This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

The books are officially closed on a decade which will be remembered for an historic real estate boom in the United States that busted in spectacular fashion, nearly taking the entire world financial system down with it.

Of course, the real story is a touch more complicated: Our housing bust was merely the most glaring crack in a global economy that grew far too dependent on cheap debt, where flows of money around the world magnetized to the hot asset, blowing bubbles first in stocks, then real estate, then commodities.

During each subsequent bust, governments rushed to the aide of markets, stitching them up with a patchwork of looser regulations, low interest rates and promises it would never happen again.

Late in 2008, the collapse of the credit markets culminated in the failure of some of this country’s most storied financial institutions. When the dust settled, Bear Stearns, Lehman Brothers, Merrill Lynch,
Washington Mutual, Wachovia, Fannie Mae, Freddie Mac, AIG, Countrywide and a host of smaller, lesser known entities had either gone bust or been bought for a song by stronger, better capitalized firms.

Some simply melted into this or that government agency, while many members of our financial complex survived only with historic government aide. Citigroup, Bank of America, Wells Fargo, JP Morgan Chase, Goldman Sachs, Morgan Stanley, GM and Chrysler are alive today thanks to massive taxpayer-funded bailouts.

But enough looking behind us; historians and journalists will be employed for decades slicing and dicing this most turbulent of decades.

Surveying the horizon, the primary fear among economists, investors and ordinary Americans is that the inflationary effects of pumping trillions of dollars into an economy must eventually come home to roost.

To be sure, there are those who remain firmly in the camp that believes the more pressing concern is inflation’s less-well understood counterpart, deflation. But even the most ardent deflationists believe theirs is a debate that is more accurately painted as one of time horizons, rather than absolutes.

The US dollar is in the crosshairs of this philosophic, as well as very practical debate. The greenback’s standing as the global reserve currency has been thrown into question as investors around the world scratch their collective heads and try to figure out how we’ll ever repay our staggering, ever-growing debt.

And now, as our economy appears to be slowly healing, the Federal Reserve faces the unenviable task of withdrawing its generous stimulus. In March, the Fed plans to scale back its purchases of mortgage backed securities, spooking more than a few market participants.

The fear, particularly for the housing market, is that any Fed pullback will push up interest rates.

Higher interest rates translate into lower purchasing power for buyers, curtailing the steady stream of homebuying demand that, coupled with ongoing foreclosure moratoria, has propped up prices in recent months.

We kick off 2010 with mortgage rates approaching the all-time lows set last spring. Sure, they could always go lower, but the smart money is betting it’s just a matter of time before rising prices force regulators to ease their foot off the monetary accelerator. Higher mortgage rates are likely on the horizon.

So as we begin the first true test of our nascent economic recovery, Cirios would like to take you through a bit of history. We’ll look first at the macroeconomic picture as it relates to home prices, inflation and interest rates. Next we’ll examine a few California real estate markets illustrative of the localized trends masked by most broad economic measures.

But first, a word of caution: As Mark Twain’s oft-cited saying goes, “History doesn’t repeat itself, but it often rhymes.”

It goes without saying that the financial upheaval of the past 24 months has been, in a word, unique. There is no historical analogue, no matter how neatly we try to jam this experience into some mold cast in the 1930s, 1970s or 1980s. By extension, any conclusions drawn from this historic perspective should be taken with a very large grain of salt.

Nevertheless, understanding where we stand and how we got here is essential to understanding where we’re headed. And understanding where we’re headed is essential to finding and taking advantage of the plentiful investment opportunities the previous decade’s turmoil has created.

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This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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A cursory look at the long term trends for inflation and home prices reveal strikingly similar patterns. Until, that is, right around 2003 (see dotted line below).

(click to enlarge image)

In the wake of the short recession caused by the dot-com bust and September 11th terrorist attacks, then-Federal Reserve Chairman Alan Greenspan aggressively lowered interest rates to spur economic growth. Leaving rates at historic lows for several years encouraged active borrowing, helping to bring the US economy out of its tailspin.

Greenspan critics now wonder, at what cost?

As homeowners, real estate speculators, investment bankers, mortgage brokers, real estate agents, appraisers and credit rating companies (among others) rushed to grab their piece of property values, the historic relationship between moderate inflation and steadily rising home prices broke down. Home prices leapt, while inflation continued its casual march upward.

