Tuesday, October 20, 2009

Inflation? Deflation? What's happening?

Are we poised for inflation, or hyperinflation? Or will the opposite happen?

On the inflationary side, we have what appears to be massive expansion of the money supply by the Fed, a weak dollar, and rising gold prices.

On the deflationary side, we have higher unemployment, and a mentality in the populace of saving vs. spending. People are downsizing and contracting, and spending less.

Robert Prechter, of Elliott Wave fame, says: “An increase in money supply is only inflationary if it is used to RAISE the total amount of credit. This is NOT happening, as both bank credit and consumer credit levels are contracting for the first time since World War II.”

Let’s think about what is happening in the housing markets: We have the highest rate of foreclosures and delinquent mortgages in history. Even “A” paper, prime 30-year mortgages, are in foreclosure or delinquent. In fact, by sheer volume, there are more troubled prime loans than there are subprime (mostly because there are lots more prime loans). A much higher percentage of subprime loans are in trouble, however.

When a home goes to foreclosure (data as of 9/2009), the bank recovers about 30% of the loan principal. In a short sale, they recover closer to 60%. However, in either case, it is a massive loss for the institution, nationwide in the area of Four Trillion dollars.

When a bank agrees to a short sale, or forecloses, money is destroyed. When the markets fall, money is destroyed. The Fed, pumping money into the system as hard as they can, is not making a dent in the money supply – the bailouts are perhaps offsetting less than 20% of the destruction of money.

So is inflation likely? Probably not. If Prechter is correct (and he often is), then the Fed’s action is not increasing credit. In fact, the only lender in the housing market is the government – 85% of loans are FHA or VA. There are almost no conventional lenders anymore. They are all out of business. And, the bank regulators are insisting that banks specifically NOT loan on real estate. Credit is contracting, and will likely continue to do so for the foreseeable future. The future of real estate, particularly commercial real estate, is in cash.

A friend of mine who invests in commercial properties, recently told me that a building owner he knew had signed a lease in which, in return for the lease agreement, would make certain tenant improvements. This is common in commercial leasing. However, he does not have the cash to make the improvements, and no financing is available to make them! This sort of financing was easy to get and considered a normal way of doing business just a few years ago.

You have no doubt heard that the recovery is underway, and that the housing market is coming back. The truth is, we have a small dip right now in mortgage resets, but the bulk of the option ARM and other bad loans will reset in the next two years. The foreclosure and short sale situation we have right now is a fraction of what we are likely to see in the next year or two. Almost 10% of Americans are at least one payment late on their mortgage. The average American family does not have more than two months of buffer in the bank in case of job loss, and many will miss a house payment if they are unemployed for just two weeks (and miss one paycheck).

Business and commercial defaults are rising, and will be a huge contributing factor to the destruction of money, along with credit card losses. The credit card industry itself will change dramatically over the one to three years. It will be hard, and expensive, to get and own credit cards.

Inflation seems impossible to me, with all these circumstances. I am on the side of the fence with Prechter, Smorch, and the other Elliott Wave guys who think we are in for a protracted period of deflation. There is no credit; only cash works today. Still, I do own some gold. Just in case.

Patrick Harvey

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