really getting somewhere in terms of
"affordability". Take a family with the median national income of $50,000
a year, let them borrow at a one year teaser rate of 3.50% (with everyone
involved pretending that will be the rate for the entire term of the mortgage),
let them use 45% of their income to cover the package of mortgages that ensures
no actual savings are needed to help fund the house - and they could now
"afford" a $418,000 mortgage and a $418,000 home ($50,000 income,
3.5% teaser rate, 45% of income to 1st & 2nd mortgages).<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>This was
still not enough, however, for people with a bad history of repaying small
loans were being kept out of the market for large loans. So they were allowed
in with the explosive growth of subprime lending, and were allowed to borrow
their down payments, even while the percentage of income available for housing
shot upwards. Changes in underwriting standards may sound a bit obscure, but
the practical result was that a family that couldn't have bought a home of any
kind in 1996, due to their lack of savings and poor credit history, could now
buy $400,000 and $500,000 homes.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>So let's
review. Going from a historical average 9.31% 30 year fixed rate mortgage to
underwriting based on fixed mortgage rates of 5.75% boosts the amount that can
be borrowed - and the home that can be purchased - by 42% (Step 1).
Underwriting at a teaser rate of 3.5% on a one year adjustable rate mortgage
boosts the amount that can be borrowed even more, up to a total of 84% (Step
2). Going from 28% of income being allowable for housing payments to 45% of
income (combined 1st & 2nd mortgage), separately boosts the amount that can
be borrowed by 61% (Step 3). Combining the lower rate and more aggressive
underwriting standard boosts the maximum amount of the mortgage by 196% (1.84 X
1.61 = 2.96), as the amount that can be borrowed by a family with a $50,000 annual
income rises from $141,000 to $418,000. Add in an expansion of the homebuyer
pool to include those who don't have enough excess income to save down payments
(Step 4), thereby increasing the competition for each home. Add in an expansion
of the homeowner pool to those who have poor histories of repaying loans (Step
5), further increasing the competition for each home. This 1-2-3-4-5
combination needs only one more ingredient to predictably set off an explosive
rise in housing prices. <o:p></o:p></span></font></p>
<p class=MsoNormal align=center style='text-align:center'><font size=3
face="Times New Roman"><span style='font-size:12.0pt'><img width=600
height=463 id="_x0000_i1027" src="cid:image002.gif@01CACE74.9E0B7680" border=0><o:p></o:p></span></font></p>
<p><b><font size=3 color=black face="Times New Roman"><span style='font-size:
12.0pt;color:black;font-weight:bold'>Human Nature</span></font></b><o:p></o:p></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Home
prices rose as payments fell and more buyers entered the market; human nature
came into play and a speculative frenzy was born (Step 6). People looked at the
sharp home price increases that were happening, month after month. They saw the
new easily available credit that was flooding the market, with banks competing
to offer massive loans allowing the purchasers to buy houses with essentially
no money down, even if the borrower didn't have the means to pay for it.
Millions of people quickly saw that buying and flipping homes would make them
far more money than just about any job for which they could qualify. So a
speculative frenzy kicked in that drove prices higher and higher as it drew
more and more people in.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>This of
course led to an unsustainable environment. Because of the speculative frenzy,
because of the easy underwriting, home prices reached levels in many
metropolitan areas where the average family couldn't afford the average home
even at very low mortgage rates. On the underwriting side, loans were being
made to individuals with poor credit histories at teaser rates, where those individuals
had no known means to make their mortgage payments when the interest rate
inevitably reset as part of the contract. The time had come when the popping of
the bubble was inevitable.<o:p></o:p></span></font></p>
<p><b><font size=3 color=black face="Times New Roman"><span style='font-size:
12.0pt;color:black;font-weight:bold'>Where <span class=GramE>The</span> Markets
Want To Go</span></font></b><o:p></o:p></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>In the
aftermath of this bubble it is quite clear what the housing market wants to do.
