Sunday, February 15, 2009

The Curse of Real Estate

I want to delve deeper into something I mentioned in an earlier blog posting because its importance is growing clear to me: THE REAL-ESTATE MONEY STANDARD.

It's key to understand that our monetary system has quietly undergone a major change during the last century, evolving from a solid gold-based currency into a pure "fiat system." While these innovations had few immediate impacts, they gradually allowed major distortions to occur. That's why I've been arguing it will take decades for the U.S. to recover from this crisis, which is closely linked to the collapse of home prices. Additionally, the inability of policymakers and politicians to understand the true nature of our problem will worsen the crisis, which is exactly what happened during the Great Depression. (See the Carroll Quigley quote in this post for more on that.)

Under a traditional gold-based money system, the demand for credit follows a natural balance between supply and demand. An economy with a strong growth potential but a lack of investment can pay high interest rates. Investors will respond by lending to profit from the high rates. That allows investment to occur, which results in growth and income. The economy in question grows, allowing people and companies save money. This results in more capital accumulation, which causes interest rates to fall. Investors then look to another country, or another industry that needs money and is capable of earning a higher rate of return, and the cycle begins anew.

This is classic credit market theory 101. Just like any other market, the supply/demand dynamic maintains an equilibrium over the long term. It determines an economy will get the right amount of credit it needs, when it needs it. Money is like a migrant day laborer who washes dishes, delivers Chinese takeout, or builds houses, depending on what pays best at any given moment.

In recent years, a very different system emerged that prevented these mechanisms of supply and demand from functioning correctly. These were related to the U.S.'s stature in the world, a speculative bull market in home prices, the nature of our regulatory system and the abandonment of the gold standard.

Banks were comfortable making home loans because "houses never lose value." Thanks to securitization and a steady decline in interest rates, mortgage lending increased steadily. As the lending grew easier, home prices continuously rose. Higher prices in turn allowed people to refinance mortgages with bigger principals, resulting in even larger amounts of debt. Homeowners spent that money by taking cash directly at closing or by saving less money because they were "building equity" in their homes.

Americans also purchased more goods from abroad as consumption rose. This caused foreigners to amass trillions of dollars in savings, which they lent back to us by purchasing corporate bonds and residential mortgage-backed securities/asset-backed securities (RMBS/ABS). This provided even more credit to homebuyers, driving prices higher again. See this posting for more.

The tendency of foreigners to invest a large portion of their money into the US credit market was a statutory factor. This is a new concept I would like to introduce. A statutory factor is one that's based on rules and cultural preference rather than market forces. For instance, Chinese factories made toys and sneakers for Wal-Mart under long-term contracts denominated in U.S. dollars. (These contracts were always in U.S. dollars, as the 10-K of any major importing company will demonstrate.)

China wanted to make as much stuff like this as possible to employ its impoverished masses. This quickly produced a glut of greenbacks that had to be managed. If the Chinese authorities allowed the dollars to be converted into yuan, it would have caused their currency to appreciate and ultimately made their exports more expensive. Secondly, it would have flooded their own economy with money and caused inflation.

In response, China forced banks to keep some of that money in the form of dollars. (This is reminiscent of the process of "sterilizing gold," when one country's government would take gold out of circulation to prevent currency appreciation and credit growth. It's worth noting that European and the U.S. countries began sterilizing, or hoarding gold, after WWI. This contributed to the financial paralysis we call the Great Depression.)

China's preference for U.S. fixed-income assets resulted from an explicit government policy, making this a statutory factor. It was not the result of normal supply/demand factors. Large amounts of money also flowed into the U.S. credit market from oil-producing states via London.

Furthermore, the U.S. dollar has been the global reserve currency since the end of WWII, serving the same role as gold in the 19th century. That also created a huge artificial international statutory demand for dollar assets like U.S. mortgage-backed securities.

Within this world of dollar assets, other statutory factors were at work. First, there was the belief that home prices could not systemically fall in value. It was never an official law, but it was the assumption of every credit model used by Moody's or S&P when they rated trillions of dollars in mortgage-backed securities. And, the rating agencies did have statutory power: The Securities & Exchange Commission dubbed them "Nationally Recognized Statistical Rating Organizations," while their opinions were used heavily by bank and insurance regulators to set capital adequacy ratios. (Also see Table 6 in this Fed report for an idea of it works.)

