America's unreal estate
problem By Max Fraad Wolff
American "castles" (homes) are
middle-class walls of separation from poverty and
want. As goes the house, so goes the family's
ability to fend off tough times and leverage past
wealth for new opportunities.
Borrowing to
bridge low-income periods, college and university
costs, medical expenses, bail, renovations,
retirement and unemployment are all common. This
is the proper frame of discussion for the
impending debt/depreciation storming of the
castle.
A few
basic facts are worth repeating. US$1 trillion in
residential
mortgages were
written in the United States last year. Nearly 70%
of Americans own their residences. The home is by
far the largest asset "owned" by the bottom 80% of
citizens. For the past 10 years, and particularly
the past six, things have gotten pretty darn wild
in the US real-estate world. Perhaps "unreal
estate" would be a better phrase.
Housing
prices, refinancing, building and improvement have
mushroomed in the US. Many Americans have made
significant gains in home-asset value - at least
on paper. There is no longer debate that things
have gone way beyond anything that might be
sustained. Such debates are silly and are better
handled by psychologists than economists. As an
economist, I will defer to those equipped to
comment from real knowledge and experience.
The coming return to earth will be uneven
and disorderly. This we know from past episodes,
and our extensive and growing experience with
bubbles - the new engine of the US macroeconomy.
The housing troubles ahead are serious, and this
is largely symptomatic of the greater shake-out in
progress.
A significant portion of the US
middle class is no more. Housing is about to turn
into another serious problem for these beset
masses. It will join health coverage and costs,
pension woes, massive debt, intergenerational
demands and stagnant wages among the litany of
woes. All of these afflictions are related and
interacting. Wages have lagged, health-care cost
increases exceed the rate of inflation several
times over, and university tuitions soar.
Aging parents require help with medical
costs, children cost more, and their early career
wages don't come close to supporting a
middle-class existence. Thus longer and more
expensive support is often required. There are no
savings, and pensions are shaky. Rising house
prices were a godsend to many Americans -
financially and psychologically. This will soon
turn on its head.
Housing appreciation has
been the lender of first and last resort for
millions of American families. Refinancing,
cashing out or interest-rate lowering has paid for
more than meager gains in wages - even after some
very modest tax relief. After-tax income gains,
skewed up by salary scales and taxation changes,
were about US$375 billion in 2005. Depending on
which estimate you accept, about $550 billion was
extracted through cash-out refinancing.
It
is clear that housing appreciation has become the
crutch for many limping families in the US. Rising
home prices - unsustainable and already
decelerating - have been an essential enabler of
bill-paying and consumption. Thus housing
appreciation did more for American families last
year than wage and salary increases. This is set
to reverse. Mortgage News Daily has recently
reported an ominous sign of desperation.
During the first quarter, the median ratio
of old-to-new interest rates was 0.98, which means
that one-half of US borrowers who were refinancing
mortgages ended up with a new loan with a rate
that was 2% higher than the old rate. [1]
Thus refinancing is clearly driven by the
need for cash from appreciated housing more than
rate changes, which should be a discouraging sign.
Such refinancing reached record levels across the
first quarters of 2006 and accounted for just
under half of the mortgages owned by Freddie Mac
(the Federal Home Mortgage Corp). Seventeen
consecutive interest-rate hikes were no match for
the needs and wants of US homeowners.
Financial firms and employment have been
massively assisted by the US housing bubble, but
they are vulnerable to price stagnation and
decline. The most recent Federal Deposit Insurance
Association (FDIC) Quarterly Banking Profile,
while upbeat, offers some remarkable numbers.
Across the fourth quarter 2005, residential home
equity lines and mortgages accounted for 38% of
new loans and leases. [2]
This simply
states that US families and financial institutions
are dependent on housing-price gains. Households
also gained - many directly and some indirectly -
from the employment generated by housing. Across
the early years of the post-equity market meltdown
(2001-04), housing and related sectors accounted
for more than 40% of US private-sector payroll
growth. Since rate hikes began to affect markets,
housing and related sectors account for less than
15% of private-sector payroll growth. This is an
ominous trend. As housing has cooled, new-jobs
creation has cooled in tandem.
The
fragility and risk associated with housing gains
are very serious. The Office of Federal Housing
Enterprise Oversight releases a housing price
index (HPI) for every quarter. In the past 21
quarters the mean annual increase measured in each
quarter was 9.32%. In the 21 proceeding quarters
the mean quarterly increase was 4.8%. Thus as
economic growth and labor-earnings growth cooled,
housing-price appreciation rates doubled.
In the past five years the average house
in the US has increased in price by 57%. Over the
same period real gross-domestic-product growth was
15%. The most optimistic White House Estimate of
real after-tax compensation increased by 8%. [3]
Unreal-estate price increases are just that. Brace
yourself for a dose of reality that will fall
heavily on the shoulders of those Americans least
able to bear the load.
Here the risks are
extreme and the potentially impacted group is
large enough to have macro-significance. ACORN
(the Association of Community Organizations for
Reform Now), a community advocacy group, released
"The Impending Rate Shock" on August 15. This
report examines 130 metropolitan areas in the
United States and offers a first glimpse at the
extent of risk and fragility of housing finance
for lower-income Americans. In 2005, adjustable
rate mortgages (ARMs) accounted for 24% of all
residential loans and 75% of sub-prime loans.
One million US households have either
received sub-prime loans or are at risk of
foreclosure from the mortgage burden. The average
sub-prime ARM term to adjustment is two years, and
the base rate is the London Inter-bank Offer Rate
(LIBOR), with added charges often equaling 5%. The
most recent LIBOR was 5.40%.
The short
adjustment horizon of sub-prime ARMs means that
many Americans face dramatic upward readjustments
soon. This will make meeting monthly payments more
difficult, increase defaults, and lower purchasing
power in affected communities. In short,
housing-wealth effects are in the process of
shifting 180 degrees. Clearly this will occur
sooner and more extensively in some places than
others. This will last several years and be more
than large enough to have negative macro-effects
on a par with the positive effects that we have
seen across this long boom now over.
We
believe a pronounced housing slowdown in the US
will be followed by localized declines in mean
residence prices. Given the exaggerated
macro-benefit that robust housing appreciation,
refinancing and associated activity have had, we
are looking for a virtuous cycle to turn vicious,
with national and international implications. Low-
and middle-income Americans will have to cut back
on all forms of discretionary spending. The heavy
dependence of this group on imports will likely
mean reduced US export earnings and increased
price pressure for non-US export-oriented firms
and regions.
What is good for housing may
have been good for the United States. Likewise,
the return of reality to real estate will exert a
pronounced downward pull on national economic
performance and have global economic implications.
Max Fraad Wolff is
a doctoral candidate in economics at the
University of Massachusetts, Amherst, and managing
director of GlobalMacroScope. He co-wrote this
work for GlobalMacroScope.com.
