Tuesday, April 08, 2008

Pareto Principle: Triggering the New American Revolution

Yesterday I posited that 4% of the American middle-class falling into poverty will have an outsized influence on 64% of the remaining middle class. I also suggested that when 20% of the middle class has seen their wealth and benefits shrivel to near-zero then 80% of the middle class will join the uprising which I call the New American Revolution (TM).

(OK, the trademark is a poke at the marketing universe's obsession with "branding" everything for marketshare/mindshare/profit. How about charging a royalty for any use of the term? If the trademark application passes the hurdles...)

Today let's consider the drivers of middle-class impoverishment and the psychology of hope/entitlement being smashed.

1. the crash of home equity to zero or less than zero. Stories are popping up in which "upper middle-class" people with homes which were recently worth $800,000 to $1.4 million being shocked that their home equity lines of credit have been cancelled: Lenders retreat as housing market plummets.

What is remarkable about these stories is the owners' strong sense of entitlement-- that the "free money" doubling or tripling of their equity in the bubble was now "theirs" for all time, and that it should be available, as it was from 2002-2006, as a permanent "slush fund" for their home improvement projects, new cars, etc.

These folks are shocked, shocked, that their homes could drop by $400,000 or more--after all, this is a "good neighborhood where house prices never drop." In other words, the operating preconception of the upper middle-class is that a decline in equity is limited to ghettos and tacky exurbs. The market is proving this preconception false.

So let's state this very clearly: equity dropping to functional zero (i.e. you can no longer extract any equity regardless of your personal beliefs about your home's value) is not limited to subprime/toxic/liar-loan mortgage holders.

Another very common situation is the middle-class household which has owned their home for years or even decades, and as a result had built up significant home equity. But then college, divorce, a job loss, extended illness, parent-care or some other major life expense came up and the family extracted the equity to handle the crisis/costs.

Like almost everyone else, they didn't worry too much because the bubble was continually granting them more equity every year. But now that values are plummeting, their remaining equity has dropped to zero.

Let's also be clear about the distinction between theoretical equity and extractable equity. Let's say a house was worth $200,000 at the top of the bubble in Q4 2005/Q1 2006, and the owners had refinanced/HELOC'd up to a $160,000 mortgage. They feel very secure holding 20% equity.
Oops, home values drop 10%--yes, even in their "nice neighborhood with good schools." Their residence is now worth $180,000 and equity has dropped to $20,000. Still, that's a nice "safety cushion", right?

Only there's a big, ugly fly in the ointment: no lender is dumb enough to extend them credit based on the last 10% of equity. The banks have finally caught on to risk and the bubble popping, and their "risk models" have been adjusted to the likelihood that the house could drop not just another 10%, wiping out all the remaining equity, but 15% or more, putting the owners (and any lender dumb enough to have extended them additional credit) underwater.

This is important: the homeowner may reckon they still hold theoretical equity of 20%, but their extractable equity is zero. Lenders are rushing back to the 20/80 model in which a 20% down payment is considered prudent, and so 20% equity is essentially zero.

Please don't email me that your credit score is 800 and there's a lender right now willing to lend you 90% of the value of your mansion. That may well be, but the average middle-class household doesn't have a credit score of 800. You are an outlier, just like the person who plunks down 50% cash when purchasing a house. Sure, such buyers exist, but we're talking about 50-60 million households' typical circumstances, not the outliers.

To summarize: here are the middle-class households who are in danger of losing all their extractable equity:

Any family which put less than 20% down when they purchased their house in the 2002-2006 time frame.

Any family which extracted equity during the bubble such that their equity was reduced to 20% by 2006.

Any household in bubble hotspots (Florida, California, etc.) with 20% remaining equity as of Q1 2008 (present).

Various pundits are amusing themselves with guesstimates of "how much more housing will drop before we hit bottom" and numbers of 15% (laughably optimistic) are being tossed about. As more knowledgeable commentators have noted, "reversion/regression to the mean" suggests another 40% - 60% decline in house prices is likely.

Here are two charts which illustrate the point: (see below)

In the first, the sharp peak is the bubble--the dot-com era tech stocks, or the housing bubble's home prices. Statistically, prices tend to revert to their starting point.
In the second chart, we see how a house purchased for $175,000 in 1995 whose apparent "rise" in value to $266,000 in 2011 is totally a result of a modest 3% annual inflation. If this house drops below $266,000 in 2011, then the owner has effectively lost value, regardless of the nominal price increase.

Yesterday we posited a Pareto Principle effect would kick in once 4% of the middle class suffered financial losses which impoverished their family. Have 2.4 million (4% of 60 million) households already suffered a complete loss of equity? By most accounts, homeowning households with zero or negative equity already exceed 8.8 million--over 10% of all U.S. homes.