Like any market that is recovering from <span class=GramE>a frenzy</span>, what
it seeks is sustainable equilibrium. Those are the fundamental economic forces
in play here.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>What the
housing market wants to do is reach a place where the average creditworthy and
stable middle-class family can afford an average home, spending no more than
about 30% or so of their income on housing. For this to happen, prices truly
must be much lower than they were at the peak in places like Southern California,
<st1:City w:st="on">Las Vegas</st1:City>, <st1:State w:st="on">Arizona</st1:State>
and <st1:State w:st="on"><st1:place w:st="on">Florida</st1:place></st1:State>.
Those were simply unreal prices. If the average home is completely unaffordable
to the average buyer, but there are sellers who must sell, then the basics of
economics tell us that prices must drop until sellers can find buyers - as with
any other market. <o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Obviously,
the specifics vary by the market, and this doesn't mean that three bedroom
homes on big lots in good neighborhoods suddenly drop below $200,000 in <st1:place
w:st="on">Southern California</st1:place>. But it does mean that townhomes with
postage stamp lots and a long commute have to return to a place where mortgage
payments are realistically affordable for a college graduate earning the
prevailing wage in that area.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>In terms
of mortgage rates, where the market wants to go is to a place where private
lenders are bidding against each other with gusto to make mortgage loans,
because the <span class=GramE>risk</span> return combination is healthy and
attractive to them. They are being substantially rewarded for taking the risk
of funding housing.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Now what
this translates to is materially higher mortgage rates, almost by definition.
The reason the Federal Reserve has taken the unprecedented step of maintaining
massive monetization to fund the mortgage market is that the alternative of
mortgage lending by private participants would have been at unacceptably high
interest rates. If true market rates return, this likely means that payments
rise for the given price of a house, which then drives down the prices still
further until home prices reach a point where - at market interest rates - the
average family can afford the average home.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Unfortunately
this return to normalcy is very difficult for many millions of truly innocent
homeowners. By truly innocent I'm not referring to the people who in many cases
were quite knowingly speculating in the housing market, or to those who never
should have been able to buy a home in the first place. No, the truly innocent
are the responsible, middle class families who could afford a home before this
bubble occurred, and would have a healthy equity in their homes right now in
ordinary circumstances. However, during the heart of the housing bubble they
needed homes, and had no choice but to pay much more than what those homes
should have been worth. <o:p></o:p></span></font></p>
<p><span class=GramE><font size=3 face="Times New Roman"><span
style='font-size:12.0pt'>Which has left them with significant economic damage
at this point, as they are effectively underwater in their mortgages by quite
substantial sums.</span></font></span> These families are essentially locked
into their homes for the indefinite future, unable to leave, unless they <span
class=GramE>either take a major loss on their home and</span> come up with cash
to pay for that, or destroy their credit rating. These millions of families are
the true victims of the reckless actions of Wall Street and the Federal Reserve
in creating the bubble.<o:p></o:p></p>
<p><b><font size=3 color=black face="Times New Roman"><span style='font-size:
12.0pt;color:black;font-weight:bold'>When Reality Is Politically Unacceptable</span></font></b><o:p></o:p></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>There is
the economic reality which we were just reviewing, and simultaneously there is
something entirely different: political reality. Looking at the situation, the
politicians in the <st1:country-region w:st="on"><st1:place w:st="on">United
States</st1:place></st1:country-region> collectively determined that they
could not accept economic reality. There was too much bad news there, which
would lead to too much voter discontent, which would translate to too many
incumbents losing elections.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>So the
decision has been made to make an all-out effort to support the housing market,
regardless of the cost and the risk.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Now,
we're not really talking about cost and risk for the politicians. They are not,
nor have they ever been, the ones who are truly bearing the risk. Rather, it is
you and I bearing the risk and bearing the costs. The politicians have made the
decision that there is no limit to the cost they're willing to pass on to all
of us to get housing to a politically acceptable place, and there is no limit
to the relative risk that they are willing for us to take. In other words,
there is no limit to the financial risk for you that the government is willing
to take to stay in power.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>So a
massive, historically unprecedented intervention by the government has been the
result. An enormously expensive intervention by a government that already
couldn't pay its bills. Even as the housing bubble was created by the
convergence of five mortgage finance factors (not including human nature), the