Then, around the beginning of 2007 (the “peak” of our 6-month moving average dataset), the relationship flipped inverse (see arrow above). Rising prices as measured by the CPI faced off with tumbling home prices, feeding the feverish macroeconomic debate of inflationists vs. deflationists.

Now, as what feels like the entirety of the financial world awaits the inevitable inflation that “must” come after trillions upon trillions of dollars in economic stimulus, we hope the following few pages shed some light on what we can expect if it turns out the majority (in this case, the inflationists) prove to be correct. Since policy-makers’ key tool to fight inflation is higher interest rates, and higher interest rates translate into more expensive mortgages, future inflation has serious implications for real estate markets around the country.

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By ANDREW JEFFERY

This post first appeared on Minyanville.

Deflation, the economic beast many feared would devour the next decade, appears to have been vanquished.

Or has it?

Superficial signs of renewed inflation are everywhere: Oil prices appear to be stabilizing, and concern is growing about future supply shortages (which, by extension, could lead to higher prices at the pump). The stock market has staged an impressive rally, with expectant bulls and former bears finding for “green shoots” of economic growth everywhere. Home prices, if you look purely at the data and ignore fundamentals, are starting to slow their fantastic decline.

Even the consumer price index, or CPI, is looking tame. Well, except for last month’s drop, the largest in more than 50 years.

And herein lies the problem.

The CPI, the market’s favorite inflation gauge, has been masking the structural deflation in our midst since the housing market fell of its wheels almost 4 years ago. Given the precipitous drop in property values, one would naturally expect the housing component of the CPI to fall in kind. Not so.

The statistical alchemists, err, experts, at the Bureau of Labor Statistics use something called “owners equivalent rent,” OER, to measure consumer housing expenses. OER tries to approximate the cost to rent the country’s typical home, and according to the Wall Street Journal makes up 24% of the CPI and 31% of the core CPI, which backs out food and energy costs.

And since even as property values have slid in record-breaking fashion rents remained buoyant, OER has vastly understated the drop in home prices. This means the CPI — were it to reflect some sort of economic reality — would have fallen more than it actually has.

As the housing slump rolls on, the pain is increasingly being felt by landlords, not just owner occupiers. Rents in big cities like New York and San Francisco are already dropping, as would-be tenants demand concessions from property owners. Vacancies are increasing, as even those driven from the housing market by foreclosures and the tight mortgage market can’t fill up empty apartments, condos and track homes.

Drive around suburbia and “For Rent” signs are nearly as common as “For Sale” signs.

Rents are likely to keep falling and as a result, OER could begin to drag down the CPI. Of course, statisticians can and likely will play games with adjustments for volatile energy prices (renters often don’t pay for utilities, so energy costs are backed out of OER). Further, government bean counters are even considering adapting OER to reflect new, high levels of home ownership (just in time for a reversion to the historic mean, thanks for being ahead of the curve guys).

As long as construing economic data in a way that makes it seem more likely for effectively insolvent financial institutions like Bank of America (BAC) and Citigroup (C) to raise capital and remain in business, that will remain the status quo.

Meanwhile, back in reality, saving is now en vogue, deleveraging is ongoing and the repayment (and destruction) of dollar-denominated debt will keep inflation in check for the foreseeable future. More importantly, the recognition that smaller can be better and less can be more are becoming entrenched in the lives of ordinary Americans.

Don’t believe the hype: Deflation isn’t going away any time soon.

By ANDREW JEFFERY

This post first appeared on Minyanville.

Of the myriad highbrow economic debates currently raging throughout the world of punditry, academia and government policy, few are as contentious as the one over the future of prices: Inflation vs. Deflation.

Indeed, the endgame for this issue is not insignificant, as many believe our economic future hinges on the Federal Reserve’s ability to deftly engineer a return to steady, manageable inflation. To say the least, this is no easy task.

With the unemployment marching upwards, credit markets still largely frozen and global trade grinding to a halt, the American economy is in desperate need of a monetary jolt. The trouble for Fed Chairman Ben Bernanke is that with interest rates already at zero, he’s being forced to rely on so-called “quantitative easing” to pump money into our badly bruised financial system.

These efforts are being managed through the alphabet soup of new lending programs like TALF, TAF, CPFF and others.

Meanwhile, a glut of savings from the developing world coupled with reckless financial alchemy caused debt loads to skyrocket to unsustainable levels. The ongoing destruction of that debt, discussed often by Minyanville’s Kevin Depew and Mr. Practical, is now raging at full speed, as assets of all types have come screaming back to earth.