Moody's Economy.com estimates that 8.8 million homeowners -- about 10.3% percent of all U.S. homes -- will have zero or negative equity by the end of this month. Another 10-15 million households are at risk of becoming "upside down" if prices continue falling. So we almost have our Pareto principle (20%) number: if prices keep falling (a given) then somewhere between 20% and 30% of all homeowners will have negative equity.
2. The other 800-pound gorilla in the fiscal-crisis room is healthcare. The Powers That Be are reluctantly admitting that a recession is underway. And what happens in a recession? Spending slows and businesses either fold or lay off employees to cut expenses.

And what happens when you get laid off? You lose your healthcare benefits. And what separates the poor from the middle-class? Healthcare benefits. Once the middle class starts losing jobs and healthcare, without equity they are essentially impoverished.

Self-employed people like me know how incredibly costly healthcare is, either cash or insurance bought on the "open market." The average salaried worker has no idea just how much it will cost to duplicate their employer-provided health insurance in the "real world."

Sure, if you're 25 and single, your health insurance is minimal, on the order of $150/month. But if you're middle-aged with kids, try $700-$1,000/month depending on how gold-plated your insurance coverage is.

Here's the key question: how many middle-class workers will lose their jobs in this recession? The official unemployment numbers are nearly useless for a variety of reasons, but let's start with the "official unemployment rate" of 5%. In an economy of 130 million jobs, that's about 6.5 million people.

Now millions more work in the underground (cash) economy, and millions more have exited the job market/given up/retired early/taking care of grandchildren but would like a part-time job, etc.

In good times, most of the unemployed are "in between" jobs; most find another job within 6 months. The "hard-core" unemployed--those saddled with felony convictions, low education, addictions, poor health, etc.--are another story, one we'll set aside for now. But in bad times, i.e. recession, people don't find another job. Then they drop off the "official statistics" and essentially disappear.

Thus we may be presented with an "official" unemployment rate which no longer counts millions of laid-off workers who once had middle-class jobs. If you're unemployed longer than 6 months, you're no longer counted. If you take a part-time job "just to tide the family over" then you're employed. If you take an occasional temporary gig (temping), then you're employed, too.

But if your family loses its healthcare coverage in a job shuffle, then you're no longer in the middle class. You're one of the working poor now. As we all know, the key to survival as a middle-class American is: someone in the family has to have healthcare benefits which cover the entire family. If nobody has healthcare benefits, then the family income has to be high enough to afford $700-$1,000+ per month for insurance plus in most cases a 10-20% co-pay.
How many middle-class U.S. households can lose one wage earner's paycheck and be able to pay a new $800/month bill? Very very few.

In the Good Old Days, practically every corporate job provided healthcare coverage. Now is not the Good Old Days. If you're lucky to merely get laid off as opposed to losing your job when your employer goes out of business, you might get hired back on a "temp" or contract basis. Nice, but no benefits.

The fortunate families are those in which one wage-earner works for a government agency or municipality. The government gigs always provide gold-plated coverage for the family, so these folks have no worries--until the agencies and cities start laying off workers as tax revenues shrivel. Millions of homeowners are rushing to have their property taxes lowered as real estate values drop, and the net result is a dramatic decline in tax revenues.

So what I am suggesting is this: 20% of the middle-class--approximately 10 million households--could lose their middle-class status via home equity declines and loss of healthcare coverage, even as the "official unemployment" number provided a Potemkin-Village assurance that "unemployment is still low."

10 million households sounds like a lot, but let's recall that there are 130 million jobs at present. If 10 million people lost their jobs, that would be a 7.6% unemployment rate--not even close to the "official rate" in the 1981-82 recession of over 11%.

As we consider how 20% of the middle class could drop into the zero-equity working poor, let's note the following:

First, the loss of one benefits-rich job in a two-wage earner family is more than sufficient to drop the family from middle-class to working poor.

Second, even if both wage earners manage to hold onto jobs, if a jobs shuffle results in a loss of healthcare, then the result is still "working poor" status unless the family income can afford a $700-1,000/month insurance bill they never had to pay before.

Third, let's state the obvious: a temp/contract/part-time job is not equivalent to a fulltime position with full benefits, yet officially the two are equivalent: you're employed, buddy, that's all we care to count.

Fourth, the low-income poor have access to government entitlements such as school lunches and some healthcare coverage. If you fall completely into poverty, and are willing to grind through the paperwork needed to qualify, then you can have some of your benefits restored--though not the shiny middle-class variety you were used to. But if your income remains middling, then you fall into the Gap of Heck: too much income to qualify for low-income benefits but not enough to pay for middle-class perks like full healthcare insurance, 401K contributions, overseas vacations, etc.

