Kitco - Exclusive Commentaries

Anyone who has become re-educated in the real world of monetary economics has concluded that the more than seventy year experiment in a "managed economy", using Keynesian and monetarist doctrines, has proven ruinous to world economic stability. However, while the Federal Reserve with its inflationary policy has debased the currency since its inception and caused booms and busts, the system to date has muddled through. The sharp downturn in the stock market in 2000, coupled with the economic and psychological shock of 9/11, looked like it could have been the double whammy bringing an irreparable blow to the economy, but the Federal Reserve massively re-liquefied the system. The economy turned around again but only with enormous debt creation. In the past, when government money messes have been created, the piper has always gotten paid and what a price it should be this time when the present money/credit system unravels.

We suspect that there is an "economic blockbuster" out there looming, which will likely be the event to cause an economic downturn, ushering in a depression with all the misery and suffering that comes with it. Moreover, the economic blow could come at the end of one of the many manias that society seems always prone to create. The one that comes to mind, in terms of magnitude, is the nationwide real estate mania, which had its beginnings in the early 1980s under Reagan, grew in intensity under Clinton, and has became supercharged with the manipulated collapse of interest rates under the G. W. Bush administration.

For two thirds of Americans, residential real estate is their absolute financial Rock of Gibraltar where they live, raise their families, and feel a sense of achievement and peace away from the hubbub of life. Moreover, Americans have seen their wealth grow year after year on paper through residential real estate, and as home prices have become inflated, Americans have grown very daring with their finances. A significant foreclosure on residential real estate would be like foreclosing on the American dream, which psychologically alone could plunge the economy into economic depression. Furthermore, we don't know of any conventional wisdom derivative to protect the multi-trillion dollar residential real estate market from a virtual collapse and turning the economy down with a vengeance.

A brief look at a few of history's famous manias produces a better understanding of how past human hysterias, though isolated instances, have ended. One can then consider how a knife in the heart of America's residential real estate market, which has become the mother of all modern manias, could usher in perhaps a major economic upheaval and even repudiate the managed economic approach. Since the beginning of recorded history, human beings have periodically engaged in mass manias, where conjured up excessive excitement or enthusiasm has created a pathological state of mind. Euphoria consumes people during maniacal behavior, creating impaired judgment and sometimes psychotic symptoms of delusions or hallucinations, indicating impaired contact with reality.

Mankind's periodically occurring maniacal behavior was the subject of the book Memoirs of Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, published in 1841. Mackay's piece was a rather humorous collection of popular delusions ranging from Alchemy to Mesmerism and covers a wide range of scams, manias, deception, and even includes witch burnings and the Great Crusades.

Perhaps the most ruinous of history's manias to consume mankind have been those spurred on by the drive to get rich.

One of the most famous financial manias in the 18th century was John Law's Mississippi bubble which culminated in 1720. Law had designed a financial system and monetary theory in 1705, which would print paper currency to permanently expand commerce. Through John Law's activities a significant portion of French government debt was exchanged for shares in a company which had a monopoly on trade with French Louisiana begun in 1719. The company's share in livre (French money of account until 1794) was around 500 in 1719, and in a huge speculative run hit 10,000 livres in February, 1720 only to drop back to 500 livres in September, 1721, leaving participants in the mania completely broke.

Another mania or bubble occurred between 1711 and 1720, known as the South Sea Bubble. The South Sea Company was another trading company in England granted exclusive trading rights in Spanish South America. In 1719 the company proposed a scheme by which it would take on the entire remaining national debt of Britain offering its own stock. From 128 pounds sterling in January 1720, the stock price through speculation finally reached 1000 pounds in early August before it started to fall. By the end of September the stock had fallen to 150 pounds, creating widespread bankruptcies among those who bought on credit, and failures even extended to banks and goldsmiths as they could not collect loans made on stock.

Of course, one of the world's greatest and most widely known manias of yesteryear was the great Tulip Mania, which began in 1634. Tulip bulbs originally brought to Holland from Constantinople in 1559 had become such a wealth symbol that market exchanges were formed and trading in bulbs began. Middle-class Dutch society became involved, and by 1635 a single tulip bulb went for the equivalent of $35,000. In 1636 a single bulb fetched the equivalent of $76,000 in today's dollar terms before the downturn began. Slowly the selling began, first gapping down 90%, and at the end prices dropped to the equivalent of less than $1.00 producing widespread bankruptcies and failures.