Another major statutory factor was the government's indiscriminate encouragement of home ownership. This took shape over decades as roadbuilding was subsidized and government-backed organizations like Fannie Mae supported owner occupancy. For instance, if you own a house as a landlord and rent it out, your mortgage is "non-conforming" and your rate will be higher. If you own an apartment building, the politicians would never dream of subsidizing your loan. This determination is written directly into the lending guidelines. Investors are just considered to be riskier, regardless of their financial strength.

These statutory factors forced capital unnaturally into certain kinds of investment. Now we must pay the price for creating such a distortion. It's like a restaurant locking a wage laborer in a kitchen and paying him less than he'd get from building houses down the road. When he finally breaks free, that restaurant will never be able to get him back again -- no matter how big the pile of dishes in the back.

Also contributing to the mess was the rise of hedge funds and "leveraged players" in the credit market, such as structured investment vehicles (SIVs). These folks added hundreds of billions if debt to the system, often borrowing in yen or swiss francs to fund their activities. That's why both currencies have been surging higher as investors scramble to pay back those loans. This posting explores the phenomenon in greater depth.

In sum, a long history of rising home prices, recycled trade dollars, "financial innovation" and statutory factors drove a self-reinforcing feedback loop: Houses kept getting more expensive and more credit kept getting created. It was a monetary perpetual-motion machine that made everyone richer until it stopped. At some point, all bubbles come to an end.

In the old system, money was fundamentally linked to the supply of gold and silver. When the Spanish stole precious metals from the Americas in the 1600s, it increased the amount of money in Europe and caused inflation. Inversely, financial panics in 1837, 1857 and 1907 each resulted from a physical removal of gold from the U.S. economy. For instance, the SS Central America, sunk with 30,000 pounds of gold on board in 1857. In 1907, gold flowed out of New York banks as insurance companies paid claims resulting from the massive San Francisco earthquake and fire.)

Today places like Las Vegas, Miami and Phoenix are having the same impact on our credit system. Under our recent bubble system, money was based on home prices. Now that they're falling, it's the same thing as a shortage of gold in the 19th century.

Each of these previous crises was severe, but relatively short as bullion flowed back into circulation. Even in the age of steamships, precious metals move more quickly than home prices. Given the likely slummification of suburban America and long history of appreciation, I fear we now face the equivalent of a long, gradual shipwreck. (For more, look at my discussion of Fibonacci analysis on the OFHEO index in this posting. I see prices dropping another 17-29%, which would represent another $3-6 trillion of wealth destruction.)

Instead of a sudden crisis, it will be a steady bleed on the economy for years to come. Even though it was never in the textbooks, our modern money system was based on rising home prices just as much as the old money system was based on physical gold. That's one reason why the Fed was unable to stop the price gains by raising the overnight lending rate. It was a bull market with its own momentum. Houses were appreciating as an asset class, generating new wealth and new credit in the process.

Now that houses are getting cheaper, it's harder to originate new loans. I first predicted this late last year, and it was confirmed in a recent article from CNBC:

With mortgage rates at 25-year lows, refinancing applications have reached record levels in the last two months. But homeowners who bought during the boom years are getting squeezed out of refinancing because the value of their home has plummeted...
For homeowners, many lenders don't have an incentive to refinance a home that's valued lower than the original price. "Unfortunately, we run into that a lot," says Steve Habetz, CEO of Threshold Mortgage. "People call us to refinance that don't have enough equity and we have to say no. We try our best, but you can't force a bank to refinance them."
In the boom times of real estate, home appraisals helped create what some say were higher than actual price values. But now experts say appraisers are taking a different more realistic approach that's actually hurting some refinancing. "My own opinion is that appraisers were under pressure to submit higher prices," says Ent Credit Union's Paukovich. "But now appraisers are more conservative. The purchasers of the mortgages want them to be conservative and much more thorough."


