Hard US lessons, harder
landings By Max Fraad Wolff
The arriving Democrats in the US Congress
are likely to plan little and execute on even less
in the way of seismic economic adjustment. Thus it
is of interest to forecast their response to the
trouble that is coming.
The US is
beginning to unwind the largest housing bubble in
modern history. There will be upswings and local
exceptions and wide regional and price variations.
This changes nothing. Hundreds of billions of
dollars in household access to cash and
debt
from refinancing, equity extraction, home equity
lines of credit and house flipping will dry up.
Housing price crashes differ from equity
price busts in three important dimensions. First,
the price corrections during housing price busts
averaged 30%, reflecting the lower volatility of
housing prices and the lower liquidity in housing
markets. Second, housing price crashes last about
four years, about one-and-a-half years longer than
equity price busts. Third, the association between
booms and busts was stronger for housing than for
equity prices.
The implied probability of
a housing price boom being followed by a bust is
about 40%. Housing and equity price busts
have,however, one important feature in common.
During the 1970s to the 1990s, they generally
coincided or overlapped with recessions. [1] The
housing market today is in the early stages of a
multi-year correction.
This will
constitute a radical reduction in the wealth
effect, access to credit, low-cost credit and
notions of improving conditions for the
long-suffering American middle class. The revolt
of these folks in the November mid-term election
is just the first in a series of cuts that their
reaction to worsening conditions will carve into
the national economy and polity. Middle class
reaction to deteriorating economic conditions will
be definitive next year and beyond.
The
debt, income and savings situation of the American
middle - if we take the three middle quintiles of
the income distribution to be the middle class -
is horrifying. Many of these people are in the
difficult situation of simply waiting to discover
themselves and be discovered as former members of
the middle class in terms of material quality of
life. 2006 will be a year where America's
aggregate savings rate is negative.
Households are simply not saving anything.
Real average weekly earnings of production and
non-supervisory workers - over 75% of all us
payrolls - have been stagnant since the mid 1970s.
If we use 2005 dollars and the CPI-U (consumer
price index for urban consumers), average weekly
earnings decreased by about $1 per week over the
30-year interval 1975-2005. The folks have thus
stopped saving and have taken on massive amounts
of housing and consumer debt.
A look
through the Federal Reserve's Flow of Funds
Accounts of the United States, or Z1, released in
September 19, is a traumatic experience. It
reveals the contours of America's debt disaster in
stark statistics that grow worse with each passing
quarter. In 1999, total outstanding household debt
was $6.4 trillion. As of the end of the second
quarter of 2006 total outstanding household debt
was $12.3 trillion.
Household debt has
increased by almost as much since 1999 as the sum
total of all debt accumulated by all households
across the preceding 220-year history of the US.
In 1999, household mortgage debt stood at $4.4
trillion. At the close of the second quarter of
2006 it had more than doubled to $9.33trillion. In
1999, consumer credit outstanding was measured at
$1.6 trillion.
Today, this stands at
approximately $2.4 trillion dollars, signaling a
50% increase in less than seven years. This is
usually soft peddled and talked down by comparison
to skyrocketing housing values. Household assets
held as real estate increased by $9 trillion from
2000-2006. This might be called the mother of all
modern bubbles. Yet household net worth struggled
up by a mere $1.2 trillion. Net worth badly lags
housing values because of waves of cashing out.
When these waves crash ashore it will be with
massive destructive force.
The last six
years have hosted the most stupendous extraction
of inflated household wealth in history. Across
the 22 quarters from 2000 through the second
quarter of 2006 disposable personal income
increased by $2.3 trillion. However, disposable
personal income as a percentage of household net
worth fell. Rising house values contributed more
than personal income increases largely derived
from these rising house values.
Owner's
equity as a percentage of household real estate
declined despite soaring prices from 58% to 54%.
Another way to describe the above two statistics
would be that American households are totally
dependent on inflating house prices and have
already borrowed and spent the paper gains that
every credible economic model suggests are now
deflating.
Last year this process of
refinancing took on a desperate air. Mean house
prices are now falling. Interest rates are above
recent lows and unlikely to test them absent a
serious recession. However, Americans keep
refinancing and re-mortgaging. Why? There really
is only one answer: desperation. Freddie Mac
informs all those who dare to look that 90% of its
refinanced loans resulted in new balances at least
5% higher than the previous loan.
This
means that the third quarter of 2006 was the
highest rate of cashing-out refinancing in 16
years. The median age of a refinanced loan was 3.4
years. If you look at rates in the spring/summer
of 2003 - when these now refinanced away loans
were written - you will note that they hit a
40-year low. Refinancing continues despite falling
house prices and rising rates. This is the
desperate top of a very troubled bubble.
In the third quarter of 2006, the median
ratio of new-to-old interest rates was 1.12. In
other words, one-half of those borrowers who paid
off their original loan and took out a new one
increased their mortgage coupon rate by 12%, or
roughly three-eighths of a percentage point at
today's level of fixed mortgage rates. This is the
highest ratio since Freddie Mac began compiling
this information in 1985. [2]
It is clear
that legions of folks are desperately continuing
to pursue survival strategies that built them
mountains of debt and no longer make any sense at
all. We know there is trouble coming from the
housing quarter and we can be certain it is
significant and will take at least a few years to
work through. This will put tremendous pressure on
Americans stuck with flat earnings, high debt,
deflating house values and zero savings. What
offsets can we count on?
The traditional
routes of savings reduction, debt increase and
government counter-cyclical spending and tax cuts
have already been over-utilized. These options
either don't exist or will have to be used
modestly and to reduced effect. As we have already
reviewed, there are no savings or the false
savings some economists claim come from rising
house prices.
The sustainability of
present debt stretches credulity. This calls into
question who still would be willing to loan to
earnings-strapped, debt-burdened Americans with
deflating collateral and home equity. Last but not
least, can Uncle Sam save the day? No!
The Federal government has gone on a tax
cut and spending bender that almost puts the
American consumer in a thrifty light. The Federal
Reserve Z1 Report of September 19 - mentioned
above - offers a handy little table called
Consolidated Statement for Federal, State and
Local Governments or L106c. Between 2001 and 2006,
all assets of all levels of government grew by 16%
to $2.4 trillion.
During the same period,
liabilities grew by $2.6 trillion, or 40%, to $7.9
trillion. Thus, the state has in fact already been
firing on all cylinders - native and borrowed - to
force up growth and economic activity level. There
is real trouble coming as tax increases and
spending cuts in some combination are required to
slow the growth of Federal debt and foreign
borrowing ahead of falling tax receipts and rising
payments associated with underfunded liabilities
from Federal programs. Thus, the government is
more likely to prove hindrance than help in the
near-term future.
The shape and speed of
the coming troubles, and mass reaction to them,
are likely to be the largest shapers of domestic
macro economic performance. We believe there are
also significant international implications.
Housing is the next shoe to drop and the first
sign of the upset that was the mid-term elections.
Notes [1] IMF World
Economic Outlook April 2003. Chapter II, When
Bubbles Burst, page 63. [2] Refinance Activity
Remains High; Cash Out Share Increases in Third
Quarter. November 1, 2006, Freddie Mac.
Max Fraad Wolff is a doctoral
candidate in economics at the University of
Massachusetts, Amherst and managing director of
GlobalMacroScope.
