BAT MEAT by Bill Bonner, Daily Reckoning

Oct 17, 2003

"It's a cold, cold world we're livin' in."

- Percy Sledge

Pity the poor tungara frog. According to a New York Times article, the little amphibian, native to Nicaragua, lives "between a rock and a hard place." In order to mate, the male of the species makes noise - "A sliding whine followed by abrupt chucks, it sounds a bit like a little boy imitating a dive bomber. Female frogs hop to when they hear it. But fringe-lipped bats also tune in; the call is their beacon for finding frogs to gobble."

"There is a crack in everything God made," noticed Emerson. The more eager the little fellow is to mate, the more likely he is to be eaten by a bat.

What kind of world has God put together for us, dear reader? We ask the question not expecting an answer, but offering one: it is a strange world. But the weirdness of the world seems to have a pattern to it...a pattern of perversity, with cracks big enough to bury a split-foyer. When the tungara frog, for example, undertakes to whine his way to what he most wants - love and immortality - he gets what he least wants: almost immediate extinction.

Nationwide, houses have been going up in price at about the same rate as increases in the money supply...that is, about 8% per year. In certain areas, the increases have been far more resplendent, lighting up homeowners' hearts with increases of 20% to 30% in a single year. Taken altogether, since 1997 total housing values have risen from $8.8 trillion to around $14 trillion.

This 'free money' has been so alluring that homeowners hopped over to their local banks to get at them, and then whined their way deeper into debt. The financial industry, ever ready to separate a fool from his money, rushed to the scene with the offer of home equity lines of credit that could be used "for everyday expenses, like groceries and gas."

Thus does the world's mouth (as the U.S. has been called) gobble down its own houses one brick at a time. The homeowner, thinking he's getting something for nothing, believes he is merely taking some of his gains off the table - like selling a few shares of appreciated stock. Little does he seem to realize, he is selling the table itself...along with the kid's bathroom and the family room.

If, for example, his house went from a $100,000 price to a price of $200,000, he may feel he can 'take out' $100,000 of equity and still be living in a $100,000 house. But what he is actually doing is selling half of the house to the mortgage lender. Even if the higher prices stick, he still has to live somewhere....and now he has to 'rent' half his house from the mortgagor.

Another important difference between stocks and real estate is realized when the bubble finally bursts. The man who has sold off half his portfolio of stocks is actually a winner. When the other half crashes...he walks away from it.

But when a real estate bubble bursts, there are at least two losers - the borrower as well as the lender - and neither walks away easily. The borrower still has to pay his mortgage or he loses his house, and often must pay a mortgage that is higher than the value of the house. Many cannot or will not pay, which bounces the loss back onto the lender.

But such is the cold, cold world we live in that the appeal of rising asset values - whether real or paper - is almost irresistible. Bats or no bats, the lumpeninvestoriat can barely wait to begin croaking.

The average house in San Jose now sells for half a million dollars, a reader tells us (below). How many people in the San Jose area can afford a $500,000 house? We don't know. But we suspect that the number is less than the number of owners. Americans have become convinced that buying as much house as you can - even more than you can comfortably afford - is a shrewd financial move.

"Generations upon generations within the United States," writes Michael J. Burry, "believe that terrific home value appreciation is both rational and certain...The current population simply possesses very little direct experience with devastating national housing deflation. Treacherous cyclicality [price deflation] is at once absolutely certain to occur and yet implicitly, patently denied by nearly all today. For all time frames, complacency is the rule..."

People believe rising real estate prices are as close to a sure thing as anything can be. But when an investment is sure...it is surely a mistake.

"Clearly, a housing deflation would not be a pleasant experience," continues Mr. Burry. "In the more recent real estate bubbles of Britain, Japan and Hong Kong, the point was made that there was and is finite land available - which was true. Such logic formed the basis for the famous late-1980s argument that the island nation of Japan, smaller than California, was worth more than all the land in the entire U.S. But the corollary that prices could not fall due to land scarcity never proved true."

Another argument frequently made is that housing prices merely reflect the increase in 'replacement cost' of new homes. Since people need to live somewhere, it is reasonable to expect that houses will not fall below replacement costs.

And yet, every capital asset does sooner or later fall below replacement costs - including houses. We recently offered for sale one of our buildings in Baltimore - an architectural gem designed by Stanford White and built in the 1880s. Builders estimated that it would cost $5 million to replace the ornate mansion. But in downtown Baltimore today, we find no line of buyers willing to pay even $750,000.

And who, save perhaps John Templeton, is old enough to recall what happened to housing in the 1930s? Mr. Bury reminds us:

"In 1933, during the fourth year of the Great Depression, the U.S. found itself in the midst of a housing crisis that put housing starts at 10% of the level of 1925. Roughly half of all mortgage debt was in default. During the 1930s, housing prices collapsed nationwide by roughly 80%."

Earlier this year, a Harris Poll revealed that 2/3rds of investors were unaware that rising interest rates would have a negative impact on bond prices. Homeowners seem unaware that interest rates can rise at all...or that house prices can fall. And they are as unprepared for it as the tungara frog for the fringe-mouthed bat.

-Bill Bonner

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