Bloomberg highlights the debate by focusing on 2 highly regarded economists with divergent views on inflation and its causes.

John Maynard Keynes, a 20th century British economist gained notoriety for his thesis that inflation was controlled by supply-demand fundamentals within an economy. He advanced the view that well-directed government spending could help a country balance economic growth with a moderate, healthy rise in prices.

Western politicians jumped on the Keynesian bandwagon during much of the last century to support a vast expansion in government spending and intrusion into the private sector.

Opposing Keynes was Milton Friedman, who instead believed that “inflation is always and everywhere a monetary phenomenon.” Friedman’s focus on monetary policy, that is, interest rates and controlling the flow of money through a country’s economy, clashed with the Keynesian view that inflation could be controlled with fiscal measures and legislation.

Bernanke is doubling down on Keynes, evidenced by recent lending initiatives, bailouts of financial institutions like American International Group (AIG) and his support of President Barack Obama’s massive fiscal spending program. The Fed’s involvement in cleaning up the balance sheets of Citigroup (C) and Bank of America (BAC), along with efforts to jumpstart the mortgage market have also diminished its ability to remain apolitical and tend solely to the needs of the economy.

The Fed’s gamble is a bold one, as inflating our way out of a deflationary debt unwind could lead to a rapid, uncontrollable rise in prices should the economy rebound sooner than expected.

For example, big oil companies like Exxon Mobil (XOM) and Chevron (CVX) will be reticent to invest in new technologies or drill new wells should crude prices remain low. Limited production capacity could squeeze supply when demand picks back up, leading to a rise in prices.

This trend of firms retrenching in response to rapidly waning demand for goods is being mirrored throughout the economy. And although the Fed promises to take back the monetary stimulus when the economic growth returns, the timing and political implications of such a move are anything but a slam dunk.

And unlike other more esoteric debates over economic ideology, the result of the inflation vs. deflation slugfest has real implications for all Americans.

Inflation, while generally viewed as a necessary evil for economic growth, lines the pockets of those invested in financial and other economic assets at the expense of those on the lower rungs of the economic ladder. If real incomes rose at the same rate prices did since the Fed was created in 1913, they would currently stand at $300,000 per year, six times the current median household income of around $50,000.

In other words, Americans earn about 80% less, in real terms, than they did 100 years ago.

Deflation, while causing a drag on the economy at large, benefits those making less money as each additional dollar they earn stretches further. Meanwhile, at the top of the economic spectrum, the wealthy dislike deflation since their stocks, bonds, commodities, homes and Rolexes all fall in value.

As calls for a stock market bottom and impending economic recovery gain momentum, so too will predictions of rampant inflation. Ironically, Bernanke and fellow central bankers around the world are counting on the hangover from the financial crisis to be bad enough to forestall a resurgence in demand and enable them to slowly, carefully withdraw their monetary steroids.

Whether that will be possible, or even politically acceptable is anybody’s guess.

By ANDREW JEFFERY

This post first appeared on Minyanville.

Washington just doesn’t get it: We don’t want more debt.

While congressmen berating bank CEOs for their unwillingness to lend out their bailout money makes for a nice media clip, it reflects the growing disconnect between our elected officials and any semblance of reality. Not that the relationship was ever particularly close – but lawmakers are floundering for good press while the nation’s economic future slips further and further from their tenuous grasp.

Bloomberg reports American consumers are wary of taking on more debt, as expectations about eroding economic conditions are forcing people, to *gasp* make responsible decisions about their personal finances.

Bloomberg cites Midsouth Bancorp (MSL) president C.R “Rusty” Cloutier, who says that, despite aggressive marketing, town hall meetings, and $20 million in TARP money, Midsouth’s customers just aren’t taking out new loans.

This is the rejection of debt Professor Depew speaks of when discussing the structural deflation we’re currently experiencing.

Credit is based on trust. And while conventionally we view this relationship as one in which the lender must trust the borrower to repay his debt — at least to an extent that’s commensurate with the interest rate — it does go both ways.

As lenders like Citigroup (C), Bank of America (BAC) and Wells Fargo (WFC) are increasingly being painted as corporate marauders out to rape and pillage the American public, would-be borrowers are wary of putting their financial future in the hands of these men of questionable repute. And with credit-card companies rushing to alter terms, it’s no surprise consumers are reluctant to extend themselves further.

