THE MELTDOWN OF PLASTIC MONEY

     In this report, I present a hypothetical scenario. You will have to decide how hypothetical it is.  Most people have a built-in incentive to conclude: "It's completely hypothetical."  I am writing this for those readers who are willing to conclude: "It's conceivable, however grim."

     It's the problem of dead digits.  The world's money supply is digital.  If the digital system goes down, so with the world's economy and the nation.  

       

     Could it go down?  Let me sketch the ways.

     In matters strategic, I rely on three little-known analysts: William Lind, Joe Douglass, and Sam Cohen.  I have known the latter two for over two decades.  Cohen worked on the Manhattan Project, which developed the atom bomb.  Later in his career, he invented the neutron bomb, which kills enemy combatants, but does not destroy
property.

     One area that has concerned all three men is the possibility of a terrorist attack on one or more American cities.  The attack could use a biological weapon or a small nuclear weapon. 


     Cohen is adamant: It would take only one nuclear explosion to bring the country to a stop -- a breakdown, in other words -- banking, exchange, the division of labor.  I have argued privately with him that it would take two: the second one announced on the Web after the first one, and promised within a week.  It then is detonated.  Then there is a second announcement of a third detonation.  Cohen thinks I am much too optimistic.  It will only take one, he insists.

     Douglass is a specialist in chemical and biological weaponry, the author of a classic book, "America the Vulnerable" (1987), on such weapons.  Lind is a specialist in 4th-generation warfare, what Iraq is all about, start here:


     Now comes Arnaud de Borchgrave, former editor of the "Washington Times," and a former journalist specializing in regional conflicts.  His article, "Al Qaeda's nuclear option," appeared in the "Washington Times" (March 24).  He takes a view very different from the Bush Administration's. The Administration insists that its strategy will produce a victory in Iraq.  De Borchgrave takes the Administration at its word.  But would such a victory make America safer?

     If Al Qaeda cannot win on the ground in Iraq, then it must look to its operatives inside the United States.  This raises the issue of nuclear weapons.

     De Borchgrave cites a report by former Senator Sam Nunn, "The Race Between Cooperation and Catastrophe."  Nunn says that the U.S. government has already spent $12 billion in working with the Russians to put a lid on the old nuclear weapons arsenals.  The G-8 countries have pledged $20 billion.  As with all government spending
projects, there is not much to show for the money.

     There are 43 countries with more than 100
     research reactors or related facilities that
     store enough highly enriched uranium nuclear
     materials to make several bombs. Only 20 percent
     of these sites are properly secured, says Mr.
     Nunn, and less than a handful meet U.S. Energy
     Department security standards. . . .

     Rather than try to steal or buy one of thousands
     of Russian tactical nukes, or nerve gas artillery
     shells, a WMD terrorist is far more likely to
     knock off the night watchman, lower the
     chain-link fence somewhere in Switzerland or
     Italy and drive off with sufficient materials for
     a nuclear device. Actually making a nuclear bomb
     after that is the easy part; the recipe is on the
     Internet.

     Mr. Nunn, chairman of the board of trustees at
     the Center for Strategic and International
     Studies, says we appear to have forgotten the
     "devastating, world-changing impact of a nuclear
     [terrorist] attack. "If a 10-kiloton nuclear
     device goes off in Midtown Manhattan on a typical
     work day, it could kill more than half a million
     people," he explains. Ten kiloton is a plausible
     yield "for a crude terrorist bomb," according to
     Mr. Nunn.

     This is the scenario that Sam Cohen says will create pandemonium on a scale dwarfing anything in U.S. history. Commerce will shut down.  You can imagine the run on the banks that this will produce.  Of course, ATMs will be empty within hours.  There is not enough currency to keep the economy running.  No truck would run.  No gasoline
deliveries would take place.  It would be total breakdown. Martial law would replace the free market, with catastrophic results.  How many businesses would survive?

     The chain of payments would break.  Debts would not be paid.  Credit would not be extended.

     The division of labor today rests on domestic peace, universal credit (plastic money), and confidence about the future.  All three would end overnight after the second nuclear explosion, and maybe the first, if Cohen is correct.

     We don't think about this because it's unthinkable. But Senatir Nunn has thought about it.

     Another Nunn scenario has a terrorist group with
     insider help acquiring a radiological source from
     an industrial or medical facility; say cesium-137
     in the form of powdered cesium chloride.
     Conventional explosives are used to incorporate
     cesium into a "dirty bomb," then detonated in New
     York's financial district. A 60-square block area
     has to be evacuated. Millions flee the city in
     panic. Only two dozen are killed but billions of
     dollars of real estate is declared uninhabitable.
     Cleanup will take years -- and many more
     billions.

