In two days, the market relinquished all weekly gains and looking at market fundamentals there really is very little doubt as to why this occurred. This past week, the two large mortgage behemoths Fannie Mae and Freddie Mac announced record quarterly losses. We also got a report that the housing market dropped at its fastest rate in 2007 from anything that we have on record. But there are areas that are on a massive tear and will continue going up because of inherent imbalances in our economy. In Investing in Foreign Currencies: Recession Proof Investing we discussed various ways you could protect your portfolio from recessionary forces.
First, we need to highlight what our forecast is for 2008.

• Continued Housing Weakness
• Credit Market Distress
• Commodity Prices Increasing
• Dollar Declining
• Yen Unwinding
• Higher Unemployment

The reason for this forecast is the insurmountable debt that we carry as a nation. If you want to look at household credit market debt outstanding, just take a look at the below chart:

The problem with the above goes in two ways. First, with the massive deflation in housing many people are now finding that their mortgage is worth more than what they initially paid for their home. What we are now seeing is an epidemic of people simply walking away from their homes. What this does in effect, is a destruction of money which is deflationary. Think about it for a minute. Someone somewhere has on their books a home that is valued at $300,000 and a corresponding mortgage for $300,000. Now let us assume the home is now “worth” $250,000, does the mortgage adjust instantaneously? Of course not. And as we all know, many people were using home equity lines to fuel the consumer economy and this is no longer an option.

Now what does this mean for our economy? First, it means the Fed is going to probably go toward a zero interest rate policy and with each cut, you will see gold and oil surging higher. We also have seen the Japanese Yen surging this year with the currency unwinding. It only makes sense since the Japanese are one of our biggest creditors and our debt is growing more and more devalued as the year progresses.

There is a great piece over at Econobrowser by Professor Jim Hamilton:

*chart source: Econobrowser

Incredibly, nearly every major commodity class is not only rising, but surging at unbelievable rates. If the Fed continues to cut rates which seems very likely, you can expect to see foreign currencies rise and commodities explode. Invest accordingly.

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As the housing market continues its crash and burn path, it is sometimes difficult to put into words the incredible amount of mortgage debt floating around in the market. Since the 90s, mortgage debt has exploded and has followed a celestial trajectory to the moon. Mortgage debt has grown since 1997 for over a decade nearly unabated. Take a look at this chart below:

Mortgage debt is an astounding $13 trillion. Given that all residential housing in the US is valued in the ballpark of $20 trillion, any moderate declines will put a damper on housing prices while maintaining the enormous amount of debt. The problem that occurs with this is that we have one moving target (housing prices) and one stationary target (debt). If you wonder why so many people are being foreclosed upon, the above graph is one major reason.

During the last decade, housing has been in an amazing growth pattern. The reason we didn’t see much housing problems during this time is that the rising sea of housing prices masked the problem loans. That is, if someone got into problems or over paid by a few thousand, it was easy to simply put the home on the market and leave relatively unscathed. So what occurred in the last year or so that has set the market falling off a cliff? Well for one, many toxic loans had teaser periods that were set to go off in 2007 - 2010. If you think we are out of the woods, just look at this chart:

We haven’t even entered the peak turning point in the housing market. The biggest month in terms of resets will be March of 2008. We are quickly approaching the zero sum moment and now we are hearing open talks about bailing out lenders for their lax lending. It will be a hard challenge for Americans to adjust to a culture where debt is tighter and fewer and fewer people will want to consume. Yet this is where we stand. Banks are cautious about giving money out since they are now in need of shoring up liquidity for further rate resets. As you can see from the chart above, we are going to have large months of resets well into October of this year.

The chart only shows one side of the story. We haven’t even started to address the oncoming onslaught of resets with PayOption ARM mortgages. A PayOption ARM gives you three pay options:

1. Full payment (principal, interest)

2. Interest only - self explanatory

3. Pay Option - negative amortization where your balance increases

I was astounded to see reports that nearly 70 to 80 percent of those that take out Pay Option mortgages elect to go with option 3 above. Many of these loans are set to adjust in 2010, right when we are finishing cleaning up the subprime mess. Now there has been much said about programs to allow owners in these toxic loans to refinance out. Well the fact that many are paying the actual bare minimum tells us that people are simply scratching by so a conventional mortgage isn’t going to help them out because it will force the balance up and push them into option 1. Now if they weren’t paying option 1 now why is a smaller lower rate going to help them out? The above graphs are scary indeed given what we are seeing in the credit markets.

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