Below is the full article, "The Great Bubble Economy," featured in August's edition of Mind-Body-Money.

The Great Bubble Economy

The one area of the economy that continues to defy logic is housing. It's increasingly looking like the U.S. is becoming a one-dimensional housing economy. In fact, housing now comprises 25% of the U.S. consumer economy, and according to many economists, up to 50% of all new jobs being created today are real estate related. The stakes regarding this housing bubble are enormous. The entire U.S. economy hinges on the housing boom continuing indefinitely, and reality says that this is unlikely to happen.

It's important to realize that the housing bubble is not an isolated problem as many would like you to believe. It is actually part of a larger bubble, which is also intimately connected to the global economy. What's happening in the U.S. is that we are becoming a nation that makes money by trading real estate amongst the populace, with each new buyer paying a higher price for the same property. The last time I checked this was called a pyramid scheme, and later in the article you'll read about what one prominent university has to say about the pyramid scheme.

Immune from Global Economics? - Not for Long

So called "real estate experts" try to drum into our heads that all real estate is "local", and doesn't have anything to do with the national or global economy. It's about time these folks are introduced to the concept of the "global economy", where economies of all types no longer work in a vacuum. Nothing is immune from the impact of global economics in the Internet Age, and that most certainly includes residential U.S. real estate. There are many who continue to underestimate the power of the Internet to create new competitors, particularly low-wage global competitors.

The Great Bubble Economy

The U.S. housing bubble dates back to 1993-1994, the same time period in which the Internet was becoming popular. At that time, the U.S. stock market began its tremendous move upward, propelled by talk of a "new era", where stock prices were "revalued" and could not go down (sound like real estate today?).

From 1995 until 2000, the U.S. stock markets, particularly the technology-heavy NASDAQ market soared due to speculative stock purchases, inflated IPO's, margin buying (borrowed money), a frenzied herd psychology, and even outright fraud. In March of 2000, the stock market bubble burst, and well-founded fears of a deflationary spiral prompted Alan Greenspan and the U.S. Federal Reserve to aggressively cut interest rates, and adopt an ultra-easy lending policy, especially related to mortgages and home equity loans. This was the only antidote the government had to prevent a deep recession or depression in the U.S.

The by-product of these interest rate cuts, resulting in some of the lowest interest rates in the 229 year history of the United States, created the largest housing bubble in U.S. history, even surpassing the housing mania of the Roaring 20's. Therefore, the collapse of the stock market bubble gave birth to the U.S. housing bubble, which rages out of control to this day.

Flippers and other Dangerous Mammals

A May 16th article by Fortune.com entitled "Real Estate Frenzy" captures the current state of the U.S. housing market by featuring a variety of real estate speculators and their exploits. For instance, Fortune describes the travails of one speculator, a 22 year-old named Zareh who is lost in Phoenix looking for two homes that he owns. How can someone be lost looking for his own properties? The article goes on to describe that Zareh is lost because

1. He does not live in Phoenix, but in Las Vegas
2. He has never seen the properties in person
3. He never intends to live in the properties
4. Zareh owns six more houses and 50% of seven others in Phoenix, which obviously has him slightly confused.

Zareh is one of countless 'new era' real estate speculators buying homes sight unseen from Realtors they have never met or purchasing them over the Internet. He is called a "flipper", an amateur or semi-pro speculator that buys real estate usually with little or no money down with only one motive - to sell it as quickly as possible for a hefty profit to the next flipper who comes along.

And this is how the game is played. An extremely dangerous game of high stakes leverage using the riskiest interest-only ARM mortgages from lenders who willingly participate in the madness.

According to University of California-Berkeley economist and real estate expert Ken Rosen;

"This is frightening, frankly. I'm worried that more and more people are using (homes) as an investment vehicle and not as a consumption market, and that's true of the peak of housing markets. This is the edgiest we've been in the market for a long time. This reminds me of the late 1980's when people were speculating in the market."

Speculation Convoys

What's making these flippers increasingly dangerous to everyone is that they now travel in loosely organized packs called "speculation convoys," moving from city to city inflating the prices of single family homes along the way. The speculators from the western U.S. have moved from California and Las Vegas to Phoenix and Albuquerque, and now seem to have their radars set on Texas, one of the few remaining affordable major housing markets in the country. Eastern speculators moved from the northeast U.S. primarily to Florida, and have thus inflated housing prices in virtually all medium and large Florida markets.

Pyramid Scheme - Real Estate Style

I was fortunate to listen in on a recent housing bubble debate featuring Chris Thornberg, Senior Economist with The Forecast Center at The UCLA Anderson School of Management. The award-winning UCLA Forecast Center is widely considered one of the most distinguished real estate forecasting institutions in the world, and is credited as the first major U.S. economic forecasting group to declare the recession of 2001. The team was also unique in predicting both the seriousness of the early-1990s downturn in California, and the nation.

I found Chris' comments compelling, and somewhat chilling, but all too familiar to me. The following are excerpts of Mr. Thornburg's comments regarding the housing bubble:

"It's a pyramid scheme. Everybody's taking the massive appreciation on their current home and they're rolling it up to the next big home. It's like any good pyramid scheme. It will work as long as you have people entering the bottom of the pyramid. You've got to have those new people entering to allow the pyramid to grow, to allow people to roll-up.