     De Borchgrave then comments on the geopolitical
implications of this strategy.

     What interests bin Laden and Zawahri beyond
     casualty lists is collateral damage to civil
     liberties, privacy and the world economy.
     America, as they see it, would be knocked off its
     pinnacle. This would be the shot heard around the
     world and hundreds of millions of either
     frightened or jubilant Muslims would flock to the
     Muslim world's black Jolly Roger of white skull
     and crossbones.

     It is clear that privacy would disappear for all financial transactions.  Cash could not replace digital money without a complete contraction of the economy.  Who has cash?  How many people have $20 bills or rolls of clad quarters?

     Some people think gold and solver coins will save them.  How?  Who recognizes them today?  Solver coins will trade at face value.  Gold coins won't trade at all in the
early stages.

     Gold and silver coins are for the rebuilding phase, not for the breakdown stage.  But coin buyers rarely think about this.  In a collapsing division of labor, the Amish may survive without too much pain, at least until the armed hordes start looking for food.  But coins will not buy much at all until the worst of the catastrophe has ended.

     This assumes that you will be able to go down to your local bank and get your gold coins out of your safety deposit box.  But will you?

     How much of a threat is the loose control system over nuclear weapons?

     In a routine exchange of information, Russia's
     chief intelligence officer in Washington notified
     his CIA liaison officer that al Qaeda operatives
     had been scouting nuclear storage sites in
     Russia. It would be a miracle if nothing had been
     stolen from Russia's long ill-guarded nuclear
     weapons storage depots during the collapse of the
     Soviet Union when anything and everything was for
     sale. We also know from sketches found in al
     Qaeda's safe houses in Kabul and Kandahar that
     bin Laden was interested in nuclear bomb design.
     Two Pakistani nuclear scientists from A.Q. Khan's
     stable were in Kandahar when this reporter was
     there three months before September 11, 2001.

     De Borchgrave ends his article with this: "'On a scale
of 1 to 10," says Mr. Nunn, "I would give us about a 3,
with the last summit between Presidents Bush and Putin
moving us closer to a 4.' " 



     Because of the high personal cost of adjusting their lives to the post-attack scenario, people do not do this or even think about doing it.  In most cases, this lifestyle change would involve a reduction of income.  A person who adopts a lower division of labor lifestyle usually suffers a fall in income.  Rural living is possible if you make your living in the Internet.  Others do not have this luxury.  To make this change in preparation for a complete reduction of income as a result of the collapse of the
division of labor is to take Nunn's scenario seriously.

     To think that the war in Iraq will keep terrorists pinned down forever is naive.  The war is providing on-the-job training for terrorists.  A victory in Iraq is no guarantee of immunity at home from a series of domestic attacks with low-cost weapons of mass destruction.

     There is another factor to consider.  Think of the revenge factor.  What if a government were to provide such a weapon to a terrorist organization, knowing that Al Qaeda will get blamed?  What is that government's risk or retaliation?  Minimal.

     On Monday, March 28, NBC Evening News reported on a group of U.S. undercover government agents who smuggled in enough fissionable materials to build two "dirty nukes."  They were trying to discover if it could be dome.  It can.


JOE DOUGLASS LOGS IN

     Dr. Joseph Douglass has specialized in matters of
government intelligence and counter-intelligence for over
three decades.  I read his book, "America the Vulnerable,"
when it first came out.  I was persuaded of its accuracy. 

     His assessment of the 9-11 Commission report is worth
considering.

     The good news is at least this will provide the
     news media and their hundreds of hired talking
     heads something to use to fill time other than
     the two political conventions.

     This has proven to be the case.  More than this, says
Douglass, is unlikely.  Here's why.

     First, as usual, Washington investigations are
     mainly held to create the impression that our
     elected representatives and government officials
     are hard at work protecting the citizenry. In
     reality, they invariably seem to spend monstrous
     amounts of money, work hardest making certain no
     sacred cows are gored, including themselves, and
     garnish millions of dollars worth of free
     publicity and newspaper headlines. Rarely if ever
     is anyone held accountable. Rather, the "system"
     is blamed, reorganizations are proposed as a fix
     as though merely shuffling the deck of cards will
     change the luck of the draw, and the size of
     government continues to grow.

