Thursday, April 14, 2005

Curtain call for housing

Max Fraad Wolff is a Doctoral Candidate in Economics at the University of Massachusetts, Amherst.

US housing prices and consumer spending- marching in lock step- have delinked from household earnings, long term trends and sustainability. In 2003, half of the nation’s $7 trillion in mortgage debt was either originated or refinanced. Credit availability, 40-year low interest rates and rising debt tolerance seized the reins from prudence and off we went. Total mortgage debt has gone up at a pace and achieved levels for which history and international comparison offer no precedent. Perhaps, it is just that the rest of the world and the past were populated by idiots who needlessly stifled credit expansion due to pathetic lack of innovative vision and creativity. Price inflation enabled refinancing and home equity line of credit bonanza. The cash out and borrow more feeding frenzy is being used to keep consumer spending and the economy outperforming reasonable expectation. The story of our housing bubble is inextricably the sto ry of the US and global economic imbalances. Housing is a microcosm of the US role in the global economy. In this opera the homebuyers are America and the lenders are our foreign creditors.

It would be impossible to over state the significance of what is at stake. The home is the only major asset most Americans posses, and the largest portfolio element for millions more. The home is fortress, symbol of American prosperity and the cornerstone of middle class society. For millions home ownership is a badge of pride, proof of middle class-dom and lender of first and last resort. The loose money policy and over extension of credit that has allowed us to ride out the explosion of past bubbles now imperils. If a worst case scenario unfolds a significant portion of the American middle class will fall.

According to the RBC Financial Group’s Outlook for North American Household Finances Report of March 2005, residential mortgages issuances grew 11.3%, 13.2% and 11.6% year-over-year from 2002-2004. Needless to say, this was a much brisker pace than US GDP and real disposable personal income growth. Over the same years home equity lending grew 7.6%. 13.0% and a whopping 27.6%, year-over-year. BEA chained 2000 dollar GDP growth rates for these years were 1.9%, 3.0% and 4.4% respectively. BEA data on percentage changes in disposable personal income were 3.1%, 2.3% and 3.5% year-over-year. Buyers appear unperturbed by such mundane fundamentals as economic growth and the ability to repay loans. OFHEO housing price indexes suggest that in the five years ending January 01, 2005 the average US hou se price increased by 50%. Meanwhile, the period 1990-2002 witnessed steady price growth and a 25% increase in the supply of single family homes. Housing prices have risen unusually rapidly, out done only by the growth in the debt associated with their purchase and extraction of equity from them.

The parallel between this situation and the dramatically declining US net international investment position, NIIP should be evident. The endless sale of housing equity represents the desperate attempt to trade purchasing power now for a pledge of future income. This nicely approximates the continuing sale of future tax revenues, earnings and profits to foreign nationals by the US economy. For consumers, this takes the form of mortgage borrowing, refinancing and home equity credit line withdrawals. For the US economy this is done by selling Treasuries, GSE bonds and corporate bonds to whomever will buy them, mainly foreign central banks and investors. It is no accident, and entirely correlated, that the domestic housing and global imbalance bubbles have been inflating together, particularly since 2000.

Cheap and easy money, lack of risk aversion, regulatory environment and breathing room for growth seem in simultaneous retreat. This does not bode well for the continuation of the definitive enablers of the recent past. The “regulators” of government sponsored enterprises have awakened to years of run away mortgage portfolio growth and questionable accounting and loss provision. Many an overpriced property is purchased to secure rental income that will not cover mortgage cost. A March BMO Nesbitt Burns study reveals that price- to-rent ratios have been climbing and have been above parity since late 1997. Despite this, a March 2004 study released by The National Association of Realtors (NAR) revealed that 24% of all 2004 home purchases were for investment. Apparently, the irrational exuberance for real estate is undeterred by earnings fundamentals. I mention this because a firm associated with Robert Shiller, of Irrational Exuberance fame, is awaiting SEC approval for a house price hedging security to be traded on the American Stock Exchange.

2004 marked the first year in some time when American families’ real income failed to keep pace with inflation. The average family saw its real income decline alongside a dramatic increase in their debt load. Over the year, housing debt increased $885 billion, or more than 13%. The Fed estimates that approximately 16% of American’s falling real disposable income went to debt service in 2004. Nearly $2 of every $3 in this burden was mortgage related. This occurred despite an average mortgage rate of 5.84% which is only 61% of the 35 year average rate of 9.5%. By my calculations, households paid just under 10% of their disposal income in mortgage payments despite anomalously low mortgage rates. The popularity of adjustable rate mortgages and no money down home loans has dramatically increased. As if that was not enough, interest rates and energy costs have begun to rise. Last, but certainly not least, there appears to be a de clining future ability of the GSE to accumulate or fully offer implied support to mortgage backed securities (MBS). This is of huge and rising importance as these agencies play a central role in securitizing hundreds of billions in mortgages. Over the past 15 years the portion of mortgages securitized has risen dramatically from 40%-60%.

Swelling along with our $61 billion per month trade gap, securitized consumer debt sale is transferring credit risk to those seeking to grow by exporting to the world’s consumption machine, America. In short, households sell their future earnings for credit to buy imports and the world loans us ever more to keep it going. This is why the housing bubble provides so nice a microcosmic operetta of the global imbalance situation. There are even more direct links. In 2004 foreigners were net purchasers of $212 billions in government backed securities, up from $140 billions in 2003.

An eerie foreboding should have spread when released their monthly update last week. Their numbers called attention to a 50% increase in home mortgage foreclosures, February to March, with increases in 47 of our 50 states. This should serve as a warning on two fronts. First, that the debt driven housing run must be nearing its end. Second, there will be real fallout as the excesses are revealed by slowing home price appreciation and higher interest rates. Market fragility is compounded by the popularity of adjustable rate mortgages (ARM). The Mortgage Bankers Association (MBA) recently reported that ARMs account for more than one-third of new mortgages. How long will folks hold deflating housing with interest rates rising?

Housing inflation (with the trillions raised in refinancing and home equity lending) is the third leg supporting our limp recovery. Alongside the monetary policy that aggravated this bubble and the fiscal stimulus bloating our nearly half trillion dollar budget deficit, housing has been propping up the dollar and GDP growth. Residential fixed investment accounted for 10% of GDP growth in 2003 according to The State of the Nation’s Housing 2004 released by the Joint Center for Housing Studies Harvard University. Thus, a subcomponent of housing contributed a dime to every 2003 dollar of economic growth. A 2003 Homeownership Alliance report written by’s Mark Zandi suggests that $3 trillion in home refinancing since 2001 has contributed more than 20% to US GDP growth. Granted this number is probably generous, it signals the massive size of this contribution. The course and health of macro performance will be profoundly shaped by the speed and severity of the coming correction. If this bubble pops violently- a real possibility- it will let loose shock waves felt around the world.

Housing’s parallel to the American debt position is irresistible. We are making unspectacular gains based heavily on massive capital inflows that must be repaid. Now we face prospects of much lower inflows and rising interest rates. This is creating a household and national debt fragility of epic proportion.

That rising din behind the debt curtain sounds like the fat lady’s song to me.


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Groetjes Albert


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