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Stratfor on Sub-Prime
August 16, 2007

I wrote yesterday that the sub-prime mess doesn't worry me because it doesn't affect a large enough portion of the economy to bring on disaster.

Stratfor Founder and Chief Executive Officer George Friedman agrees. From his August 13 Geopolitical Intelligence Report:
Stratfor views the world through the prism of geopolitics. Not all events have geopolitical significance. To rise to a level of significance, an event -- economic, political or military -- must result in a decisive change in the international system, or at least a fundamental change in the behavior of a nation. The Japanese banking crisis of the early 1990s was a geopolitically significant event. Japan, the second-largest economy in the world, changed its behavior in important ways, leaving room for another power -- China -- to move into the niche Japan had previously owned as the world's export dynamo. The dot-com meltdown was not geopolitically significant. The U.S. economy had been expanding for about nine years -- a remarkably long time -- and was due for a recession. Inefficiencies had become rampant in the system, nowhere more so than in the dot-com bubble. The sector was demolished and life went on. Lives might have been shattered, but geopolitics is unsentimental about such matters.

The measure of geopolitical significance is whether an event changes the global balance of power or the behavior of a major international power. Looking at the subprime crisis from a geopolitical perspective, this is the fundamental question. That a great many people are losing a great deal of money is obvious. Whether this matters in the long run -- which is what geopolitics is all about -- is another matter entirely.

When the subprime defaults started to hit, the banks that had loaned money against the mortgage portfolios re-evaluated the loans. They called some, they stopped rollovers of others and they raised interest rates. Basically, the banks started reducing the valuation of the underlying assets -- subprime mortgages -- and the internal financial positions of some hedge funds started to unravel. In some cases, the hedge funds could not repay the loans because they were unable to resell their subprime mortgages. This started causing a liquidity crisis in the global banking system, and the U.S. Federal Reserve and the European Central Bank began pumping money into the system.

Told this way, this is a story of how excess emerges in a business cycle. But it is not really a very interesting story because the business cycle always ends in excess.

There currently are three possibilities. One is that the subprime crisis is an overblown event that will not even represent the culmination of a business cycle. The second is that we are about to enter a normal cyclical recession. The third, and the one that interests us, is that this crisis could result in a fundamental shift in how the U.S. or the international system works.

We try to measure the magnitude of the problem from the size of the asset class at risk. But we work from the assumption that proved true in the S&L crisis [of the 1980s]: Financial instruments collateralized against real estate, in the long run, limit losses dramatically, although the impact on individual investors and homeowners can be devastating.

The S&L crisis involved assets of between 8% and 10% of GDP. The final losses incurred amounted to about 3% of GDP, incurred over time.

The size of the total subprime market is estimated by Reuters to be about $500 billion. This is the total asset pool, not nonperforming loans. The GDP of the United States today is about $14 trillion. That means this crisis represents about 3.5% of GDP, compared to between 9% and 10% of GDP in the S&L crisis. If history repeats itself -- which it won't precisely -- for the subprime crisis to equal the S&L crisis, the entire asset base would have to be written off, and that is unlikely. That would require a collapse in the private home market substantially greater than the collapse in the commercial real estate market in the 1980s -- and that was quite a terrific collapse.

Unlike commercial real estate, in which price declines force more properties on the market, home real estate has the opposite tendency when prices decline -- inventory contracts. So, unless this crisis can pyramid to forced sales in excess of the subprime market, we do not see this rising to geopolitical significance.

From this, two conclusions emerge: First, this is far from being a geopolitically significant event. Second, it is not clear whether this is large enough to represent the culminating event in this business cycle. It could advance to that, but it is not there yet. We cannot preclude the possibility, though it seems more likely to be a stress point in an ongoing business cycle.
I reiterate a point I made yesterday on this free site and have made repeatedly to subscribers: smart investors are looking for chances to buy in this downturn.

That doesn't necessarily mean piling into what fell the most yesterday. It means knowing in advance of the sale what you think could be unjustly marked down in the likely mood ahead. Watching the list of such targets in a market-wide scare, waiting for them to get to prices that seemed impossible just weeks before, and then buying at a significant discount to profit when -- yet again -- the crisis passes, is the way to wealth.

