We are swimming in a world of debt. Somewhere in the past decade debt lost the negative connotation of being a four letter word. In fact, the language of so many things has changed and the ultimate ramifications now have sweet language to soften the utter destructiveness of the underlying instrument. Junk bonds are now looked at as high yield bonds. I don’t like junk but I sure love the sound of high yield! The most profound change has been the idea that credit has now supplanted the concept of debt. When we talk about the worldwide credit crisis what we are really talking about is the global debt problem. When you think of credit the underlying meaning is positive. You received credit for completing the assignment. Hey Joe, I give you great credit for working so hard on the project. We credit you sir for the excellent job here! It would be extremely different if credit cards were title debt cards. Or what if we called them, “instant layaway” cards instead of calling them platinum premium member cards.

The psychology of this housing bubble is absolutely fascinating and disturbing. When you really boil it down, you have to wonder what people were thinking. There were folks who are reluctant to place a $100 bet in Vegas yet they were able to purchase an overpriced home and many are now sitting on $100,000 or more of negative equity. Many would like to think they weren’t speculating because it was real estate but there was no fundamental reason for home prices to reach the level that they did. The irony of this all is that we still keep hearing that this is a credit crisis. The fact is that Americans were unable to keep this economy going without massive amounts of debt. Debt that fueled spending and accounted for a large percentage of our GDP.

In reality it was a large Ponzi scheme and in the end like all Ponzi schemes they come crashing down on their own weight. Today in our lessons from the Great Depression series we are going to look at a book written in 1932 called a Bubble that Broke the World by Garet Garrett. It is a fascinating look at the social reasons why bubbles form and ultimately collapse. It is worth a full read but we’ll go through some important passages here and parallel them to our current situation. This lesson is part IX in our continuing series:

1. Personal Story by a Lawyer from a Previous Asset Bubble. Can we Learn from the Past and How will the Housing Decline Impact You?

2. Lessons From the Great Depression: A Letter from a former Banking President Discussing the Bubble.

3. Florida Housing 1920s Redux: History repeating in Florida and Lessons from the Roaring 20s.

4. The Menace of Mortgage Debts: Lessons from the Great Depression Series: Part IV: Where do we go After the Housing Crash?

5. Business Devours its Young: Lessons from the Great Depression: Part V: Destroying the Working Class.

6. Crash! The Housing Market Free Fall and Client #10 Contagion.

7. Winston Smith and the Bailouts in Oceania: Lessons from the Great Depression Part VII.

8. Sheep Back to the Slaughter: Lessons from the Great Depression Part VIII: All the Change and Bear Market Rallies.

A Bubble That Broke the World

“Mass delusions are not rare. They salt the human story. The hallucinatory types are well known; so also is the sudden variation called mania, generally localized, like the tulip mania in Holland many years ago or the common-stock mania of a recent time in Wall Street. But a delusion affecting the mentality of the entire world at one time was hitherto unknown. All our experience with it is original.

This is a delusion about credit. And whereas from the nature of credit it is to be expected that a certain line will divide the view between creditor and debtor, the irrational fact in this case is that for more than ten years debtors and creditors together have pursued the same deceptions. In many ways, as will appear, the folly of the lender has exceeded the extravagance of the borrower.”

I think it is important to note that in this current bubble it does take two to tango. Many borrowers bought in many cases as speculators even though they thought they were making a prudent decision. It can be said that this is no more logical than buying a luxury car and expecting more than what you paid for it 5 years later. Ultimately when you go to sell the market will dictate the price. But not everyone participated in this mania. Look at these sobering numbers and I’ve tried to word it to change your perspective on what is going on.

According to the U.S. Census Bureau, 31.8 percent of all U.S. owner-occupied homes have no mortgage. 32 percent of the country rents. The vast majority of those remaining with mortgages have been financially responsible. Why should it now be the responsibility of those who managed their finances prudently to bailout the few who speculated — including irresponsible lenders who made loans to people who had no chance of ever paying it back?

Let us continue with the article:

“The general shape of this universal delusion may be indicated by three of its familiar features.

First, the idea that the panacea for debt is credit. Debt in the present order of magnitude began with the World War. Without credit, the war could not have continued above four months; with benefit of credit it went more than four years. Victory followed the credit. The price was appalling debt. In Europe the war debt was both internal and external. The American war debt was internal only. This was the one country that borrowed nothing; not only did it borrow nothing, but parallel to its own war exertions it loaned to its European associates more than ten billions of dollars. This the European governments owed to the United States Treasury, besides what they owed to one another and to their own people. Europe’s attack upon her debt, both internal and external, was a resort to credit. She called upon this country for immense sums of private credit-sums which before the war had been unimaginable-saying that unless American credit provided her with the ways and means to begin moving her burden of debt she would be unable to move it at all.

