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Financial Chickens Coming Home to Roost   (May 13, 2006)

Allow me to quote my entry from May 6:

"The Fed meets on May 10. Mark your calendar: May 11 the decline starts and then rapidly picks up velocity. The "smart money" has been exiting all month while the con was set. Reality has a nasty habit of trumping wishful thinking."

With the stock markets in a free-fall, it would seem the call was correct. While I would like to claim the mantle of financial genius, it was actually easy; so many chickens are coming home to roost, the henhouse was bound to collapse. Here are just a few of the issues with lit fuses:

Let's start with an expose of a very risky practice: borrowing money against one's stock and bond portfolio, a.k.a. margin debt, to spend on consumerist frivolities. As reported by the Wall Street Journal: Margin Loans Make a Comeback: Wall Street Pushes Investors to Borrow Against Portfolios to Buy Cars, Homes
UBS AG's wealth-management division says about 75% of its more than $10 billion in securities-based loans are used for purposes other than buying additional securities, including for purchasing real estate and cars or for paying tax bills and a child's tuition.

"Things can go very wrong with a margin loan," says Sue Stevens, director of Morningstar Inc.'s financial-planning practice. Although such loans can help meet short-term cash needs, she recommends that investors pay the loan back within three months, since the markets can shift quickly.

In total, margin debt at New York Stock Exchange member companies, as tracked by the exchange, was $222.78 billion in February, the most recent month for which figures are available, up from $173.22 billion at the end of 2003. That compares with a peak of $278.53 billion of margin debt outstanding in March 2000. For Wall Street, margin lending is becoming a bigger contributor to revenues.
With the prime rate at 8%, that margin debt isn't so cheap anymore. And as stocks plummet, some of those unwise investors will get margin calls, requiring them to sell stocks to bring their cash back up to at least 50% of their account value. Then that selling drops the market more, triggering more margin calls...I think you see the direction this takes: down.

Here's a snapshot of stock speculation running wild from Yahoo Finance on Friday, May 12:
"Schwab reports April activity that includes: Net new assets brought to the company by new and current clients in April 2006 totaled $4.6 bln. Total client assets were a record $1.300 trillion as of month-end April, up 22% from April 2005 and up 1% from March 2006. Client daily average trades, which include Schwab Investor Services asset-based trades and Schwab Institutional asset-based trades, were 293.3 thousand in April 2006, up 44% from April 2005 and up 5% from March 2006."
What do you reckon is driving a 44% increase in trading? Could it be speculation? The short answer is: what else drives trading up 44% in one year? Is it the smart money dumping and the soon-to-be-impoverished investors buying wildly? And where did that 22% increase in assets come from? Borrowed off some real estate, perhaps?

Here's an editorial from the Wall Street Journal, decrying the lack of a sensible energy policy in the nation:
When the House had a chance to take a positive step to increase gasoline supplies and lower prices last week by making it easier for oil companies to expand their domestic refinery capacity -- Northeastern Republicans teamed with Democrats to bring the measure down. The U.S. now consumes 21 million barrels of oil a day but has a refining capacity of only 17 million. As usual, the loudest Congressional complainers about high gas prices voted as a bloc to keep supplies precariously low.
The key takeaway here is that the U.S. isn't just dependent on foreign suppliers of raw oil--we are also dependent on foreign refiners. If you think gasoline is expensive now, what do you reckon would happen if anything happened to disrupt that 4 million barrels a day of refined petroleum products being shipped to the U.S.?

For a quick look at housing, let's turn to the S.F. Chronicle: Cooling market squeezing Bay Area developers:
At GreenCity Lofts, a 62-unit development in Emeryville that touts sustainably-harvest wood floors and edible landscaping, 1,100-square-foot lofts that recently sold for about $650,000 are now being offered at $499,000.
That's a 23% drop in a matter of months. How do the buyers who paid $150,000 more for a smallish loft feel now? Just like everyone else who overpaid last year--lousy, angry, scared, and maybe in a mood to sue the developers.

Here's another staggering real estate tidbit from the Wall Street Journal on negative equity:
A full 29% of people who took out mortgages or refinanced in 2005 have no equity or negative equity in their homes, according to Christopher Cagan of First American Real Estate Solutions, a data provider. That's a shocking figure, compared with 10.6% of people who took out mortgages in 2004.
And a final wrap-up of the housing bust from the Wall Street Journal: Night of the Living Debt:
The biggest and most underrated development in the U.S. economy over the past year is that the personal-savings rate went negative. In other words, Americans spent more money than they made last year -- for the first time since, oh, the Great Depression. The average worker hasn't participated in the economic recovery. Inflation-adjusted hourly and weekly wages are still below where they were at the start of the recovery in November 2001, points out the Economic Policy Institute.

As we all know, people made up for this by borrowing more, primarily from their homes. As short-term rates rose, however, home-equity loans and low-cost mortgages became less attractive. Home prices seem to be stalling out.
So let's see: we have no coherent energy policy, margin debt is being used to finance consumer baubles and second homes, a third of recent home buyers have either no equity or negative equity-- and what exactly is going to persuade them to make payments when money gets tight?-- wages are flat, but really, folks, everything's great. Please repeat this mantra until your critical facilities cease functioning: energy costs don't matter anymore, real estate is simply "returning to normal," unemployment is low, the GDP is growing healthily and everything is peachy.

If you're having trouble swallowing that mantra, try doubling your daily dosage of Zombiestra (TM).

For more on this subject and a wide array of other topics, please visit my weblog.


copyright © 2006 Charles Hugh Smith. All rights reserved in all media.

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