New Century, Old Worries

Have you noticed how quickly theories about the current market correction are being spawned then subsequently abandoned? We went from China, to the carry trade, to hedge funds, to the new "Daylight Savings Y2K", to subprime lending all in about two weeks. (See our past commentary "A Gore-y Correction?")

At a Mortgage Lender, Rapid Rise, Faster Fall: Wall Street Fueled Growth at New Century; A Party-Hard Culture
By James R. Hagerty, Ruth Simon, Michael Corkery and Gregory Zuckerman, The Wall Street Journal (*site requires registration)
https://online.wsj.com/article/SB117366027973133733.html?mod=home_whats_news_us

This article positions itself as a proxy for the possible coming woes of the entire US housing market. It never explicitly says that of course, but it doesn't take a lot for the average reader to infer as much. We can't help but say to ourselves "Gee Wiz, the last time we heard ‘party-hard culture' was the tech bubble! Oh dear, it's 1999 all over again!" Today we read stories like this all over the financial press.

It's sort of amazing that New Century is front page news in the first place. Even at its height the company wasn't worth more than a couple billion bucks by market capitalization. In other words, it was always very small. By contrast, the average weighted market cap of a representative company in the MSCI World index is over $75 billion dollars. Even if New Century was wiped off the face of the earth, it wouldn't remotely impair the markets or the overall economy, which deals in many trillions of dollars daily. Whatever this story is, it's not a big deal for markets.

Merrill Lynch investment strategist Richard Bernstein once wrote: "We view financial risk much like popcorn popping in a microwave. Until the first kernel pops, one tends to believe that nothing is happening. The initial pop seems like a random event until a second occurs. A third. A fourth. Then the popping goes wild."

Now, we think Mr. Bernstein is a very smart man with a lot of success and a lot of wisdom about financial markets. And we certainly aren't putting words in his mouth here about the US housing market. But his quote is a good example of market psychology and how a lot of people tend to think. This dictum is only right when there are legitimate fundamental reasons for it to be so.

Our brains are pattern recognizers. Those masses of gray matter stuffed into our skulls want desperately to extrapolate today's events into the future. The core of the economy is very strong, risk is well spread among market participants, and the fundamentals just don't point to a housing catastrophe whatsoever. The reality is New Century was among the most aggressive of the subprime lenders and didn't take nearly the measures in controlling risk that the vast majority of financial institutions did. That doesn't mean the whole market is ready to implode.

Is it really such an incomprehensible thing that on the margin an extremely speculative enterprise goes belly up? (For more on de-mythologizing subprime loans see our past commentary: "Don't Go Blind From the Subprime")

Many believe housing is the cornerstone of all US prosperity and we're nothing without it. That's a big reason all this talk about mortgage defaults is so scary. "Americans have all their savings in their homes" is a familiar mantra. Here are some facts:

• Since mid-2002 (the end of the last so-called recession) US Household Net Worth is up 44%. Even if you strip out real estate gains, net worth still surged 38%.
• Cash and equivalents alone are $6.4 trillion, and have shot up 33% since 2002. We're not spending all our cash, we're hoarding it.
• Non-residential real estate accounts for $22.4 trillion of household wealth. That seems big, but it's out of over $67 trillion in total assets, or only about 33%.
• Total mortgage debt is $9.5 trillion…only 42% of the value of our real estate!
Source: Federal Reserve Flow of Funds Accounts; As of 9/30/2006

Take those stats and join them with low unemployment, low interest rates, thriving global trade and economies…and a mortgage collapse just isn't in the cards.

For a bit of perspective, we leave you today with an essay on the virtues of risk and the individual. The entrepreneurial spirit is what makes capitalism and prosperity thrive…and there is no such thing as entrepreneurship without risk.

I Think I Can, I Think I Can...
By George Anders
https://online.wsj.com/article/SB117329955003029939.html?mod=ITPWSJ_20