The Coming Credit Crunch

By: Robert McHugh | Sat, Mar 24, 2007
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We believe a credit crunch is underway. It started with the housing slowdown, which resulted in deteriorating real estate prices (collateral values), is now fed by adjustable rate mortgages resetting higher, that make it difficult for many homeowners to make payments on time. Without rising values, refinancing isn't an option, resale isn't an option (folks owe more than they can get, net of real estate sales commissions and taxes), and so they are forced to hand lenders the keys. This has resulted in losses for subprime lenders, who generated loans to marginal borrowers based upon unsubstantiated incomes, and a belief that collateral values would continue rising. Now on the radar screen, politicians have put pressure upon regulators such as the Federal Reserve to account for how this could've happened. Regulators "on the defensive" always generates an overreaction. This overreaction means more frequent and more intense bank examinations, tighter standards imposed upon lenders, subjective classification of loans as worse than they are in reality. If a loan is a few months delinquent, while before that meant "keep an eye on the borrower," now it means the lender must set aside earnings into a reserve for possible loan losses. This kills bank earnings. This intimidates lenders into not lending. This creates a credit crunch, which lowers money supply, which causes/worsens a recession. That is where we are headed fast. It is like a black hole, sucking the life out of the economy. Eventually this loan scrutiny affects all loans, not just residential real estate. In effect, we end up with a bank examiner generated recession. They get tough too late, at the wrong time. It happened before, under George the 1st's regime, in the late 1980's/early 90s.

Evidence is piling up that Alt. A market loans, a grade above subprime, but below pristine, are showing signs of deterioration, which will spread further. As banks tighten the screws (they have to, or the Fed and other regulators will have these people for lunch), it will be wise to hold onto your cash. Credit lines will be reduced once paid down. So if you are going to need cash, hang onto it. Don't count on borrowing cash in the next year or two. If you are one of the lucky ones to keep your line of credit in full, great, but don't count on it.

Countrywide's foreclosure rate was 9.89 percent in 2000. Samuel Sanders, the company's executive managing director, recently was quoted as saying that current foreclosures may exceed that level, according to a story this week at www.cnnmoney.com . There is growing pressure on Congress to not bailout the subprime lenders. Our belief is that if there is going to be a bailout, it will have to be a direct bailout of the American homeowner, via a dollar devaluation, hyperinflation event, which would boost collateral values, and perhaps include a dollar distribution to American households. There is simply no other way out.

The Federal Reserve left short-term interest rates steady this week. What else were they going to do? If they raised rates, financial markets would've collapsed, housing would've taken a hit, the debt crisis would've taken a hit, and the credit crunch would've been accelerated. The cost of leaving rates alone is a deteriorating dollar. The Fed has two choices: Let the economy tank, or let the dollar tank. We believe they will choose to sacrifice the dollar. They may not realize it yet, but they will soon enough. With monetary expansion through the credit creation function about to contract, it will be up to the Fed's printing press to take up the slack and hyperinflate the economy out of this mess. If they do it through Wall Street, which is the preferred method of this administration, the debt crisis that American families and the government faces will not be resolved. The Master Planners prefer the status quo. Buy bond and stock markets with freshly printed cash via the Fed's Open Market Committee and via the Plunge Protection Team. Securities are withdrawn from circulation (placed and held in government controlled vaults) in exchange for more fiat dollars placed into circulation. But this approach fails to reduce debt held by individuals or government entities. It places money in the hands of those who own financial securities, while boosting the earnings of investment bankers, all at the expense of the U.S. Dollar, with no help to borrowers or lenders.

To reduce debt -- which ends the debt and lending crisis; to reduce demand for debt -- which will stop the credit crunch; to increase collateral values -- which improves the housing markets; to bail out subprime lenders, homeowners, banks, and the economy, a 50 percent dollar devaluation via a monetary handout to every American household, to the tune of hundreds of thousands of dollars of freshly printed cash to each, will be necessary. If this handout is taxable, it will reduce government debts, and bring government budgets back into balance. This is because debt contracts do not have inflation provisions, thus old debt dollars will be paid back in more abundant, less intrinsically valuable dollars.

This will boost precious metals prices. The last step for the economic bailout would be to establish a new currency backed by gold and silver, and end Artificial Economics once and for all.

The Master Planners are in no political mood to do this now, but down the road they will become quite fond of the idea as the mess we find ourselves in gets worse and worse and worse. Deficits are already massive, so fiscal stimulus (such as another war) is not going to be an option. It will have to be a monetary solution. Had the Fed lowered rates, the dollar would've dropped harder than it did this week, and the reality of a coming recession would've damaged market psychology, crushing markets after an initial period of rejoicing.

Existing Home Sales rose in February, the largest percentage rise in three years, up 3.9 percent from January, according to the National Association of Realtors. However, it is a percentage increase, not an actual units increase, so the calculation is coming off a low base to begin with. As compared to February a year ago, sales were down 3.6 percent. Price declines helped sales. But that won't help those who owe more than they can sell their properties for. Those folks are stuck.

Housing Starts rose 9.3 percent in February 2007, from January's nine year low, according to the Commerce Department. February 2007's starts were 28 percent below February a year ago, which keeps things in perspective. The Plunge Protection Team is doing its part, buying Bonds to keep interest rates low, but that still hasn't helped mortgage demand, which depends upon rising collateral values for refinancings and resales. The Mortgage Bankers Association reported that its seasonally adjusted Index of Mortgage Application Activity fell 2.7 percent in the latest reporting week. Building Permits fell 2.5 percent in February as Builder confidence remains weak.

Will the dollar tank? The above chart says yes. Big time, over time. Nothing has changed from the last several weeks. The pattern is a Head and Shoulders top. These patterns are highly reliable. It is not yet a "confirmed" pattern, meaning until prices drop below the neckline decisively, say below 80.00 to 77.00 or so, the probability of the minimum target of 40.00ish being hit is not as great. However, should we see the Dollar drop down to 77.00ish, we are in a high risk situation of a devaluation of the dollar all the way down to 40.00. Not all at once, but over the course of several years. Perhaps all at once, should the government elect to flat-out issue an edict that a dollar is now worth 50 cents. Would they? Maybe. Why? It is a way to repudiate half of all the debt in the United States. Why would they want to do that? Perhaps if a recession became a depression, or the risk thereof. Perhaps if housing was to absolutely dive into the tank. It would be a way to relieve mortgage holders of a huge chunk of their obligations in lieu of mass foreclosures.

The pattern is ominous as far as its size, its timeframe, and as far as its downside implications. This pattern is textbook. No flaws. In fact it carries a rare added textbook feature of a weaker right shoulder than left. That is not good.

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Robert McHugh

Author: Robert McHugh

Robert D. McHugh, Jr. Ph.D.
Main Line Investors, Inc.

Robert McHugh

Robert McHugh Ph.D. is President and CEO of Main Line Investors, Inc., a registered investment advisor in the Commonwealth of Pennsylvania, and can be reached at www.technicalindicatorindex.com. The statements, opinions and analyses presented in this newsletter are provided as a general information and education service only. Opinions, estimates and probabilities expressed herein constitute the judgment of the author as of the date indicated and are subject to change without notice. Nothing contained in this newsletter is intended to be, nor shall it be construed as, investment advice, nor is it to be relied upon in making any investment or other decision. Prior to making any investment decision, you are advised to consult with your broker, investment advisor or other appropriate tax or financial professional to determine the suitability of any investment. Neither Main Line Investors, Inc. nor Robert D. McHugh, Jr., Ph.D. Editor shall be responsible or have any liability for investment decisions based upon, or the results obtained from, the information provided.

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