Wealth Creation and Asset Inflation
The housing market has become more than a national pastime or an entertaining hobby. It has become so ingrained in the fabric of American society that there will be serious economic consequences to a downturn in housing prices. It serves as a real-world example of why the Austrian School of economics warns against allowing the formation of credit-fueled asset bubbles in the first place.
The consequences of a burst bubble are inflicted on everyone in some fashion. Leveraged speculators armed with utterly irresponsible loans bid up houses and condos in many local markets with their funny money. In true lemming fashion, the fear of being left behind occurred right at the tail end of the speculative blowoff. Why work hard or take the risk of producing something original of lasting value when your house is “working” for you or you can get in on the millionaire-making housing-related job market?
A Virtual Bank or a Money Pit?
The idea of your house being a theoretical bank in which you deposit your money and extract it to finance your retirement is absurd. But that doesn’t stop it from happening. At its very essence, the value of any investment is equal to the cash that can be extracted out of the instrument in the future. Aside from embarking on a leveraged rental strategy, what cash can be extracted from residential real estate?
Economists bring up the valid point that the avoidance of future rental payments has considerable value. Fair enough, but you must not forget to offset this by maintenance and depreciation of the physical structure. Bill Bonner provides the ultimate example of this with his continued saga of sinking money into his French chateau. Also, don’t forget taxes, insurance, homeowners association dues, a new roof, new HVAC, new appliances, etc. In economics, there is no free lunch.
What we are left with, then, is the continual increase in price of the ground on which the structure sits. But why should land prices increase over the long run? Is land being put to more productive use year in and year out? In an agrarian economy, it makes sense that land prices would fluctuate in tune with commodity prices, and, ultimately, growing conditions (droughts, pestilence, and the like). Interesting research has been done linking 19th-century banking crises with growing conditions for farmers.
However, in the modern American “knowledge” and “service” economy, shouldn’t the price of land decline over time? After all, how much of the great wide open is required by highly productive semiconductor fabs, software companies, Hollywood studios, Wall Street firms, and the service industry that has sprouted up around them?
I am entering very sensitive, theoretical territory regarding the definition of “wealth,” which probably invites more wide-ranging opinions than the Democratic Convention, so I will return to the simple lessons we can glean from our country’s experience in the 19th century.
Fiat Currency Inflation and Capitalism Do Not Mix
The primary factor behind the long-term inflation we have seen in housing prices is the absence of a gold standard. The discipline of the international gold standard, in place for much of the 19th century, put a short leash on government deficits and excessive consumer spending.
Excessive spending that led to trade deficits was naturally corrected when gold accompanied gold-backed currency on trips overseas to pay for imports. When this gold foundation left the monetary system, domestic bank reserves contracted, and credit was rationed to the extent that a recession ensued. This nipped spending and investment excesses (bubbles) in the bud. The international gold standard prevented any participant in international trade from enjoying long periods of consuming more than they produce.
However, the tides of history and the necessity of fighting two world wars led first to a more “elastic” currency, and, finally, to a completely faith-based, or “fiat,” currency. Needless to say, history is littered with the remains of countless pure paper currencies. A capitalist economy cannot function properly over the long term in the midst of a popular democracy with a fiat currency.
With the ability to write checks that would never be cashed, the federal government’s spending and resource-misallocating influences ran unchecked during 20th century. A mix of taxes, federal debt, and outright inflation of the currency, rather than good old-fashioned real savings, could now finance wars and the unprofitable enterprise of vote buying.
The stage was now set for a bubble-fueling alliance: Housing inflation (often mistaken for “wealth creation”) on the asset side of the national balance sheet was kicked into high gear by growth of the liability side of the balance sheet. At the epicenter of the mortgage industry’s growth was government-sponsored credit provision in the forms of Fannie Mae and Freddie Mac.
The ultimate conclusion of this scenario is limited to either high CPI-level inflation or depression. The delay of either of these results has been made possible by insatiable overseas demand for U.S. dollar-denominated assets. Demand for these assets is now showing signs of waning; these ingredients do not form a recipe for continued long-term advancement in living standards.
The natural order in a properly functioning capitalist economy is for prices of new products and inventions to start high and gradually decline to the marginal cost of production. Once a period of patent protection ends, for example, creative destruction is brought about when competitors expand capacity, gain economies of scale, lower prices, and drive down profits until they approach zero.
