 Real Estate
Bubble 3
Scott Wright, Zeal LLC
[Adam Hamilton's partner]
May 27, 2005
Fed to the rescue! After the
tech bubble had popped in 2000, the U.S. economy was tightening
and recessionary trends had been unleashed. In order to rescue
the economy, the Fed began to drop
rates at a blistering pace.
As Fed Funds rates plummeted,
mortgage rates followed. Home prices were already rising, but
in unison with the falling rates a speculative mania in the housing
markets caught sail. The combination of such has led to a mass
Real Estate investing, refinancing and cash-out refinancing frenzy.
Alan Greenspan's architecturally
brilliant plan was coming together. It was now time for the
GSE forces of Fannie Mae and Freddie Mac to jump onto this bandwagon
and fulfill their mission by injecting the economy with massive
amounts of capital liquidity. Consumer spending was up big,
buoying the economy and putting a halt to the recession. A successfully
fabricated false sense of wealth was infused into our consumption-based
economy, hence the birth of the Fed-generated Real Estate bubble.
Skeptical contrarians were
not the only ones watching this unfold. The Office of Federal
Housing Enterprise Oversight (OFHEO), the government unit tasked
with regulating Fannie Mae and Freddie Mac, recently published
a research paper stating the obvious about the latest economic
recovery. "The housing market contributed significantly
to the Nation's economic recovery Falling mortgage rates stimulated
housing starts and sales, and many refinancing borrowers took
out loans that were larger than those they paid off, providing
additional funds for consumption expenditures."
Any economist can recognize
that the housing market has rescued and boosted the economy of
recent, but at what cost? Even before the Real Estate bubble,
our consumption-based economy had been accumulating household
debt much faster than it could pay it off. How can this consumption-laden
mortgage frenzy be healthy for our economy?
In 2004 total residential mortgage
debt outstanding (MDO) grew by a staggering 13.2% to $8.7 trillion,
the fastest rate of annual growth since 1986. Numbers in the
trillions are unfathomably ridiculous. To put this massive MDO
number in perspective, our national debt is just about $8 trillion.
Wow! Residential MDO is greater than our Federal Government
Debt!
We've already discussed how
this Fed-generated Real Estate bubble has come upon us, the fruition
of a speculative
mania along with the Fannie Mae and Freddie Mac debt-laden
time-bomb that is rearing its ugly head. Now let's focus
on how this will affect the average consumer and the socioeconomic
burden that Americans will have to bear.
There used to be an old rule
of thumb that your total housing expenses, which include your
principal and interest mortgage payment, property tax and home
owners' insurance, should at the most amount to 25% of your gross
monthly income. In today's society, that does not seem to be
the case anymore. Many families are spending far more than 25%
of their gross income on housing expenses.
A recent study conducted by
the Center for Housing Policy revealed that in the last five
years the number of working families paying more than 50% of
their income for housing has jumped by 76%. Millions of households
are paying more than half of their income for housing. This
is a staggering reality that should be troubling for anyone.
There are several attributing
factors that led to this trend. First are the lingering effects
of the Real Estate bubble, and the fact that home prices are
rising much faster than the average median income. Countless
Americans who choose to buy a home or upgrade to fit their growing
families are forced to buy at artificially inflated prices in
fear they will miss out and in the near term the same home will
have gone up 10%-20%. This fear has been overshadowed with greed
and confidence that even though they are overextending right
now, it will be a good investment because of the perceived guarantee
of future appreciation.
The socioeconomic conundrum
Americans are faced with can be explained visually in the chart
below. This chart shows the national percentage savings rate
mapped against annual household debt in trillions of dollars.
Notice the distinct trends over the past 40+ years. Household
debt is on a near parabolic upward trend and personal savings
rates are tailing to precarious lows. Since 1980, household
debt has risen an obnoxious 623% while personal savings rates
have pitifully decreased by 3/4ths.
This chart alone tells the
story of the state of our economy. America is so blinded by
short-term bliss that it doesn't think about the future. Today's
society is taught that debt is good, and acceptable. Unfortunately
it's a highly contagious and dangerous epidemic. We certainly
don't have a good mentor on this issue either. Big Brother has
been piling up debt like it's going out of style, with war and
terror as government's latest excuse to keep it rolling.
Before the Real Estate bubble
household debt was becoming a major problem, but the recent infusion
of cashflow created from increases in home equity has not only
delayed the attention this problem demands, but has made it far
worse. To add to it, the fragile
state of the U.S. dollar is not contributing a warm-fuzzy
feeling to this situation. The dollar is in a bear market that
is capable of knifing through the already dangerous lows we are
witnessing today. Our dollar-weakened, debt-laden economy will
likely experience turbulent times ahead.
