End of the Housing Bubble?
The early flowers of a springtime recovery are everywhere – like the lilacs and wisteria in Bedford Square. Factory output is up. Fewer people are asking for unemployment benefits. Cash registers are ringing in the new season of growth, like the first red birds to appear on the clothes line. Even here in London, the sun is shining.
Now comes Jonathan Laing, in Barron’s with a dark cloud.
You will recall the relevant facts, dear reader. The business sector collapsed last year. Profits fell more sharply than they had anytime since the Great Depression. Business investment, too, suffered a monumental decline.
The consumer, meanwhile, held his ground. Almost as a matter of patriotic pride, consumers maintained their confidence and kept spending. It is widely believed that they rescued not only the U.S. economy…but the entire world economy.
And now, in America’s credit-led economy, he must continue to play the hero…spending money he does not have…or all is lost.
Here at the Daily Reckoning we do not question the consumer’s resolve. His bravery is beyond reproach, having shown himself willing to expose himself to reckless financial risks on many occasions. What troubles us is his ability.
During the ’90s, the wealth effect of a rising stock market gave him something to stand on. His stocks were up, he could tell himself, so why not take out some of the gains and spend them? But for the last three years, stocks have gone nowhere. And taking Investor Business Week’s gauge of mutual fund performance as a measure, the average investor is probably continuing to lose money.
But into the breach left by declining share prices came a boom in residential real estate. Not coincidentally, lower rates allowed him to refinance his home, "unlock" some of the accumulated equity, and continue spending.
As long as house prices keep rising, he is all right. He will have money to spend. But what if housing prices stabilize…or fall?
More background information:
In the last two years, home prices have added about $2 trillion to the "wealth" of American consumers. "Last year’s epic $1.2 trillion of mortgage refinancings not only saved Americans an estimated $15 billion or so in annual debt service," writes Laing, "but also allowed folks to take out an additional $80 billion from their homes over and above the old mortgages they paid off."
But the "wealth effect" of real estate is not the same as the "wealth effect" of stocks. More people have more of their wealth in their homes than in their stock portfolios. A recent academic study suggests that increases in house prices encourage twice as much consumer spending as increases in stocks. So, while $3.9 trillion was lost in stocks in the last two years, it was more than offset (in terms of consumer spending) by the $2 trillion increase in home prices.
A natty reflection: We have often compared the U.S. economy to the Japanese one. The Japanese are the pace setters, we have argued, with the U.S. following 10 years behind.
Not so, say our critics. Because while the U.S. economy has experienced a huge run-up in debt and stock prices, it has never had the sort of real estate bubble that distorted the Japanese economy. Oh?
Residential real estate rose at a double digit rate in February, according to the National Association of Realtors. Since 1995, houses are up more than 40%. And in some markets, they have gone up almost as much as telecom stock: up 96% in Boston, 83% in San Francisco, 70% in Denver.
"Inventory levels of unsold new and used houses now stand at near-record low levels," writes Laing. And building stocks, such as Centex and Pulte, are trading at or near their 52-week highs. So are appliance makers, such as Whirlpool and Maytag.
Is the real estate market a bubble waiting to burst? Ian Morris, chief economist at HSBC Securities, thinks so. His report, "The U.S. Real Estate Cycle, The Other Bubble," concludes that falling house prices could soon deliver the coup de grace to the U.S. consumer…and the U.S. economy. For not only would falling real estate prices mean the end of the consumer’s ability to save the economy with greater feats of spending…it would leave him desperately looking for ways to save himself.
Morris points out that the ratio of residential real estate wealth to disposable personal income is 1.62 – its highest level ever.
What’s more, at the end of WWII, the average homeowner owned 85% of his home – he had mortgage debt equal to only 15% of it. Today, he owns only 55% of his home. (Is a person who owns only half his house richer than one who owns the whole thing? We ask the question only because so many Americans seem to believe the answer is yes.)
Of course, a lot of homeowners don’t have mortgages at all. Of those who do, probably about 65% of the value of their homes is mortgaged. Twenty years ago, consumers’ debt payments – mortgages, credit cards and auto loans combined – equaled about 60% of disposable personal income. Today, the figure is slightly over 100%.
The situation has been made worse by the good intentions of the federally-sponsored mortgage mongers – Fannie Mae and Freddie Mac. In attempting to make it easier for marginal borrowers to get a home loan, and increase their own book of business, appraisals have been compromised, bad loans disguised by generous "work out" procedures, and borrower credit checks have been relaxed.
Easier credit has done to the real estate market what it does everywhere – called into question the value of the resulting asset. A home worth $200,000 may really only be worth half that much. And the borrower, if he meets with adversity somewhere on life’s highway, may be less able to overcome it than previously thought.
Already, delinquencies at the low end of the mortgage market – among FHA clients – have risen to 11%, their highest level in 30 years.
April showers come and go. We are grateful for them. For as the song tells us, they bring the flowers that bloom in May. But, occasionally, there is also a bad storm that knocks the bloom off the rose.
April 18, 2002 — London, England
Poor Bernie Ebbers. He should have stuck to his career as a gym teacher. At 60, he could be enjoying the glory of coaching a basketball team to the local championships and looking forward to a comfortable retirement.
But nooo…He had to get caught up in Long Distance Discount Service. Then, in the boom of the ’90s, he looked like a genius, buying one telecom company after another as if he were putting together a collection of beer mugs. In a few years, Bernie had a shelf of more than 60 acquisitions, including the big one, MCI, which cost him $60 billion.
