For What It’s Worth, II

Being a financial advisor is a lot like being Cassandra, the Greek prophetess everyone completely ignored; her last piece of advice had to do with the wisdom of bringing a wooden horse inside the walls of Troy. Becoming a financial advisor isn’t difficult, nor does it require a great deal of arcane knowledge; the core of my advice was always: spend less than you make, carefully invest what you save, plan for misfortune, and pay off your debts so you can live on your savings. If I was lucky, clients would get two out of four.

Why? Lots of reasons. Easy credit, low interest, and no concept of waiting for something you want. But to really see how our debt-economy has distorted value and become unsustainable, let’s look at the housing market.

In the end, they were building everywhere.

I’ll start with what should have been universally recognized as a truism; any time the value of something rises faster than inflation, something is driving it. For example, the rising cost of college education (nearly double the rate of inflation) has been driven largely by the government-enabled student grant and loan system, which has inflated demand. Colleges find they can charge more because people can use loans and grants to pay, so they do. For the past few decades, nationwide real-estate values have risen faster than inflation. Why?

In the case of localities, there are different causes–nor did property values rise everywhere. For example, in Roosevelt (in northern Utah) property values plummeted when the oil-extraction industry mostly shut down and a lot of workers left town. Suddenly there were plenty of homes on the market and few buyers (lots of supply, little demand). But in Las Vegas, my hometown since the early nineties, until 2007 the opposite was true; an exploding hospitality and entertainment industry (see picture at top of page) fueled an incredible and sustained housing boom. When I moved to Vegas the metropolitan population was around 500,000; today it’s close to 2 million.

This had an interesting effect on real estate prices. Normally, the value of a home will rise in lock-step with inflation unless the desirability of its location and surrounding conditions change. For example, a house on the extreme edge of town will increase in desirability and therefor value as the town pushes beyond it and the neighborhood around it acquires shops, schools, libraries, theaters, restaurants, etc. The local population explosion had an interesting effect on home values; most properties in town appreciated at an annual rate well ahead of inflation–even the ones already in fully developed neighborhoods.

And here we come to the sustainability issue. Because modern Americans average negative savings rates, home equity was the one source of capital accumulation many of my clients ever saw. A home purchased for $100,000, worth $150,000 three to five years later, meant +$50,000 in equity on a client’s balance sheet. On paper, he’s $50,000 richer because his “investment” has appreciated.

But he’s not, because easy credit cards put him $20,000-$30,000 in debt, at anywhere from 9% to 25% interest, and his $20,000 car is a depreciating asset, so eventually, his debt-to-income ratio approaches 50%. Say 20% of his pay goes to taxes, he only keeps 30 cents on every dollar with which to pay his month to month bills, entertain himself, and try and save a little money.

But there’s all that equity “saved” in his home, so he refinances or takes a second mortgage. This eliminates his high-interest credit card debt, may pay off his car, and brings his debt-to-income ratio down to a manageable 25% to 30%. Wonderful! Except that his spending habits remain the same, which means that in 3-5 years he will again be up to his neck in credit-card debts and new car loans.

In the course of my financial advisor career I met many people like this. They had great jobs, beautiful houses, and nice cars, and took expensive vacations every year–and never saved anything. Lose the job, or even take a cut in pay, and they were at most three months from disaster. The only thing that made their lifestyles sustainable was the ever-increasing value of their property, and they owned a mortgage, not a home.

Which brings us to the implosion of the housing market.

As I said before, real-estate values can rise quickly as the property becomes more desirable. They can also rise beyond their “real” value (beyond the local conditions that warrant them), simply on market momentum; then you get a real-estate bubble where homeowners and investors will pay more than the property is worth now because they believe it will be worth still more later. Fortunately these bubbles are usually local and self-correcting.

But what happens when real-estate values stop rising? We’re not even talking about losing value yet, but suddenly my client has no easy way out of his debt-trap. He can’t refinance his home again to pay off his credit cards, and he can barely pay the interest on the cards. Forget about saving. His lifestyle takes an immediate hit because he can’t finance it with debt anymore. He will spend years pulling himself out of debt, making no more major purchases and living frugally, if he’s lucky.