I'm pleased to note that the home builder we're watching to buy fell another 16% yesterday. That stock, as just one example, is now selling at an 81% discount to its September 2005 price. Insiders bought recently, an encouraging sign. I wrote to subscribers over the weekend about this stock: "My initial buy target is $17, which is 16% below Friday's close." We already got there, but we haven't bought yet. This sale isn't over.

Watching and waiting is the key to this business and this is the time, folks! Crises that look frightening to the general public but are non-events to those who live in the market are manna from heaven.

When others look back in six months or a year and say, "Darn, I should have bought something," smart investors will smile and say, "I'm glad I did."

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Why I'm Not Worried About Sub-Prime
August 15, 2007

Back in May, I ran a series of articles in The Kelly Letter in which I examined the state of real estate in Colorado and California. I spent more than a month driving around, talking to realtors, comparing the word on the street to bold headlines, and sending along my findings to subscribers.

From my May 19 report:
I wrote a couple of weeks ago that housing prices in Colorado were no bargain. Now I see that they're no bargain in southern California, either. The popping of the bubble, the bottom of the market, the slump, or whatever else the media wants to call their phantom news story about housing's demise, is nowhere. True bargain hunters are holding cash, because bargains are hard to find.

I had dinner with another friend of mine, a fairly wealthy investor who's always on the lookout for something new. His circle of friends, he told me, are watching real estate and waiting...and waiting...and waiting. They've been waiting for three years. The media keeps reporting a fire sale, but nobody's seen any smoke.

What I've concluded is that the general real estate market is not a buyer's paradise.
Since then, the sub-prime issue has ballooned to an even bigger news event, but my subscribers and I remain undaunted for a couple of reasons.

First, we've thought since the end of April that the stock market would see a weak medium term after rising higher in the short term. That's exactly what's played out.

Second, and more important to this article, is that the stakes are not as high as shrill headlines would have you believe.

True, the housing market has slowed. Ask yourself, however, what it has slowed from. Did it slow from a moderately good pace to a bad pace? Did it slow from a bad pace to a dismal pace?

No. It slowed from a breakneck amazing pace to a decent pace. Nobody thought the runaway housing market of the past few years could last forever, did they? To put this in perspective, home sales and housing starts are about where they were in 2002. Those levels were considered fine back then. They're still fine today.

Next, ask yourself how much of the U.S. economy housing represents. By the tenor of the news these days, you'd think half of the U.S. gross domestic product comes from the housing market. It doesn't. Housing accounts for a mere 5% of the economy. Even if housing slipped by 50%, the overall economy would suffer only a 2.5% loss. That's not nothing, but it's not the stuff of The Big One. Besides, housing is nowhere near falling 50%, so we're actually looking at a hit to the overall economy of maybe 1%.

Folks, this is no disaster. The stock market is not finished. We're not seeing the front edge of a storm that will demolish all we've built over the years.

We probably have further downside ahead, but it will be followed by up, and we'll still be standing. Smart investors are watching for good entry prices on stocks they've wanted to own for years and hoping for a lower market in the near term. You read that right: hoping for a lower market.

The Kelly Letter has already bought one stock in the downturn so far, and we're looking to buy more, including a home builder.

If you can't recognize the word O-P-P-O-R-T-U-N-I-T-Y between the headlines these days, you're in the wrong business.

Tomorrow: A similar conclusion from Stratfor.


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The State of Real Estate
June 11, 2007

In May, I reported that I saw no signs of a crashing real estate market in either Colorado's front range or Southern California. It was taking a bit longer to sell homes than it did a couple of years ago, but prices were nowhere near what I'd call "bargain basement," and not even cheap in many cases.

I am but one person, though, and my findings in specific areas of just two states are not expansive enough to command authority when considering the national situation. To get closer to that, I asked Kelly Letter subscribers to send me information from their neck of the woods. As ever, loyal readers came through for me and I'm delighted to pass along their observations.

Chris Kolb lives in a development in Western New Jersey near the Pennsylvania border. Most of the homes there are fairly large with four bedrooms and at least two baths. The age of the homes ranges from five to 10 years and their lots from half an acre to 1.5 acres.