As you can see above, the average
personal savings rate for Americans has pitifully fallen below
2%. There are those that save far more than 2%, but sadly there
are those that not only save nothing at all, but spend more than
they make. These individuals and families are coined net borrowers.
An old proverb puts it plainly, "If your outflow exceeds
your inflow, then your upkeep will be your downfall." Unfortunately
many people will learn this lesson the hard way.
A recent study by the European
Central Bank (ECB) and the European Savings Institute showed
that Europeans on average save three times as much as Americans.
Many Asian countries save even more comparatively. This study
also indicated that when borrowing was thrown into the equation,
Europeans were net lenders and Americans were indeed on average
net borrowers.
The savings rate information
in our chart above is provided by the Bureau of Economic Analysis
(BEA). According to the complex formula they use to get their
numbers, borrowing is supposed to be taken into account. There
could be other factors that go into the aggregate European study
that the BEA doesn't include, but either way, these are astounding
figures. Head ECB economist Gabriel Quiros puts it quite eloquently,
"As a result of the high level of savings in Europe we have
two different worlds European households are clear savers and
net lenders while in the U.S. families are net borrowers
this has huge macroeconomic implications."
With American household debt
piling up at this rapid pace, it's no wonder personal savings
rates are declining so fast. People cannot afford to save anymore.
Today's consumption-based society has lost whatever discipline
previous generations have taught us. The baby boomers who are
retiring today saved and invested like they should have. They
took the discretionary out of discretionary income and just saved
it.
To me the chart above is very
sad and frankly a little embarrassing. How on earth can people
save for emergencies or retirement with savings rates like that?
Social Security is sure not going to bail them out. Social
Security was never intended to be a person's only source of income
for retirement. In fact, if the government doesn't find a way
to bail out Social Security, it will go negative cash flow in
as little as 10 years and bankrupt in 35 years. My father always
told me, "Don't rely on someone else for your financial
well-being. Work hard, save as much as you can, and try to have
fun while doing it."
Now it is natural for household
debt to rise over time, gradually. A myriad of underlying factors
can contribute to this. Some of the major factors include the
increased use of credit as a convenience for supposed discretionary
income purchases as well as a higher percentage of the growing
population becoming homeowners. But even with that, and all
logical factors combined, it cannot explain the acceleration
of household debt we've seen over the last 5, 10 and 20 years.
This near parabolic rise in household debt is preposterous,
irrational and unsustainably dangerous.
You may be asking yourself
at this point, what does the Real Estate bubble have to do with
this? You've shown me a frightening reality, but what do personal
savings rates and general household debt have to do with the
Real Estate bubble? To put it plainly, the Real Estate bubble
has directly contributed to the rampant growth in household debt
and rapid decline in savings rates.
For all naysayers who still
don't believe there is a Real Estate bubble, I'll show how the
so-called housing boom has created a mythical wealth effect that
has contributed to the socioeconomic nightmare that we are in
the midst of, and how damaging it has been and will be for our
already fragile economy.
Most Americans today, plain
and simple, do not know how to effectively and efficiently manage
their finances. With housing prices increasing at break-neck
speeds, people have been using this as increased leverage for
their spending habits. Not only are they using these home equity
gains to consolidate other debt in order to take advantage of
the low rates and tax advantages of mortgage interest (in effect
transferring debt so they can get into more debt), but they are
using it to consume, consume, consume.
A major problem with our consumption-based
society is the lack of discipline. We will use a home equity
loan or line of credit to pay off credit card debt, but our eagerness
to consume brings us full circle right back into this trap.
"Gee, my credit card debt is gone, so I now have room to
treat myself to a few things. I'll be able to pay it off, it
won't get out of hand like last time." How many people
do you know live above their means? If you can't afford to pay
it off right away, then don't buy it! This concept is inherently
simple, but apparently difficult for people to grasp.
We also must give credit where
credit is due. Supported by the secondary mortgage market, the
banking and mortgage brokerage industries have done their best
to brainwash and convince people that drawing money from their
homes, for any purpose, is wise, good and expected. In the last
10 years, the fastest growing job market has to be in the mortgage
brokerage industry. Mega-bucks have been spent to market this
front.
I'd like to provide some situations
I'm sure you've witnessed over the past few years in which your
friends, family, co-workers or perhaps even yourself have taken
part. Situations in which they unknowingly contributed to the
increase in consumer spending, have been given a false sense
of increased wealth and in turn have helped the buoyancy of the
economy.
First, lets look at it from
the eyes of those actually conscious about loan-to-value (LTV)
ratios. My hypothetical condo worth $150k several years ago
is now appraising for $200k because of the Real Estate boom.