government's efforts to prop up housing prices fall into three broad
categories.<o:p></o:p></span></font></p>
<p><b><font size=3 color=black face="Times New Roman"><span style='font-size:
12.0pt;color:black;font-weight:bold'>Attempting To <span class=SpellE>Reflate</span>
<span class=GramE>The</span> Bubble - The Public Face</span></font></b><o:p></o:p></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>The
public <span class=GramE>face of the government's efforts to support the
housing market are</span> the homebuyer tax credits, as featured in all the
headlines. These are tax credits of up to $8,000 for first time homebuyers and
$6,500 for previous homebuyers. Some estimates are that total tax credits will
end up costing the government about $20 billion in foregone tax revenues. <o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>This
could be viewed as an explicit partial socialization of home purchases, where
homebuyers who supposedly act in the national interest by purchasing homes are
funded by the rest of the population. Another way of looking at it is every
household in the <st1:country-region w:st="on"><st1:place w:st="on">United
States</st1:place></st1:country-region> pays an average of $180 each, so a
lucky few households can get up to $8,000 each. In some ways, this could be
viewed as a partial funding of the down payment for homes, allowing people to
participate who otherwise would not, thereby supporting the market.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>The
homebuyer tax credits are a very explicit short term attempt at market
manipulation. As soon as the tax credits stop, the housing market can be
expected to seek whatever levels it would've gone to if the tax credits had
never existed in the first place. Indeed, the market may even temporarily fall
further than it otherwise would have, because anyone who could have reasonably
purchased a home and benefited from the tax credit would already have done
everything in their power to do so, thereby depressing the pool of homebuyers
for the months or years after the program ends.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>While
they are the best known facet of the government's housing support program, and
the only component where the cost is being openly included in the federal
budget and voted upon in Congress, the homebuyer tax credits are arguably the
least important of the big three housing support programs. <o:p></o:p></span></font></p>
<p><b><font size=3 color=black face="Times New Roman"><span style='font-size:
12.0pt;color:black;font-weight:bold'>Attempting To <span class=SpellE>Reflate</span>
<span class=GramE>The</span> Bubble - Bigger Risks, Less Publicity</span></font></b><o:p></o:p></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>A more
important form of governmental support for the housing market is both more
obscure than the homebuyer tax credits and potentially much more costly to the
nation as a whole. As previously discussed, it was the relaxation of loan
underwriting standards that drove the expansion of the housing bubble as much
or more than the reduction in interest rates. The popping of the housing bubble
effectively destroyed the use of private mortgage underwriting standards.
Private investors no longer want to take mortgage credit risks, at least not
without payments of substantially higher fees and severe restrictions on who
qualifies for loans. <span class=GramE>Which would be politically unacceptable.</span><o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Therefore,
the overwhelming majority of mortgage financings these days have to meet the
underwriting standards of FHA, Fannie Mae or Freddie Mac. These entities now
effectively bear the credit risk - the chance the homeowner won't make payments
and the losses that then need to be taken - for nearly the entire mortgage
market. Since the failure of Fannie Mae and Freddie Mac and their takeover by
the federal government, this means that the federal government directly
controls virtually all aspects of the mortgage credit process, determining who
gets mortgage loans, how large of a mortgage loan they get, and under what
conditions. The federal government determines the standards for loan to home
value, for payments to income, for what constitutes income for underwriting purposes,
for credit scores, and far more. This is terribly dry and obscure stuff, and
not at all suitable for headlines or passing coverage by TV news anchors,
despite being more important than the far more public homebuyer tax credit
programs in determining how many people can afford how much house in the real
world. <o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Along
with the federalization - that is, the straight up politicization - of mortgage
underwriting <span class=GramE>comes</span> the complete socialization of
mortgage credit risk. The federal government sets the standards because it is
willing to bear the cost of all the mistakes, for all the loans that go bad,
for the entire housing market.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Except
that, of course, the federal government doesn't really take any losses. It's
you and I who take the losses and bear all the risk.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>So a more
accurate way of phrasing what is happening is that political appointees under
instructions to keep the housing market propped up regardless of costs - and
effectively operating almost out of view of the media and the public - are taking
massive risks in the name of extending credit to as many homebuyers as
possible. <span class=GramE>Expensive risks that could dwarf the homebuyer tax
credits - but that don't have to be included in the budget.</span> After all,
the losses haven't occurred yet, and can therefore be quite easily made to