In this particular case, the pyramid is being built upon these marginal buyers, people who shouldn't be in the market, who don't have the financial wherewithal to be in the market. Yet, they're being enticed with these crazy kinds of loans.

And the sad thing is that the populations that are getting involved right now are those that are going to be most vulnerable in the event of a crash…it's these new buyers, the one's who are getting sucked in with the interest-only variable rate loans who are just getting by…they're in this market right now cause it's the next big thing they're being told by these lenders;'If you don't get in now, you're going to miss out, you're going to miss the 10%, 15%, 20% returns.'

It's exactly the same kind of furor and overselling that was going on in the NASDAQ. In fact, the analogy between the NASDAQ bubble and the real estate bubble particularly in California, and South Florida are remarkably similar. And a lot of the illogic that people are using in real estate kind of glosses over the facts that…prices shouldn't be going up; don't worry about that, that's old thinking. Now it's the same idea. Well, for [real estate] prices to go up rents have to go up. Rents aren't going up anywhere in the U.S. right now. Therefore, again, indicating that we shouldn't be seeing this run-up in real estate prices.

In terms of these lenders, it's exactly these kinds of high risk loans that are fueling the pyramid, and as soon as that collapses, this whole pyramid's going to collapse in on itself, and the whole real estate market will cool off. There's a feeding frenzy out there right now, and it keeps building on itself…What this all implies is that housing is a low return asset for the next ten years.

As for broader implications, it's a big worry for us. In fact, the single largest risk for the U.S economy right now overall is this housing bubble, because people have been spending way beyond their means in the U.S. for a number of years and part of that is that they feel flushed - they feel wealthy. When this housing marker cools off, and they're no longer getting the 10% or 15% returns on their houses, they may pull back sharply on their home spending, and the effect could really harm the economy - could pull us into another recession."

Inflated Appraisals Fuel Bubble

In order to have what UCLA calls a massive "pyramid scheme," you must have a large number of people cooperating to expand the pyramid. The people responsible for the massive pyramid scheme raging in the U.S. aren't just confined to the "usual suspects" of real estate agents, mortgage brokers, banks, and developers, but now we are discovering that the appraisers themselves, the people we rely upon to 'audit' the system are actually fueling the bubble (doesn't this sound a bit like the CPA's who audited Enron in the 1990's?).

Appraisers are feeling increased pressure to increase valuations by real estate agents, mortgage brokers, and loan officers all eager to close a sale. According to a May 26th Wall Street Journal article, and a 2003 survey by October Research Corp., "Fifty-Five percent of appraisers say they have felt pressure to overstate the value or condition of a property."

According to David Callahan, senior fellow at The Public Policy Organization, and an expert on appraisal fraud; "What is actually happening is lenders and brokers are telling them what value they want. If [appraisers] don't play ball, they don't get paid or don't get work again."

Inflated appraisals create an artificially-inflated market, and can have disastrous consequences for all homeowners subjected to such abuses. David goes on to say, "There are a lot of people who have refinanced for more than their homes are actually worth and they're effectively upside down even without a bubble bursting. Down the road, if they have to sell or decide to refinance, a more accurate appraisal might show that they owe more than the house is worth."

Of course, inflated appraisals can have a ripple effect through entire communities as other appraisers may use the inflated appraisal as a comparable sale price on future appraisals. According to the FBI, in some mortgage schemes, appraisers act in collusion with borrowers to provide misleading valuations (source: WSJ, May 26, 2005). I've got to wonder how many lawsuits worth how many billions of dollars will result from over-inflated appraisals once the housing bubble bursts.

The appraisal problem is so epidemic that 8,000 appraisers, representing 10% of the industry, have petitioned the federal government to take action (source:CNNMoney.com, June 2nd, 2005). I'm sure a great number of appraisers fearful of being 'blackballed' by local realtors and mortgage brokers have abstained from the petition. Bravo to those who were willing to stand up for what's right! I'd hire one of those appraisers in a second.

1920's Housing Nostalgia

In an informal interview, Mr. Thomas Kendig, a longtime client who remembers the real estate market of the 1920's, told me that today's housing market reminded him of the real estate speculation of the 1920's. In the 1920's version of the housing bubble, after the bubble burst, massive foreclosures resulted.

In another nostalgic trip down Memory Lane, we find that the destined-to-be-infamous interest-only mortgages of today are nothing new, as they were first used during the Roaring 20's. The big difference between then and now was that in the 1920's interest-only mortgages were "fixed" for the life of the loan (usually 5 or 10 years), not adjustable like they are today. At the end of the term borrowers would simply refinance. However, real estate prices collapsed and most interest-only loans went into foreclosure contributing to The Great Depression of the 1930's.

Today's interest-only mortgages are far more dangerous than the 1920's style, not only because they are tied to an Adjustable Rate Mortgage, but also because after the initial term, the payment is raised to the full amortizing level. The ultimate dangers with today's interest-only mortgages is that either the borrower's payments will rise so high that he or she won't be able to make them, or that the price of the property will drop so far that the mortgage is worth more than the value of the home.