This is a prescription for long-term advancement in living standards. In this purer form of capitalism, competition would force homebuilders to charge home purchasers little more than their marginal cost of production; yet their profit margins are enormous due to the bubble mentality currently deluding their customers.
Wealth Creation vs. Asset Inflation
Dell Computer (DELL) stands out as an example of a company that has profited enormously over the past 20 years by fully embracing the capitalist concept of creative destruction. It adapted to the rapid obsolescence cycle of the PC industry by transforming itself into an assembly- and logistics-focused company.
The company has perfected the direct distribution PC business model by outsourcing the capital-intensive R&D work to its suppliers, while aggressively lowering prices for its customers. Dell has been rewarded, and should be, for acting as the most efficient liaison between PC consumers and hardware manufacturers.
Contrast the example of Dell as a microcosm of capitalism with what has become the core driver of the economy in the great state of Florida: bubbly local housing markets. The hearty firewood of southward-flowing Social Security and pension payments has fueled the fire under these markets.
Continuing with this metaphor, low interest rates and reckless mortgage financing practices represent the lighter fluid on this fire. This weekend’s Barron’s , however, confirms that this environment is now in the rearview mirror. The lighter fluid has been cut off and the bubble in condos and vacation properties is imploding in true Nasdaq fashion:
“Today, about the most visible activity in [the Naples, Florida] area are the 400 or so daily additions on the multiple listing service — and price reductions by the dozens. In the 35 years that [president of Naples’ VIP Realtors Charles] Ashby has been in the business, this is the first downturn he’s seen, even counting recessions. ‘The mule died,’ he says.
“With mortgage rates rising and home-price appreciation slowing or vanishing, buyers in Naples have pulled back in a big way. The area’s sales of homes costing less than $1 million declined 45% in unit volume in the first four months of this year. More expensive homes fared somewhat better, falling 34%. But pressures at the higher end clearly are mounting. All along the pricey Gulf shore, builders still are tearing down old ranch houses and replacing them with two-story mansions, pushing the market toward a classic glut.”
People need to live somewhere, whether it’s owned or rented. This fact, along with far lower turnover, is what distinguishes the national housing market from the stock market. When you expand your comparison to include second homes and vacation homes, the distinction between housing and stocks becomes far more ambiguous.
Take the extreme example of an investor using a 10% down, interest-only loan to finance a condo in Naples that he plans for personal use and a little yield from vacation rental. Condo prices have gotten to the point where the meager, spotty rental yield will not come close to covering the mortgage, taxes, utilities, and association dues.
At its essence, this “investment” is the use of 10 times leverage to speculate on the future price of the condo, right when all signs point to a developing glut. Would you open a futures trading account to buy live cattle on margin right after the announcement of a mad cow disease breakout?
Allow me to continue with the most important, yet entertaining portion of the Barron’s article:
“Behind all this is a fervor eerily reminiscent of the late 1990s on Wall Street. Some 65% of second-home owners surveyed by the National Association of REALTORS said they considered their second homes better investments than stocks, and 29% said they planned to buy additional properties within two years [emphasis added]. An eye-popping 64% of investors with four or more properties planned to buy another property within two years.
“But those high rollers could lose their nerve quickly if prices continue to weaken.
“‘People don’t believe in the laws of supply and demand anymore,’ says Alan Skrainka, chief market strategist at Edward Jones. ‘We’re not saying it’s a bubble, but we’re saying that prices are overstated and will likely correct 20-25% over four or five years.’
“He rejects a notion advanced by housing bulls that shore communities in Florida and California will be protected because of the limited supply of coastline. ‘Japanese real estate and land prices went down for 15 years and Japan is an island,’ Skrainka says.”
Shorting Miami Condos
The Barron’s article goes on to cite some equally “eye-popping” stats. To paraphrase, a JMP Securities study estimates that 50,000 new condo units are currently in the planning stage in Miami-Dade County, in addition to 50,000 either under construction or in the process of breaking ground. This compares with the estimate of roughly 10,000 condo units added to the area’s supply over the past 10 years. You could hardly imagine a better example of a bubble if you tried.
It would seem like a “no-brainer” short-selling opportunity if there were a way to short Miami condos. Speculators may want to look into shorting Florida-based community banks who have foolishly entered the fray and missed a critical class at the School of Hard Knocks: Banking in the 21st Century. This class would be titled Mortgage Origination 101, and lesson No. 1 is: Unload the toxic waste loans onto unsuspecting institutions like Fannie Mae or pension funds looking to juice their fixed income yield by a few basis points.