disappear through the flexible use of optimistic assumptions.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>There is
no way for anyone outside of the government to quantify the full extent of the
risk, and it is indeed unlikely that anyone inside the government is keeping
track on a multi-agency basis (with real world assumptions anyway). However,
recent congressional testimony about the Federal Housing Administration can
provide insight into a small part of the bigger picture. FHA is in big trouble,
with reserves down to about 0.5% of mortgages insured, compared to the legally
mandated 2.0% minimum. The agency is treating mortgage modifications by people
who previously couldn't pay their mortgages, as if they were essentially of the
highest credit quality, rather than subprime. Yet at the very same time, the
FHA commissioner assured Congress that there wouldn't be any problems. A
political appointee telling incumbent politicians exactly what they wanted to
hear, which was that the housing market could be aggressively supported through
government guarantees of questionable but politically desirable loans -without
worrying about bothersome technical details.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>The
headlines about what has been happening with the complete politicization of
lending standards for one of the largest loan markets in the world may indeed
become quite common - after it is already too late.<o:p></o:p></span></font></p>
<p><b><font size=3 color=black face="Times New Roman"><span style='font-size:
12.0pt;color:black;font-weight:bold'>Attempting To <span class=SpellE>Reflate</span>
<span class=GramE>The</span> Bubble - Risking Everything</span></font></b><o:p></o:p></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>The
Federal Reserve had already created close to $1 trillion through straight-up
monetary creation as covered in my article "Creating <span class=GramE>A
Trillion Out</span> Of Thin Air" for a short-term intervention in the
commercial paper market and emergency bank lending. It was a daring risk, a
tremendous risk on a scale that was unprecedented. On a scale that risked the
value of the dollar itself, and therefore put in peril the value of all of our
savings. <o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>The
Federal Reserve succeeded in their first gamble. The original plan, as covered
in my article "Containing Inflation <span class=GramE>Via</span> Unlimited
Money Creation: The Fed's Strategy", was to quickly return that cash to
the void from whence it came, before the value of the dollar was jeopardized.
However, because of the problems in the housing market and political
requirements, the Fed took a different approach. They doubled down and more as
they took that fabricated money, and instead of getting rid of it, they just
put it back out in a much riskier strategy than the original one. What the
Federal Reserve did was create an entirely artificial market for mortgages, which
means an entirely artificial market for housing. The Federal Reserve wanted
mortgage rates lower than what a rational private lender would loan at.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>So the
Fed effectively bought the entire new mortgage security originations market,
essentially funding every conforming new mortgage that was coming down the
pipeline, and thereby funding the purchase of nearly every home that was being
sold in the <st1:country-region w:st="on"><st1:place w:st="on">United States</st1:place></st1:country-region>.
With the source of that money being the trillion dollars that had been
effectively created out of thin air. This put a floor beneath the fall of the
housing market, but it didn't create a healthy market. <o:p></o:p></span></font></p>
<p><b><font size=3 color=black face="Times New Roman"><span style='font-size:
12.0pt;color:black;font-weight:bold'>The Plausibility <span class=GramE>Of</span>
The Exit Strategy</span></font></b><o:p></o:p></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>The
economists at the Federal Reserve know that this is an unsustainable and risky
situation. They know that they can't indefinitely fund an artificial market in
the most real of assets through creating money out of thin air, with no
economic growth to support that money and no taxes to support that money. So
they know that they have to leave. And they're saying that their plan is to
start withdrawing from the housing market by around the end of March of 2010,
and to steadily pull out. Indeed, the Federal Reserve is already expanding its
list of eligible counterparties for transactions designed to drain the cash it
created from the system, and the New York Fed has been conducting live trial
runs in the marketplace. There are some complications here, however. <o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>The Fed
can do the fiscally responsible thing and get rid of the excess money and
unwind its positions, but what would really happen if mortgage rates jump 1%?
And what if this shuts down a housing market which is already in pretty bad
shape, and is not responding all that well even to these artificially low
mortgage rates?<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Even
worse, what happens if mortgage rates rise 2%, and not just the housing market
shuts down, but the construction industry also stops in its tracks? What do the
politicians do at that point? <o:p></o:p></span></font></p>
<p><b><font size=3 color=black face="Times New Roman"><span style='font-size:
12.0pt;color:black;font-weight:bold'>The Midterm Elections</span></font></b><o:p></o:p></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>There are
some crucial political equations that we need to be taking into account here.