A primary loan can now be taken out for up to $160k and I can
still stay under the magical 80% LTV ratio, and not be required
to pay mortgage insurance.
My existing loan is at $105k
(original loan amount was $115k) with an interest rate of 7.50%.
Hmm, $35k can go a long way for me. I can buy a car or that
fishing boat I've always wanted or perhaps take the family on
a really nice vacation, pay off some of my credit cards and save
the rest. Not a problem, because now I can refinance taking
out a loan for $145k ($5k in closing costs) lowering my rate
to 5.5%, get my $35k in cash, and have virtually the same payment
as before. It's magic! Poof! $35k into my hands so I can go
out and spend doing my part to keep the economy liquid.
Next let's look at it from
a different viewpoint. I am a typical American, up to my eyeballs
in debt. I have all kinds of credit card debt and can currently
only make minimum payments. I am virtually maxed out on the
equity of my home, but, the value of my house is starting to
rise again, yippee. Several years ago my house was worth $150k,
now it is worth almost $200k.
My current loan is for $142k
(original loan amount $145k) with an interest rate of 7.75%.
I can now refinance again tapping into my new equity, reduce
my rate, pay off my credit cards and have a little extra to save,
or spend. I can take out a new primary mortgage for $180k (90%
LTV) at a rate of 6.125% (can't get the best rate because of
my credit and LTV). Sweet, I now have an extra $33k ($5k in
closing costs) to consolidate some of my other debt with a little
extra to spend. The best part is my payment only goes up about
$50 per month.
These are simple, straightforward
examples of some of the scenarios we've seen the last few years.
There are a plethora of other more complex and devious schemes
to get people into more housing debt. The above examples used
fixed rate, 30-year mortgages. I dare not venture to give examples
of excitable second and third mortgages, variable rate loans,
greater than 30-year terms, LTV ratios up to 120% and so on.
In the last 10 years lending vehicles like these and more have
been created that are ridiculous and dangerous for consumers.
To add to the ridiculousness,
adjustable rate mortgages and the new fad of interest-only mortgages
are becoming more and more popular. People are using these mortgage
types to get the lowest payments possible so they can buy even
bigger homes, and hence take bigger loans. In my opinion, there
are very few situations that would warrant these types of loans,
especially in today's environment where interest rates are starting
to rise and may not be as stable.
It's estimated that nearly
one-third of American household debt is outstanding on variable
rate loans, mostly between mortgages and credit cards. Some
metropolitan areas where speculation is rampant have over 50%
of their mortgage loans packaged as dangerously volatile interest-only
loans, yikes!
Please don't take this the
wrong way, as I am certainly not trying to tell you all refinancing
is bad. As rates go down far enough, it is absolutely logical
to refinance in many cases. I personally took advantage of the
low rates last year. There was enough of a difference in my
existing rate and market rate that I was able to not only lower
my monthly payment a little, but reduce the term of my mortgage.
Notice that I did not add to the term of my mortgage or increase
my loan amount; I took advantage of the situation to better the
future financial outlook for my family, which unfortunately seems
to be a rarity in today's refinancing arena.
It's unfortunate but apparent
that this generation of homeowners takes less merit into paying
down or even paying off its mortgages. Previous generations
deemed this as a lifelong financial success if they were able
to retire without a mortgage payment. As ironic as it may seem,
the word mortgage is actually derived from a 16th century Old
French word that literally means "death pledge". Far
too many people will be taking mortgage payments to their grave.
What's fascinating is residential
Real Estate was never really considered a major investment or
source of personal wealth until the last 30 to 40 years, and
more so in the last 5 to 10 years. Before the 1960s, your home
was a roof over your head where you cooked a warm meal, raised
a family and grew old in it.
With the Real Estate bubble
helping to drive household debt up and send savings rates down,
I do not see how the outlook for Americans can be better than
bleak. Even worse, if the Real Estate market spirals down to
reality with the surge of an oceanic vortex, the bleakness will
be accelerated.
Here's how it may pan out when
the Real Estate bubble unfolds. First, probabilities lean toward
a future of rising interest rates and falling home prices. As
interest rates rise, countless homeowners will be exposed to
variable-rate mortgages, those that have blessed people with
such low payments and have allowed so many people to afford oversized
homes. As rates rise so will their payments, and many homeowners
will not be able to keep up with them.
As home prices fall, many will
be underwater on their mortgages, meaning they will owe more
than their house is worth. What if they need to sell their house
to get out from under this burden? They won't be able to, unless
if it's at a loss, which they will not be able to afford either.
