Hard US lessons, harder landings

The US is beginning to unwind the largest housing bubble in modern history. As it unfolds, 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. Don't expect Uncle Sam to help. He's maxed out too.

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.

(Copyright 2006 Max Fraad Wolff)

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