The essence of Mackay's treatise is that human beings are borne with the herd instinct, and. when they go mad they do so in herds. When people come to their senses it has proven usually to be a slow process and occurs one by one and in the wake of the usual financial ruin.

Manias, especially stock market manias, were prevalent in the 20th century, with one of the standouts being the great stock market speculation in the 1920s and the crash in 1929. The roaring 20s bred excessive greed, which culminated in the 1929 blow off of the Dow Jones Industrial Average at 381. Over the next three years the DJIA had fell to 41. Almost forty years later stock prices rallied again in the late 1960s on what was called a "new synergy", only to crater once again, and by late 1974 stock prices had evaporated in value to depression levels.

The summa cum laude of stock market manias, however, occurred in the 1982 to 2000 period through the technology mania, which then morphed again into the dot com mania, and the whole world participated. As a prelude to what was ahead for general stocks and technology stocks in particular, the dot coms collapsed at the beginning of the new millennium. The general stock market soon followed suit. From its low of 871 in January, 1982, the DJIA ran up to 11,908 in January of 2000, then declined 36% by September 2002. The NASDAQ rose a phenomenal 2000% between 1984 and March 2000, but then fell 77% by September 2002. By late 2002, some $7 trillion in market cap had evaporated around the world.

The Federal Reserve's massive monetary stimulus over the past three years, though effective, has produced a dichotomy with regard to the stock market. Money has flowed into the big Dow stocks, pushing the DJIA back above the 10,000 level until just recently. The NASDAQ, however, has not been able to recover even 50% of its losses from the 2000 top, while the S&P 500 has recovered 32% of its losses from the 841 bottom in February 2003.

Government intervention over the past three years has kept the stock market maniacal attitude alive. NYSE and NASDAQ volumes have each remained at levels well over one billion shares a day, the financial cable news programs are still talking up the market, hedge funds have sprung up in record numbers, and Wall Street still believes we are in a bull market.

So far, the intervention has kept the stock market bullish mindset alive, and it would probably take a slide to at least the 1991 DJIA level of 3100 to demoralize Wall Street to the point where the maniacal attitude has been wiped out. At the bottom of the primary bear market in common stocks, investors will be depressed and a lot of money will have been lost, but life from day to day will likely go on with people just feeling a lot less wealthy, and pulling in their financial horns.

Our look at manias has led us to an area which, for Americans, has become both spectacular and now dangerous: residential real estate. For twenty-five years, residential real estate has appreciated at an annualized rate of about 10%. In some areas of the country, 20% plus increases have occurred in recent years. Federal Reserve stimulatory efforts over the past three years, in the form of rate cuts, have forced interest rates to levels not seen in 47 years. Mortgage rates tumbled, and many Americans, who were the big rollers in the eighteen-year bull market in stocks, were quick to jump on the new game in town, the illiquid residential real estate market. With money so cheap, the real estate market, which was strong in the 1990's due to relatively cheap interest rates, shifted into overdrive after 2000 when money became ridiculously cheap. In many areas of the country such as San Diego, a real estate market mania sprung up where the medium price of a home has risen to $480,000, and, for that price, one obtains what is described as a one-bedroom shack. San Francisco's medium price is now $640,000, and what one gets for that price is reportedly even less impressive.

Banks are originating mortgages in a widely inflated real estate market with no down payment, and in some hot areas, 110% mortgages are extended. Federal Reserve Chairman Greenspan is claiming that ¾ all mortgages have been made with 20% down payments, but the data we have found indicates that down payments are closer to 3% or 5%. New subdivisions in areas like Phoenix and Las Vegas have prospective home buyers camping out in long lines to obtain one of the proposed new homes, and home builders and real estate agents, grouping themselves among the ranks of the world's financial tycoons, exhibit symptoms of maniacal behavior themselves. Real estate agents routinely knock on doors in hot real estate areas, trying to entice homeowners to sell and re-buy elsewhere.

