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This Way There Be Dragons May 29, 2009 By John Mauldin
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Thoughts from the Frontline Weekly NewsletterThis Way There Be Dragons
by John Mauldin
May 29, 2009
In this issue:
This Way Be Dragons
A Housing Update
More Prime Foreclosures In Our Future
Are We Paying Too Much for Health Care?
Naples, London, and Home for June
fantasy novels the intrepid heroes come across a sign saying "This Way Be
Dragons." Of course, they venture on, facing calamity and death, but such is
the nature of fantasy novels. We live in a very real world, and if we don't
turn around there will be some very nasty dragons in our future. This week we
look at three possible paths we can lead the world down. We then review a
number of charts and data on the housing market.
If you just read the headlines on
this week's data, you could be forgiven for assuming the worst is over -- not. And then finally we look at some rather
stark comparative data on the health-care systems of the US, Canada, and Great
Britain. Everyone knows the US pays way more in terms of GDP than the latter
two countries. Are we getting our money's worth? There is a lot to cover, and I
hope to finish this on a flight to Naples, so let's jump right in.
This Way Be Dragons
More and more we read about the
growing concern over $1-trillion-dollar deficits. Stanford professor John
Taylor (creator of the famous Taylor Rule) jumped into the debate with a rather
alarming op-ed in the Financial Times this week, echoing much of what I
wrote last week, but with some real insights into what trillion-dollar deficits
"I believe the risk
posed by this debt is systemic and could do more damage to the economy than the
recent financial crisis. To understand the size of the risk, take a look at the
numbers that Standard and Poor's considers. The deficit in 2019 is expected by
the CBO [congressional Budget Office] to be $1,200bn (859bn euros, 754bn pounds). Income
tax revenues are expected to be about $2,000bn that year, so a permanent 60 per
cent across-the-board tax increase would be required to balance the budget.
Clearly this will not and should not happen. So how else can debt service
payments be brought down as a share of GDP?
"Inflation will do
it. But how much? To bring the debt-to-GDP ratio down to the same level as at
the end of 2008 would take a doubling of prices. That 100 per cent increase
would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in
half, back to 41 from 82 per cent. A 100 per cent increase in the price level
means about 10 per cent inflation for 10 years. But it would not be that smooth
-- probably more like the great inflation of the late 1960s and 1970s with
boom followed by bust and recession every three or four years, and a
successively higher inflation rate after each recession."
You can read the rest
While Obama gives lip
service to cutting the deficit in half, his actual budget increases it over the
next 10 years. As I have been writing for some time, this is a very dangerous
path. And it is one that the bond market seems to be concerned about, as
interest rates are rising, even on mortgages that the Federal Reserve is buying
in massive quantities in its effort to hold down rates and stimulate the
"The good news,"
Taylor concludes, "is that it is not too late. There is time to wake up, to
make a mid-course correction, to get back on track. Many blame the rating
agencies for not telling us about systemic risks in the private sector that
lead to this crisis. Let us not ignore them when they try to tell us about the
risks in the government sector that will lead to the next one."
Taylor is right that
the massive tax increases necessary to fund these deficits and programs should
not happen. But it is not clear to me that they won't. A Democratic Congress is
talking of adopting John McCain's plan to tax health-care benefits. While this
would be a tax on the middle class (on everyone) that Obama said he would not
do, he is clearly willing to sign a bill that has such a tax.
The administration is
starting to float trial balloons about a new VAT, or value-added tax. Many of
my non-US readers will be familiar with VAT taxes, especially in Europe. A
combination of a VAT and taxing health-care benefits would raise enough to get
us to a deficit of "only" a few hundred billion. Take away the Iraq war and you
get even closer. You can make an economic case that a VAT tax would be
preferable to an income tax.
administration is not talking about a substitute but an additional tax. There
is momentum in the heavily Democrat-controlled Congress for large new
health-care programs. While there is resistance to large deficits on the part
of a few moderate Democrats, there is a chance they could be brought on board
with a tax or a series of new taxes that would offer the potential to pay for
the new programs. (Even though everyone knows that the cost overruns on new
health-care benefits will be much larger than estimated.)
As much as it grieves
me to say it, a tax on health-care benefits or a VAT tax large enough to hold
the proposed deficits to something under 3% of GDP would be preferable to
running decade-long trillion-dollar deficits, which would destroy the US
economy and the dollar and do severe damage to the world economy. (For the
record, I am assuming the Bush tax cuts are history.)
