Monday, April 07, 2008

Will Delinquencies Trigger a New American Revolution?

Two years ago I predicted we'd soon see 5 million foreclosed/distressed homes, 5 million REO/investment/2nd homes languishing on the market and lender/thrift losses of $500 billion. I seem to have undershot the losses, but how many analysts/pundits/ media types are on record in April 2006 with predictions like these?

Foreclosures and Financial Ruin: How Bad Will It Get? (April 26, 2006)
How Many Foreclosures Will Hit the Market? (May 1, 2006)

I went on to posit that the Pareto Principle suggested that a mere 4% of homeowners could influence 64% of all housing's value: Can 4% of Homeowners Sink the Entire Market? (February 21, 2007)

And here we have it: The delinquency rate for all mortgages climbed to 5.82 percent in the fourth quarter. Since housing has in aggregate dropped some 15% since I wrote that entry, it certainly seems to bear out a 4/64 Pareto effect.

The Pareto Principle we are familiar with is the 80/20 rule: 20% has an outsized influence on the 80%.

And now we see the magic 20% number has been hit in subprime mortgages: Mortgage delinquencies hit 23-year high (March 6, 2008)

The delinquency rate for all mortgages climbed to 5.82 percent in the fourth quarter. That was up from the 5.59 percent in the third quarter and was the highest since 1985. Payments are considered delinquent if they are 30 or more days past due.

Homeowners with tarnished credit who have subprime adjustable-rate loans were the hardest hit. Foreclosures and late payments for these borrowers also swelled to all-time highs in the fourth quarter.

The percentage of subprime adjustable-rate mortgages that entered the foreclosure process soared to a record of 5.29 percent in the fourth quarter. That was up from 4.72 percent in the prior quarter, which had marked the previous high. Late payments skyrocketed to a record high of 20.02 percent in the fourth quarter, up from 18.81 percent — the previous high — in the third quarter.

The association's survey covers almost 46 million home loans nationwide. I now suggest that when housing-related losses in equity and recessionary job losses stemming from the credit/housing-bubble debacle impoverish 4% of middle-class Americans, that will heavily influence 64% of the remaining middle-class.

And when 20% of middle-class Americans have suffered significant financial losses in equity, income and benefits, that will trigger a New American Revolution (TM)--a bloodless revolution, but a Revolution nonetheless.

So how many people are in the American middle-class? Let's start with a diagram courtesy of the FDIC on home ownership, for that is a fairly reliable guide to membership in the middle class. Why? Not only is a house the basis of most family's wealth, it is also the bedrock of retirement and whatever wealth the older generation can pass on to its children and grandchildren.

What this graph reveals is that home ownership peaked at 69% in the bubble, and the 5% who really couldn't afford to buy a house except with exotic/toxic subprime/no-doc/etc. loans, will likely lose their homes as the recession deepens, dropping homeownership back to its historical average of about 64%.

Please note that many who are losing their homes bought long ago with conventional loans. But since they extracted most of their equity during the bubble via refinancing and HELOCs (home equity lines of credit), they are now as underwater as the subprime buyers who bought a house with no money down.

So how many people are we talking about when we posit that 20% of the middle-class dropping into financial insecurity will spark a political uprising?

Let's refer to:
Income Inequality (Middle Class) - Narrative (US Census Bureau)
American middle class (wikipedia)
US Census Bureau QuickFacts
Financial Services factbook

I know this is mind-numbing, but we're talking numbers so we have to source all this and put it together. Let's summarize the big numbers:
population of the USA: 303 million (as per US Census website, link above)
number of households: 105 million
Housing units: 126 million
primary residence single-family houses: 75 million (25 million owned free and clear, 50 million mortgages)

Second-Home Market Surges, Bigger Than Shown in Earlier Studies (March 2005):

An examination of 2003 data from the Census Bureau shows there are 43.8 million second homes in the United States, including 6.6 million vacation homes and 37.2 million investment units, compared with 72.1 million owner-occupied homes. As with all data from various sources, it's easy to get confused. Let's note that almost two million new housing units were built every year during the bubble-boom, so that explains how 2003 data can list 72 million owner-occupied homes and later data states 75 million.

