US deflation risk
To assess the US deflation risk,
we first revisit the definition
of deflation: a contraction in the volume of money
and credit relative to available goods. This is of
utmost importance as it relates to US deflation risk,
because this is exactly what's occurring in America.
A massive deflation in real estate is in full effect,
and real estate's peak in 2005 was a leading indicator
of US deflation risk. The worst thing about real estate
is its lack of liquidity during a bear market. At
least in the stock market, when your stock is down
60 percent and you realize you've made a horrendous
mistake, you can call your broker and get out. With
real estate, you can't pick up the phone and sell.
You need to find a buyer. In a deflationary
depression, buyers just go away.
What screams "bubble" – giant, historic
bubble – in real estate today is the system-wide extension
of massive amounts of credit to finance US (and worldwide)
property purchases. As a result, a record percentage
of Americans today are nominal "homeowners."
US deflation risk could perhaps be no greater than
it is now. People can buy a house with little or no
down payment in many cases. They can refinance a house
for its entire value. "How can this be?"
you ask. "Isn't at least 20 percent homeowner
equity required?" Well, sort of. Credit institutions
are supposed to be penalized for lending more than
80 percent on an uninsured mortgage. But if they get
it insured, which is generally not difficult, the
limit can go up to 90 percent. With VA or FHA approval,
it can go up to 95 percent. "Prime borrowers"
can refinance for up to 125 percent of a home's appraised
value. Each loan of this type expands US deflation
risk. The problem with these schemes is that their
success and continuation depend upon continuously
rising property prices. Once the bank extends a loan
of that size, it owns the house at full value. Then,
any drop in that value directly causes a drop in the
value of the bank's capital. By contrast, when the
bank lends only half of the value of a home, its value
can drop as much as half, and the bank can still get
all of its depositors' money out of the deal by selling
the house. With these latest methods of "creative
financing," depositors' money is utterly unprotected
from market risk. Now do you see the US deflation
risk?
Another remarkable recent trend adds to US deflation
risk. Many people have been rushing to borrow the
last shred of equity in their homes. They take out
home equity loans to buy stocks and TVs and cars and
whatever else they desire. This widespread practice
is brewing a terrible disaster, further exacerbating
US deflation risk. A home equity loan turns ownership
of your home over to your bank in exchange for whatever
other items you own or consume. It's a reckless choice
that stems from the extreme confidence of a major
top in social mood. In 1957, Hamilton Bolton
penned a personal letter about US deflation risk to
Charles Collins:
In reading a history of major depressions in the
U.S. from 1830 on, I was impressed with the following:
(a) All were set off by a deflation of excess
credit. This was the one factor in common.
(b) Sometimes the excess-of-credit situation seemed
to last years before the bubble broke.
(c) Some outside event, such as a major failure,
brought the thing to a head, but the signs were
visible many months, and in some cases years,
in advance.
(d) None was ever quite like the last, so that
the public was always fooled thereby.
Bolton's words are more valuable today than ever
when assessing US deflation risk. With so much debt
tied to the faded sellers' market in real estate,
US deflation risk is not only monumental; it's cataclysmic.
For more on deflation, Download Robert Prechter's FREE 60-page eBook, The Guide to Understanding Deflation.
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