by Scott Wright
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 section 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.
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