Fifth, it is precisely the formerly middle-class workers who are most likely to drop off the official stats. The working poor are already in the lower rungs of the economy, and while they will suffer as restaurants and other service-rich businesses close, they are less likely to become contract workers, consultants, etc. and less likely to start a small business--all avenues formerly middle-class wage earners tend to pursue when finding a job equivalent to their old one becomes The Impossible Dream.

Sixth, let's recall that about 27% of U.S. households are low-income, and 32% of all the people filing income tax forms pay no Federal income tax. (See yesterday's entry.) If 10 million people are officially unemployed, how many are working poor and how many are/were middle class? That is a tricky calculation, but back-of-the-envelope suggests that if there are 10 million unemployed, 7 million are/were middle-class.

If unemployment rises to 10% or more, as it did in the 1981-82 recession, then that is about 13 million people out of work/looking for a job. If 70% of those folks are/ were middle-class, you have 10 million middle-class people in danger of falling into the working poor.

To summarize: an official unemployment rate of, say, 7.5% could easily mask a reality in which 10 million formerly middle-class households are now in the ranks of the working poor.

Now let's discuss the middle class sense of entitlement. For a variety of reasons-- mostly stupidity and general orneryness--I have been self-employed/operating a small business for most of my working life. Those of you in the same boat know the drill--your sense of entitlement is pretty limited. You hope for customers, and try to take care of those you have. You pay outrageous taxes and fees for the privilege of retaining modest freedoms, and are used to paying for everything: your own medical care and insurance, your own retirement (if any), and all the rest.

It's still a free market when you're in business for yourself. Businesses go under and wipe out the owner's savings, livelihood and esteem on a regular basis, even in good times.

Writing payroll deduction checks to the Feds every week for your employees' tax witholdings--five figures on those checks, my friend--gives you a different perspective, to be sure. So does paying your employees medical insurance, Workers Compensation, Temporary Disability and unemployment insurance costs. After years of that I am now happily a sole proprietor--no employees, just quarterly taxes and gargantuan property taxes to pay. It's like child play compared to the benefits costs for employees. Sure, my net income is poverty level, but life is a trade-off.

For the self-employed, entitlements are reserved for the poor and the elderly; we're the ones who are paying for the entitlements, not receiving them.

But those who have had good-paying jobs in the corporate or government sectors seem to be prone to "creeping entitlement" disease, in which healthcare and other benefits are "rights," along with rising equity and 401K retirement accounts.

The loss of benefits and middle-class status will not pass unnoticed. Heck hath no fury like an entitled person scorned, and people who were born to expect a lifestyle equal to or better than their parents will not go quietly into the night when they have to stand in line at the county hospital for healthcare, like all the other working poor.

Instead of ever-rising equity and the HELOC every year or two for new cars, fancy vacations and all the other luxe perks of the bourgeois, now they find themselves scraping by with no equity, a shrinking retirement (if they haven't pulled it out already) and insane medical bills. Sure, bankruptcy is a solution, but where does that put you? More or less on square one in a recessionary economy.

Here is the clincher: the poor don't vote, and the young don't vote, but the middle class votes. The poor are either too busy being poor or too overwhelmed by problems to have time for luxuries like political organizing. The wealthy just move to Costa Rica or stop reading the paper for awhile because it's "depressing." But the middle class is used to having a voice, and being heard by politicos is one of their entitlements.

Marx expected the proletariat (factory worker) to rise up, but he was wrong; political movements such as unions and regulations on "The Jungle" of rapacious Capital effectively co-opted the Revolution Marx forsaw. So who co-opts an angry, suddenly disenfranchised middle class? Unions? Regulatory improvements? A third political party?

I don't have an answer, but the Pareto Principle suggests that when the middle class sees their friends and co-workers descend into the working poor, and they sense their own systemic vulnerability to the same fate, then a politically righteous anger will arise which cannot be ignored or brushed aside with the usual phony PR shows and regulatory touch-ups like "medical savings acccounts."

Brilliant! Here you have 10 million households with no savings and a huge decline in income, and you set up "savings accounts" with "tax credits." So 50 million people won't owe any tax instead of only 42 million not paying a dime, and that's going to solve the U.S. healthcare crisis? That is beyond laughable.

Is it possible the middle class won't fall for the usual shuck and jive, that they will finally demand real change, and vote out the usual suspects of both parties as the toadies they are? Perhaps not, but I wouldn't underestimate the staying power and the welling rage of those who feel entitled to what is no longer attainable in the Current Political and Financial System.

This is the same human characteristic which might cause China to convulse in social disorder in the coming decade: when hopes for a better, more luxe life die, they die hard, and they take down the political structure which led to hope's demise.

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