What Will Collapse Housing Prices?
The Grand Disconnect
89 Booming Cities
Where's The Unemployment From Housing?
Two Price-Break Triggers
The Fed to the Rescue?
Some Observations on The Big Easy
This week I am in New Orleans at the annual New Orleans Investment Conference and quite frankly with so many good friends that I have given myself permission to not write a letter this week. But you will be getting an even better writer than me for this week's letter.

I arranged for good friend Gary Shilling to condense his 40 page letter on the housing market for you. While this letter will print long (for those of you who print the letter out), it is mostly charts, which Gary excels in. Gary argues that housing prices are not in for just a small decline but a material drop. I have argued that it is housing that will be one of the main causes of the next recession sometime next year. So without adding too much more copy, let's jump right into Gary's analysis.
By Gary Shilling

I am convinced that the housing bubble is gigantic and will burst before long with massive implications here and abroad. In fact, it's the key to the global economic outlook.

Setting the Scene 
House prices in recent years have leaped well beyond their normal relationships to the CPI.

Even when the increasing size of houses--the McMansion effect--is excluded, inflation-adjusted house prices have jumped as never before in over a century.

Furthermore, for the first time since the 1920s, the bubble is nationwide, and it's been driven by four national forces. First, the decline in mortgage rates.

Second, the loose lending practices designed to accommodate those who have been priced out of the market under conventional mortgage terms.

We're referring here to interest-only Adjustable Rate Mortgages as well as option ARMs that allow borrowers to make even lower monthly payments that result in a rising mortgage principle, or "negative amortization." Then there are unrealistically high property appraisals to justify oversized loans and the lack of full documentation that allows borrowers to overstate their ability to make mortgage payments. Lenders also accommodate financially-weak borrowers with high loan-to-value ratio and piggyback loans, which in effect finance more than 100% of the houses' prices.

The Grand Disconnect 
These loose lending practices are a manifestation of the massive speculation that infected stocks in the late 1990s and was never eliminated, despite their 2000-2002 collapse. Substantial ease by the Fed and other central banks, aided and abetted by big tax rebates and cuts and U.S. government spending on homeland security and military needs, kept the 2001 recession short and speculation intact. It simply shifted from dot com stocks to private equity, commodities, emerging market stocks and bonds, hedge funds and, especially, real estate as investors remained convinced that they deserved 20% returns each and every year. If U.S. stocks didn't do the job, surely other investments would.

So, gigantic levels of speculation remain. But they won't be eliminated and the yawning Grand Disconnect between the real world of goods and services and the financial world of asset speculation won't disappear unless forced by significant events. Speculations never end voluntarily or in orderly fashions. Meanwhile, the game continues for five reasons.

Reason A, the world has been awash in liquidity, which amply feeds speculation. It comes from the leap in house values, which have been liquefied by refinancings and home equity loans.

Reason B, speculation feeds on itself, as was seen with the dot com bubble and, more recently, in gold and emerging market stocks. There's nothing like making money to insure speculators that their bets are correct and should be redoubled.

Reason C, institutional and other investors yearn for huge returns. Their clients demand them. Many pension funds still have 9% or so expected returns. And money managers that don't produce consistent high gains lose money to those who do. So there's great willingness to take sizable risks.

Reason D, a perceived risk, at least until recently, has been low. With roaring profits, junk bond default rates remain low. The low anticipated volatility in stocks and bonds has desensitized many investors to the increased risks they are taking. So, too, is the conviction that the Fed will continue to bail out speculators.

Finally is Reason E. Loose mortgage lending has been encouraged by the development of mortgage-backed securities that allow lenders to package mortgage loans and sell the securities to yield-hungry investors. So, why not make riskier loans when they can be sold easily and the risks transferred with the sale? It's like a bookmaker who expands his business without adding risk by laying off his customers' bets to others.