Based on the data available, the various types of American residential real estate constitute just about $30 trillion in market value, and in the minds of millions of Americans, real estate values can only rise from here on. Already highly leveraged, Americans have borrowed extensively against inflated real estate values via home equity loans. Of the $9.4 trillion in household debt, $7 trillion constitutes mortgage debt. When the bubble breaks, declines of between 11% and 22% on average are expected in real estate prices by many experts, particularly in areas of the country like California, where real estate inflation has been rampant. It is thought that declines of 40% to 50% could occur when the time comes.

The real estate situation is, unfortunately, altogether different because large numbers of Americans have redirected money from the securities markets, which are for the most part liquid, to the real estate market, which is illiquid and inflated in price all as a result of the flood of cheap money created by Federal Reserve policy. Real estate is not sold with a quick phone call like stocks, where the transaction settles in three business days! Countless numbers of Americans have joined the "bull run" in residential housing in recent years, and are now sitting with expensive homes they really can't afford with big mortgages, record household debts, and gigantic monthly payments.

Complicating the real estate picture and economic fallout ahead even more is the existence of the government sponsored giants, Fannie Mae and Freddie Mac, which carry $1 trillion and $1.4 trillion in mortgages, respectively, on their books. Moreover, both institutions have received very negative press recently, and investigations into Fannie Mae may uncover serious wrongdoing.

Fannie Mae has been one of the big engines of growth behind the housing mania, and has been fundamental to holding the mortgage market together. Government sponsored Fannie Mae does not make mortgage loans outright, but rather buys mortgages from lenders, holding on to some while packaging others in the form of debt securities for sale to investors. Fannie Mae has evolved as the second largest debt issuer in the nation after the Federal government, and Fannie Mae debt is everywhere. Foreign investors hold Fannie May debt, as do mutual funds, banks, and various other institutions. In fact, American banks can make unlimited investments in Fannie Mae debt because of the implicit government guarantee behind the institution; six out of ten of the nation's banks have more than half of their equity capital invested in Fannie Mae and Freddie Mac debt.

Fannie Mae is embroiled in an accounting and managerial scandal, which if not resolved, could weaken the company. The fallout could produce a weak dollar should foreigners decide to sell their holdings in Fannie Mae debt. That's for starters! If the real estate market indeed succumbs to the pressure anticipated, taxpayer bailouts of Fanny Mae and Freddie Mac down the line are inevitable. The real impact on America and American homeowners, however, will arrive when real estate prices stop rising and begin to fall because Fannie Mae's relaxed mortgage underwriting standards have enabled home ownership for people who historically would not have had the financial ability or credit to qualify for a mortgage loan. If Americans' incomes don't rise, when real estate prices stop rising, and interest rates rise considerably, there will be a significant number of people under water with their mortgages and facing foreclosure of their homes.

It is one thing for the stock market to go down taking 401Ks with it and causing the population to feel poorer. But it is quite another matter when society's Rock of Gibraltar, thought to be a fountain of wealth, drops precipitously, leaving the mortgagors unable to make payments and facing foreclosure and eviction. That real estate scenario alone could overwhelm Americans economically and psychologically, leaving all the stimulation by the Federal Reserve ineffective, and if there were ever a reason for the world to stage a real run on the dollar, that would be the time.

There is an excellent chance that history will bear out our contention that the Achilles heel of the American economy is the highly leveraged and grossly overvalued residential real estate market. Perhaps there will someday be an addendum to Mackay's book to include America's real estate phenomenon.

Possibly the only natural protection against a real estate debacle is the world's oldest known derivative money, which has never defaulted, namely gold.

**Barry Downs and Bill Matlack are stockbrokers specializing in gold and mining equities with Aegis Capital Corporation, a registered broker/dealer, in New York, New York.

Company Risk Disclosure In addition to the risks involved in investing in commodities generally, we also highlight the following risks that pertain to this commodity. Gold is highly levered to the relative strength of the U.S. dollar, the U.S. balance of trade, and inflation generally, as well as to political and economic stability worldwide.

Analyst’s Certification We, Barry Downs and William Matlack, hereby certify that the views expressed in this report accurately reflect our personal views about the subject commodity. We also certify that we have not, are not, and will not receive, directly or indirectly, compensation for expressing the specific recommendations or views in this report.

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