Still, lawmakers are pushing through an economic stimulus package that depends, in part, on a willingness on the part of consumers to keep spending. Their delusion is only outmatched by their hubris – the belief that a bunch of self-interested politicos can coerce the average American into making ruinous financial decisions for the betterment of the country.

Floundering industries — notably automakers and homebuilders — are counting on government subsidies to encourage Americans to keep borrowing to buy their products. But what General Motors (GM), Ford (F), Centex (CTX) and KB Homes (KBH) don’t understand is this: We just don’t want what they’re peddling. And we certainly don’t want to borrow against it.

The transition from a debt-dependent, credit-drunk consumerist society won’t be immediate: It’s taken 18 months of financial panic for evidence of the shifting social mood to make its way into the mainstream.

But as the economic outlook continues to darken, the country becomes more disenfranchised, and the government grows ever-more addicted to sound bites and empty promises, reality will set in.

For the past 20 years, we’ve been blithely driving along an economic road that ends in a cliff. And that cliff is now in our rear-view mirror. We’re tumbling, groping for any branch that can save us from the fall. But each one of these new government programs, bailouts and rescues simply tries to set us gently back on the road from which we only just plummeted.

We already know where that path ends, and it ain’t pretty. What say we try another road?

By ANDREW JEFFERY

This post first appeared on Minyanville.

In recent months, headlines have been popping up noting that rents – finally – are beginning to follow home prices into the abyss.

Since the housing market began to crumble, would-be homeowners were forced to become renters, keeping demand for rental units relatively strong even as home prices fell. Now, however, as landlords convert condos into rentals, supply is beginning to move in tenants’ favor.

And while this is welcome news for millions of renters around the country, its impact on consumer price measurements could materially impact mounting deflation expectations.

The reason can be found in the nuances of how the US Bureau of Labor Statistics measures the Consumer Price Index, or CPI. The CPI is the most widely quoted gauge of inflation, it being the easiest to explain to the consuming public. Tally up a basket of commonly purchased items, see how their prices compared to last month, then last year and voila! consumer prices at your fingertips.

In realty, of course, it’s a bit more complicated: Just take a gander at this sophomoric equation from a recent CPI release:

Riiiiiiiiiight.

The most heavily weighted item in the CPI is something known as Owners’ Equivalent Rent, or OER, which accounts for almost 24% of the total index. OER is the government bean counters’ preferred method for measuring the cost of owner occupied housing, calculated by figuring out how much the median homeowner in the country would have to pay to rent his or her family’s dwelling.

Many observers, Minyanville’s Professor Mish Shedlock included, believe the CPI has been understating inflation for years by ignoring housing prices. Now, that rents are beginning to fall, however, inflation readings could become dire.

As Professor Kevin Depew noted last week, the December CPI registered the lowest inflation reading since 1980. And while most media outlets touted the effect of dramatically lower energy prices, OER is quietly reversing a long-standing trend and contributing to the decline.

Examining the data, available on the BLS’ website, OER has been steadily trending upwards for years. Even though the housing market peaked in late 2005, OER rose in 2006, 2007 and even 2008. The rate of change, however, is slowing. Notably, in December 2008, OER rose just 0.08% from November, breaking from the rest of the year’s trend.

And while 1 month does not a trend make, the data support stories from Manhattan to Los Angeles of landlords giving in to thrifty tenants shopping for the best deal. With mounting job losses and weak economic conditions persisting, this will be an important trend to watch in coming months. Property liquidations by big banks like Wells Fargo (WFC), Bank of America (BAC) and Citigroup (C) will add to housing supply, further pressuring rents.

CPI data matter, despite their myriad of potential problems, because of their effect on inflation expectations - or in this case, deflation expectations.

Federal Reserve officials, including Chairman Ben Bernanke, are wary of these expectations because they represent future consumer behavior. In a speech last summer, as energy prices rose to all-time highs, Bernanke said “Some indicators of longer-term inflation expectations have risen in recent months, which is a significant concern for the Federal Reserve.”

Fearful of higher prices in the future, consumers increase buying now, spurring demand and pushing prices up even further. The same is true the other way. If the public thinks prices will keep falling, they will delay purchases, waiting for a better deal down the road. This weakens aggregate demand, accelerating price declines.

So as rents, the largest component of the CPI, continue to fall, pricing measurements are likely to signal deflation, even as conventional wisdom calls for hyperinflation. And as a deflationist attitude gains currency, social mood continues to darken, and consumerism is shunned, lower prices will ultimately become a self-fulfilling prophecy.