Editor’s note: The author, Bob Chernow, prefers to speak his mind on the condition that he be referred to as a Milwaukee businessman, because he is speaking strictly from his own perspective, and his viewpoints do not represent those of his company. He has more than 30 years of experience as a stock broker and is a noted futurist. The following are excerpts from a speech Chernow gave at the World Future Society in Toronto, Canada, in July 2006. Many of his forecasts about a pending crisis in the subprime lending market and a credit crunch, are coming to pass.
In the early 1970’s, the Hunt Commission deregulated the S&L and Mutual Savings industries. Deregulation gave them freedom, but there was little oversight regulation over them.
The S&L and Mutual Savings industry borrowed their money short-term, but made long- term loans. This strategy was doomed in an inflationary economy.
Deregulation and the lack of oversight led me to predict the collapse of the industry – something that I tried to prevent in a series of speeches and articles to the industry and letters to my senator, Bill Proxmire (then Chair of the Senate Banking Committee) and the Federal Home Loan Bank, now part of the Federal Reserve.
In addition, the "guns and butter" policies of President Lyndon Johnson and President Richard Nixon’s imposition of price controls (without making changes in the economy) made inflation inevitable.
The lack of any response made me understand what it means to be a "Cassandra." You can see the future, but you are cursed that no one believes you!
Now I have another dire prediction. This one concerns trends in mortgage finance. Mortgage lending is based on the premise that the homebuyer or lender has a stake in a property. Federal regulations require a 20-percent down payment if no mortgage credit insurance is involved. Mortgage insurance from private industry covers either the top 20 percent of a loan or the entire mortgage. This tactic is designed to ensure that appraisals are not inflated and that the lender has a vested interest in being "honest." FHA and VA credit insurance also has controls to ensure that appraisals and credits are in line with reality.
Yet in "hot" real estate markets, many buyers avoid mortgage insurance because lenders encourage them to take out second mortgages as down payments. These second loans have higher interest rates and are often adjustable to variable interest rates. These types of loans encourage speculation by artificially allowing buyers to stretch what they have to buy homes they normally could not afford.
According to the Federal Reserve, 35 to 40 percent of all recent mortgages were "interest only" variable loans. This type of mortgage allows buyers to buy homes when prices are inflated. It is interesting that the last time interest only and balloon mortgages were popular was during the 1920’s. This was a major reason that banks became insolvent during the depression and was a reason why amortized mortgages were created, as these types of mortgages let buyers pay down principal.
What is wrong with "interest only" mortgages? Well, for one, the homeowner has no economic stake in the property. He can walk away if he cannot pay. He is, in essence, "leasing" the home in the hope that property values will increase. This is the "greater fool" theory of investing. What’s that joke? "If you don’t see a greater fool, look in the mirror!"
Fourteen percent more homes were lost to creditors in 2005 than in 2004. Realtytrac.com says that 33 percent more people are in some state of foreclosure than in 2005. What is interesting is the number of the affluent that these numbers represent.
Regardless of what the "new" bankruptcy law dictates, banks will be hard-pressed to collect on much of this debt.
Note as well that $2 trillion of variable loans are due to have their interest rates reset shortly. What we have seen so far may only be the tip of the iceberg.
Another concern is appraisals that are made to fit purchase prices. "Incomes" adjust to meet mortgage payments. Today’s bankers and mortgage lenders often view their world as short-term. Since most loans are sold off, this is no surprise. The problem becomes someone else’s! The irony here is that the secondary market in home loans is being perverted by the system rather than generating liquidity for home buyers.
Thus I see a major problem for banks, the mortgage industry and housing. Will the banking industry collapse? I do not think so, but I do see significant strains and the loss of billions of dollars of inflated real estate. Since loss reserves have been reduced for the banking industry by new accounting rules, the situation will not be pretty.
What is needed is federal regulation of the mortgage industry, the outlawing of 100-percent second mortgages for down payments and the monitoring of appraisals and credit practices.
Control and regulation of predatory lending practices should be implemented, especially when regulated banks buy these loans. Importantly, prepayment "penalties" should be forbidden for predatory loans.
The sub-prime market is about 19 percent of all loans originated, according to the Christian Science Monitor, a ten-fold increase since 1994. This industry has ethical challenges. Household International paid a $500 million settlement for charging higher rates than disclosed. And Ameriquest agreed to a $325 million settlement to 725,000 borrowers for similar abuses, such as concealing high interest rates.
