Are subprime mortgage lenders like New Century Financial and Novastar taking it on the chin? And is this just a local problem affecting a few imprudent, overleveraged operators? Or are investors right to sell out of stronger lenders such as Washington Mutual, as I did recently? Perhaps the collapse of the housing bubble will even lead to a credit crunch that will last for a year or two like that of 1966. But maybe it would be a small price to pay for the boom of the past few years, if we could have a result similar to the earlier event (which involved no recession and was relatively painless). Or is housing finance an issue that could affect the U.S. economy for a much longer period of time?

In fact, it matters a great deal. For instance, the rise in housing values has provided a boost to American consumption, hence the U.S. economy, up until early 2006 when we started to see a softening of housing prices, which was reflected in the decline of housing sales and also borne out in the decline of the housing stocks. The latter hasn’t hurt the consumer yet, but will soon, an important consideration when one considers that some 1%-2% of annual GDP growth has been due to home equity-driven spending, enough to make the difference between growth and recession. And, in finance, besides the little guys, HSBC (formerly Hong Kong Shanghai Bank) is a global player that could become the modern Credit Anstalt.* Meanwhile, others such as Jamie Dimon’s JP Morgan Chase, which has relatively few such loans on its books, and claims to be a more astute player in this market, is a prime broker to a large number of hedge funds, at least some of whose portfolios are stuffed with mortgage-backed securities.

As pointed out by Professor Robert Shiller of Yale (who, as Doug Kass and I have noticed has become a housing bull since his 2001 warning about Irrational Exuberence), the rise in housing prices during the 100 years between 1896 and 1996 basically tracked inflation. So adjusting for inflation, his index was 100 in 1896 and about 100 in 1996, with only a brief dip into the 60s during the 1930s and a rebound since. But between 1996 and 2006, house prices doubled in real terms from around 100 to almost 200 in 10 years. It’s interesting to note that this parabolic rise closely tracks the rise in home equity extraction, via securitization, home equity loans, and related products such as interest only-and negative amortization mortgages. Perhaps the best analysis and graphics regarding this phenomenon was put out by Paul Kasriel of Northern Trust in 2005, showing essentially zero equity extraction prior to 1996, with essentially all of it having come since then. 

Why did this happen recently, and not at some other time in American history? Previously, a house had just been a place to live in, as well as a store of value. The advantage to homeowning, over renting, was that home equity, built up over a professional lifetime, was at least portable, whereas rent payments were not. That is, the sixtyish owner of a house paid up over thirty years could sell it and presumably buy an equivalent home in a retirement community in warmer weather, or else purchase a smaller home somewhere, and live off the difference in values, whereas a renter would have nothing to show for decades of paying rent. But even real estate investors such as owners of apartments formerly bought them as they would bonds or TIPs (Treasury Inflation Protected Securities), primarily for rents, and maybe some inflation protection, rather than (real) capital gains. Until recently, therefore, rental properties would almost always “cash flow” (be priced to allow rents to more than cover the cost of mortgage payments and maintenance expenses).

But the securitization of housing made it possible to treat it as an investment, because homeowners could readily borrow against it in times of need. Since it “always” went up (at least since the 1930s, which everyone has forgotten and almost no one thinks will happen again), this was not an imprudent thing to do, went the argument. The cycle reinforced itself, as genuinely greater liquidity reduced the “cap rates” (relative to rents) on homes, pushing up house prices at a faster rate than inflation. Then the sudden availability of housing-related credit made it possible for homeowners to ratchet up consumption by monetizing the newly-created equity. Once housing acquired these desirable investment features, it seemingly could be priced as a risk-free investment, a point (wrongly) made regarding stocks by the authors of “Dow 36,000” in the year 2000.

A similar thing happened to stocks in the 1920s. Prior to that time, they had been bought primarily for income, like low-grade bonds, as companies typically paid out 60%-70% of their earnings in dividends (as utilities still do), reinvesting less than half. While present, capital gains mostly matched inflation, as was the case with housing until 1996. The transition from owning stocks for income to buying stocks for real capital gains was a challenging experience that created a bunch of excesses, including 10% margin requirements, that brought about the 1929-1932 stock market crash that also took down housing values by nearly 50% (versus a decline of nearly 90% for Dow stocks). Although the resulting creation of the SEC eliminated those particular excesses, a similar thing may have happened in housing today, with 0% down, “low doc” loans, for some 40% of new buyers and 25% of all buyers, even (until recently) subprime borrowers. This could quite possibly produce a similar result in both the housing and the stock markets.

So where does all this leave the consumer? Well, today, the average family income is something like $40,000 a year (using round numbers) and the average house price is more like $240,000, versus a trend-line value of $120,000. The old rule of thumb was that a family could afford a house worth 3 times its income, meaning that a family with income of $40,000 a year could afford a hypothetical average house costing a trendline $120,000. This would consist of a down payment of perhaps $20,000 and a mortgage for 2.5 times income, or $100,000. 

But when the average house actually costs about $240,000, or 6 times the average family income (which is a more suitable ratio for a Japanese person who can borrow at a 2% rate), that’s when an average American’s problems begin. With no money down, supporting a house of that cost on a $40,000 income will leave precious little money for other needs. And if the “New Economy” metrics no longer hold up and the value of the average American house mean reverts to its trendline $120,000 (adjusted for inflation), the average U.S. homeowner will have taken a huge capital loss that will be a spending- and lifestyle- crimping event for some decades to come. Under such circumstances, “rent and invest the difference” (to paraphrase term life insurance advocate A.L. Williams), would have been the smarter thing for consumers to do. And lenders should have felt the same way, which would have enabled them to avoid the mess they’re now in.

No positions.

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© 2007 Thomas P. Au
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