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Monday, August 17, 2009

Marshall Auerback and the depression level of housing wealth

How much pent-up demand will there be from people without money? After losing nearly $7 trillion, the American homeowner is now saddled with a debt instead of a retirement nest egg, because his home is underwater or his debt to equity is much higher.

America’s biggest economic problem? We’re all broke. Literally.
from New Deal 2.0 by Marshall Auerback
August 8, 2009

Almost half of U.S. homeowners with a mortgage are likely to owe more than their properties are worth before the housing recession ends, Deutsche Bank AG estimates. The percentage of “underwater” loans may rise to 48 percent, or 25 million homes, as prices drop through the first quarter of 2011, Karen Weaver and Ying Shen, analysts in New York at Deutsche Bank, wrote in a report yesterday.

In December 2006, only a few months after the peak of the housing bull market, the total value of U.S. residential property stood at $21.9 trillion. Prices have dropped by 31 percent since the end of 2006, so the estimated value today is about $15 trillion; however, the mortgage debt remains more or less unchanged and stands at $10.6 trillion. In other words, whereas debt-to-equity in the U.S. housing market was 48% as recently as in December 2006, it is now 70% and will rise to 80% once house prices have mean-reverted.

Although painful, a rise in debt-to-equity of that magnitude would actually be manageable if it were not for the fact that income and wealth in the US is extremely skewed. The top 1% of income earners in the U.S. account for more than 20% of national income while the median household has seen no improvement in income for the past ten years. Within the median household sector itself, then, there is still a tremendous financial vulnerability which has not been addressed at all by the Obama administration. Home ownership in the U.S. is far greater than in most modern economies. Equity ownership is also high. The bursting of the real estate and equity bubbles has destroyed the wealth of the U.S. middle class to a devastating degree. And it is with this middle class that the high private indebtedness lies. If there is going to be a further financial crisis in the U.S. it is probably going to be focused on the household sector. If balance sheet recession dynamics are going to depress aggregate demand through wealth destruction and debt repayment, it is probably household sector demand where this will surface.

Almost one-third of all U.S. households have no mortgage. If you adjust for that, the 70-80 percent debt-to-equity ratio suddenly becomes a major challenge because it means that the two-thirds who do have a mortgage already face a debt-to-equity ratio in excess of 100%. Even worse, once the mean reversion has run its course, two-thirds of US households will be facing a debt-to-equity ratio of 120-125% on average. U.S. CONSUMERS ARE EFFECTIVELY BROKE.

Obviously, households have assets and liabilities other than property and mortgages. But it’s clear that the U.S. consumer has been repeatedly on the losing end of the serial “bubblelisation” of the American economy. The collapse of the dot.com bubble and the more recent plunge in real estate means that the great majority of U.S. households are more financially stressed at any time since the Great Depression. And yet policy has been largely directed toward “solving” the “problems” of the financial sector (where much of the country’s existing wealth is concentrated), and only minimal efforts have been applied to solve the debt problems of households and non-financial businesses

As the DB Securities report illustrates, households’ ability to spend is a function of three factors - cash flow (which again is driven mainly by income, mortgage rates and tax), credit (bank lending) and homeowner equity (property prices). Now, with negative equity against their main asset, with even more pressure on income as a result of the recession and with virtually no savings to cushion the pain, the majority of U.S. households have no choice but to cut back drastically on their consumption. And with the U.S. consumer being forced to pull back, the global recovery story turns very pale indeed in the absence of sustained fiscal stimulus WHICH PUTS THE FOCUS ON AGGREGATE DEMAND, NOT BANK BALANCE SHEETS, as we have repeatedly argued.

The U.S. economy is today crushed by massive household indebtedness. Maintenance of the status quo is not a solution. Administration proposals to relieve debt burdens by encouraging lenders to renegotiate mortgages have failed miserably. Personal income is falling at a terrifying rate. Already 6.5 million have lost their jobs—with June, alone, adding a half million job losses. The administration’s promise that the stimulus package will create 3.5 million jobs over the next two years is unsatisfying in the face of the challenges faced. And yet we are told to “be patient.”

We need federal government spending programs to provide jobs and incomes that will restore the creditworthiness of borrowers and the profitability of for-profit firms. We need a package of policies to relieve households of intolerable debt burdens. In addition, given that the current crisis was fuelled in part by a housing boom, we need to find a way to deal with the oversupply of houses that is devastating for communities left with vacancies that drive down real estate values while increasing social costs. And we’ve got to reign in the born-again deficit hawks who, having got their fill from the government’s fiscal trough, have all of a sudden become preoccupied with “paying for” additional spending through tax hikes or spending cuts elsewhere.

If home prices revert to their mean the average mortgage indebted American homeowner will have a deeply negative home equity. Given the paltry liquid wealth and 401K holdings, most of such households may have no net worth at all. Under current U.S. law widespread negative home equity could lead to mass debt repudiation as opposed to debt paydown, which could lead to an ever growing number of foreclosures which in turn could further weaker house prices. Because so much of the broad U.S. middle class will have their personal net worth decimated, it might lead to a social and political crisis of sorts. Such a crisis could materialize sooner and more abruptly than is now appreciated in Washington. The brief populist anger felt in the wake of the AIG bonus payouts might be child’s play compared to what is in store in the future.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.

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