Global Outlook Vs. U.S. Outlook

The IMF has adjusted its predicted GDP growth regarding the U.S. and Euro zone. The forecast for U.S. GDP growth in 2007 has been retracted from 2.9% to 2.2%. For the 13 countries that use the Euro, the forecast has been raised from 2.2% to 2.3%

They IMF has stated that the reason for the retract in predicted GDP growth for the U.S. of A is stronger than expected housing slump. According to the IMF, the last time the Euro zone out paced the U.S. in GDP growth was the period following 9/11.

The IMF also expects global GDP to grow at 4.9% compared to 5.4% in 2006. According to these numbers, the U.S. is growing at less than half the pace of the world growth.

I would like to touch on a couple points here. The first is the housing market. Again, I spit on the notion that we have hit a soft landing, or that there is one coming soon and let me tell you why.

I believe the second wave of the housing slump is on its way and it will be much worse. Remember when "easy" Al Greenspan dropped the Fed Funds Rate to 1% and said that U.S. consumers should take advantage of ARM mortgages. Well many listened, while lenders encouraged this. The whole idea is that the borrower can experience a couple years of low mortgage payments. In the mean time, they will be able to either increase their income or use their home equity to make payments, being that home prices were going through the roof.

Why would lenders encourage this? First off, the actual mortgage consultant would receive a kick back or commission of sorts for selling these kind of mortgages. Secondly, they would receive a second commission when the borrowers would come back for to refinance to non-ARM mortgage.

So why is the second wave of the housing slump going to be worse than the first? First off, nearly $1 trillion worth of these ARMs are scheduled to reset higher this year. So what, no problem all of these will be able to refinance or use their home equity to make their payments...WRONG!

This is wrong for a couple of reasons. The first is that over 50 of the sub-prime lenders have already gone kaput. So many of these ARM holders can't go to their original lenders that promised them the option of refinancing to a fixed rate.

Next, is that some 40% of these sub-prime ARM holders can't pay more than the bare minimum on their mortgage. Example: A family with a combined $60k income and two kids got was able to buy a $200k home paying just $150 a month because they either lied on their loan application about their income, or the lender just didn't care.

From the lender side, they will lend to just about anyone, because they figure that if the property gets foreclosed on, they will still win because the property will have appreciated in value. WRONG! The same reason that sub-prime borrowers can't use the equity on their homes because of depreciating values, is the same reason we are seeing so may sub-prime lenders go bust.

So how did these sub-prime lenders get the money to make these loans? They were financed by Citibank, Morgan Stanley, Barclays, Goldman Sachs and many others. I have a very important point on this topic that I will discuss at the end of this post. With these investment banks taking losses, they are forced to increase the mortgage lending rates.

This not only decreases the demand for homes, but also makes it much harder for these ARM holders to refinance. This is where the whole things comes circle. With a decrease in demand for homes because of higher mortgage rates, causes home value depreciation. This home value depreciation causes the inability for home owners to use their equity to make payments causing more foreclosures. More foreclosures means a larger market supply. More supply means more home value depreciation.

Let's tie this whole thing back to the beginning and how it will effect the GDP growth of this county.

We are facing home value deflation for the above mentioned reasons. This is a very important note: Japan's extreme deflation in the early 90's started from home value deflation. After 15 years of economic misery, they are just recovering now. The Japanese government ignored the effects of home deflation until it was too late.

I expect the $1 trillion in ARM that planned to reset higher this year to bring a whole new wave of foreclosed homes to the market. That's in addition to the already huge supply of homes in the market.

I promise I'm getting to the consequences of this on the economy. The U.S. has been riding consumer spending over the past 6 years or so, and the consumer has been riding rising home values in order to use equity to purchase cars, boats, and other gizmos. The spending wasn't based on actual money, but instead was based on debt.

Back to the investment banks. The ones who really own the these sub-prime loans and the question of what they do with them. They package them up into nice bonds and sell them to the market. Some of the largest holders of these are pension and investment funds. All though the sub-prime lenders are going bust, it will be the holders of these bonds, which number in the 1oo's of billions of dollars, who will really feel the brunt of these bankruptcies.

In conclusion, as home value tanks, home equity tanks, and consumer spending tanks. That combine with the countless billions of dollars that will be lost when these mortgage securities backed bonds are worth nothing but the paper they are written on, will be the reason housing deflation will get much uglier in the near future, as will the GDP that's based 70% on consumer spending. Among other circumstances, the U.S. will be lucky to experience what Japan experienced in the 90's.