But while a large tax
increase would keep the economy from crisis and collapse, it is not without
very serious consequences. It will put a serious crimp in economic growth. It
will lock in European growth rates and European-like unemployment rates. And we
will be using those tax increases to fund new spending and will still not have
solved the future problems with Social Security and Medicare, which are going
to require massive increases in spending in another 5-7 years. Which of course
means that either a cut in benefits or another round of growth-crippling tax
hikes is down the pike.
A third path would be
to simply go ahead and raise taxes on the rich, say no to increased spending on
programs until we can afford them, hold the line on any new spending, and see
if we can reintroduce the gradual budget control that was the result of the
stand-off (and to some extent cooperation) between Gingrich and Clinton.
put about a 5% probability on the third scenario happening. Better than the
chances of a snowball in hell, but not much. The first disaster scenario is
about a 35% probability, which is quite scary. If we do choose such a path,
then short the dollar, buy gold, and invest abroad. It will be a very tricky and
assign a 60% probability to the middle path. Maybe it's my basically optimistic
nature and I am simply being naive, but I am hopeful that cooler heads will
prevail and we will not run continual massive deficits larger than the growth
of GDP. While that means rather large tax increases, since the current
leadership wants to create massive new health-care entitlements and will do so,
I would rather have to simply overcome higher taxes in my business rather than
deal with a collapse of the dollar, high unemployment, high interest rates, and
an extremely sluggish economy.
scenario will create a different investment environment. Ironically, the middle
scenario could be good for the dollar over the long term. But it will be hell on
corporate profits from US sources. Given the above, it seems like a 95% chance
that we should start looking at investing a significant percentage outside of
the US and Europe. Think Canada, Australia, Asia (not Japan), Brazil, South
politics does not have all that much of an impact on the stock market. As an
example, both Democrats and Republicans can take credit for the '90s, but it
was really the dynamic of the free market that worked in spite of government.
Same for the Bush years. While the tax cuts did help, it was the free market
and increasing leverage that were the dominating factors.
This time it will be
different. The choices we make as to how to fund, or not fund, the increases in
spending that are our clear and sad destiny, will have a major impact on not
just the US but the world economy. As US consumers have been a major part of
the growth of the developing world, and especially Asia (China), a slowing of
consumption in the US will mean a very slow recovery for the rest of the world.
It will happen, but the choices made by politicians this year will have many
unintended consequences. Just as deciding we would take a major part of the
corn crop and turn it into expensive ethanol raised the price of tortillas in
Mexico, raising taxes in the US will mean lower global consumer spending and
trade. It is a very tangled web we weave.
A Housing Update
you read the headlines the last few days you would think that the housing
market has turned. Mostly they read something like "Home Sales Rise 0.3%," and
of course the reflexive bulls started talking about green shoots and a bottom
in housing. And while someday we will actually have a bottom in housing, it
will not be this month. It has been awhile since we have looked at the housing
market, and it is time to review.
Of course home sales rose. It is April. Look at the graph below. It is the time
of the year when home sales rise. And 0.3%? Really? The margin of error is
close to plus or minus 10% or so, so 0.3% is a meaningless number. It
will be revised. Who knows which way? I don't. (I am on the plane so I cannot
access the exact margin of error, but 10% is not that far off.)
My main thesis since 2006 has been
that the housing market was in a bubble that would burst. We built something
like an extra 3 million homes over trend growth, and those homes are going to
have to be absorbed in the normal way, through growth of population and the
economy. We "need" about 1 million new homes a year to take care of population
growth and demand. Further, we have cut off home availability to buyers who are
in the subprime category, whereas during the boom you simply had to have a
pulse, even a lying pulse, to get a home for which you did not have a chance of
actually paying the mortgage.
The earliest we see a real bottom
to housing is late 2010 or 2011. By real bottom I am talking about housing
values in general being to rise (assuming we do not visit scenario one and have
significant inflation.) There is nothing that can be done about that. We have
to work through the excess capacity. (More later on that below.)
We had the Case-Shiller home price
data come out this week. Home prices are still in free fall. They are down
almost 19% year over year and 32% from their 2006 highs (see chart below). If
we get back to the long-term price growth trend, we would see another average
10% drop; and as prices tend to overshoot on the upside and the downside, in
some markets they could fall even further.
Yet there is hope that we will not
see a fall below trend. Housing in many areas is starting to once again become
affordable (see chart from Moody's below) to more and more Americans and even
first-time home buyers. The cure for the housing crisis is actually lower
prices, as that brings more and more potential home buyers into the market.
While housing sales are still quite depressed, what are selling are homes in
foreclosure, as buyers perceive that there are bargains. And they are right.