Being that the midterm elections are approaching, will the government really
withdraw its support for the mortgage market and thereby the housing markets?
Will the government be willing to endure steadily growing pain as the economy
likely plunges down along with the housing market, with voters feeling ever
more pain every month as the election approaches? Will incumbent politicians of
either party voluntarily lose the upcoming elections for the economic good of
the country?<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Or will
they instead choose an approach that stretches our fantasy mortgage and housing
markets out just a little bit longer?<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>That's
the problem with a strategy like this. There never is a convenient time to
leave the strategy, because the markets always want to return to fundamental
levels. And the decision has already been made that those fundamental levels
are not politically acceptable. So any exit strategy may be doomed before it
even starts.<o:p></o:p></span></font></p>
<p><b><font size=3 color=black face="Times New Roman"><span style='font-size:
12.0pt;color:black;font-weight:bold'>Increasing Foreclosures</span></font></b><o:p></o:p></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Housing
prices have temporarily stabilized, and have even recovered a bit in some
areas, but some fundamentals are getting even worse. Between five and seven
million homeowners are seriously behind on their mortgages, and may be
foreclosed upon at any time. The reason they haven't been foreclosed upon is
that the banks have been under intense political pressure not to foreclose on
too many homes. This creates another form of artificial market, where there is
an overhang of millions of people living in homes upon which they haven't been
making payments. There are strong indications that the pace of foreclosures may
pick up again in 2010, in which case a flood of repossessed homes on the market
could quickly drive down prices.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>This wave
of foreclosures is however quite different from the previous wave, because it isn't
about subprime borrowers. It's about responsible people with good credit
records who didn't borrow too much - but have lost their jobs in the greatest
depression/recession since the 1930s. Prime mortgages extended to unemployed
borrowers are what most threaten the mortgage markets now.<o:p></o:p></span></font></p>
<p><b><font size=3 color=black face="Times New Roman"><span style='font-size:
12.0pt;color:black;font-weight:bold'>Could Anyone Have Predicted This?</span></font></b><o:p></o:p></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Using my
background as a mortgage derivatives expert and author, in a series of public
articles in early 2008, I connected the dots as I saw them, and drew what
seemed to me to be the obvious conclusions: that the subprime crisis would get
much worse, and would have the potential to melt down Wall Street in a week.
Not from accounting losses, but rather from creditors pulling loans from the
highly leveraged financial giants when they realized the extent of the losses.
I further predicted that the government would not allow this to happen, and
that instead there would be a massive bailout that would not only lead to huge
deficits, but necessitate the Federal Reserve resorting to creating money out
of thin air in an attempt to contain the damages. In other words - what has <span
class=GramE>happened.</span> While a number of people predicted catastrophe, to
the best of my knowledge, this makes me the only person to accurately publicly
predict not just that there would be a crisis, but how the crisis would unfold,
the government bailout, the Federal Reserve's monetization, and where the
response to that crisis would logically lead: to the place we are covering in
this article in early 2010. In my opinion - this is a time where some more dot
connecting is badly needed.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>(The
referenced articles from early 2008 are "<i><span style='font-style:italic'>The
Subprime Crisis Is Just Starting</span></i>", "<i><span
style='font-style:italic'>Credit Derivatives Dangers <span class=GramE>In</span>
2008 & Beyond</span></i>", and "<i><span style='font-style:italic'>Why
Inflation Will Trump Deflation</span></i>".)<o:p></o:p></span></font></p>
<p><b><font size=3 color=black face="Times New Roman"><span style='font-size:
12.0pt;color:black;font-weight:bold'>Connecting <span class=GramE>The</span>
Dots</span></font></b><o:p></o:p></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>All three
components of the government's attempts to <span class=SpellE>reflate</span>
the housing market are massive and need to be understood - but they aren't
enough. What history shows us is that there is no credible reason to believe
that an asset bubble can be successfully <span class=SpellE>reflated</span> in
real terms (inflation-adjusted) by a government. The irreplaceable element
required for an asset bubble is millions of people who are not just willing,
but eager, to risk their own financial security to bid prices to irrational
levels - even after just having been burned in the same market only a few years
before. Bubbles can quickly follow each other when the market changes, as shown