In 2007-08, millions across the country got very unlucky. The bubble wasn’t localized–it was nationwide, and had been building for decades. What drove it?

The extent of the damage of the real-estate implosion had a lot to do with unregulated and badly monitored derivative markets, etc (yes, Wall Street must share the blame for the real-estate market’s collapse nearly taking down the entire financial sector), but the size of the bubble and depth of the implosion was almost purely the fault of the US government.

Most minorities in America have been significantly less likely to be homeowners (not all minorities; Asians outstrip white Americans in homeownership). This has been seen as discriminatory, a social injustice. I won’t debate the point here, other than to suggest that a rational, sustainable remedy might have been better education, which has always increased opportunities. Instead, the federal government started leaning on the banks to “be fair.”

But the banks were already fair: they extended home loans to applicants who proved they were likely to be able to pay them off. How? By saving money first–usually 20% of the home’s value–and showing a healthy credit history and debt-to-income ratio that reassured the banker that the applicant knew how to survive some hard times without defaulting on the loan. They also only extended loans for homes likely to appreciate in value, or at least not lose value. This meant that lower-income applicants (of which minorities make up a larger percentage), and applicants living in less desirable neighborhoods, had a hard time getting loans and becoming homeowners. But banks are loaning other people’s money; they represent their depositors and have a fiduciary responsibility to invest prudently, and foreclosures rarely recover all of the money sunk into a mortgage by a bank.

This wasn’t good enough for the federal government. They threatened banks with penalties for “discriminatory lending” if they didn’t extend enough loans to sub-prime (more risky) applicants. Since it’s almost impossible to disprove a charge of discrimination unless minorities are as well-represented on the bank’s books as everyone else, the banking industry responded by creating a market for risky mortgages. By the time I became a financial advisor, balloon-payment loans (loans where only the interest is paid down until the very end), zero-down loans (no down-payment required), and ARMS (Adjustable Rate Mortgages: the initial interest rate is kept lower than the market rate for the first few years so the homeowner can make the payment, gambling that the rising real-estate values mean that in five years he can refinance the home based on the new equity) were common. I even saw refinance loans for 110% of the property’s value, and does anyone know what a “liar’s loan” is? Banks took on way too many risky loans–but hey, they also took on mortgage insurance to cover themselves in case of default (and added the charge to the cost of the loan).

Remember how value is subjective? The easy credit in the real-estate market meant more dollars chasing housing–leading to a nationwide boom in housing prices and in the construction industry. But the boom couldn’t continue forever; eventually enough people became homeowners, fully debt-leveraged, that the demand began to slow. Declining demand, while supply continued to increase (developers building homes in expectation of purchase), meant home prices first stagnated, then began to drop as the market became saturated.

The first loans affected were those sub-prime ARMS; as the rates adjusted to current market rates, with no built-up equity in the home, home-owners began defaulting in huge numbers. This put more homes back on the market, further depressing real estate values.
Only in New Orleans were homes more underwater.

If that had been the end of it, things would just have gotten bad, but with so many bad loans on the books, now backed by property not worth the mortgages, banks began to fail. The construction industry started hemorrhaging jobs–an added disaster in places like Vegas, where it had become a major local employer. The financial sector in general was rocked to its foundation by the sudden revelation of the extent of bad investments in the derivatives market and the hit taken by all the re-insurers who had taken on those mortgage insurance policies. Credit dried up. Investment portfolios took huge hits. The shockwaves multiplied, spreading to the government sector as tax receipts plummeted due to rising unemployment, sales drops, and lowered property values. This exploded state and federal budget deficits–and for governments a budget deficit means borrowing, increasing the state’s debt-to-income ratio, or taxing, taking more money out of an already hemorrhaging economy.

And we finally see just how unsustainable a borrow-and-spend economy, based on increasing property values (or GDP), was. We should have seen it coming; economists have always known that prices, the value of things, cannot endlessly rise at rates higher than inflation. Ever. Government policy artificially inflated real-estate values nationwide and caused over-investment in the construction industry. A toxic cocktail of government banking and investment policy encouraged Wall Street to create investment instruments and portfolios tied to the ticking bomb, and we all went down together. Real estate prices are still seeking their “real” value—i.e., what buyers can and will pay for homes now—and most homeowners who haven’t defaulted on their loans are underwater; if they could find buyers and could sell their homes tomorrow, they would still be in debt to the bank. It will be a long time before the market value of their homes approaches what they paid for them, and they certainly won’t be tapping the equity to pay off their other debts.                                           Not to be used as a floatation device!