On the negative side, the supply of
homes available for sale is again rising, as more and more foreclosures come
onto the market. And as we will see, this foreclosure trend is going to slow
down soon. (Thanks to Greg Weldon at www.weldononline.com
for the chart.)
Notice in the above chart that the
supply of homes for sale is over ten months. But that average can be
misleading. If you are in Florida, I read recently that in many areas it is
over 40 months. And that is for homes that can be financed with government-sponsored
"conforming loans," typically up to $719,000. But what if your home cost more
than that? National Association of Realtors chief economist Lawrence Yun said
that the supply of existing homes for sale over $750,000 has reached a forty-month
Diana Olick, the very on-top-of-it
CNBC real estate reporter, had the following to say (emphasis mine).
"That's going to mean a new phase
of the current housing recession. So far we've seen the 'correction' of a boom
market that was driven by faulty, exotic loan products, investors looking to
make a quick buck, and average Americans using their homes as ATMs. Now the
losses are being driven by traditional economic factors and by sweeping price
drops across the nation.
"Yesterday Fitch ratings estimated that up
to 75 percent of the modifications now being done through the administration's
Making Home Affordable
program will re-default in six months to a year.
I'm not talking about the old modifications, which were largely repayment plans
that could actually raise monthly payments. I'm talking about the new mods,
which lower monthly payments to 31 percent of a person's income. I couldn't
understand Fitch's reasoning, so I called them.
"Diane Pendley, managing director
at Fitch, said the problem is not on that "front-end" ratio, but on the back
end, which is all of the borrowers other debt (credit cards, car loans, student
loans, etc.). She said that in talking with servicers, she's hearing other debt
is so high that most of today's troubled borrowers cannot afford any loan
payment at all, even at a very modest debt-to-income ratio. 'Just getting the house payment
done doesn't mean their lifestyle is sustainable,' she said.
"Another problem is that with home
prices continuing to fall, more and more borrowers, who are essentially just
renting their mortgages now because they will never see any home equity, are
walking away. Even if the mortgage payment is low, the property taxes and home
maintenance costs are padding that payment, and without an upside to the
investment, there's simply no reason to pay. Suffice it to say, the foreclosure
crisis, on the high and low ends, is not getting any better."
it gets worse.
More Prime Foreclosures In Our Future
The Mortgage Bankers Association
noted that a record 12%, or 1 in 8 homeowners, in the US are now behind on
their payments or in foreclosure. 10.6% of the mortgages in Florida are now
somewhere in the process of actual foreclosure. (My seatmate here on the
flight says the prices on the condos where he lives are now back to 1998
levels. It would be scary, he said, if you had to sell. There are new
developments that only have 10% actual occupancy, as the bulk of the condos
were bought for speculation. Now those 10% of buyers are having to shoulder all
the fees for upkeep. Nobody will buy, because the upkeep costs can be more than
the mortgage. It is a vicious cycle.)
In Nevada foreclosures are 7.8%, Arizona
5.6%, and California 5.2%. 25% of subprime loans are now in foreclosure, 14% of
FHA (government, taxpayer-guaranteed) loans and a growing 6% of all prime loans
are now in foreclosure. (Note: the seasonal adjustments may overstate the
actual numbers, as we are in new territory in terms of actual foreclosures.)
Quoting from the MBA press release:
"In looking at these numbers, it is
important to focus on what has changed as well what continue to be the key
drivers of foreclosures. What has changed is the shifting of the problem
somewhat away from the subprime and option ARM/Alt-A loans to the prime
fixed-rate loans. The foreclosure rate on prime fixed-rate loans has doubled
in the last year, and, for the first time since the rapid growth of subprime lending,
prime fixed-rate loans now represent the largest share of new foreclosures.
In addition, almost half of the overall increase in foreclosure starts we saw
in the first quarter was due to the increase in prime fixed-rate loans."
How could so many prime loans be in
foreclosure? These were people with good credit and jobs. The answer is the
very deep and lengthy recession, coupled with high and rising unemployment. The
number of foreclosures will not abate until unemployment starts to fall. And
even optimistic forecasts assume unemployment will keep rising into 2010. As I
have written for a long time, I think it is quite likely that we will see
unemployment rise to over 10%. When I first wrote that a few years ago, many
called me just another doom and gloom guy. Now, many think I am Pollyanna. Such
is the life of those who believe in Muddle Through.
For those who think the end of the
recession will be like all past recessions, the problems in the housing market
should make for serious concern. As we will see on Monday in my Outside the
Box, the average homeowner with a mortgage has very little, if any, equity.