Result: The burden of Europe’s private debt to this country now is greater than the burden of her war debt; and the war debt, with arrears of interest, is greater than it was the day the peace was signed. And it is not Europe alone. Debt was the economic terror of the world when the war ended. How to pay it was the colossal problem. Yet you will find hardly a nation, hardly any subdivision of a nation, state, city, town or region that has not multiplied its debt since the war. The aggregate of this increase is prodigious, and a very high proportion of it represents recourse to credit to avoid payment of debt.”

How the tables have turned. We are now a largely debtor nation. We owe money to China, Japan, Europe, and many other foreign players. We are no longer a lender but the world’s greatest borrower. We are now a debtor in this game. In fact, each day we have to borrow large sums of money to keep consuming at current levels. Our trade deficits show this unnerving fact clearer than anything else. Simply looking at cargo coming into our large ports in San Pedro and Long Beach we see that 3 cargo containers come in with produced goods and we send out 1 container; many times when we export items it is raw materials. This imbalance is harming us. And of course, if we are to learn from Europe during the early part of the 1900s is that war debt drags an economy down into the dumps.

“Second, a social and political doctrine, now widely accepted, beginning with the premise that people are entitled to certain betterments of life. If they cannot immediately afford them, that is, if out of their own resources these betterments cannot be provided, nevertheless people are entitled to them, and credit must provide them. And lest it should sound unreasonable, the conclusion is annexed that if the standard of living be raised by credit, as of course it may be for a while, then people will be better creditors, better customers, better to live with and able at last to pay their debts willingly.

Result: Probably one half of all government, national and civic, in the area of western civilization is either bankrupt or in acute distress from having over-borrowed according to this doctrine. It has ruined the credit of countries that had no war debts to begin with, countries that were enormously enriched by the war trade, and countries that were created new out of the war. Now as credit fails and the standards of living tend to fall from the planes on which credit for a while sustained them, there is political dismay. You will hear that government itself is in jeopardy. How shall government avert social chaos, how shall it survive, without benefit of credit? How shall people live as they have learned to live,

and as they are entitled to live, without benefit of credit? Shall they be told to go back? They will not go back. They will rise first. Thus rhetoric, indicating the emotional

position. It does not say that what people are threatening to rise against is the payment of debt for credit devoured. When they have been living on credit beyond their means the debt overtakes them. If they tax themselves to pay it, that means going back a little.

If they repudiate their debt, that is the end of their credit. In this dilemma the ideal solution, so recommended even to the creditor, is more credit, more debt.”

Was this written yesterday? Talk about repeating history again. This psychological notion that one is entitled to a better life regardless of your savings is not new. In fact, it seems that the mentality then is the same as today; if you can’t afford the artifacts of middle class life with your own saved money then it is probably the fault of lack of credit. Forget that it means you probably can’t afford it. And the solution offered at the time? More debt! I can hear Bernanke saying, “more credit for liquidity” and we are back at square one. Remember that Ben Bernanke is a student of the Great Depression so none of this is lost on him. Yet somehow he thinks the problem wasn’t too much debt but not enough “credit” quick enough. Well he just saw how impotent the Fed was with their rate cuts. He bought a bit of breathing room but we are still nowhere out of the woods. If we keep thinking that the only problem is the need for more debt we are going to spiral downward into a debtor’s hell. In many cases we may already be at this point.

“Third, the argument that prosperity is a product of credit, whereas from the beginning of economic thought it had been supposed that prosperity was from the increase

and exchange of wealth, and credit was its product. This inverted way of thinking was fundamental. It rationalized the delusion as a whole. Its most astonishing

imaginary success was in the field of international finance, where it became unorthodox to doubt that by use of credit in progressive magnitudes to inflate international trade the

problem of international debt was solved. All debtor nations were going to meet their foreign obligations from a favorable balance of trade. A nation’s favorable balance in foreign trade is from selling more than it buys. Was it possible for nations to sell to one another more than they bought from one another, so that every one should have a favorable trade balance? Certainly. But how? By selling on credit. By lending one another the credit to buy one another’s goods. All nations would not be able to lend equally, of course.