This is chump change to these folks, and they are not the worst offenders in this market that serves the most vulnerable of our population.
The Federal Reserve Bank could dampen overheated real estate markets by restricting interest only loans, by forbidding "second mortgages” for down payments and by closely monitoring appraisals and credits. Will Federal Reserve Chairman Ben Bernaeke take these steps rather than use interest rates as a blunt instrument? It is doubtful. His interest lies with his banker friends, not the long-term health of the economy. The Fed is currently devising regulations to curtail interest only options and other "exotics." There is no sign that these regulations will be created soon.
Now let us look at what the investment world will look like in 10 to 15 years?
First of all I see a divide between the rich and the rest, and a battle for cost efficiencies vs. performance.
But what is little understood by pundits and public administrators is the battle for talent. Talent is rare and is becoming rarer as the bad and mediocre crowd out the competent, say, most currently, in the hedge fund arena.
Talent is needed to create and preserve wealth. The market will pay for talent. Boutiques and giant firms will dominate and the small independent or financial planner will become a "consultant" for clearinghouses, or disappear.
I see, therefore, an industry where most people will use packaged products and index funds and will purchase these products at a fixed fee or price. Brokerage firms will dominate, but banks and insurance companies will take an increasing piece of the pie. Discount houses will maintain their share of "do it yourselfers," but many will "move up the chain" to become more full-service.
People will continue to pay for wisdom, not merely information or "smarts." They will pay for human contact, a give-and-take, and, importantly, courage.
People might also deal with financial experts who are not local. Inexpensive telephone calls have allowed brokers and other financial types to deal with clients who live outside their territories. Geographic expansion will expand, and if regulatory licensing eases, non-US based brokers might serve clients in America.
Computers will some day be developed so that there will be "virtual relations," but I am guessing that this will not take place within the next 15 years. In this scenario, you interact with a robot. But these robots will need to be creative, thinking out of the box.
The crowding out theory is also at work here. When too many people jump on the same wagon, few succeed. The convertible market once had many bargains; it was an exotic. Over the last decade, institutions and mutual funds have entered this market, and few "bargains" exist, in my opinion.
Many economists predict that the baby boomers will convert all or part of their assets into fixed income when they reach retirement age. Others- a minority, like me – see baby boomers changing careers, but still working. My guess is that the segment of the baby boom population that has money will be bored in retirement and will continue to be productive.
Financial planners may still see 65 as the retirement age, but my guess is that it will be closer to 75 or 80. Even Social Security recognizes this!
What kind of investment world will we have? Health care and education will be fields to watch for increased productivity and efficiency. In health care, nurses, not doctors, will use diagnostic machines; biotech will allow us to prevent as well as correct disease. We will have fewer hospitals. Medicine may stabilize Parkinson’s and Alzheimer’s (and certainly we will be able to identify these and other diseases earlier.)
For education, the computer, the Internet and telecommunications will allow us to design individual programs. Distance learning, especially in business, will continue to dominate. Lectures will be transmitted to individuals. Grading and student notes may be complied through voice recognition.
Certain industries, such as the telephone industry, will probably be obsolete.
New investment categories, such as the purchase of toll bridges and roads, municipal water and power systems, will be sold by municipalities and packaged by Wall Street.
New industries will grow, and old industries will be reborn. Nanotechnology, nuclear, wind and solar energy, new types of materials (such as titanium) are examples. Emerging markets like India and China will continue to grow. Other countries such as Brazil and Indonesia will surprise.
What could go wrong with this scenario? We could have a SARS epidemic, global warming, an energy crisis and weapons of mass destruction. Personally I have long thought that oil and gas would be in surplus because of a dramatic increase in energy efficiency.
A major area of concern is how we regulate. In the United States, regulation comes after a scandal that is after the "barn door" has been opened. The S&L/Mutual Saving bank crisis is an example. The unregulated hedge funds industry is another. The reason for this is self-interest. Unregulated hedge funds make up 30 percent of the volume of U.S. stocks traded. The derivative market – also unregulated – personified the "crowding out" theory discussed earlier. Self- dealing in the mutual fund industry also arose from greed.
In truth, managers in the financial industry (banking, brokerage, and insurance) have but a glimmer of how business is obtained and retained, and whose personalities are best suited to do this work. Regulators don’t have a clue.
Whether my observations and opinions are valid, only time will tell. Or as Warren Buffet once quipped: "It’s only when the tide goes out that you know who has been swimming naked."
