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.
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 dot.com bubble of the 90s, and carried everyone along with it.