     Douglass rounds up his usual prime suspects: chemical
and biological weapons, which he thinks are state-
sponsored; the drug trade, which he thinks is partially
state-sponsored; and nuclear weapons, which are obviously
state-sponsored.  There is an on-going link, he argues,
between the state manufacture of terrorist weapons (the
production system) and the criminal underworld (the
distribution system).  Douglass then asks two rhetorical
questions:

     Does not the public have a vested interest in
     knowing what the U.S. intelligence assessment of
     this reported threat really is? Is the Senate
     Committee convinced that U.S. intelligence now is
     doing all that they could reasonably be expected
     to do?



     Here is the problem: having a vested interest and admitting that one has a vested interest are two different things.  If a person's vested interest is such that he would be wise to make major changes in his lifestyle and spending habits, let alone his geography, the average person decides that the price of his vested interest is
just too high.  This is why men die without writing wills.

     As for the Senate Intelligence Committee, this is an oxymoron: Senate, intelligence, and committee.


ADVANCE WARNING?

     If any national political leader believed that a nuclear bomb had been smuggled into his country, would he warn his people about this?  Of course not.  The warning would create such horrendous economic effects -- call this the ATM effect -- that it would paralyze the country.

     The movie "Deep Impact," about a comet heading for earth, is like all of the other movies about the Great Collision, beginning no later than George Pal's "When Worlds Collide."  Everything runs smoothly until the object actually hits the ocean, creating a huge wave.  When the wave comes, everyone is still living on the Eastern
seaboard -- or, in the case of the Pournelle/Niven novel, "Lucifer's Hammer," the West Coast.  But it would never happen this way.  The entire economy would collapse long before the comet/meteor/planet struck.  The division of labor would disappear, along with just about everyone living in an urban society.  Who would go to work?  Who would not clean out his bank account?  What bank could survive?

     Dr. Douglass makes a crucial point: it is possible,
even likely, that the same underworld network that is
bringing in illegal drugs is capable of bringing in
biological weapons.

     The anthrax letter attack seems to me to display
     the systemic problems within our government even
     more than 9-11. It is important to understand how
     serious the CBW (chemical and biological warfare)
     threat is -- not the CBW threat as described in
     government announcements and the media, but the
     threat as represented in data that often does not
     get into intelligence estimates. Information on
     the CBW threat that goes well beyond nerve agents
     and anthrax and plague has been both suppressed
     and/or deliberately not collected since 1969. The
     history of this is extensive. The conclusion that
     comes out of this material is that it would be
     child's play, notwithstanding the Department of
     Homeland Defense and remedy of the various
     "structural problems," to mount a massive
     terrorist attack on the U.S. homeland using
     advanced CBW agents and without the government
     seeing any warning or afterwards being able to
     link the attack with any perpetrator. Recall from
     the above that terrorists or saboteurs and
     sufficient CBW agents can be brought into our
     country using drug trafficking networks and
     mechanisms.


     The war on terrorism is being brought to us by the
same high-efficiency organization that has waged the war on
drugs for five decades.  We should expect similar results.

     We now face a determined and growing number of enemies
who are willing to die for their cause, who seek vengeance,
and who may be supplied with weapons of mass destruction by
unnamed states whose leaders have scores to settle with the
United States.  This country is no longer loved, let alone
well-loved.

     Americans don't seriously believe the war in Iraq can
come home.  They don't think that Osama & Co. can get to
us.  They really don't believe in weapons of mass
destruction in enemy hands.  They do not believe that the
mass production of such weapons by the Soviet Union
(R.I.P.) could lead to a black market transfer of a nuclear
bomb to a Muslim terrorist or a disgruntled Communist
posing as a Muslim terrorist. 

     There comes a point where an aggressive foreign policy
starts producing negative results.  That point came for
this country no later than 1898. 

     But there were no suitcase nukes in 1898.


CONCLUSION

     We do not hear anything specific about portable
weapons of mass destruction that already exist or are cheap
to create, such as anthrax.  We assume that because such
weapons have not been used yet, they will not be used,
ever.

     We hear nothing about the steps being taken by
government agencies to reduce this kind of threat.  There
are two possible reasons for the silence: (1) The
authorities will not tip their hand on the nature of our
national defenses; (2) The authorities really don't have a
handle on the extent of the threat, and they don't want
voters to know this.  Either way, the real threats are not
discussed publicly.  The public worries about subway
bombings, but not very much.

     I worry about two words: "card rejected."  This is the
overhanging legacy of government-licensed fractional
reserve banking.  Call it digital fallout.  It can kill
you.
 