Chris wrote, "I had mine built in 2000 and within the delivery time the base price of the homes went up $20,000 already, without me even having moved in yet. It never stopped appreciating since."

In the past six months, however, he's noticed a lot of houses up for sale. What's more, the "asking prices have somewhat dropped since last year and I believe they will drop quite a bit more before rebounding."

Chris has a neighbor who recently put his house on the market but says he's in no hurry to sell. That's good because the neighborhood is already overflowing with homes for sale.

A quick glance at my own notes from phone calls to brokers in Estes Park, Colorado showed that the number of homes up for sale is higher than it's been in the past five years, and that their time on the market is longer.

Meanwhile, Wesley Williams is finding the same abundance of FOR SALE signs near where he lives half an hour north of New Orleans, but also the same relatively unchanged sale prices.

Word on the street down there is that prices are down 6%, but Wesley hasn't been able to confirm it. "I can probably get lower prices by making an offer, since property is sitting for so long," he surmises, "but sellers are not lowering prices of their own initiative."

Tell that to Jeremy Diamond over at Annaly Capital Management. In his June 4 report, Home Prices: The Underappreciated Economic Indicator, he wrote, "Home prices nationally...are going down. Not since the Great Depression have home prices in the U.S. declined on a national basis. No matter how you measure it or which index you prefer to follow, prices are struggling: In the latest reporting period, year-over-year median new- and existing-home sale prices are down 10.9% and 0.8%, respectively...[Even] the trade group representing real-estate agents is forecasting falling prices."

The problem is, that forecast has been in place for almost two years now, and a year-over-year drop of 10.9% in an asset class that has done as well as homes have done is nothing. Besides, that's for new homes. Existing home prices declined a puny 0.8%. If that fly speck of a drop sounds trumpets of alarm, what is sounded for a 30% decline?

To read the rest of this article and every other article sent to Kelly Letter subscribers in the past two years, please try my one-cent, one-month trial. You'll see my current stock portfolio, read the multi-part real estate article series, and follow along with my current market sentiment. And, yes, it really is just a penny.

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Southern California Real Estate
May 28, 2007

In The Kelly Letter, I focus almost exclusively on stock market investing. Recently, however, I've supplied subscribers with a five-part series on investing in property as a way to diversify outside of the stock market. The following, Part Three, was sent to subscribers on May 19:

I spent this week in southern California. I'm writing to you from Los Angeles, where the weather has been cloudy in the mornings and sunny later in the day.

That pattern seems to be one that's held for real estate here as well. The housing market has supposedly been primed for a crash since 2004. Rather than crashing, though, prices have been rising. Every homeowner I spoke with says they expect the value of their home to begin shrinking any day now, and that they've been expecting that for more than two years.

There's a disconnect between what the media is reporting and what's actually happening. It's as if they've run the "collapsing bubble" story so many times that they believe it themselves and keep ignoring numbers to report it again. Meanwhile, the real estate buyer sees it nowhere.

Just this week, the L.A. Times reported that "Home Sales Hint at Longer Slump Ahead," as if a slump were already underway. The paper reported that home sales in April "plunged to a 12-year low, suggesting that the region's real estate slump is far from over."

Yet, in the same story, we find evidence that no slump has even begun. "Prices were up overall, rising 6.1% from a year earlier to a median of $505,000," wrote Times Staff Writer Annette Haddad.

Huh? Rising prices do not happen in a slump. Prices go down in a slump. When was the last time you read about the stock market that "the Dow slumped to a new high this week"? Never. Prices "slump" lower and "surge" higher.

Nonetheless, housing commentators stuck to their scripts. "Demand is not there and supply is greater; prices are bound to go down," said Esmael Adibi, an economist at Chapman University in Orange. "No question that the bottom of the market hasn't hit yet."

I should hope not, considering that it's still going up! He should be saying that we've hit the top of the market or that we haven't seen the top yet, but he's talking about the bottom. I tell you, if this is a housing market crash, I can't wait for the boom times.

As ever, real world research cuts through the haze.

