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Strategies & Market Trends : Mish's Global Economic Trend Analysis -- Ignore unavailable to you. Want to Upgrade?

To: mishedlo who wrote (16460)	11/21/2004 6:39:17 PM
From: GraceZ	Read Replies (1) \| Respond to of 116555

After I wrote that note I started thinking about the implications. The enormous rise in RE lending lead to an enormous expansion in the money supply, which completely offset the unprecedented contraction in commercial lending. Lending standards remained loose, no one wanted to borrow. Why would a company borrow money in a situation where returns on capital investments are doubtful? The bottoming and rise in C&I shows that companies now feel more positive about receiving a return on new investments, a return sufficient to cover the interest and risk. This is good news, it means US companies are out of their contraction phase. They see growth on the horizon. It remains to seen if they are correct. Some of the small fast growing companies I follow have greatly improving prospects for earnings and cash flow. They are feeding off the fast growth in Asia instead of threatened by it. The RE lending raised the money supply steeply, but it's effects were almost completely confined to inflating the price of housing, subordinate industries and final consumer demand (money that leaves the country pumping up China). Very little of that money went to actually create anything with a productive value here in the US. The reason I say that RE lending is independent of the Fed is because a rise in RE lending can happen without the Fed by the simple action of money moving out of demand deposits or time deposits into MBS. The reserve requirements are so much lower for mortgages so a smaller reserve base can support more loans than can be supported in commercial lending. RE lending is expansionary but the money doesn't really go anywhere, it's tied down. What we saw was a large increase in temporary operations, the temporary money needed to support the large number of RE transactions and refis which increased the amount of money floating from one place to the other. RPs can't be used for long term loans, only short term cash needs. The lack of money velocity when RE lending predominates is similar to Japan's permanent creation in the last five years. The BOJ creates Yen and the Japanese people essentially destroy it by putting into savings accounts instead of letting it bounce around from merchant to merchant and having the normal multiplying effect it would have if the money was spent. Now the thing is, if RE lending slows down, which everyone expects it to do, what will be the effect on the money supply? Will we see a reverse? The effect on the money supply won't be symmetrical. First off, you have to account for the fact that mortgage loans act differently in low interest rate environments due to the exponential curve of compound interest. At 5% principle pay down is a higher percentage of your first five years of payments than it is with a 8 or 10% loan at the same term. Multiple that over millions of loans and you have a lot of principle being returned that will flow into other areas unless people continue to borrow it back. This could happen, the lending industry has made RE borrowing almost completely frictionless. The one thing that would put a halt would be a severe widespread drop in housing prices (greater than 20%) or a serious rise in defaults on conventional loans. Right now the foreclosures are almost all FHA where the zero down and first time buyer government programs allowed less sophisticated, financially weak borrowers buy houses in marginal neighborhoods. RE contractions tend to be rolling. They start in one place while somewhere else the market is still expanding, to be followed a year or two later by contraction as the correction finally rolls around. On the East Coast they tend to start in the marginal areas and roll inward to the high demand areas. Whereas, I've heard, out in the West they tend to start where prices have been rising the longest and roll outward to the marginal areas were prices rose last. This may be because RE inflation is so much more deeply entrenched out on the West Coast. Whereas here in the East we know only too well that houses depreciate. Forclosures and defaults could expand to the pool of conventional mortgages in a hurry if we get a serious RE rout that some are expecting. That would put a lid on HE loan action and have the mortgage lenders slam the barn door (again). Frankly they need to tighten their lending standards and I see it as typically short sighted of them to be loosening standards here at the end of the cycle. It's as if they are crying out to get punished. In my experience even good credit risks suffer when they finally get religion. Prudent borrowers would be paying down those HELOC loans or rolling them into the principle mortgage, especially those that are near the end of their term. Banks won't automatically roll them over if we get a sharp credit squeeze or the collateral falls off sharply in value. I wouldn't have any kind of RE loan that can get called in at this point in the cycle.