Consequences of a Credit-Driven Bubble
The fallout of the bursting bubble in second homes and vacation homes will spread to the general housing market, yet not to the extent that it will at ground zero; places like Miami, Naples, Myrtle Beach, Phoenix, Las Vegas, and many coastal California cities can expect to completely reverse the bubble gains of the last few years.
If you happen to live in any of these areas and believe you cannot move for practical reasons, beat the rush and downsize if your mortgage is uncomfortably high, or pay it down to a comfortable level. Just don’t expect to get out of your house anytime soon at prices anywhere close to comps from down the street circa summer 2005.
The consequences of a flat-to-downtrending national housing market go way beyond the personal finance level. A key competitive advantage of the U.S. economy, labor mobility, will be seriously impaired if families are reluctant or not able to sell their houses in order to pursue a better career opportunity. Many poorly written mortgages will be underwater (greater than 100% loan-to-value ratio) and many “owners” will effectively become “tenants,” making payments to the bank that really owns the house.
The Predictable Federal Response
Fed Chairman Ben Bernanke will have his first major test in responding to this nightmare scenario, and anticipating his response is not rocket science: He will slash the Fed funds rate to zero, and if that doesn’t work by pulling down long rates (and thereby mortgage rates), he will enact his well-outlined “unconventional” policy measures.
Savers around the globe may balk at financing a spendthrift federal government that’s delving deeper into the “Ponzi” stage of financing its operations — meaning, the interest portion of the federal budget has grown so large that it becomes necessary to constantly roll over debt as it comes due with savings from new sources.
At this point, the Treasury must find its “buyer of last resort” in the Fed, as it can create money out of thin air to put a floor under the bond market. It’s not hard to imagine the establishment of a “Bernanke put” in the bond market as the centerpiece of his unconventional monetary policy bag of tricks.
Instead of real savings financing deficits in exchange for a fixed future return, money printed demand will flow from the Fed to the Treasury Department, and work its way into the economy wherever federal spending flows. Voila! The federal debt is monetized.
Such extreme measures in the United States have thus far only been outlined in research papers in a brainstorming effort to avoid the liquidity trap scenario marring Japan since 1990. So maybe Fed Chairman Bernanke is only bluffing about “unconventional” policy measures.
After all, the overseas holders of U.S. dollar-denominated assets might have something to say about unconventional measures, and that something will include “SELL.” This is a dilemma of epic proportions. The outcome will be determined by who really has more influence over interest rate and currency markets: the Fed or foreign creditors (including foreign central banks).
Taken to its logical conclusion, Bernanke’s depression-avoiding measures would ultimately lead to Weimar Germany-style hyperinflation. Continued growth in the supply of Treasury bonds to finance budget deficits? Fine, print money to buy them up. International holders of $1 trillion-plus in Treasury bonds rushing to the exits? Fine, print money to buy them up. You see where I am going: The time to expiration in the experiment of fiat currency-based Keynesianism is rapidly approaching.
The profound words of Austrian School economist Ludwig von Mises drive right through the soft underbelly of fiat currency-based Keynesianism:
“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
I find it sad that it has to go this far, yet no one can argue that the situation in most Florida housing markets is not “a boom brought about by credit expansion.” Many will continue to argue that the nationwide housing boom was brought about by factors other than easy credit.
That may be the case in many areas, but it misses the point of examining the Florida bust and its fallout: The Fed has set a long precedent of bailing out unwise investors, and thereby sowing the seeds for the next round of asset inflation and its accompanying bust. This cycle must continue as day follows night.
When the tipping point is reached where asset inflation spills over into the CPI, head down to the local hardware store and buy a wheelbarrow, because you’re going to need it, rather than a wallet, to go shopping. This tipping point will likely be reached when enough of us leave the work force and are at the receiving end of that aforementioned flow of Social Security and pension payments.
The Fed’s current remedy for a burst bubble that’s originally brought about by inflated fiat currency is still more inflated fiat currency. The monetary system has passed the point of no return long ag The inflation must continue or the system will implode. You can choose to lament this situation or you can understand it, anticipate it, and adapt to it. I choose the latter.
Dan Amoss, CFA
June 2, 2006