Of course, it's very easy to see how both of these events could happen simultaneously to millions of Americans, effectively "trapping" them in their own home! Therefore, today's interest-only mortgages are much riskier and potentially more harmful to the borrower.

In Sarasota, Florida, the housing bubble has gotten so ridiculous that "work force housing" is a big issue. That's where workers such as teachers, police officers, and nurses live in government-subsidized housing. In other words, these hard working people will now be reduced to living in today's equivalent of low-income housing projects. How degrading is that?

By the way, no society in the history of the world ever thrived without a prospering middle class. Will this time be different? The middle class obviously has no place in a society that has exported most middle class jobs in favor of speculative asset bubbles.

The China Syndrome: Bursting the Local Market Theory

Absent from most discussions of the booming housing markets in California, Florida, and the northeast U.S. is the direct connection between the U.S. housing market and events concerning the global economy, particularly our business relationship with China. To understand how this works, let's look at the highly disturbing U.S.-China economic relationship:

Because of its low-wage work force, and huge investments from western and Japanese corporations, China has created a big trade surplus, most notably with the U.S. With the profits from this enormous trade imbalance, China buys large quantities of U.S Treasury Securities, essentially lending money to the U.S. to the tune of an estimated $300 billion in 2005. The Chinese do this to keep the value of their currency low, in order to make their goods cheaper in the global marketplace.

All this money coming into the U.S. keeps interest rates artificially low here, fueling a massive housing bubble. The housing bubble in turn fuels a larger U.S. economic bubble creating artificially inflated wages, autos, medical care, etc. The result is that the U.S. goes deeper and deeper in debt to China and the rest of our lenders, while Americans live lavish lifestyles in an enormous debt-driven housing bubble. This is not a formula for long-term prosperity for America, but it is the corner the Federal Reserve has painted us into.

The U.S is highly dependent on low-interest loans from China. If the Chinese were to ever change its currency policy and stop buying U.S. Treasury Securities (i.e. loaning the U.S. hundreds of billions of dollars a year), U.S. interest rates would skyrocket, and the housing bubble would collapse, creating an avalanche of bankruptcies and a financial crisis in the U.S. at the same time.

Alan Greenspan's Interest Rate "Conundrum"

Alan Greenspan, Chairman of the Federal Reserve is obviously counting the days until his retirement on January 31, 2006, and understandably so. Astonishingly, in the face of eight short-term rate increases by Mr. Greenspan and his Open Market Committee, in an attempt to cool the housing bubble, mortgage rates have actually decreased, providing the opposite of what he had hoped for - more fuel for the raging housing inferno. This has resulted in his coining the term "conundrum," the 21st century equivalent of his "irrational exuberance" term of the 1990's he used to describe the stock market bubble in 1996 (four years before the stock bubble burst). In this case, conundrum (meaning unexplainable and contradictory events) is used to explain the fact that attempts to increase short-term interest rates has resulted in decreasing long-term rates such as mortgage rates.

Alan Greenspan knows that he is in uncharted and extremely dangerous economic waters with his interest rate conundrum. On the one hand he needs rates to rise, preferably in a gradual way to slowly deflate the bubble. On the other hand if he jacks up short-term rates too high, too fast, he could cause panic in the streets and create a sudden and massive economic shock that causes the housing market (and the rest of the economy) to crash.

The obvious question arises: what if interest rates don't go up?

To me this is not a good thing, and is looking more like what is happening. I have been hoping for a mortgage rate rise since last year that simply hasn't materialized. Rising rates are the best solution to defuse the ticking housing time bomb. If rates do not rise, then we are faced with a more treacherous predicament. Those fueling the bubble will become further convinced of their convictions, driving prices even higher, and setting up a greater possibility of a full blown housing crash.

Lehman Brothers Chief Economist Ethan Harris suggests that housing prices can fall even if mortgages rates don't go up. "The history of speculative bubbles is that often they collapse for what appear to be minor causes," he says. A recession could also cause a housing decline. As the Wall Street Journal puts it, "Lousy job markets and falling paychecks could make that $500,000 two-bedroom condo in Sarasota lose its luster in a hurry." (Source: WSJ, May 27, 2005.)

Another possibility is that with short-term rates getting very close to long term rates (called a flattening yield curve), banks have less incentive to lend. When yield spreads are wide, banks rake in profits by borrowing at super-low rates, and lending at much higher long-term rates. When the spread narrows, the profit margins shrink and they have less incentive to lend. Also, there's less cash to cover bad loans, so borrowers are scrutinized more closely.

The bottom line is that fewer borrowers mean fewer buyers. In the last housing boom, an inverted yield curve (short-term rates higher than long-term rates) is credited by some as the event that killed the Savings & Loans, and caused a major recession.

My hope is that this month's review of the housing market will give you insight into the realities of the global economic picture, and how you may adjust your thinking and actions based on the information. Remember to take control of your Money by taking control of your life, and that means Mind-Body-Money.