The Fed subtly and quietly removed the word "measured" from its official statement about future rate increases, opening the door to raising them in bigger chunks than just a quarter-point. Reason: Gold is screaming "inflation." So is silver, copper, steel, aluminum, oil and virtually every natural resource on the planet. Even the Fed's own inflation indicators are busting out of the Fed's "comfort zone." We've been warning about this for a long time. Now it's getting closer. And it's about time. But it could be too little, too late. As Sean explains below, commodity prices — especially oil — are veering out of control. OPEC Losing Control of Oil Prices? You Bet! by Sean Brodrick In a farewell comment to America, what if Alan Greenspan came on TV and said something like ... “I have no control over interest rates. Market forces will determine them. Same goes for the dollar. Good luck!” Would investors welcome it as a refreshing breath of truth? Or would it send the market reeling? Probably both! So my question is: When Saudi Arabia, the “central bank of oil,” makes a very similar kind of statement about oil prices, why is it ignored? Granted there’s a lot going on in the Middle East these days: Iran is pursuing its nuclear option ... Iraq is going from bad to worse ... terrorists were just elected as the new government of Palestine. So maybe the market just missed the statement by Saudi Arabia’s oil minister, Ali Naimi: “I have no control over [oil] prices.” This may be no surprise to readers. But to a world that counts on Saudi Arabia to use its spare capacity to moderate the price of oil when it gets too high ... it should come as a shock. Saudi Arabia produces about 9.6 million barrels per day (bpd) of crude oil. If it pumps flat-out, it might be able to tap another million. With all the oil from other sources, that adds up to 84 million bpd worldwide. So why the alarm? Because global demand ran about 83.3 million bpd in 2005 — up 1.3% from the previous year — and should rise more than 1.8 million barrels per day in 2006. In other words, even if the Saudis pump the extra million, it’s still not enough. Still, some people are pooh-poohing the impending shortages. Their view is that you should listen to the IEA, which expects OPEC production capacity to rise by a million bpd this year, while non-OPEC supplies rise by 1.3 million. Are they right? Too soon to say for sure. But the clincher for me is that the IEA’s estimates of non-OPEC production have a history of being extremely optimistic. In 2005, the IEA expected non-OPEC production to grow. Instead it stagnated.   And in places like the North Sea, production is falling off a cliff.   Even OPEC’s output is lagging. Kuwait’s largest oilfield — the Burgan — hit peak production last year. So it’s mostly downhill from here, and things may be worse than most of the world realizes: According to Petroleum Intelligence Weekly ... Kuwait’s oil reserves may be only 48 billion barrels ... or less than half the officially-estimated 99 billion barrels. With Kuwait accounting for a whopping 11.7% of all global reserves, that’s an explosive revelation. Plus ... Iran’s oil production is in trouble, too. All nine of Iran’s major fields, which produce 90% of its oil, are past their peak. At the same time, domestic oil consumption is growing. As a result, Iran’s oil exports — which were 4 million bpd during the reign of the Shah — have slumped to just 2.5 million bpd today. Iran can’t even keep up with its own OPEC production quota! Another former OPEC exporter, Indonesia, has seen its production fall so sharply that it’s now an oil importer. And other OPEC members are seeing their major oil fields, discovered 40 or 50 years ago, come under increasing strain to keep up. With oil production decaying or crumbling nearly everywhere, Saudi oil becomes more pivotal than ever. Well, America can always count on its good friends, the Saudis, right? In a word: NO. Saudi Arabia Is Rushing to Make New Deals with China And India — a Bad Omen for America’s Energy Future! Saudi Arabia’s oil planners see the handwriting on the wall. They see China and India racing around the globe, locking up future production, leaving Uncle Sam in the dust as they do it. Indeed, that statement by Saudi Arabia’s oil minister Ali Naimi — that he couldn’t control oil prices — was made in New Delhi, while he was visiting India to forge a new energy deal, the “Delhi Declaration.” The deal, signed by Saudi King Abdullah and Indian Prime Minister Manmohan Singh, tightened the two countries’ energy relationship to the point that Saudi Arabia can supply a huge chunk of India’s needs — not just now ... but into the future as well. Saudi Arabia already supplies a fourth of India’s oil. And India, which imports 70% of its oil, needs more and more all the time. Its citizens are buying cars at an even faster rate than the Chinese. Whereas growth in Chinese car sales is expected to increase more than 10% this year, sales of passenger vehicles in India rose more than 18%, year-on-year, through July. India’s oil consumption has doubled over the past 20 years to 2.5 million bpd, and is accelerating. It’s expected to grow 5% this year alone! The Saudi King told reporters this was the first declaration he signed with any country. Well, that may be true, but the first international stop he made as the new King wasn’t in India — it was in China. At a formal welcome, China’s president, Hu Jintao, proudly told King Abdullah: “Your Excellency is the first Saudi king to visit China. This is also your Excellency’s first visit to another country since coming to the throne. And