Next Time (If there is one): personal debt, government debt, and sustainable budgets.

April 2012 Update/Note: since the political-financial causes of the housing bubble continue to be hotly contested–and I’ll be the first to admit I’m no expert–I thought I’d add a more measured judgement recently given by Warren Buffet in his annual letter to shareholders.:

“All of us participated in the destructive behavior — government, lenders, borrowers, the media, rating agencies, you name it. At the core of the folly was the almost universal belief that the value of houses was certain to increase over time and that any dips would be inconsequential. The acceptance of this premise justified almost any price and practice in housing transactions.”

In other words, the irrational conviction that home prices would continue to rise created a classic market bubble, like the bubble of the 90s, and carried everyone along with it.

6 thoughts on “For What It’s Worth, II

  1. I do wish that good writers wouldn’t repeat bad information. The community development loans that were targeted at minority communities had a much lower rate of failure than other loans. They were, like many of the more regulated areas of the economy, a better risk than what Wall Street was doing on its own. Government regulations tend to stabilize economic conditions– less high swings, yes, but also less devastating failures.

    The simple fact is that while the failures did come in low-income areas, those were not urban ones. They were rural, primarily white areas, where there was little government intervention and less lending information. People who had neither personal nor generational experience with lending information were lied to by the banks, who turned around and lied to the government and to ratings agencies about what they had done. ARMS and other unusual financing options were used as methods of extraction: to remove as much money from the borrowers as possible before they exited the market in bankruptcy.

    Government debt is not like personal debt; among other things, it tends to drive economic expansion because it means that there is investment into things like infrastructure, clean air, and education. The exploding debt is not because of entitlements– many, like Social Security, pay for themselves. Remember, Social Security is neither bankrupt nor a contributor to the debt. It is solvent, and is due to remain so for decades under the worst possible scenarios: every baby boomer is (a) living, and (b) noncontributory to the economy. The latter is insulting to the many retirees who are in non-physical intensive jobs; the former raises a few eyebrows; contrary to the media blitz, we’re not living longer save by a few months at the extreme edge of lifespan. Instead, our average life expectancy at birth has increased, because there are less childhood deaths. Something which, sadly, our medical situation is becoming retrograde on, but that’s extending a digression.

    What lead to the loss of construction jobs? How did we see a lack in education, that made more people vulnerable to the predatory culture currently administering the banks? In a simple statement: poor choices in governance. You’re right that we can and should look at the debt here– or rather its source. The two single largest contributors to the debt are the Bush-era Tax Cuts that were unfortunately extended, and the wars in Afghanistan and Iraq. The latter is a political question, rather than an economic one, about how much investment we should continue there. The former, though, runs into two economic realities that can be easily analyzed. First, the tax cuts were unnecessary, as at the time, we had a decent economy and revenue stream; second, they were unhelpful. Tax cuts, especially for the wealthy, provide the least ratio of dollars spent by the government to dollars generated in economic activity (Infrastructure provides the greatest).

    As panic about the debt– which did not extend to the bond markets, which until the default crisis was still consuming US government bonds rapidly, and indeed has recovered much since– rose, politicians became unwilling to spend on necessary projects, let alone expansion or repair damage done by deferred maintenance, educational funding not keeping up with the expansion of use, and so forth, let alone return taxes to a point– Clinton or Reagan-era, possibly– where economic activity and basic services could be funded.

    That is where the damage to education came in. When I was in elementary school, they started by cutting funding to the arts, music, shop, and other “nonessential” classes. Shop and similar trade classes prepared students for quite lucrative technical/worksman courses, and provided a reason for students to stay in school. Arts and music have been shown to perform two functions: retention as above, and in learning acquisition. Arts help develop spatial and order senses; music has been shown to be one of the great keys to understanding mathematics, even for the nonmusically inclined.

