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October 17, 2002

With Fall comes a new look at the world.  The season’s change, kids are back in school and we gain a new perspective on life.  We often forget that the average consumer is also the average borrower as well as the average employee.  We are struck by how the average consumers are buying houses, cars and refinancing their homes.  We went to the Freddie Mac web site for some answers.  Here is what we learned.

Solid home price gains have sharply outpaced stocks, which have been in a slump for nearly two years. In a five-year span, average home prices have jumped 38%, versus a 3% Standard & Poor's 500 stock index rise.

Our view of the world is that home prices have gone up the same way bond prices go up when interest rates drop. You know the drill, if you hold a 10-year bond and it pays 6% and interest rates drop over a two-year period to 4%, your 10-year bond is worth more.  That is one part of the puzzle as to why housing prices have been going up.

The second reason home sales are strong is the easy credit for first time buyers. Freddie is making it very easy for first time buyers.  In many cases you can buy a house for as little as 5% down.  And many buyers are getting the 5% from personal loans or credit card advances.  So its no-money-down and you are a homeowner.  We firmly believe that Freddie has lowered credit standards to a point that it would be hard to lower them any further because foreclosure rates are at a high water mark.

The third reason housing sales are strong is desire. The questions is how much more desire is there?  We read about some urban planners that believe that all the first-time home-buyers in their community have purchased a house and there are no new customers until the next generation. Pent up demand has been quenched.  They have 85% of the resident population in houses and believe they have reached a limit.

Here is more important information from Freddie:


Not surprisingly, rising home prices have built homeowners' equity. Total home equity grew more than $500 billion in 2001, of which $150 billion was unlocked through cash-out refinancing. This year, cash-out refinancing is expected to take out $100 billion in home  equity.


This one is a real puzzle to us. Why would so many people refinance and take money out?  We had just assumed that the refinancing was to get lower rates, but with much of the refinancing being motivated by wanting/needing to take money out, we began to feel uneasy.  We read that 66% of the money from cash-outs is being used to pay for consumer goods.


If home prices are going up because of low interest rates and people are taking out the value of that increase with refinancing, what happens when interest rates go back up and housing prices go down?   Is it like the great depression in which the home is worth less than the mortgage and people have no equity in their home?  Could this happen to home lenders? Wow, the thought leaves us speechless!

Then we turned our attention to income from the average consumer and the amount of debt they have accumulated. For the average consumer their total debt amount has increased from 80% of their annual disposable personal income to 100%.  This amount is now greater than the inflated equity in their house and in their stock account.  In essence, they have a zero net worth. And the Federal Reserve numbers show that the average consumer is using 16% to 40% of their disposal income to make debt payments.

Ouch! This is the consumer/borrower behind those mortgage payments.  This consumer/borrower does not look like a good credit risk to us.  Can this consumer keep holding up our economic growth?  Seems like a difficult bet to us.
























News from Mainstreet is distributed for $900 per year by Gladstone Management Corporation, 1750 Tysons Blvd, McLean, VA 22102.  Publisher:  David Gladstone. Owner Gladstone Management Corporation.  Staff may have positions in securities discussed herein.  David Gladstone is President of Gladstone Management Corporation (GMC), a registered investment advisor.  In his capacity as GMC president, David Gladstone may be buying or selling securities recommended herein concurrently, before or after recommendations herein.  This is not a solicitation for GMC.  Views herein are the editor’s opinion and not fact.  All information is believed to be correct, but its accuracy cannot be guaranteed.  The owner and editor are not responsible for errors and omissions. © 2002 GMC.  Information and advice herein is intended purely for the subscriber’s.  Under no circumstances may any part of a News from Mainstreet fax or email be copied or distributed without prior written permission of the editor. Given the nature of this service, we will pursue any violations aggressively.