Wednesday, May 28, 2008

The Housing Capital Trap Snaps Shut

Astute reader Jim S. suggested examining how the capital trap snapping shut in housing will affect the middle class, which relies so heavily on home equity for its wealth--and for the past six years, for its spending.

Excellent idea, Jim, so let's dig into how the Trap was formed and how it's snapping shut with such pernicious force.

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1. We used to save money from earnings, now we don't. In the high-inflation 70s, savings actually spiked up. In the dot-com mania, savings plummeted into negative as everyone felt so wealthy from their stock gains they spent more than they earned. The housing bubble created the same "spend more than we make, withdraw savings" mentality.

2. We're spending money we didn't earn.

3. Housing assets have become a dominant part of household wealth and the U.S. economy.

4. We're spending an ever greater share of our income servicing the debt we took on during the equity-extraction mania. Refinancing, second mortgages and home equity lines of credit (HELOCs) enabled us to extract all that wonderful "free" unearned equity created in the housing bubble. Alas, the monthly interest remains even though the bubble has popped.

5. This decades' "Wealth Effect" was entirely the result of the housing bubble.

6. Real estate and housing have grown their share of banking assets. So not only has housing grown into the dominant asset of the U.S. middle class, it's also become a greater percentage of the banking industry's asset base. As the bubble pops, it diminishes the wealth not just of homeowners but also of lenders and everyone who owns mortgages or derivatives based on mortgages.

Back in the good old days, house prices rose about 1% above inflation, and people paid off their 30-year fixed-rate mortgages as they retired in order to leave their children an asset. A house was widely seen as a brick-and-mortar savings account, and for decades a house cost about 3 or 4 times annual income. The idea that you'd refinance your mortgage in order to extract equity to spend right now was anathema for a variety of cultural and financial reasons.

In the good old days, if you bought a house for $30,000 and had to move in a few years, if you sold it for $32,000 you'd have been tickled pink. You took whatever equity you had from the sale and bought another house with it. HELOCs, like $100,000 hospital bills for a few days' stay, did not exist. If you maintained your house, you could sell it into a stable market; people bought and sold when they moved, and speculation was of the "buy, fix it up and rent it out for longterm appreciation" mindset.

People saved up money from earnings in order to buy a new car or take a vacation. If you needed a new washing machine, you might put it on a Sears credit card. No one borrowed a year's pay off their house to buy stuff; that equity was untouchable.

From one point of view, the equity in one's house was a capital trap. It just sat there, untouchable, growing by a mere 1% per annum above inflation. But since interest rates were stable and the interest earned from savings or dividends was also low/stable, just like inflation, that return on investment wasn't considered too out of line with that earned by other assets. After all, other than brief recessions, housing rose at a slow rate similar to a savings account.
But in one important sense, it wasn't trapped; except for brief recessions, there was always a market for your house. If you had to sell, worst-case scenario was a modest loss in equity due to the transaction costs (realtor commission, etc.)

Fast-forward to the present: everyone expects a 20% annual return on their leveraged "hot money," inflation is rising and house values are plummeting--by 14% in just Q1 of 2008. This is quite a different story. Even as income remained stagnant, Americans borrowed ever-larger sums off their bubble-inflated housing equity. Now that the bubble has popped, the interest on all that new debt (and rising food-energy inflation) is squeezing incomes even as "paper wealth" in home equity vanishes like a puddle of water in Death Valley.

House have become a massive Capital Trap. Why? Let's look:

When an asset starts depreciating rapidly, the smart investment decision is to sell it quickly and conserve whatever capital you still have--unless it's illiquid, in which case your capital is trapped. Is real estate still liquid? In some parts of the country, yes. There is a "false bottom" buying binge underway in some areas, where speculators/owners are so anxious about missing the "great bottom in housing" that they're jumping in five or six years too early.

Once those bubble-echo sales dry up, then the Capital Trap snaps shut. Homeowners who were "waiting for prices to go back up" will be unable to sell, even as their capital declines every month. That is the very definition of a capital trap.

Cash and cash instruments are much better investments; even if they're not quite keeping up with inflation, they're not dropping by 15% a year, either. And they can be moved into precious metals or other investments for very low transaction fees, too.

When will the capital trap open? As I have covered here before, housing is entirely, totally, completely dependent on readily available, cheap money. Once money becomes dear to borrow or can't be borrowed readily, housing dries up and blows away.

So when is money going to become cheap and readily available? As speculators flee the extreme risks of mortgages and as interest rates inexorably rise, that day recedes ever farther into the future.

We all know many millions of homeowners are now "under water," i.e. they owe more on their mortgages, second mortgages and HELOCs than their homes are worth. They represent an enormous pool of ready sellers once prices edge up. How many would be glad just to get out from under their mortgage? And what does that overhang of ready sellers do to prices? It undercuts any sustained price rise. Every time prices rise, another wave of sellers emerges to get out, driving prices right back down.

So what does this capital trap mean for the middle-class, whose household wealth is largely measured in home equity? Rather obviously, the "house ATM machine" has been carted off; but it also means household wealth will plummet along with housing values.

Jim S. offered this thought-provoking commentary on the political consequences of this gigantic Capital Trap:

Historically, ALL major bubbles have retraced to their origins, and, as Soros noted within the last week, overshoot for a while below the starting point and then recover to the starting point. Until proved otherwise, buyers not forced to buy for some reason should wait for that confirmed uptick of home appreciation that history says is necessary for any possibility of reasonable appreciation. The 'falling knife' of home depreciation has a long way to go, and should be viewed as a great risk.
At a time when policy makers propose that Fannie Mae/Freddie Mac proceed with 3-5% down to facilitate home sales, which only continues 'subprime' results as it is occurring during a falling market with no bottom in sight, a serious homebuyer should recognize that, with further home equity declines of just up to 10-15%, they will have long been permanently buried and possibly financially destroyed. It just seems screaming common sense to consider new home ownership as a non-starter as it seems to be a sure thing capital and financial trap.
With the value of all middle class homes being quoted as about $20 trillion, a mere 5% drop across the nation reduces middle class wealth by $1 trillion...e.g. a drop of 15% erases $3 trillion. Some analysts have projected $8 trillion in losses before bottom is could be more, it could be less. Considering that some analysts say a bottom will not be reached until 40-50% loss, the future is daunting.
In any event, this thing is so massive that the middle class may never recover in our lifetimes the home equity values they are going to lose in this evolving 'L' shaped recession. It is not possible to generate an economy that will provide real wage increases that result in recovered wealth or productivity for large numbers of people.
As money is necessary these days for any entity to achieve political effectiveness with our political parties, the middle class is going to lose such a mass of wealth as to significantly impair its representative powers on behalf of its own and the nation's interest.
This aspect of the debacle has not been addressed yet by commentators, but it will in just a few years be a significant loss for the middle class and a relative empowerment of special interests. This wealth loss of the middle class should be detectable from the election of 2012 and onward.
In short, the housing debacle is going to be a prolonged one, a deep one, and one that threatens the ability of the middle class to represent itself financially in the maintenence of its own perceived freedoms.

Well said, Jim, and thank you for extending the Capital Trap's effects into the political sphere.

Please read these two new provocative Readers Journal Essays:

While Your Were Out... (Harun I.)
How Will Gas Prices affect the Blue Collar/Poor? (Noah Cicero)

Thank you, J. Dorsey ($25), for your extremely generous donation to this site. I am greatly honored by your support and readership.

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