"We are not in a great depression scenario ... When you had the market crash in 1929, the next three years you were on the gold standard, and you actually tightened the money supply."
--Steve Auth, Chief Investment Officer, Federated Investors on CNBC 2/20/09
I have recently been arguing that our financial system has stealthily moved itself onto a mutated version of the gold standard in recent years, but people have yet to recognize the dynamic at work. Instead of gold bullion, the value of real estate has served as the basis for our money: As homes appreciated in value, more credit was extended. It's the same thing as 100 years ago when banks' ability to lend was directly tied to the presence of physical gold in their vaults.
Of course, this notion is nowhere to be found in text books, but it is scattered throughout the economic data and financial news over the last several years.
For instance, a New York Times article from Jan. 14, 2005, spoke of consumers' suprising ability to keep spending:
...Feeling on solid ground, consumers have taken advantage of cheap money to borrow. They have bought cars on credit and taken out home equity loans to refurbish their homes. In the third quarter, total household debt grew more than 9 percent. And the personal savings rate has plummeted to merely 0.3 percent of disposable income in November - virtually nothing...Stories such as this were extremely common in the 2003-2006 period as people kept chorusing: "The consumer isn't dead yet!"
Here is a brief summary of how real estate came to resemble gold as a source of credit in the economy:
As home prices rose, people had more money. This is why the Fed was unable to halt the growth of credit using traditional monetary tools like the overnight lending rate, causing Alan Greenspan to complain about a conundrum.
On one side, residential real-estate was an asset class. Despite regional differences, it was united by the same sources of financing, the same tax treatment and more or less the same demographic trends. This caused a secular bull market for years as people moved to suburbia and babyboomers had families in the post-WWII period. (See this posting and this posting for more.)
On the other side, you had increasingly sophisticated financing mechanisms that learned to work their way around traditional controls such as the Fed's tightening policies or shortages of domestic savings. The new money machine subsisted on securitization, a globalization of capital flows, a surge in financial wizardry and hedge-fund speculation. Topping it all off was a 28-year bull market in U.S. bonds, one of the most important, yet least appreciated, trends in financial history. (It contributed to or caused two junk-bond bubbles, two LBO bubbles, an emerging market bubble and the housing bubble.) See this posting and this posting for more.
All bubbles are built on solid foundations. That causes people to trust the asset itself -- whether it be houses, stocks, oil or tulips -- and ignore the fundamentals. Once they come to believe the asset can only go up, complacency takes root and the cultural basis for a bubble is established.
Residential real estate in the U.S. was no different. It began on extremely solid footing, with equity representing 80% of total real-estate value in 1952. In comparison, an individual home mortgage is considered "well capitalized" at just 20% today. That national level dropped into the 65% range by the mid-60s, and remained there until the late 1980s. Salomon Brothers had just started securitizing mortgages and Fannie Mae was an increasingly active player in the market. (Its shares would rise more than 80-fold over the next 15 years. From 1985-2001, the mortgage pools of government-sponsored lenders like Fannie and Freddie Mac rose from $289bln to $2.8 trillion -- a factor of 10x. Meanwhile, GDP rose just 2.5x, from $4 trillion to $10 trillion. After 2002, Fannie and Freddie actually backed off and were replaced by non-government subprime lenders, who drove the system to calamity.)
As mortgage debt proliferated, less and less home value backed the loans, squeezing "cushion" out of the asset class. The ratio plunged when the lending boom hit a fever pitch as the housing bubble peaked. It will continue to fall as long as home prices continue to drop because debt remains fixed until it is written off, while houses will keep getting cheaper.
The only way to reverse the trend is to reduce mortgage debt, which is exactly what's happening now. Unfortunately, this will stand as a huge obstacle to increased mortgage lending.
Less mortgage lending translates into less demand for houses. (If people can't get a mortgage, or can't borrow very much, they can buy less house.) When demand falls, prices also fall. Of course, there are two ways to fix this situation: Reduce supply or increase demand. That is why I proposed three simple policy suggestions at the end of this blog posting. They are:
1-Stop foreclosures (reduce supply of houses on the market)
2-Dismantle houses (reduce supply of houses on the market)
3-Encourage more real-estate investors and end the unnatural preference for owner-occupancy (increase demand for houses)
I am not an expert on houses per se, but I understand markets. They all follow the same principles. Maybe my specific ideas won't work, but we need something that will attack the same issues.
The next chart shows this same dynamic at work. The top line is the value of household real-estate in billions, and the bottom line is the overall amount of household debt, most of which is related to real-estate. It shows how the household as an enterprise/industry leveraged itself over time. As the purple line approaches the blue line, more households become insolvent.
It's hard to deny the relationship between home prices and the availability of credit in the economy. As I argued in a previous blog entry, real estate assumed the same role as gold in the 19th-century financial system. The problem is that financial systems are slow moving animals that evolve over decades, not months or years. The accompanying economic paradigm -- "the consumer story" -- took shape over a similar amount of time.
The thing that worries me now is our credit system is linked to a socio-economic process (consumer spending/home prices), which is not going to rebound anytime soon. In essence, our ability to borrow is tied to the value of an asset class that is plunging in value because of the factors I describe above. It's a process of decline that's going to last for years.
This is much worse than life on the gold standard, when a country merely had to raise interest rates to attract new money. By trying to make everyone a homeowner, have our politicians tied a ball and chain to our economy? Is that weight called home prices?