Each should lend according to its means. In that case this country would be the principal lender. And it was. As American credit was loaned to European nations in amounts rising to more than a billion a year, in the general name of expanding our foreign trade, the question was sometimes asked: “Where is the profit in trade for the sake of which you must lend your customers the money to buy your goods ?”

The answer was: “But unless we lend them the money to buy our goods they cannot buy them at all. Then what should we do with our surplus?” As it appeared that European nations were using enormous sums of American credit to increase the power of their industrial equipment parallel to our own, all with intent to produce a great surplus of competitive goods to be sold in foreign trade, another question was sometimes asked: “Are we not lending American credit to increase Europe’s exportable surplus of things similar to those of which we have ourselves an increasing surplus to sell? Is it not true that with American credit we are assisting our competitors to advance themselves against American goods in the markets of the world?”

Welcome to our new world. Guess where these foreign nations are putting their money? Does the idea of sovereign wealth funds ring a bell? Not only are they placing it back into their own countries building stronger internal economies but they are also buying the best businesses in the United States for cheap. This is all well in good if you look at it from a strictly economical stand point but what about countries like Russia or Venezuela that clearly do not have the same political ideologies as we do here. In fact, in some cases they are against the values of the country that is sending loads of money to them. Therein lies the problem. The solution would be simple in say the case of Venezuela in that we stop buying oil from them. But do you think the American people would go for that and see prices sky rocket? Of course not.  They jumped to arms about a $30 tax break for the summer so you really have got to be kidding when it comes to mass psychology. If we are unwilling to reshape our economy and see the interconnectedness of the problem debt brings on we are going to wake up and see that America is up for sale to the world, pennies on the dollar. In fact, this may already be unavoidable and you need only look at the dollar for this to resonate.

“The answer was: “Of course that is so. You must remember that these nations you speak of as competitors are to be regarded also as debtors. They owe us a great deal of money. Unless we lend them the credit to increase their power of surplus production for export they will never be able to pay us their debt.”

Lingering doubts, if any, concerning the place at which a creditor nation might expect to come out, were resolved by an eminent German mind with its racial gift to subdue by logic all the difficult implication of a grand delusion. That was Doctor Schacht, formerly head of the German Reichsbank. He was speaking in this country. For creditor nations, principally this one, he reserved the business of lending credit through an international

bank to the backward people of the world for the purpose of moving them to buy American radios and German dyes. By this argument for endless world prosperity as a

product of unlimited credit bestowed upon foreign trade, we loaned billions of American credit to our debtors, to our competitors, to our customers, with some beginning toward the backward people; we loaned credit to competitors who loaned it to their customers; we loaned credit to Germany who loaned credit to Russia for the purpose of enabling Russia to buy German things, including German chemicals. For several years there was ecstasy in the foreign trade. All the statistical curves representing world prosperity rose like serpents rampant.

Result: Much more debt. A world-wide collapse of foreign trade, by far the worst since the beginning of the modern epoch. Utter prostration of the statistical serpents. Credit representing many hundreds of millions of labor days locked up in idle industrial equipment both here and in Europe. It is idle because people cannot afford to buy its product at prices which will enable industry to pay interest on its debt. One country might forget its debt, set its equipment free, and flood the markets of the world with cheap goods, and by this offense kill off a lot of competition. But of course this thought occurs to all of them, and so all, with one impulse, raise very high tariff barriers against one another’s goods, to keep them out. These tariff barriers may be regarded as instinctive

reactions. They do probably portend a reorganization of foreign trade wherein the exchange of competitive goods will tend to fall as the exchange of goods unlike and noncompetitive tends to rise. Yet you will be almost persuaded that tariff barriers as such were the ruin of foreign trade, not credit inflation, not the absurdity

of attempting by credit to create a total of international exports greater than the sum of international imports, so that every country should have a favorable balance out of which to pay its debts, but only this stupid way of people all wanting to sell without buying.”

Our trade imbalance is a danger to our country’s long-term prosperity and has global implications beyond economics. It is certain if we continue on this path there will be a worldwide meltdown. There has been no desire from any political party to reign in the manic spending of the American people. Somehow they thought that for a decade of trading paper back to one another, flipping houses, and taking money out of homes to add upgrades was the idea of a healthy economy. What we ended up doing is simply rearranging the deck chairs on the Titanic while the world built up stronger production capacity and has siphoned off a competitive advantage in many areas. Spending more than you make impacts the world more than you think. It is time to get serious about this and make it a national priority to get our books in order. Former Federal Reserve Chairman Paul Volcker knew this and jacked up the Fed Funds Rate into the double-digits to reign in inflation. People did not like this but in the end it made us more productive in the 80s and 90s. Who will be the next person to reign in spending before this bubble breaks the world?