Bubbles usually follow years of steady price increases, which lead people to trust the asset in question: Tulip bulbs appreciated steadily for decades before reaching a fever pitch and collapsing in 1637. U.S. stock prices had risen steadily for over a decade, and proven their mettle by rebounding after the October 1987 crash. That kind of resiliency was an essential component of the bubble that finally broke in March 2000.

The thing that makes a bubble a bubble is that nothing, and no one, can stop it. Like a plague striking a new population, an economy's defences are impotent against it. (This is what makes it a bubble.) In many cases, the regulatory structures themselves are co-opted by the fever, just as a virus takes over cells in the body to reproduce. (For instance, the SEC allowed more leverage, and the rating agencies promoted securitization.) Things that once protected the host economy, such as rules of credit analysis and concepts of safe lending, were exploited by the illness.

In the late Middle Ages, rising farm productivity and widening trade allowed the rise of towns and cities. People lived longer, had more access to information and more economic opportunity. It all all sounded great, until the Bubonic Plague came in 1346 and flourished precisely because of concentrated population centers and transportation networks. If it hadn't been for Europe's relative wealth and success over previous centuries, people would have still been living in isolated villages. The plague wouldn't have swept the continent like fire through a dry forest.

Similarly, without decades of successful mortgage lending in the U.S., the housing bubble never would have hit the U.S. economy. Despite economic crashes in 1981, 1989 and 2001, home prices kept going up nationally. (The OFHEO home price index never fell more than one quarter in a row, or dropped more than 0.4% at once until 2007. In Q2 of 2008, an unprecedented phase of declines began. I fear it will last for years.) That made the credit system trust home lending, laying the cultural basis for the bubble.

Rising home prices begot more credit, which in turn pushed home prices higher and allowed more lending and consumption. As I argued above, none of the checks and balances present in the self-correcting model were present in the housing boom.

I want to conclude with a few thoughts on inflation. Many people expect some kind of runaway inflation in the U.S. because of all the "stimulus" and "bailout money." I think we're actually going to get deflation because these same actions will prevent economic recovery and keep the credit market in a kind of medicated coma.

The inflation hawks point to places like Weimar Germany and Zimbabwe, where the government literally printed huge amounts of money. I would also include the cases of the United States during the War of Independence and the Confederate States during their failed bid at seccession. Both suffered runaway inflation after printing worthless paper money. In all of these cases, the supply of money increased faster than the supply of goods and services.

In our current situation, we're seeing an opposite situation, where the supply of stuff is going up along with the new money being created. Based on the pace of home sales (months of inventory), we now have more houses than at any point on record. We also have so much oil that full tankers wait at sea, millions of workers stand idle while factory utilization plunges. All the data suggests we have too much stuff right now, not too little. For instance, the last GDP report was artificially inflated by excessive inventory building. (This is another similar characteristic we share with the Great Depression.)

Our situation is completely different from previous bouts of inflation. The potential for price gains does exist in the future, but it will probably result from a collapse of the dollar and economic growth outside the U.S., which could drive prices higher for commodities and merchandise. That will probably happen at some point, but it will take a lot longer than people think. After all, the global economy is dependent on the U.S. consumer. The people of China and India will eventually pick up the slack, but it will take years.

Few things have attracted as many passionate debates as the causes of inflation. Thanks to Milton Friedman, many economists rely on confusing strings of Greek letters to explain the dynamic between prices and money:

(Friedman's "Quantity Theory of Money". See this for more.)

I won't pretend to understand what this formula means, but I know Friedman's most famous dictum: "inflation is always and everywhere a monetary phenomenon." I think it's best to avoid using the word always when you're dealing with groups of people. After all, many were convinced "home prices always go up." Markets frequently do all kinds of crazy things few people expect or immediately understand. (That's why they're so much fun.) As we saw with bubbles and plagues, systems often sow the seeds of their own destruction.

Friedman was famous for embracing human freedom. If he were still alive, I would ask him: If people shouldn't be constrained by a conscription or a monopolistic public school system, why should prices be restrained by the actions of a government or central bank?

In reality, they're not. Like everything else in economics, it all comes down to supply and demand. If people want stuff and are able to pay for it, prices rise. If producers make too much stuff, or people stop buying the stuff, the price goes down. Sometimes -- but not always -- the government's creation of money corresponds to more demand for stuff. This is often true during war, which consumes huge amounts of materiel. But, it wasn't true for Japan over the last 15 years, and it's not true for the U.S. now.