    Then class sizes grew and there was insufficient funds for new schools and expanded campuses to deal with them. Studies show that the best learning happens between 16-20 kids in the classroom. Below that, you might be alright– it takes extra work to get discussion going– but above that, and more time is spent on discipline and learner difficulties than it is on instruction. Our technical requirements grew, but there was no money for increasing our technical capacity. Finally, deferred maintenance began to kick in. Just like infrastructure below, items in schools need repair, and ultimately replacement. Textbooks, desks, even the buildings, all require income flow that was denied.

    The last blow was NCLB. An unfunded mandate that expanded standardized testing to not merely cumbersome, but damaging levels, not only did NCLB cost schools (and states) for implementation, it damaged education activities and school culture. The results of the so-called accountability mandate have been to dramatically increase cheating, and to decrease learning time and appropriate education. Where standardized testing has been implemented, honest schools pay– literally, and in confidence– as all other methods of assessment drop. Less creative thinking, less application, and less overall capability have all been seen; the alternative, generally, is to cheat, as abhorrent as that is. My personal vote would be for ethical behavior, though I can comprehend the mindset that leads to cheating.

    Construction died when we started deferring maintenance, much needed repair, and upgrades. Not only did it lower the basic level of construction activity needed to maintain construction companies through dry periods of private activity, but it also increased costs. As the roads worsened, the costs of transporting materials rose. Wear and tear on machinery increased. Private construction fell, driven by those problems, and the housing bubble.

    Speaking as an economics teacher and former archaeologist, if you’re blaming government debt, government regulations, and minority investment for the current economic crisis, I have to say, you’re not a Cassandra. You’re reflecting the conventional, Chicago/Austrian-School wisdom that lead to the current crisis. Lack of demand and a weakened public sector are driving the current recession, and the economic crisis was born out of simple human greed, short-sighted by nature and allowed to operate in the dark. Information, honest and complete, is a requirement for free markets, but that’s simply not what happens in unregulated markets. Humans band together into social groups because we operate efficiently in large numbers; we develop rules and consequences because otherwise, cheaters exploit the system and damage it.

    I enjoyed Wearing the Cape a lot, except for some irritating cultural and psychological blindspots, though I appreciate that not everyone takes as much of an interest in the true nature of cultures and human development as I do. I simply get irritated at people making the same erroneous statements about humans and human activity again and again. Nothing is going to get fixed like that.

    1. Thank you for your considered reply. It was not my intention to start a debate over government programs; my main focus is on what we, as individuals and as a people, can afford. I will be the first to admit that my experience in these things is, as I said, on the personal financial side of it; I have much more experience with bad borrowing practices than I have knowledge of community investment policy. As to the ultimate causes of the current downturn and the reasons for our lack of recovery, I’m afraid we’ll have to disagree. BTW, I too am no fan of NCLB; I considered it a technocratic “solution” to what should have been treated as a market problem, but that’s a whole other rant I won’t go into here.

      1. I got my undergrad in ’01, and started graduate school after working at a small technical firm for a year afterwards. Ever since I started observing humans professionally, it’s been a fairly despairing about the way that human beings ignore history and themselves time and time again. It is your blog, of course; becoming an author does not remove you from the right to say what you want on the internet. 🙂 I am glad that we can agree to disagree with the current situation.

        For what it’s worth, I’m looking forward to December and the complete version of Villains Inc. I read too fast to buy books piecemeal– it drives me batty. On the political front, I’ve been reading David Weber for years; the only two authors I’ve stopped reading for political reasons are Orson Scott Card and John Ringo (and the latter of which verged off into bad taste and Protection From Editor syndrome above and beyond the political)

  2. “On the political front, I’ve been reading David Weber for years; the only two authors I’ve stopped reading for political reasons are Orson Scott Card and John Ringo (and the latter of which verged off into bad taste and Protection From Editor syndrome above and beyond the political)”

    I love David Weber and the way that he weaves political history into the far-future Honorverse. I don’t know much about Card’s politics, but I am very careful starting anything of Ringo’s these days–also on matters of bad taste well outside the political.

    1. I suppose the best benediction I could ask upon an author is “may you become popular enough to be able to make your money exclusively from books, and wise enough to remember you always need an editor.” They don’t get nearly enough credit.

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