China is the first stop of your Excellency’s tour. These three ‘firsts’ demonstrate the importance you attach to Sino-Saudi relations.” True. It’s not happenstance that the first stops for the new Saudi king were China and India. King Abdullah’s dislike for America is well known, and his actions speak louder than words: He’s putting Uncle Sam on notice. In China, he finds an eager customer. A decade ago, China’s domestic oil production was able to meet its consumption. Now, as China’s 1.3 billion people make the transition from bicycles to scooters to automobiles, they import over 3 million barrels per day. And according to the U.S. Energy Information Agency, China’s oil imports are projected to more than triple — to 11 million bpd — in the next 20 years. But we won’t have to wait that long to see China’s demand for crude oil surge. They’re already gearing up to refine more crude for gasoline and other fuels. And this year alone, China’s primary refining capacity will increase by 650,000 bpd, according to Reuters. Guess who’s helping China build some of those refineries? Saudi Arabia! Along with building new refineries at home, Saudi Aramco has teamed up with ExxonMobil and the Chinese state-controlled oil group Sinopec in a $3.6-billion refinery project in China’s southern Fujian province. The refinery is being built specifically to process Saudi Arabian crude. And Saudi Aramco is also in talks with Sinopec for a minority share in its 200,000-bpd refinery project in China’s eastern Shandong province. Bottom line: Saudi Arabia, the world’s only oil producer with any extra capacity, is busy finding and developing new customers in two countries with the fastest growing energy demand in the world. Some people are trying to persuade you that you shouldn’t make too much of the Saudi overtures to China and India. But I take my clue from the old Arabian proverb: Once the camel’s nose is in the tent, the rest is sure to follow. Meanwhile, our own oil demand — and dependence on foreign imports — is also growing by leaps and bounds. Take a look at the chart above to view the IEA forecasts of North American oil demand through 2006. You could argue that America needs to go on an oil diet (that is, start conserving energy). Indeed, the United States represents just 5% of the world’s population but already consumes a fourth of the world’s oil. Meanwhile, even as our demand has been rising, our domestic production has been falling — steadily for over 30 years! Some key facts: 90% of all our transportation is powered by oil. 95% of everything you buy requires oil in its manufacture or its long-distance transport. The U.S. has only 2% of the world’s oil reserves. The average fuel efficiency of U.S. vehicles is falling. And our electricity use is rising. In other words, we’re becoming more dependent on oil, not less. Like it or not, we’re going to have to get more and more of our oil from the countries that still have significant reserves … like those in the Persian Gulf. The Middle East: A Game of Matches in a Gasoline Pit That brings us back to the Middle East, which is turning its face from the U.S. to China and India, even as age-old grievances spiral out of control. Any hopes we might have for less expensive energy seem mired in a desert morass of rising fundamentalism, imperial hubris gone bad, and wannabe nuclear tyrants. The camel’s nose is in the tent. We can only hope that our leaders are up to the challenge of pushing the camel back out ... or finding a better tent. As one oil minister said recently, at the rate that global oil demand is rising, the world needs to find a new Saudi Arabia every few years. Where Is America Going to Get Its Next New Energy Supplies? Whenever I have this conversation — and I have it a lot — someone always mentions Canada’s oil sands. While there may be a lot of oil locked in those sands, don’t kid yourself — it’s no pot of black gold at the end of the rainbow. This is a topic that I’ll save for next week. For now, I’ll just say that the oil in Canada’s tar sands is expensive to produce and has other problems as well. Don’t count on South America, either. Venezuela, for example, is busy making new deals with China. So are Ecuador and Bolivia. Africa? Again, we’re being beaten to the punch by China and India. Maybe it’s just coincidence that every step in China’s quest for new oil and gas resources is another kick at America’s underbelly of energy dependence. My view: China is already thinking about the end game in the new global chess match for energy, while Uncle Sam has yet to make its opening moves. If you want to wager that our leaders in Washington can guide us to a future of energy independence, that’s up to you. It’s your money. Good luck with it! But if I were you, I’d be moving quickly to protect your portfolio — and potentially reap a barrel of profits as oil and gas gush higher. For starters, here are two mutual funds I like a lot … #1. Fidelity Select Natural Gas Portfolio (FSNGX). This fund invests in stocks that produce and distribute natural gas, as well as companies that provide equipment and services to natural gas drillers, including Burlington Resources, Valero Energy, Chesapeake, Halliburton and more. FSNGX racked up a 45.7% return in 2005, and 38% average returns over the past three years. And it did it with a low expense ratio of 0.96% (compared to the group average of 1.49%). #2: The Enerplus Resources Fund (ERF) This is a Canadian royalty trust with nearly 3,000 natural gas wells and 2,000 oil wells. What’s more, Enerplus pays a hefty dividend — between 8% and 9%. And this fund is heading higher in a hurry.