For years, I've eyed a community called Toluca Lake for potential bargains. It's a modestly upscale neighborhood nestled against the hills below Universal Studios, within the city limits of both North Hollywood and Burbank. A lot of show business executives live there. From most of the homes of interest to me, residents can walk to the Lakeside Golf Club. The streets on the way are flanked by gorgeous flowerbeds, reaching palms, and a variety of home styles. It's a quiet, pleasant place to live, and has easy access to freeways for getting around the big city.

Back in 1999, when I bought the rental home I wrote about last week, homes in Toluca Lake went for $400k to $500k. This week, I returned to the area and walked around looking for an abundance of "For Sale" signs and evidence of people doing whatever it takes to sell. After all, if what the media has been reporting for the past few years is true, we should be seeing signs of fallout.

There are no more signs than before. Prices are triple what they were in 1999. The best indicator, however, stared at me from beside a showcase home on the corner of two main streets.

The house next to it had dirt and dead grass where the rolling green lawn should have been. The paint was peeling. The front window was bent inward in some places and curved outward in others. There was rust on the front step handrail. Parts of the concrete driveway were pockmarked. This was the proverbial lump of coal in a bag of diamonds.

I have nothing against lumps of coal among diamonds. In fact, I'm a collector of such. It's better to own the worst looking place in an area because that one's value will be lifted by the appeal of the others. There was a "For Sale" sign pounded into the packed dirt of the front yard, so I called the realtor from in front of the house.

Remember, I don't use realtors when buying or selling real estate, but when a sign with a phone number hangs in front of a house of interest, calling is the fastest way to hard numbers.

He told me that the house was listed at $1.3 million, but that it was already in escrow. It had been on the market for only a week, and a bidding war among buyers sent the final price to "well over the asking, which is often the case."

A bidding war? A final price higher than the asking? These are not factors consistent with a buyer's market, and a buyer's market is what we should be finding after years of oft-predicted housing collapse. Remember what economist Esmael Adibi of Chapman University told the L.A. Times earlier in the week: "Demand is not there and supply is greater; prices are bound to go down." Really? A bidding war and a price paid higher than list show a great deal of demand and no excess of supply.

"What should I expect to pay for, say, a 2,000-square-foot home in Toluca Lake?" I asked the realtor. Around $1.5 million, but up to $2 million if it's fairly new and well kept. The realtor was happy to tell me about the new place he's listing along the lake for $8 million.

Perhaps this was a case of Toluca Lake defying the odds, I thought. Maybe the affluent execs at Disney and Warner could keep their areas flush by buying and selling to each other on the backs of lucrative bonuses while the rest of the real estate market floundered.

Not true. Lower income neighborhoods have become what Toluca Lake used to be. You can't move into Eagle Rock between Glendale and Pasadena for much less than $500k now, and it looks nothing at all like the Toluca Lake of that price range just eight short years ago. Eagle Rock is a collection of small houses scattered on hillsides with old cars parked in front and portable basketball hoops wheeled onto streets. It's in a process of gentrification, but to my eye nowhere near justifying current asking prices.

Yet, Eagle Rock is the new Toluca Lake, while Toluca Lake is the new San Marino, and San Marino would be the new set for Lifestyles of the Rich and Famous, if it still aired. You can't touch San Marino's grassy, tree-lined paradise unless you just signed a commercial contract with Nike or write books about a wizard kid named Harry. In all fairness, San Marino has always been as green with money as it is with grass, but it's a whole lot greener than it used to be.

The point is that neighborhoods considered cheap less than ten years ago are catching up. Their prices are still rising. There's no sign of slumping anywhere, despite its widely reported presence.

The National Association of Realtors reported Tuesday that existing home sales across the country fell 6.6% in Q1, and that the median price dropped 1.8% to $212,300. If a drop of less than 2% has economists already making references to "the bottom," this is one shallow barrel we're talking about.

After my walking tour of Toluca Lake and my drive-through of other neighborhoods including a trip to San Diego, I called up an old friend of mine who works at the heart of southern California's mortgage business. He's vice president of a major mortgage servicing company and he's been working overtime as the sub-prime mortgage market melted down. He didn't want me to use his company's name because lawsuits are still flying.

