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COMMENTARY - September 19, 2006 - Few subjects have garnered as much attention of late as the question regarding whether there is a real estate crash already underway or at least brewing up in the American market. The question is of more than just minor interest to precious and base metals investors.

All of us retain images from the movies of our youth where a group of pioneers, surrounded by hostile natives, looked forlornly for some kind of miraculous assistance. Suddenly, the camera would pan to a group of furiously ridden horses as the cry went up, “The cavalry to the rescue!” That analogy serves to illustrate the American economy in the period immediately after the hi-tech led NASDAQ crash of 2000. Hundreds of billions in equity were wiped out. The economy teetered on the brink of a consumer-led collapse, when suddenly the cry was heard, “Real estate to the rescue!”

Thanks to the deliberate Fed-led collapse of interest rate down to as low as one percent, the American real estate market surged forward. Prices, which historically have risen at a rate of approximately five percent per year, began to surge eight, ten, fifteen and even twenty percent - or more - annually in some markets. Equity piled up at a staggering rate. Home sales surged and profits accrued beyond the wildest dreams. Most importantly, homeowners and commercial real estate owners found themselves able to cash in on hundreds of billions of dollars via home re-financings and cash-out profits. Those hundreds of billions fueled a revived consumer economy and the securities markets embarked on a five year gradual recovery from the sharp declines of the beginning of the decade. The Dow Industrials and the S&P 500 now stand close to all-time highs.

But is this all sustainable? We believe the answer, at least for the next several years, is ‘No”. As short-term interest rates began to rise from their record low levels, one of the main supports of those ultra-high price increases was removed. Monthly payments on conventional thirty-year mortgages became unaffordable for most Americans. And so, in order to keep the ‘boom’ going, lenders and buyers alike turned to increasingly imaginative - but fiscally unsound - methods of financing purchases. Variable rate mortgages became the norm. Then followed ‘hybrids’ where the first year or two of the mortgage was kept artificially low through the use of ‘negative-rate mortgages’ structured so the monthly payments were not even sufficient to cover interest-only payments, with the shortfall being added to the mortgage balance. For many mortgages, no down payment was required and now, both borrowers and lenders find themselves owing on or holding mortgages greater than the value of the underlying property.

All of this flies in the face of sound lending practices. During my career as a mortgage lender, back in ‘prehistoric’ times such as the 1960’s and 1970’s, there were several rules. Included among them were these:

The applicant must have the demonstrated capacity to repay, that is the ability to meet all their obligations from current income, with a safe margin to spare.

The security, or collateral value of the residence must exceed the loan value by a safe margin.

The borrower must be a person of sound character as demonstrated by credit history, security of employment, stability in the community, etc.

All of those standards have been thrown out the window. As a result, millions of home owners find themselves owing more than they can afford to pay, unable to borrow additional amounts on their property, and, therefore, in danger of losing their homes.

Two events are now occurring which threaten the American real estate market. (1) Buyers are becoming scarce and the inventory of unsold homes is rising sharply, forcing many sellers to cut asking prices. (2) In addition, many present homeowners, faced with the reality that they can no longer afford their home, are being forced to put those homes on the market, further swelling that inventory. Both these circumstances are putting pressure on real estate prices - and those prices are now beginning to buckle.

Recent figures from American government sources show that prices are now virtually unchanged during the past year and many markets have entered declines. Foreclosures across America are now up more than fifty percent over last year. As Caesar is reported to have said when crossing the Rubicon, “The die is cast.”

It appears to us that a chain has been set in motion. Home prices have stopped rising and are beginning to fall in many areas. Borrowing power is evaporating. Tens of millions of homes were sold during the past five years with unsound financing, to put it mildly. Those homeowners, in increasing numbers, are likely to find they can no longer afford their homes. Millions of those homes could enter the market like a tidal wave, crushing real estate prices, and taking away much of the American consumers’ ability to support the consumer-driven economy.

As apparent danger grows, this could put pressure on the US Dollar, thereby forcing interest rates higher as the government was forced to defend the greenback, because that currency is the lynchpin of international commerce and cannot be allowed to collapse - but higher interest rates would only sharply exacerbate the dilemma.

There appears to be no easy solution to this growing problem. And uncertainly, particularly on an epic scale, has historically been the friend of precious metals investors.