Richard Suttmeier on Real Money hit the nail on the head when he said yesterday that the real estate explosion is about to implode. Like him, I believe that the subprime collapse is not just a speed bump in the “New Economy.” Instead, it is a sign of wider problems in mortgage lending that threaten the viability of the New Economy itself. That’s because the collapse of the housing bubble means that a major “band-aid” has been ripped off of America’s Achilles heel, the cash-strapped, savings short American consumer, exposing the scab underneath.
Who would have thought it would come to this? For three decades after World War II, the average American worker’s income grew by 2-3% a year after inflation, and stateside consumer spending grew apace. But after the mid-1970s, these income gains slowed to a crawl, while spending growth continued at the same pace. But Baby Boomers felt that the 2%-3% average annual real income growth enjoyed by their parents was their birthright. And when they didn’t get it, they settled for “the next best thing,” 2%-3% average annual spending growth financed by artificial means. The result is that the average American is now spending at a level not sustainable by income, but only by asset values, specifically in real estate. And when those asset values collapse, and they’re doing so as we speak, so will U.S. consumer spending and overall economic growth.
But that can’t be so, some might say. The country is much wealthier today than in the 1970s, which would support much higher consumer spending. That much may be true for the country as a whole, but it’s not for the whole country by any means. The reason is that while (President) John F. Kennedy’s “rising tide lifted all boats” through the 1960s, most of the gains since then have accrued to the top 20% of the population. For instance, as late as 1980, the average CEO made only about 40 times as much as the average worker, now it’s more like 400 times. On the other hand, antipoverty programs and removal of lingering discrimination have greatly reduced the number of the truly poor. So the person in top decile (90th percentile and higher) of the economic ladder, is decidedly better off than the equivalent thirty years ago, and someone in the bottom decile (10th percentile and lower) is somewhat better off. But the average person (the one at the 50th percentile, and 30 percentiles on either side) is the one who has gained very little real income in the past three decades. Nevertheless, it has been in the interest of U.S. economic policy to pacify this person by allowing him/her to maintain spending growth at historical (post World War II) levels, even though income growth hadn’t been keeping up.
The housing bubble was a good a tool as any for this purpose. At first the gap was plugged by reduced savings. But as savings rates plummeted in the 1980s, this fuel could not last for long. So credit card debt took up the slack. But that soon played out, especially when the deduction for credit card interest (but not mortgage interest) was removed in the 1986 tax reform. The ray of hope was the fact that interest rates were falling through the 1980s, and periodic refinancings meant that homeowners could save money by capturing progressively lower rates on their mortgages, and using the difference for spending. What’s more, interest on this mortgage-related spending could qualify for the tax deduction denied credit card interest.
But if falling interest rates meant that constant mortgages required progressively lower monthly payments, they also meant that a homeowner could choose to “invest” by maintaining constant payments, taking out larger mortgages, and buying more house. And if a synchronized housing boom was underway, or at least could be orchestrated, many might be persuaded to do so. And so it was done, which is why housing values doubled in real terms between 1996-2006, an unprecedented rise in American history. Now the consumer had a house (or two) that could also double as an ATM, i.e., the best of both worlds (a framework that could serve as both a place to live, and a source of “income” for other consumer spending). Using this twisted logic, going over one’s head (taking out a mortgage that consumed 50% or more of income) was a smart thing to do because it meant a more valuable asset and more spendable income down the line.
Thus housing became the nation’s latest Ponzi scheme, one that could work only if more and more people were sucked into it. But even if the housing market was on fire, as it was in the past decade, it needed firewood to burn. And if there was a growing shortage of “firewood,” to feed this boom, there was always “kindling” (soft materials such as leaves and hay that burn for only a short period of time), in the form of such monstrosities as interest only and negative amortization loans to subprime borrowers. From a financial point of view, however, such borrowers were placed in the position analogous to “tearing down their (financial) house for firewood” (pun intended), i.e. being forced create a problem of less house for tomorrow because today’s problem of freezing to death was so severe.
The collapse of the housing bubble is bringing about an end to this game, and will soon face average American consumers with the fact that their consumption standards of the mid-2000s, were way out of whack with income levels that had reached only a mid-1980s trendline (given perhaps ten, not thirty, iterations of 2%-3% growth off the mid-1970s base). To bring income and consumption back into balance, average Americans will have to fall back two decades in terms of standard of living, which would still put them back at Western European levels of today. But such a pullback would represent “the modern 1930s.”
That’s because the original 1930s took American consumption back to 1910s levels, which then represented “prosperity” by prevailing global standards. But that was a big comedown for an American public that had just experienced the 1920s, which gave a glimpse of a prosperity that would be experienced in the 1950s by their children, but not by themselves.
Likewise, the Internet Boom of the 1990s gave adult Americans of the time a glimpse of the world that their children will inherit for their middle age – in the 2020s – as the Boomers get ready to shuffle off this mortal coil. Like the peers of Moses, who saw the Promised Land but never got to enter it, Americans will wander the desert for two generations until their children are ready to take the big step. (And yes, I believe that those children will fight the modern “battle of Jericho” to get there.) But getting from here to there will not be a pleasant experience.
Tom Au, CFA
for Markets and Money