Because of this, many mortgages will become delinquent and/or
not paid at all.
To continue on the "ifs",
what if someone loses their job as corporate America tightens
up in a recession? Our consumption-based economy has encouraged
people to be up to their eyeballs in debt. The average household
already pays far too high of a percentage of their monthly income
on a mortgage payment and does not have liquid funds to fall
back on if hardships happen. In fact, most households today
need to have dual wage earners in order to afford their mortgage.
All it takes is for one of them to lose their job for a mortgage
payment to go unpaid.
The combination of rising rates
and falling home prices are among several economic forces that
will cause mortgage delinquency and default. Undisciplined consumers
will not be able to keep playing the game they are today. Now,
it won't be a majority of the populace that will be in this situation,
but it doesn't take but a healthy-sized minority to create serious
ripples in the financial markets.
What many people do not understand
is thanks to the secondary mortgage market, most mortgages act
as an underlying asset to a security that is traded in the open
markets. These securities rely on the cash flow from these mortgages
to fund their investors. As more people become delinquent on
their mortgages, there will be a shortage of cash flow for those
that guarantee these securities (Fannie Mae and Freddie Mac primarily).
If there are enough delinquencies
and forced prepayments, there is the possibility that the guarantors
of these securities could default on these obligations. If that
were to happen it would be disastrous! In the previous
essay we talked about the implications of such and
how it may affect the global financial markets.
Delinquencies aside, as interest
rates rise and home prices fall, consumer spending will come
to a screeching halt. The resilience of the consumer will be
tested. As consumer spending decreases a domino effect will
likely occur that would bring the economy back into a recession.
Corporate profits would fall, less money would go into the stock
market, unemployment would rise, bankruptcies would rise, etc
To top it off, we may be in
line for another banking crisis similar to if not worse than
the Savings and Loan crisis in the 1970s and 1980s. Events that
led up to the S&L crisis climax are possibly being played
out all over again today. Assets are overvalued and when these
assets start to lose value the loans that are backed by these
assets have a much higher probability of default.
A frightening reality was revealed
to me by a friend in the banking industry. From what he says,
banks are getting more and more concerned with the potential
fallouts of this Real Estate boom. The way they look at it,
when interest rates increase, less people will qualify for loans
or it will be for smaller ones. People still have to sell houses
so they are forced to reduce prices to fit the pool of qualified
buyers.
He tells me that unfortunately
it is too easy to walk away, or default, on a home loan. Those
people that bought too high and realize their home is not worth
what they bought it for will need to move, downsize, etc so if
they can't sell their home timely or equitably, they may just
walk away from their home loan.
Depending on the state, certain
deeds of trust allow for or require what is called a judicial
foreclosure, in which the lender can get a deficiency judgment
against the borrower for the balance of the loan after the property
is foreclosed upon. From what I am told, that is an extremely
rare occurrence in those states that do not require it. Banks
are not in the Real Estate business, they are in the money business,
and are just not willing to put forth the time and expense involved
in a judicial foreclosure if they do not have to.
In most cases when a borrower
walks away from a mortgage loan, the lender performs the trustee
sale method allowed in many states, also called a non-judicial
foreclosure. In a trustee sale, the home is foreclosed upon
and auctioned through the courthouse, usually at a big market
value loss.
Due to the "one form of
action rule", once the lender performs this trustee sale,
the borrower has no further liability to the lender. If someone
were to walk away from their home loan, all it would seem to
hurt personally is their credit, and that's it. Huge bubble
states like California are not required to perform these judicial
foreclosures, and tend to lean towards the trustee sale method.
It will be interesting to see if banks change this approach
as defaults increase over time.
When a trustee sale occurs
in a declining market, the lender will most likely not recover
the original loan amount taking a loss on its books. Enough
losses and the lender becomes insolvent, just like what happened
in the S&L crisis years back. A banking crisis may or may
not become a reality, but if an increasing number of homeowners
start to default on their loans, the economic repercussions will
be alarming.
We've provided just a small
glimpse of how the Real Estate bubble has affected our economy
past and current and how it may affect it in the future. In
our series focusing on the Real Estate bubble, we have outlined
our case for affixing the dreaded bubble
tag to today's housing market, discovered the forces that created and
exploited it and looked at the socioeconomic repercussions
of such.
Though it seems like the damage
has been done, there may be more to come. Time and awareness
are now our allies as we watch how this plays out. Regardless,
it is time to be aware of what we may be up against. Join us
at Zeal as we take our research and analysis to the next level.
No matter what forces are pulling at the markets, there is always
room for prudent speculations and investments.
Scott Wright
[Adam Hamilton's partner]
May 27, 2005
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