 

 

9/29/05

 

The housing market bust we’ve been warning you about has now begun.

You cannot yet see home values sinking.

Nor will you hear any bells ringing when they do.

But we now have a rapidly growing body of evidence that the market has reached a peak and is in the early stages of a sharp decline.

First, the inventories of unsold homes has suddenly surged — not just for existing homes but also for new homes.

Second, the sales of new homes have just plunged.

Third, higher interest rates are now beginning to choke off demand, with Fed Chairman Greenspan warning stridently about the risks of still higher rates.

Fourth, in the stock market, the shares of home building companies have begun to suffer sharp declines, signaling the likelihood of equally sharp declines in home values.

Today, we will give you the hard facts, as we see them. Then, we will make some tough recommendations, based on where we think real estate is headed.

Naturally, where you take it from there is entirely up to you. But no matter what you decide today, please keep an open mind. If you begin to personally witness the first stages of a real estate bust in your area, don’t close your eyes.

Remember our facts and the warnings you’re reading here today. Then make a rational, objective judgment.

Here Are the
Hard Facts ...

When there’s a shortage of homes on the market, home values rise. When there’s an over-abundance, home values fall.

There’s simply no escape from this simple reality. And anyone who thinks the law of supply and demand can somehow be repealed for the housing market is going to wake up to the shock of their lives.

Right now, the supply of unsold new homes has just ballooned to 479,000 units, the highest in history. Even assuming no further decline in the pace of sales, that’s 4.7 months of supplies, the worst reading since June 2000!

If this were strictly true about new homes, it might be questioned.

But existing home supplies also surged — by almost 100,000 units between July and August. At 2.86 million units, they are now the highest in over 19 years — since May 1986.

If home sales were rising apace, it might also be questioned.

But home sales have just plunged 9.9% to a seasonally-adjusted annual pace of 1.24 million units in August, down from 1.37 million in July.

If there were no obvious reason for the decline in home sales, you might argue that it’s a fluke.

But alas, Americans have the most powerful reasons in history for recoiling from home buying:

	The affordability of the average American home is now the worst since 1991, even with today’s still-low interest rates.
	There has been no lack of warnings or publicity about the danger of a bust.
	Even Fed Chairman Alan Greenspan is now warning homebuyers to proceed with great caution ...

Greenspan Issues His Most
Strident Warning So Far

With his long reign coming to an end, it appears the last thing Alan Greenspan wants is to go down in history as the Fed Chairman who presided over America’s greatest real estate boom ... but never warned us of America’s greatest real estate bust.

We believe that’s why, in recent weeks, he has stepped up to podium after podium, each time raising the pitch of his warnings by several octaves.

Consider for example, his comments this week:

Second home purchases “arguably are at
historically unprecedented levels.” — Alan Greenspan

Yes, the National Association of Realtors recently said vacation home buyers and other real estate investors accounted for more than a THIRD of all home purchases. These aren’t primary homes; they’re pure investments, like high-flying stocks. And when Americans get nervous about their investments, they could start dumping their properties en masse.

“Speculative activity may have had a greater
role in generating the recent price increases
than it customarily has had in the past.” — Alan Greenspan

Of course. It’s a bubble. We knew that. Now, however, with officials like Alan Greenspan confirming the dangers, the press will be more definitive in its warnings ... speculators will start selling ... and demand for homes will plummet.

“The apparent froth in housing markets may have
spilled over into mortgage markets.” — Alan Greenspan

This is a major change in Mr. Greenspan’s views. Last year, for example, he said: “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.”

We welcome the Chairman’s change. But we fear that for many home owners buried in debt, it may be too late.