There is little room for home equity withdrawals -- if banks were lending.
And recent data shows a very serious and un-American-like drop in credit card
borrowing. US consumers are retrenching, and global trade figures echo that.
We are in for a slow, Muddle
Through recovery, with the real potential to slip back into recession when the
tax increases hit. Stay tuned.
Are We Paying Too Much for Health Care?
I want to pass on this quick note from Dennis Gartman's eponymous letter. It
should give all of those who favor a nationalized healthcare system pause,
before they jump right in. Quoting Dennis:
"Canada is a wonderful place to
have a nasty gash on one's forehead stitched, or to break one's nose in a game
of pick-up baseball; but have cancer, or need eye surgery, or want an MRI, and
the business of medicine in Canada and/or the UK breaks down badly in favour of
medical care here in the US. For example... and we wish to thank The
Investor's Business Daily for the data noted here this morning...
"... here in the US men and women
survived cancer at an average of just a bit better than 65%. In England only
46% survive. In the US, 93% of those diagnosed with diabetes receive treatment within six months; in Canada only
43% do, and in the UK only 15% do! For those seniors needing a hip replacement
and getting one within six months, 15% get it done in the UK; 43% get it done
in Canada ... and in the US 90% do! For those waiting to see a medical
specialist, 23% of those in the US get in within four weeks, while 57% in
Canada have not yet done so, and in the UK 60% are still waiting after four
it comes to proper medical equipment, in the US there are 71 MRI or CT scanners
available per million people. In Canada there are but 18, and in the UK there
are only 14! Ah, but the best figure of all is this: 11.7% of those 'seniors'
in the US with 'low incomes' say they are in excellent health, which in and of
itself sounds rather low ... rather disconcerting ... and an indictment of the
system itself, doesn't it? But in Canada only 5.8% do!
"Yessiree bob, ya' jus' gotta' luv
that collectivized, socialized medical care! Let's all go break a collective
arm and enjoy the benefits of socialized medicine in the Commonwealth! (Canada)
... but heaven help you if you've got something really, really wrong. If that's
the case, you'll be running south to the border faster than you can reach a
specialist anywhere in Canada; of that we are certain."
we pay too much for health care here in the US? Everyone says yes. And there is
a lot of waste (and waist) in the system. But if you are the person who needs
treatment, maybe the answer is "not really." If you can't get the medical help
you need when you need it, maybe the fact that it is theoretically free doesn't
an aside, I have two friends who have had immediate family members diagnosed
with Lou Gehrig's Disease. For all practical purposes, it is a death sentence.
Yet one family was told (at a top-five cancer hospital) there could be a cure
within a few years, or at least clinical trials. But just not now.
Unfortunately, the prognosis is less than a year.
I can guarantee you, if that was me
or my family, I would like to be able to make the decision whether to try a
radical treatment. What's my downside if I die a little earlier? Shouldn't that
be my choice?
And if I don't want some nameless
bureaucrat dictating who gets to live or die in the name of his scientific
system, why in God's name would I want a bureaucrat deciding to ration my
access to health care? But that is what the majority in Congress are planning
for our future. And bluntly, I find that far harder to swallow than my taxes
Naples, London, and East Europe
am literally in the taxi in Naples as I finish this letter (even for me, this
is a first). I am supposed to go right into meetings when I arrive. Ground zero
for the housing crisis. But it is still a pretty city. Hopefully I can get out
and do a little power walking on the beach tomorrow. I am looking forward to
being with good friend and fellow writer Gary Scott and business partner Steve
Blumenthal, as well as my friends from Jyske Bank.
schedule says I am home all of June. Then I am off to London in the middle of
July for my partner Niels Jensen's 50 birthday, and then a
vacation to far Eastern Europe. Thanks to everyone who wrote with suggestions
and offers to help.
is just about over for youngest son Trey, and we have been spending a lot of
time reviewing material for his finals (with some success!) But then you get a
call from the vice principal. Seems there was a little trash talk and the other
(bigger) kid hit first, and then ... "Really, Dad, it wasn't my fault. This is
just so stupid." Well, you know how that goes. (Trey is fine.) After seven
kids, I should get used to the regular surprises. Well, there is always next
year to teach him how to avoid bullies. (Which of course Dad was soooo good
is time to hit the send button. We are pulling up to the resort. I have a good
feeling about this summer. It will be busy (what else is new?), but I think it
will be fun. Have a great first week of summer!
Your real life just keeps on coming at you analyst,
Copyright 2009 John Mauldin. All Rights Reserved
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