But, what ho!, the price of beer mugs…I mean, telecom companies…suddenly took a dive, Bernie’s stock sank, and now the poor schlep faces his golden years $341 million underwater. His company, meanwhile, is looking at $30 billion in debt…and, like the CEO…has no easy way to pay it.
After selling his yacht, "Aquasition," in order to pay down his debt, poor Bernie will have to do his fishing from the pier.
But help may be on the way. "Factory sector output is best in two years," says a USA Today headline. The nation’s factories managed a 0.7% boost in output in March, according to the article. Unmentioned was the fact that the last two years had produced the worst downturn in the manufacturing sector since the Great Depression.
Meanwhile, housing construction fell by 7.8% in March – its biggest decline in 2 years. "Housing is no longer going to be adding strength to the economy," said an economic consultant with Northern Trust. Uh…that could present a problem…more below.
But first, over to you, Eric:
Eric Fry in New York…
– The stock market has become quite manic-depressive these days. Over the last six trading sessions, the Dow has not managed to head in the same direction for two days in a row; it’s been up one day and down the next. If the Dow were human, you’d recommend therapy or medication, or both.
– On Tuesday, investors witnessed the market’s manic side – that’s the side of its personality that’s fun to be around because it is so gosh-darned positive. When the market is manic, the glass is always half-full…if not one-quarter full.
– But yesterday, the market’s depressive side took over. Sure, Intel’s earnings result was "in line" with estimates, but why wasn’t it better? And, yeah, the Fed didn’t raise interest rates, but doesn’t that mean Greenspan thinks the economy is still weak?
– By the end of the day, the Dow had slumped 80 points to 10,220 – or almost exactly where it was trading six days earlier. The Nasdaq slouched 6 points to 1,810.
– Maybe the market felt a little blue yesterday because it senses that the economy is losing some important props: interest rates are beginning to rise; the mortgage refinancing boom is over; and the consumer is looking somewhat tapped out. None of these trends will aid and abet Wall Street’s "rebounding economy" theory. Like "The Doors" without Jim Morrison, the economy without a free-spending consumer will go absolutely nowhere.
– "Historically," Dr. Kurt Richebacher explains, "private consumption has accounted for about two-thirds of GDP in United States…During the second half of the 1990s, that ratio soared further to 77% of GDP growth. In the wake of this raging consumption boom, domestic saving has been virtually annihilated, and the trade deficit ballooned to new records. From a structural perspective, the economy’s saving-investment pattern went from bad to catastrophic…"
– In other words, with American savings rates near zero and personal debt levels at record highs, the consumer may be running out of piggy banks to break open.
– "Credit cards can no longer support the US economy," asserts breakingviews.com. "And alongside the Federal Reserve’s interest rate cuts and mortgage lending, they have helped power U.S. consumer spending. But recent results suggest that the boom in credit is deflating. Citigroup reported a rise in both credit losses and delinquencies at its U.S. credit card division in the first quarter of the year."
– The story is the same throughout the credit card industry, says breakingviews.com. From Discover to Capital One to Metris, both credit losses and delinquencies are rising.
– No discussion of household indebtedness would be complete without also mentioning the house itself – or more precisely, the red-hot housing market that has helped many a consumer to continue consuming.
– "Make no mistake," writes Barron’s Jonathan Laing, "the residential realty market is showing sure signs of a bubble psychology."
– "Over the past two years," says Laing, "home-price growth alone has added nearly $2 trillion in wealth to U.S. households’ balance sheet – not a trivial amount in a $10 trillion dollar economy. Homeowners were able to tap some of this wealth by means of home-equity loans and "cash-out" refinancings. Last year’s epic $1.2 trillion of mortgage refinancings not only saved Americans an estimated $15 billion or so in annual debt service, but also allowed folks to take out an additional $80 billion from their homes over and above the old mortgages they paid off."
(Faithful Daily Reckoning readers will recall that the recent drop in General Electric’s share price would more than erase this $80 billion windfall from the housing market.)
– "In addition," Laing continues, "the untapped equity makes Americans feel wealthier and therefore willing to incur more debt and spend more than they might otherwise do because of what economists call the wealth effect."
– But rising rates have brought an end to that game. Where now will consumers turn for their spending money? Perhaps Bill knows.
– Today’s the day he promised to "take a closer look at what rising home prices did for the U.S. economy and what is likely to happen in the housing market in the months ahead."
– So, without further ado, I’ll hand my crystal ball over to Bill.
*** A front page report in yesterday’s Times worries that "guerrilla war threatens to tie down foreign troops for years." Gee…who could have imagined that the Afghans would resist occupying forces? Or that they would use guerrilla tactics? Isn’t life amazing…one surprise after another.
*** "Already, fundamentalist guerrillas have returned to attack posts occupied by Afghan troops loyal to the coalition," continues the report. "Ten people in a guerrilla war are worth 1,000 in a conventional conflict," said a Northern Alliance officer.
*** The English papers are always a welcome relief from their self-important and often delusional American cousins. Unlike American rags, which focus almost exclusively on politics, the British papers spend their ink on things that really matter; murder, sex, betrayal…On page 4 of the Times, for example, we learn that a couple is suing their son-in-law, whom they suspect has murdered their daughter. Paula Ramsden fell to her death at Beachy Head, while taking a walk in the dark along the cliff with her husband, Paul. Perhaps unbeknownst to her, Paul was having an affair with another woman and had recently increased the life insurance on his wife by 121,000 pounds.
*** In an article on the facing page, we see a touching photo. It is the tombstone of two young children, who – according to the stone’s graven epithet – "fell asleep" only months after they were born. "Cot death" explained the mother. "Life" said the judge, sentencing her after her conviction for murder.