He told me that in April 2006, his company received 40,000 loan applications from sub-prime lender Ameriquest. Last month, they received 400. That's a gutted industry, and onlookers have been expecting spillover or fallout or something bad to come of it. On May 14, NPR's "Morning Edition" featured confessions from former Ameriquest mortgage employees that included these gems:
  • Customers were told that their mortgages were fixed for "as long as they wanted" when they were fixed for just two years.
  • "Sending papers to the Art Department" was slang for doctoring up the income numbers on W2s and other forms.
More than 30 sub-prime lenders have gone bankrupt already. However, the only "fallout" I see is that the ones left standing have implemented tougher lending standards. This has not been a crisis at all, but merely a slight negative for the greater economy and one that's already on the mend. Heck, the sub-prime fiasco has not even had much of a negative impact on the housing market, as evidenced by still-rising prices.

I wrote a couple of weeks ago that housing prices in Colorado were no bargain. Now I see that they're no bargain in southern California, either. The popping of the bubble, the bottom of the market, the slump, or whatever else the media wants to call their phantom news story about housing's demise, is nowhere. True bargain hunters are holding cash, because bargains are hard to find.

I had dinner with another friend of mine, a fairly wealthy investor who's always on the lookout for something new. His circle of friends, he told me, are watching real estate and waiting...and waiting...and waiting. They've been waiting for three years. The media keeps reporting a fire sale, but nobody's seen any smoke.

What I've concluded is that the general real estate market is NOT a buyer's paradise. Pay no attention to stories of the end of a bubble or the slow motion train wreck underway. I don't know why it's being widely reported, but it is, and it's wrong. The beauty of researching investments is that reports are so easy to see through. Just get to the numbers. In this case, the numbers are high.

However, that does not mean there aren't bargains to be had. There are always bargains. Next week, I'll look at one of my favorite ways to find them: REOs. That stands for real estate owned, and it refers to a property that a bank owns on its books after the borrower defaulted and the property failed to sell at auction. The bank needs to sell it, and will often do so at a substantial discount.

There probably aren't many more REOs now than at any other time, despite the reports, but there must be some. I'll be checking in with small, local banks in California and Colorado to see what's waiting to be scooped up.

If you'd like to read about REOs -- the article I sent just yesterday to subscribers -- and the rest of this real estate investment series, please sign up for a one-month, one-cent trial to The Kelly Letter by clicking here.

My drive from Colorado to California and back again was gorgeous. The light greens of spring covered the Rockies over the continental divide and down the western slope, slowly giving way to the rolling hills of western Colorado, the canyon lands of Utah, and the mesmerizing desert of Nevada leading to Las Vegas. I finally had a chance to see the wonder that is Wynn Las Vegas, Steve Wynn's newest resort on the strip, but now second fiddle to his crown jewel in China's Macau, the world's largest gambling location.

Southern California afforded the excitement that I've always loved about it, bringing far more to the table than the traffic and pollution that everybody talks about first. The show business restaurants, Venice Beach's motley crowd on Sunday, the botanical gardens, the comedy shows, the flowers, the weather, and my favorite little watering holes all rose up to welcome me back.

On the return to Colorado, I stopped in little cafes to talk with locals about gas prices and the value of their homes. They told me. I love that about Americans. We talk, about real subjects in a depth that's not always available in other countries where strangers get courtesy, but that's all. I heard about farm prices in Richfield, immigration in Colorado, and the changing face of gambling in Nevada. Where are the $2 lobsters, locals wanted to know. Their absence, more than gas prices, is a sure sign of inflation I was told.

What a great country this is. Do you know that the same drive on Japan's toll roads would have run me $500 round trip? It's true. That puts gas prices in perspective, especially when you consider that gasoline in Japan is already $4 per gallon. Motorists there pay that in addition to highway tolls.

I'm lucky to be American. Today, we remember those who died to keep roads open through wondrous lands, gasoline widely available, a robust economy in action, property private for buying and selling, and any church of your choice in full view and wide open for entry.

A special thanks to your relatives and mine who died for this country, with a hope that no more need do so.


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