By Porter Stansberry

Saturday, January 19, 2008

Like anyone with working eyeballs and functional gray matter between the ears, I've known for a long time that real estate prices reached unsustainable levels in 2006.

But even so, I have to admit being very surprised by how rapidly the crisis has accelerated since August and how far prices on mortgage paper have fallen.

The principal cause of the crisis is structural: A shocking number of people simply cannot afford to actually pay for the houses they've bought...

Countrywide Financial makes and services about one in seven American mortgages. It is the largest mortgage lender in America and the largest mortgage-servicing company. This month, it announced 7% of its loan book (7.2% by value) is in default – more than 60 days late. That's up two full percentage points, from 5%, in only one month.

Almost all of the loans in default feature adjustable-rate mortgages, which have reset to higher rates based on changes to LIBOR, an international interest rate. With another 2 million homeowners facing higher interest resets on their adjustable-rate mortgages, it seems the total number of defaults is going to keep climbing. And that's trouble...

There's a well-known and historically proven correlation between the default rate and the recovery rate, which is how much money banks are able to salvage from their loans in a foreclosure. When default rates are low, the market for housing is strong and banks can generally recoup the full amount of the defaulted loan. But when default rates are high and rising, recovery rates plummet.

Buyers know the amount of supply is rising. Nobody wants to be the first guy to buy a foreclosed property when he knows millions of properties are in the pipeline. Prices, at least temporarily, can spiral down 50% or more.

Think I'm exaggerating how bad the real estate market is likely to get?

Consider Morgan Stanley Real Estate paid 40¢ on the dollar for an 80% stake in 11,000 Lennar properties, located in 32 different communities across eight states. That's a 60% discount from the retail price only two months ago.

Northland Investment Corp., a vulture real estate firm, bought five apartment complexes in Florida and one in South Carolina for $156 million this month, roughly 50¢ on the dollar. Orleans Homebuilders sold 1,400 lots in December for $32 million – roughly $50 million less than the book value of the land, a 62% discount.

The size of these discounts indicates that the real estate bust will spread into the financial system. Sure, I know that sounds obvious after watching Merrill Lynch raise its mortgage-loss estimate from $5 billion to $8 billion to $15 billion over the last six months. The truth is, Merrill Lynch has no idea how bad the damage to its portfolio and its balance sheet will be. The same is true for Citigroup... but its losses are probably even bigger. And the only investors with enough money to save them live in the Middle East.

I now believe our country's mortgage crisis will spill over into the general economy because the fallout has already spread from development companies to mortgage banks to investment banks and now to credit-card companies. Capital One, the largest independent credit-card issuer in the U.S., recently announced it would take a $5.9 billion charge for bad debts in 2007. That's up from $3.1 billion in 2006 – a 90% increase in only one year.

Currently, the charge-off rate is only about 5% of Capital One's loan book. Watching Countrywide Financial, you'd have to assume the rate of bad credit-card debt will continue to grow higher. If 7% of people in America aren't paying their mortgages, I figure at least that many people aren't going to pay off their credit cards either.

As you can see, the system's leverage is magnifying the impact of falling real estate prices. And even worse, the damage to the banking system means it will be much more difficult for the Federal Reserve to stimulate economic growth through additional lending.

This is a time to be extremely cautious with your own finances. I believe the S&P 500 will fall this year, by more than 10%. Most stocks will probably decline this year. Thus, simply holding cash and gold isn't a bad strategy right now – your cash will probably outperform your stocks in 2008.

Good investing,

Porter Stansberry

Further Reading:

How To Lose Money on a House

What Caused the Housing Bust

Market Notes

EASTERN EUROPE'S BULL MARKET ENDS

For the past several years, we've watched with interest the bull market in Eastern European stocks... chiefly through the huge uptrend in the iShares Austria (EWO).

Although this region gets little attention in the mainstream press, its "flat tax" policies are light years ahead of horrendous codes in Western Europe and the U.S... and producing a much faster rate of growth than the likes of France, Spain, and Italy.

With a heavy weighting in banks, this ETF is the easiest way to play the financing of Eastern European growth. Since taking off in early 2003, EWO was one of the best regional plays you could possibly own... rising nearly 400% to its high last year. The "shoot first, ask questions later" mood of investors right now has changed all that. EWO hit a new 52-week low this week.

As our Stat of the Week demonstrates, Australian stocks, which represent raw materials, are being sold indiscriminately. Austrian stocks, which represent banking, are being sold indiscriminately. The message from the market: "I don't care what the hell you do to make money, I'm selling."

– Brian Hunt

Who Is Still Paying Their Mortgage?

Market Notes

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