That's why the current moment is such a challenge. To borrow the analogy of the tree falling in the forest, if the Fed prints money and no one uses it, does it create inflation? Right now they are trying to replace money destroyed because homes lost value. Unlike printing money to pay for a war, this process doesn't result in real demand for anything, or real purchases. No human being is putting in extra hours of work to built a fighter plane or tank. Fuel and steel isn't being diverted from the consumer economy to a war effort. Abstract concepts like "money supply" or M1/M2 don't explain what's happening, because all of those concepts simply assume that money created by a central bank will actually be used. As Ayn Rand constantly said: "Check your premises." In this case, the premises of the inflation hawks are completely wrong.

This is the paradigm I use to understand the inflation of the late 1970s: Too many people wanted stuff, but there wasn't enough to go around. The Vietnam War and devaluation of the dollar started the price increases in the early 1970s, and were followed by the oil shocks. But, the icing on the cake was the maturation of the baby-boom generation. Millions of people born after WWII became major consumers as they started families and bought extra cars, bigger houses and washing machines .... more of everything. The U.S. economy was also much more self-contained, with oil as the only major import. In 1974, the trade deficit was just 0.05% of GDP, compared with more than 5% when the credit bubble peaked in the 2005-2007 period. That allowed domestic producers to control prices in a way that doesn't exist in today's world of global supply chains.

John Kenneth Galbraith described this in his classic book Money: Whence it Came, Where it Went:

The market power of corporations and unions ... could keep prices going up ... Everywhere the less privileged were asserting more strongly their claims to some part of the consumption that previously had been thought the natural right of only the privileged... The tendency for the claims of consumers to press ever more insouciantly on the capacity to supply them -- and the associated and by no means unnatural reluctance of governments to limit these claims -- was one cause of inflation in the industrial countries. (Excepted from pages 348 and 355-6 of the 1975 paperback edition.)

This only ended when Fed Chairman Paul Volcker caused a recession by raising the overnight lending rate to 20% in 1981, which halted the rise in oil prices and broke the back of inflation. Importantly, consumer discretionary items like apparel and durable goods kept getting more expensive despite the recession because they were still largely manufactured in the U.S., with high labor costs. In subsequent decades, these same industries would attract major foreign competition. Many of the jobs moved to Asia, which made the merchandise cheaper than ever. (This also caused the trade boom, which eventually fueled the housing bubble, as I explained above.)


Energy: -10.4%

Housing: +30%

Apparel: +14.8%

Consumer Durables: +22.5%

Services: +42%

All Inflation: +27.1%

(To replicate my data query, begin here.)

Again, inflation is all about supply and demand!


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Clown George said...

I won't pretend to understand what this formula means, but I know Friedman's most famous dictum: "inflation is always and everywhere a monetary phenomenon." I think it's best to avoid using the word always when you're dealing with groups of people.

your point is well taken, but to quibble a bit on semantics ...
i don't know the context of friedman's famous dictum, but from what i understand, the definitions of "inflation" and "deflation" have changed somewhat over time. they now seem to be interchangeable with "rising prices" and "falling prices," respectively.
but i think the traditional uses of the terms did, in fact, describe strictly "monetary phenomena." inflation was an increase in the supply of (or decrease in the demand for) money, deflation a decrease in the supply or increase in the demand. generally (but not always, as you've pointed out), the first results in higher prices and the second in lower prices.
so i have a feeling what friedman was saying is that "inflation" is a phenomenon that involves the supply of and/or demand for money, which affects prices in somewhat the same way as any good's supply and demand. but money is a medium of exchange and not a good in of itself, so the effect on general prices is much broader. still, the decline in the supply of oranges after a bad winter making their price go up, or the decline in demand for MC Hammer records making them available in 99 cent bins are not examples of "inflation" or "deflation" as traditionally understood.

David said...

Clown George might be right, but how much does it matter? The key thing is prices. That's what influences people's ability to get paid and to buy things, and to service debt.
If inflation is nothing other than a number reflecting some hypothetical supply of money somewhere that no one uses, then who cares?