System of a Downer (Part 3)

Wealth is rare. There are people with extraordinary disposable income who are a divorce or a bad real estate deal away from financial oblivion. Their income is either generated beyond the span of their control (like most of us who are not self-employed) or goes out as fast as it comes in. What makes wealth such a rare thing is that to build it takes time and discipline. Webster’s dictionary defines wealth as the abundance of valuable material possessions or resources. A further definition adds all material objects that have economic utility. Wealth is the accumulation of stuff that keeps generating cash flow beyond its cost to support. My favorite treatise on wealth comes from Chris Rock who not only defines wealth in comparison to income (being rich) but offers up a few ethnic based examples of the struggle to achieve financial independence (you’ll never look at hub caps the same again).

In the last post I focused on how monetary policy interacted with the housing market to create the housing bubble. A benefit of that bubble was a ‘wealth effect’ for homeowners. The wealth effect comes in two flavors: The first is having wealth. The second is feeling wealthy. It is the later of the two that enabled a decade of spending from which the US economy benefited mightily. As home prices rose in a feverish market, homeowners took advantage of the growing equity in their homes along with low interest rates to borrow against their equity. Home equity loans and mortgage refinancing became to the decade of the 2000’s what stock investment clubs and day-trading had been in the 1990’s. And with similar results: A lot of people made a lot of money but very few became wealthy.

The system below shows the interaction of home equity with wealth (feeling wealthy), consumption, and home prices. As with any systems diagram this is a simplified view of how many moving parts work together to influence each other.

As home prices rose the level of home equity increased for most homeowners. Rising home equity brought on a wealth effect that encouraged homeowners to borrow against the increased value of their homes. The cash taken out of the home equity loans, lines of credit, and mortgage refinancing was increasingly used for general consumption (vacations, paying off credit cards or car loans, and buying stuff) instead of being used for investment back into the home that could have added value to the home and potentially built wealth. The wealth effect also enabled homeowners to trade up from, almost always, a smaller home to larger one. The growing consumption increased demand for many goods and services, least of all was more housing and housing services. This, in turn, drove up home prices. This cycle spiraled upward with the help of low inflation, low interest rates, and ‘innovative’ financing (Mortgage Backed Securities (MBS), zero down payment mortgages, interest only loans, and loans to people you wouldn’t pee next to at a Red Sox game).

When home prices began to tank not only did the amount of equity decrease for homeowners, in some cases it went negative. The decrease in home equity led to a decrease in consumption. In the cases of negative home equity it led to homeowners owing more on their homes than those homes were worth. Demand shrank with diminishing consumption which led to a further decline in home prices. Some found themselves unable to sell or refinance an asset they owed more on than it was worth. Life then proceeded to rub salt in their wounds by reminding them they had adjustable rate or interest only mortgages and as time progressed and interest rates ticked up in 2007 and 2008 the shit hit the General Electric GE90-115B jet engine and sprayed across the global financial system.

With home prices down, demand for homes down, and consumption down only an easing of interest rates or an increase in available credit could help kick start the system back into upward spiral mode. But unfortunately many of the institutions that could have been there to help were so strung out from the financial heroin they had been mainlining the only thing they could do was call their friends Hank and Ben for a ride to the methadone clinic.

Now the headlines in the financial posts remind me of the final scenes in Rocky and Bullwinkle cartoons but instead of titles like “You've Got Me in Stitches or Suture Self “ or “Mud-Munching Moose or Bullwinkle Bites the Dust” we get “Your Money: Does God Want You to Be Bankrupt?” or “Americans Sell Valuables at Home Parties”.

So what happens next? That’ll be next week.

Later