by the housing bubble so quickly following the tech stock bubble. <span
class=GramE>(Particularly when the central bank deliberately intervenes to
facilitate creation of the second bubble, in order to mitigate the economic
damage from the first bubble.)</span> However, the public has to be able to
convince themselves that the second bubble really is different from the first
bubble that just burned them, and this is near impossible to accomplish in the
same market.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>This is
why the housing market has not yet "recovered", despite desperate and
massive efforts by both the Federal Reserve and the US Government. Everybody
just got burned in the last bubble, and it is very hard to get them to
participate in another bubble with what is left of their savings, particularly
in the midst of depression / recession. To <span class=SpellE>reflate</span>
the bubble requires people risking everything they have to return prices to
fundamentally irrational levels - and it's no small wonder they don't want to
do that. As fundamental as this problem is however, it is also more or less
irrelevant as a determinant of government policy, for the reasons previously
reviewed. <o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>The
Federal Reserve may be talking the talk when it comes to the economic necessity
of draining its artificial cash from the system and exiting the mortgage market
- but will it really pull out just as foreclosures accelerate and new mortgage
investors fail to return at below market rates? <span class=GramE>During an
election year?</span><o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>The
complete control of credit underwriting standards for the housing market by
political appointees, with the federal government unconditionally guaranteeing
the results of those political decisions - is financial dynamite. Particularly
when the explicit goals for the agencies involved are now political, in terms
of supporting the housing market rather than minimizing losses. Off budget
though they are now, the eventual financial outcomes of this unprecedented
change is sadly only too predictable.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>In more
general terms - the question is one of the public good versus the re-election
of incumbents (in both parties, this is very much a bipartisan issue, and has
been so at each stage of creation and response). If the <span class=GramE>value
of the dollar and of our investments that we have worked our lives to build are</span>
to be preserved - then this extraordinary creation of an entirely artificial
mortgage market funded by an already bankrupt federal government must be
abandoned. <span class=GramE>Even if the cost is the destruction of the careers
of many career politicians.</span><o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>How do
you think that decision will work out?<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>And more
importantly, what are you doing to protect what you have?<o:p></o:p></span></font></p>
<p><b><font size=3 color=black face="Times New Roman"><span style='font-size:
12.0pt;color:black;font-weight:bold'>Bubbles & <span class=GramE>The</span>
Redistribution Of Wealth</span></font></b><o:p></o:p></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>We face a
tragic situation for many millions of people who have done nothing wrong.
Government policy and fundamental economics are combining to create a situation
of simultaneous monetary inflation and asset deflation. The government can't <span
class=SpellE>reflate</span> the housing bubble, but the political dynamics
require the attempt to be made. Even at deadly risk to the value of the dollar,
and to a lifetime of savings for many tens of millions of households. So the
value of the dollar falls, the value of the assets fall, and eventually the
fall in the value of the dollar exceeds the fall in the value of the assets,
thus finally creating the façade of a <span class=SpellE>reflating</span>
bubble in nominal dollar terms (but not inflation-adjusted). False profits,
existing only because the value of the dollar is falling, are then generated
across multiple asset categories, which lead to inflation taxes, and the
hapless average citizen ends up <i><span style='font-style:italic'>simultaneously
losing the purchasing power of their money and the purchasing power of their
assets, while paying whopping tax bills in the process</span></i>.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>This dire
situation may appear overwhelming, and even hopeless, if one is limited to
conventional investment methods. For these methods generally do not provide
solutions for even one of these three problems, let alone the catastrophic
damage that can be wreaked by all three working in combination. However, the
good news is that where there is crisis there is also opportunity, and this
crisis is indeed rife with personal opportunities. When we see with clarity and
utilize unconventional methods, then simultaneous asset deflation and monetary
inflation can become an environment of investment opportunity. Indeed it can be
a potentially "target-rich" environment, because so few investors see
the world in those terms. <o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>As one
