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Clive Roffey on the panic selling of Durban Deep shares

Section: Daily Dispatches

By Bill Fleckenstein
MSN Money
Monday, February 28, 2005

This week I'd like to put into perspective a few recent developments:
Problems in the housing-ATM food chain, inflation concerns and news
that the South Korean central bank planned to diversify its dollar

Prerequisite to current events: Bubble 101

To do so, it's important to take a step back and recognize that in
the wake of the biggest mania in the history of the world, which
ended in March 2000, it would have been reasonable to expect a fairly
severe recession and a radical decline in many asset markets. That
occurred in the stock market, to some degree (principally Nasdaq
stocks). But the bear market was temporarily arrested, as was the
recession, by the fact that 13 interest-rate cuts (plus a couple of
tax cuts) jumpstarted the housing market -- and ultimately created a
new bubble as I noted on June 28, 2004.

As housing prices rose, lending standards dropped along with the
decline in interest rates. The ensuing boom in refinancing and the
serial extraction of equity from homes allowed folks to live way
beyond their means. This process has put many people in the position
of now owing far more than they ever have, using the increased value
of their home as collateral. That, in a nutshell, is what I have
meant in repeated discussions about the housing ATM.

Does Fannie major in financial engineering?

Meanwhile, even as insanity in the housing market has continued in
some locales, cracks have been appearing in the dike for the last
couple months in the form of the well-publicized problems at Fannie
Mae, where it is no longer financial business as it used to be.
Problems there definitely matter, since Fannie is the 800-pound
gorilla of home finance.

In another turn for the worse, Fannie's regulator, the Office of
Federal Housing Enterprise Oversight (OFHEO), last Wednesday stated
that it has "identified (additional) policies that it believes appear
inconsistent with generally accepted accounting principles." When I
read the OFHEO headline (concerning Fannie's "held for sale" loans
and hedge accounting), I thought it smelled like Enron, ergo my new
nickname for Fannie: Fanron.

Warts also have sprouted in various facets of consumer lending, such
as Capital One, New Century, Countrywide Financial, and Novastar
Financial. I expect the sector to see more trouble, which will
disable the housing ATM as a vehicle for consumers to spend beyond
their means.

Awaiting an inflation epiphany

Further weighing on the housing-finance arm and consumers generically
has been the recent rise in long rates that has finally accompanied
the year-long rise in short rates. A week ago Friday, the bond market
was hit pretty hard and managed to complete a reversal on its chart
(signifying the end of a move) after the producer price index was
reported to be up 0.8%. When I wrote about those results in my daily
column, I said that it was not yet knowable if this is the start of
real inflation concerns or just transitory noise. I felt that how the
markets reacted to the Consumer Price Index data, released last
Wednesday, would give us more information.

Not the CPI itself, mind you, because, as I noted last February, the
CPI will never show inflation of any consequence. The CPI has been
engineered specifically NOT to. Housing-price increases have
essentially been removed, via the way in which owner-equivalent rents
are calculated, and they cannot possibly reflect what's happened to
house prices. Then, when one adds in hedonics (which strips out many
price increases by assuming they are quality improvements) and
factors in the substitution allowances in the data, it is clear that
the CPI is not going to ring any sort of alarm bells.

A statistic unfriendly to finagling

The PPI is a little more untamed; it's harder to apply a hedonic
adjustment to producer prices for copper or zinc, etc. Also, those
prices are more directly impacted by a drop in the dollar. So, while
a PPI might show some inflation, I repeat, the CPI never will show
inflation of any consequence. My belief is that inflation in this
country is running at 4% to 5% a year, at a minimum, and yet the CPI
chugs along at 2% to 3%, depending on whether the government
concludes we had a 0.1%, 0.2% or 0.3% increase in any given month.

I have believed that so long as asset prices were marching higher and
folks felt better off, they would never come to the conclusion that
the CPI is a charade. Consequently, I think that to expect the public
to look through the CPI at this moment in time is perhaps a bridge
too far. That doesn't mean, however, the bond market won't see
through the CPI.

In any case, it will be interesting to see how the bond market
behaves in the next few weeks. If the markets determine that the Fed
is behind the curve, then the Fed will have to raise rates
irrespective of what's going on in the economy. That will not be
pleasant for the stock market. And, if the Fed chooses not to
continue down that path, at some point, the bond market and currency
market won't like that outcome.

The Oscar for worst performance by a Central Bank

Speaking of the currency market, the South Koreans appeared to yell
fire there last Monday night, when they announced plans to diversify
their foreign-reserve holdings away from dollars. (They are not the
first to do so, as the Indians, the Russians and others have said the
same thing.) Then the following night, they said "you misread us," as
they tried to cover their tracks.

The real news, of course, was the foreign-currency market's reaction
last Tuesday -- as the announcement itself was really just
evolutionary, not revolutionary. What we saw was a dress rehearsal
for the day when everyone realizes that they might be the rotten egg
stuck holding a currency in serious decline. That the decline in the
dollar has been upgraded to "noteworthy" (via the South Koreans) and
that inflation may be a topic of conversation increases the risks
interest rates will go higher. That, of course, will further pressure
the housing ATM. Interest rates and the housing ATM are inextricably
intertwined. So, if inflation or dollar concerns push interest rates
higher, that will only exacerbate the problems already under way.

Trouble binds a variegated quilt

Given the fact that the housing ATM has allowed the consumers to live
beyond their means, as I have described, and that they are already
showing signs of reining in spending, we may be at an ominous
juncture. I have made no secret of my belief that 2005 was going to
be a year of trouble. The catalysts that could set those troubles
into play are now either in place or lurking beneath the surface.
These problems affect not just the housing market but also the
economy and the stock market, which are of course interrelated.

I think it's important for folks to think about this and realize that
finally, after about as much speculation as any economy could ever
endure, our asset markets and economy might finally be ready
to "revert to the mean."


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