Let's also note that the Census Bureau's 126 million "total housing units" includes second homes, investment units and large multi-unit apartment complexes.

Interestingly, there are 20 million vacant dwellings in the U.S., of which only 7 million are vacation homes. So much for any perceived "shortage" of housing, of any type.

Now let's turn to Summary of Latest Federal Individual Income Tax Data.

There are 132 million tax returns filed, which not surprisingly is about the same number of jobs in the "official" (non-black market/undocumented worker) economy.

42 million file a return but don't pay a dime. 90 million file and pay something. The top 1 percent of taxpayers (income over $364,657) earned approximately 21.2 percent of the nation's income yet paid 39.4 percent of all federal income taxes.

90.6 million of the tax returns came from people who paid taxes into the Treasury. That leaves 42 million tax returns filed by people with positive AGI who used exemptions, deductions and tax credits to completely wipe out their federal income tax liability.

The top-earning 25 percent of taxpayers (AGI over $62,068) earned 67.5 percent of the nation's income, but they paid more than four out of every five dollars collected by the federal income tax (86 percent). The top 1 percent of taxpayers (AGI over $364,657) earned approximately 21.2 percent of the nation's income yet paid 39.4 percent of all federal income taxes. That means the top 1 percent of tax returns paid about the same amount of federal individual income taxes as the bottom 95 percent of tax returns. The top 10% of taxpayers earn 46% of the total gross income.

OK, let's put this all together. 26% of the nation's population is at or near poverty level. That's about 27 million households. (Let's use households rather than population because it correlates to housing units. These low-income wage earners-- 42 million--pay no taxes.)
13 million taxpayers earn almost half the total gross income, so let's call them wealthy, i.e. "not middle-class." Some households have two such earners but just for simplicity let's say 27 million households are impoverished and 13 million are wealthy, which leaves 65 million households in the middle-class.

That aligns rather nicely with the FDIC homeownership rate, which states there are about 67 million homeowners.

Other analysts (see above links) place the number of middle-class households at 50 million, which may be more accurate. Consider who owns their home free and clear; some are wealthy households, no doubt, but many are elderly retirees who paid off their 30-year conventional mortgage and who may now be living on modest "non-middle-class" incomes. (The median household income in the U.S. is about $46,000/year).

Since there are about 25 million homes owned free and clear, we can surmise that many are owned by people who are old enough to have paid off their 30-year mortgages and are now living on Social Security and pension/retirement incomes.

If so, we have to divide the 65 million middle-class homeowners into those who are receiving government entitlements (Social Security and Medicare) and those who are paying through the nose in taxes.

So let's posit that there are about 50-60 million middle-class taxpaying homeowners/ households. There are about 50 million mortgages, and that aligns pretty well with the guesstimate of 50-60 million middle-class households.

According to the Pareto Principle, 4% of the middle-class losing their equity, jobs and healthcare will have an outsized effect on 64% of their brethren. That suggests that once as few as 2 million formerly middle-class households lose their equity (they could hang onto paper ownership of their home, but if their mortgage exceeded the value of the house, then their wealth has effectively vanished), or their jobs and healthcare, then a political earthquake will be unleashed.

And once 20% of the middle-class --10 million households--have experienced major degradation in equity, income and healthcare benefits, then the New American Revolution (TM) will begin.

What shape will the revolution take?

I think it is safe to say the New Revolutionaries will demand that a distinction be drawn between investment bankers making $300 million each for playing around with risky leveraged paper and true entrepreneurship, i.e. real people starting businesses which produce tangible goods and services and "real-world" meaningful innovations.

I would guess that the new Revolutionaries will demand a government which lives within its means, and thus the government must scale back entitlements which are unaffordable.
I also suspect that many of the New Revolutionaries will demand a currency backed by precious metals.

I would imagine/hope the New Revolutionaries would see the wisdom of regulations, transparencies and checks and balances to rein in the worst excesses of human greed, avarice and duplicity, just as American Revolutionaries in previous generations so wisely did.
You would be completely justified for reckoning my prediction of Middle-Class Political Revolution as absurd, wild, etc.--but then look at how well the Pareto Principle predicted the housing bubble's consequences.

More on this topic tomorrow--

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