example, this environment creates major opportunities for precious metals
investing. Unfortunately however, purchasing gold as a simple monetary
inflation hedge at the highest prices in a generation with no protection from
inflation taxes may lead to substantial losses for most investors in after-inflation
and after-tax net worth, <b><font color=black><span style='color:black;
font-weight:bold'>even if gold does rises to $10,000 an ounce or higher with an
effective collapse of the dollar</span></font></b>. When we buy gold or silver
with an informed understanding of how precious metals perform during a time of
severe economic crisis - with simultaneous asset deflation and monetary
inflation - then we have the ability to potentially create wealth on a
multigenerational scale. Because during crisis, gold performs best as an asset
deflation play, rather than as a monetary inflation hedge, and if we don't see
that, then we may miss the best precious metals investment strategy of our
lifetimes.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Real
estate is where things get counterintuitive. Yes, <b><font color=black><span
style='color:black;font-weight:bold'>even if substantial real estate price
deflation persists in real terms over the coming years</span></font></b>, we
can still potentially reap rich rewards through real estate investing. Indeed,
the Federal Reserve has created an unprecedented opportunity for wealth
creation through its actions. However, these opportunities are not based upon
the simplistic real estate investment methods of maximizing leverage that are
so successful when bubbles are inflating, but can be deadly during a time of
ongoing asset deflation. Rather, to make money as a bubble continues to deflate
even while markets are systemically manipulated, we must play monetary
inflation off of asset deflation, using a calculated and deliberate
methodology, and in the process, create wealth in a risk-reduced and
tax-advantaged manner.<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Simply
put, what we have reviewed in this article creates a situation of enormous
potential volatility. The pressure may be released at almost any time, and in
the process lead to a massive redistribution of wealth that devastates most
people, pension funds and governments. Conversely individuals can take personal
action to position <span class=GramE>themselves</span> so that they benefit
from this redistribution. The difference between individual peril and
opportunity is one of vision - and education.<o:p></o:p></span></font></p>
<p class=MsoNormal><font size=3 face="Times New Roman"><span style='font-size:
12.0pt'><o:p> </o:p></span></font></p>
<p><i><font size=3 face="Times New Roman"><span style='font-size:12.0pt;
font-style:italic'>Would you like to find practical solutions to the issues
raised in this article? Find out how to position yourself to benefit from what
happens when political decisions place the value of the dollar at risk? Do you
want to know how to <b><u><span style='font-weight:bold'>Turn Inflation <span
class=GramE>Into</span> Wealth?</span></u></b> To position yourself so that
inflation will redistribute real wealth to you, and the higher the rate of
inflation - the more your after-inflation net worth grows? Do you know how to
achieve these gains on a long-term and tax-advantaged basis? These are among
the many topics covered in the <u>free</u> "Turning Inflation <span
class=GramE>Into</span> Wealth" Mini-Course. Starting simple, this course
delivers a series of 10-15 minute readings, with each reading building on the
knowledge and information contained in previous readings. More information on
the course is available at DanielAmerman.com or <span class=GramE>InflationIntoWealth.com
.</span></span></font></i><o:p></o:p></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Contact
Information:<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Daniel R.
<span class=SpellE>Amerman</span>, CFA<o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>Website: <a
href="http://www.danielamerman.com">www.danielamerman.com</a><o:p></o:p></span></font></p>
<p><font size=3 face="Times New Roman"><span style='font-size:12.0pt'>E-mail: <a
href="mailto:mail@the-great-retirement-experiment.com">mail@the-great-retirement-experiment.com</a><o:p></o:p></span></font></p>
<p><i><font size=3 face="Times New Roman"><span style='font-size:12.0pt;
font-style:italic'>This article contains the ideas and opinions of the author.
It is a conceptual exploration of financial and general economic principles. As
with any financial discussion of the future, there cannot be any absolute
certainty. What this article does not contain is specific investment, legal,
tax or any other form of professional advice. If specific advice is needed, it
should be sought from an appropriate professional. Any liability,
responsibility or warranty for the results of the application of principles
contained in the article, website, readings, videos, DVDs, books and related
materials, either directly or indirectly, are expressly disclaimed by the
author.</span></font></i><o:p></o:p></p>
<p class=MsoNormal><font size=2 face=Arial><span style='font-size:10.0pt;
font-family:Arial'><o:p> </o:p></span></font></p>
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