“The vast majority of homeowners have a sizable
equity cushion with which to absorb a potential
decline in house prices.” — Alan Greenspan

This view will also change. Sooner or later, Mr. Greenspan will recognize that the averages are misleading, reflecting the Americans who bought their homes years ago.

The reality: The vast majority of recent home buyers and speculators have no such cushion.

Moreover, just as in a stock market crash, you don’t need a majority to get the ball rolling. All it takes is a small minority — far less than 10% — of investors to begin selling ... and you could see a cascade of home price declines.

Plunge in Housing Stocks
Signals Risk of Decline
in Most Home Values

You can’t call your broker or check on the Web to find a reliable quote on the average American home. And even if you could, it would not be up to date.

So by the time you get firm confirmation that home values have begun to fall in your area, they could already be down substantially. And if the selling frenzy is anywhere near as intense as the earlier buying frenzy, the decline could be precipitous.

But you can get a glimpse of what might be ahead by checking the price of housing stocks; and right now, they are falling.

Toll Brothers, for example, has come down from its recent closing high of $58.25 on July 20 to $41.51 on September 20. It rallied a bit in recent days, but yesterday turned back down again, closing at $43.35 late last night.

We see the same pattern with Lennar Corporation — down from its high of $68.27 to its recent low of $53.49.

Like the housing market itself, these leading home building companies had a major run this year, and it’s too soon to say their rise has been reversed. But it’s also too soon to say their bust has already begun.

What To Do Right Now ...

Nearly everyone’s situation is unique. But there are some general principles that we feel should apply almost across the board:

Step #1. If you’re looking for a place to live, rent. Do not buy at this time! Last Sunday’s New York Times explains why:

“After five years in which rents have barely budged while house prices in New York, Washington, Los Angeles and elsewhere have doubled, renting has become a surprisingly smart option for many people who never would have considered it before.

“Owning a home often ties up hundreds of thousands of dollars that might be invested more safely and more lucratively elsewhere over the next decade. And while real estate brokers may hate to acknowledge it, home ownership involves its own versions of throwing money away, like property taxes and the costs of borrowing.

“Add it all up — which The New York Times did, in an analysis of the major costs and benefits of owning and renting, including tax breaks — and owning a home today is more expensive than renting in much of the Northeast, Florida and California ...

“In the Bay Area of California, a typical family that buys a $1 million house — which is average in some towns — will spend about $5,000 a month to live there, according to the Times analysis. The family could rent a similar house for about $2,500, real estate records show, and could pay part of that bill with the interest earned by the money that was not used for a down payment.

“In Manhattan, 1,000-square-foot, two-bedroom apartments on the Upper East Side now rent for about $3,700 a month. Buying a similar apartment costs around $1.1 million, which can translate into monthly payments of $6,000 or so.

“The single biggest misconception about home ownership, some brokers and economists say, might revolve around tax deductions. Many people seem to believe that buying a home can actually save them money because the interest on their mortgage is tax deductible. But all that deduction does is reduce the cost of borrowing the money — a cost that would not exist if the family were not buying the home.”

We agree. In most regions of the country — especially the housing boom areas — the advantages of renting today far outweigh the disadvantages.

Step #2. If you own strictly your own residence, the choice of whether to buy, hold, or sell is primarily a personal, family decision — not an investment decision.

Investment property, however, is another matter entirely. If you are making a decision about investment properties, carefully consider the risk factors we’ve just told you about and recognize that, in a real estate bust, their value could decline sharply.

Step #3. If you decide to sell now, you won’t have to sell in haste or at a steep discount. You can afford to wait for a fair price, or better.

If you wait, however, don’t expect the same result. You may find yourself in a market that’s continually sinking faster than you drop your prices.

So once you’ve made the decision, go ahead and list the property without delay. Remember that holding onto real estate isn’t like holding a stock. You also have to factor in the cost of:

	Carrying your mortgage. Right now, the average mortgage outstanding is between 5 or 6 percent. But if you bought a long time ago and have not refinanced, your cost may be in excess of 8 percent. If you have an ARM, check the contract carefully to see when and how the rate will be adjusted. If the fixed-rate period is expiring soon, rising rates could add significantly to your carrying cost.
	Property taxes. Some localities cap tax increases to a couple of percentage points a year. But others don’t, and because home values have skyrocketed, so have property taxes.
	Condo or neighborhood association fees, management fees, repairs, and more. Don’t underestimate their cost — let alone how much they can go up.

Sure, rental income can help offset these costs to a degree. But as The New York Times has pointed out, renters are at a great advantage right now. Landlords are not.

Step #4. Sell for cash only!