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Related Posts:

■The Menace of Mortgage Debts: Lessons from the Great Depression Series: Part IV: Where do we go After the Housing Crash?
■Crash! The Housing Market Free Fall and Client #10 Contagion. Lessons From the Great Depression: Part VI.
■Lessons From the Great Depression: A Letter from a former Banking President Discussing the Bubble.
■Winston Smith and the Bailouts in Oceania: Lessons from the Great Depression Part VII.
■Business Devours its Young: Lessons from the Great Depression: Part V: Destroying the Working Class.

Once again the ministry of truth tells us that inflation is tame so long as you don’t eat or drive which makes for a fascinating Wall Street spectacle. At this point, it has become an utter joke trying to rely on the BLS data for inflation numbers. Practically speaking they are making it up as they go along. For a better frame of reference and your own sanity, it is better to simply grab the pulse of your surroundings and arrive at your own conclusions. After all, sometimes the best way to see how the weather is going to be is to stick your head out your own front door. California has now reached another disturbing point where 1,000 foreclosed homes were auctioned off each day in April:

“California’s foreclosure crisis passed another ominous milestone in April, when more than 1,000 foreclosed homes were auctioned off every weekday at courthouses across the state, the auction tracking firm ForeclosureRadar reported today.

The April total of foreclosure sales at auction — 22,838 for the state — represents a jump of 44% over March totals and the highest level ever in California, ForeclosureRadar reports.”

Not exactly a report to be happy about. But what happens? The market rallies because inflation is contained in a delusional world where people don’t eat, don’t need fuel, and somehow only live in prime areas. Is it any wonder why people are so furious?

Today we’ll be looking at another short sale home in Southern California which only demonstrates how absurd this housing bubble was and still is. Today we salute you Compton with our Real Homes of Genius Award.

Third Time’s the Charm in Compton

Today’s home takes us to one of the 88 cities in Los Angeles County. This Compton home is 828 square feet and has 3 bedrooms and 1 bath. How you get 3 bedrooms in 828 square feet may be the real story here but let us move on and look at some more details here. The home was built in 1954 and has an exotic blend of carpet and linoleum floor coverings. Clearly the HGTV crew has been given pointers here. Before you start feeling bad if you are not from California, after all the median home price across the country is hovering around $190,000 to $200,000, let us take a look at the sales history of this home:

Sale History

12/22/2005: $310,000

09/30/2004: $235,000

11/05/2003: $110,000

How this home sold for $235,000 and then $310,000 only one year later is beyond me. What happened in 2005 that made this home jump up by $75,000? Maybe it was the lime trim because I heard there is a shortage on that color. Or even more, what happened in 2004 that pushed this home up in value by $124,000? This home doubled in price in 10 months! I guess the person that bought in 2004 and sold in 2005 was only trying to repeat the magic Southern California recipe. The person in 2005 was probably looking to sell for $500,000 but the magical chair game of housing ended rather abruptly. Now the Ponzi scheme is unraveling at the seams revealing the sand castle of finance built on our Pacific Coast beaches.

Now the interesting thing about this home is that it was listed less than a month ago. A new emerging trend is sellers and lenders are no longer throwing out an absurd pie in the sky price and do the housing cha-cha where they cut the price every week as if they were doing you a big favor. This house was put on the market for $175,000. We are now quickly approaching the price of 2003 in a reverse appreciation situation (otherwise known as depreciation although they probably have banned that word in California real estate for the past decade).

So is this a good deal? Well now that we have to rely on actual data and local area incomes, let us suppose a local family was to purchase this place. Let us run the numbers:

Local household average income: $46,000

Rental Price for a Similar Size home: $900 to $1,000

Principal and Interest: $944 (Fixed 30 year at 6% with $17,500 down)

Taxes and Insurance: Approximately $200 per month

After tax savings and given the current rental rates, this may not be a bad offer. But again, this is the issue with only looking at the data and not knowing the dynamics of Southern California. Even with the current price (which is almost half off from the 2005 price) is still a tough economic one strictly on fundamentals. What if the economy in California starts deteriorating further? Will rents not also follow suit and go lower in certain areas?  As an investor this makes no sense since you’ll be negative cash flowing.

Either way, when you look under the hood of some of the homes in Southern California, you realize that billions of dollars are going to be washed away once we mark to market these homes.

Today we salute you Compton with our Real Homes of Genius Award.

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