In this market, there should be no need to accept promissory notes or other paper. Then, place the proceeds of the sale in a portfolio of investments that help protect your principal and protect you against threats to the economy.

Some Major, Burning
Questions from Readers

Still not convinced? Then, consider these questions, along with our answers.

Question 1. If I sell my home now, where will I live?

Consider this scenario: You sell now and pocket a large sum, possibly tax-free. You cut your monthly living expenses by renting a comparable home for less money.

A few years from now, when real estate prices are far lower, you repurchase a similar or even better property at a lower price, if you wish. Or you can just retain the flexibility of renting for a few more years. With home values down, you shouldn’t have to be concerned about rising rents for quite some time.

Question 2: What about the capital gains tax hit I take by selling?

If you’re selling your primary home and you’ve lived there for at least two of the past five years, you can generally avoid paying taxes on up to $500,000 in gains (for married couples).

Yes, you may have to pay taxes when unloading a second home or other investment property. But, as with any such tax, you or your heirs will have to pay it someday, no matter what. So don’t let the tail wag the dog. Base your decision on your financial needs and where you think the market is headed — not on any tax consequences.

Question 3: But my real estate broker tells me that banking my equity right now is crazy. Why should I be among the few who are cashing in?

You’re not. Millions of homeowners have also cashed in. But they’ve done it in a different, riskier way: They’ve borrowed against their equity via second mortgages and home equity lines of credit.

Many have cashed out on their equity from one property and using the proceeds to buy another ... and another ... and still another.

Others have embarked on even riskier ventures with the borrowed funds — like investing in volatile stocks. Indeed, the National Association of Securities Dealers is apparently so worried about this trend that it has issued special alerts about the dangers involved in using liquefied home equity to invest in stocks.

Heed their warning: If you’re cashing out, do so prudently. Pay off your debts and put away most of the net proceeds in a safe place, like a money market fund that invests strictly in short-term Treasury securities.

Question 4: I was just transferred. I need to buy a new home right now. What should I do?

First, consider renting. Second, if you do decide to buy, avoid buying with a high loan-to-value mortgage. Sadly, lenders will encourage big borrowing without batting an eyelash. But now that the market is slowing and prices may soon be going down, you could end up upside down, or owing more than your home is worth.

Question 5: If mortgage rates go up like you predict they will, won’t buying a house get more expensive? Shouldn’t I rush to buy now to lock in low rates while I still can?

Not necessarily. Remember: The affordability of a home is determined by both interest rates and price, with the price usually being the more important of the two.

Indeed, even with low interest rates, homes have become less affordable in the last few years. So don’t base your purchase decision solely on interest rate trends. Factor in what you expect for prices, too.

Question 6: We’re looking at a new home that we can either buy now or a year from now. We have estimated what our monthly payments would be if (a) interest rates go up and, at the same time (b) the price of the home goes down. But it’s pretty much a wash. So what difference does it make?

You’re thinking strictly about your monthly payments. But what about your principal? If the value of your home goes down, so will your net worth.

Question 7: I have a big chunk of my net worth tied up in residential real estate, including my home. For both sentimental and financial reasons, I must hold on. What can I do to protect myself from the fact that values may suffer a downturn?

Your best protection is to keep the balance of your net worth relatively safe and liquid, with a substantial portion in short-term Treasury securities or equivalent.

If you have speculative funds, also consider investments designed to go up in value in the current environment. These investments are not for everyone. But they can help reduce your overall exposure and risk. For example, you can buy long-term put options (LEAPS puts) on some of the most vulnerable housing stocks.  

Question 8: My wife and I haven’t seen residential real estate values go down in our entire lifetime, and with the kind of boom going on right now, we may never see a decline. So why should we wait to buy?

You’re right in that we don’t have a good historical precedent. Most residential real estate busts in the past half century have been limited to certain regions and short periods of time. For example, home values plunged in southern California after the booming ’70s, in Texas and Louisiana in the wake of a 1980’s oil bust, and in New York City after the Crash of ’87. We haven’t seen a nationwide housing bust since the Great Depression.

However, so much is new and different about the current boom — the 45-year lows in interest rates, the big growth in riskier debts, and the rush of speculative buying — that recent history is mostly irrelevant.

Plus, we see real estate declines already getting under way in countries like Australia and Britain where interest rates rose sooner than they did in the United States. The same is likely here.

Bottom line: You need to look beyond the U.S. and beyond history and face the facts in the most rational and prudent manner possible. If you do, we think you will agree that more caution is urgently needed.