iTulip.com - Past Commentaries

March 22, 2006 - Frankenstein Economy Made in U.S.A. 1995 What does a Mr. U.S. Economy look like? Can’t recall, exactly. Haven’t seen him in nearly 20 years. As I remember, he was fit, well proportioned, muscular to the point of intimidating. If you are under 30, you’ve never seen him. But he was there, many years ago, providing a good example, setting the pace, spreading the wealth, kicking ass and taking names. Evidence of his past influence on the average Joe can be seen in old movies, movies with scenes like this. The average North American, call him Joe, living in the era of Mr. U.S. Economy, walks into a bank to get a loan to fix up his falling apart house, rather than add another thousand square feet to make room for the Made in China, Bose branded Home Entertainment center. A dour looking loan officer, call him Ed Noway, sits behind a laminate faux walnut desk facing the nervous applicant. Prominently displayed on the edge of Ed’s desk, a brass nameplate on a wood block that reads “Ed Noway, Loan Officer.” While Joe fidgets, Ed pours over a pile of paperwork that Joe dutifully spent until midnight filling out with his wife the night before. They did not cuddle afterwards. She’s not sure Joe can close the loan with Ed. Joe's not sure he wants the extra hours he’ll have to work to make the additional payments. Ed finally looks up to grill Joe about his employment and credit history, his assets, his attitude about saving. Ed wants to know if Joe is likely to pay the loan back or not. He, Ed, the loan officer, is responsible for the decision. He doesn’t want the bank, nor he as its representative, left holding the bag if Joe punts on the loan. Ed will look bad. He might even lose his job. Ed’s ass is on the line. So is Joe’s. Here we have the basis for a sound business transaction. But those days are over. The Frankenstein Economy is here. Today, Joe can borrow against the theoretical future value of his home and the statistical probability that he’ll have the future income stream needed to pay it back. There is no Ed at the bank to know or care whether Joe can actually pay back a loan, or if he actually uses the money to make home repairs or buy eight tons of snow to build a ski slope in his back yard to snow board in August. The connection between Joe and his newly minted debt today is a collateralized debt obligation, part of a securitized interest in a pool of non-mortgage assets, and Joe’s default risk is perhaps sold in a portfolio of private label subordinate pieces to a pension fund of a municipality in Germany. Who’s the counterparty of the credit derivative that's hedging Joe's default risk, you ask? No you didn’t. You don’t know what the heck I’m talking about. Don’t feel bad. Ninety nine percent of the lenders selling these loans don’t either. They just know the money is there to lend and they’d better lend it or their competition will. Over the past 15 years or so, the Fed replaced Mr. U.S. Economy in a free market ideology based fit of deregulation. Mr. U.S. Economy, whoever he was, is no more. In his place, the Frankenstein Economy. The Fed may have had had the best of intentions when making the Frankenstein Economy, but let’s see what he’s left behind as he’s stomped across the North American economic landscape. Since at least 1950, before Mr. U.S. Economy was put in cryogenic storage and replaced by the Frankenstein Economy, U.S. households purchased financial assets at an increasingly higher rate than they took on liabilities. They did this, except during recessions, until 1990. Then they started to take on more and more liabilities. In 1995, when the Frankenstein Economy appeared on the scene, a 50 year trend started to turn upside down. Net acquisition of financial assets not only stopped growing but turned negative, as the chart above from Paul Kasriel at Northern Trust shows. Large and sudden reversals in long-term trends imply future regressions to the mean; the Frankenstein Economy has made a mess of the markets. The folks at the Fed, of course, think the Frankenstein Economy is doing great! Before we go into that, let’s view a few more pictures of the monster’s gruesome trail. Also starting in 1995 -- not by coincidence, in our view -- under the influence of the Frankenstein Economy, North Americans developed religious expectations about the value of their homes. While the nominal (inflation adjusted) value of their homes declined, market value skyrocketed. A few voices of reason were dismissed as egghead mumbo jumbo, such as Yale professor Robert Shiller, whose research concludes that except for two periods — the early 1940s and the late 1990s — when adjusted for inflation, home prices in the U.S. "have been mostly flat or declining." Justifications for the post 1995 real estate bubble shown in the chart above, again thanks Paul Kasriel at Northern Trust, are legion. The favorite: land scarcity. Little country, the U.S.A. One of the hottest real estate markets? Las Vegas. (Tip for Vegas real estate buyers: land scarcity and thus land value in the desert can be repealed as quickly as the zoning laws that created it.) What about a nation that has an actual shortage of land relative to population, such as Japan. How did the housing bubble turn out there? Theirs, much like ours, started right after their stock market bubble burst, but unlike ours conked out a couple years later. The chart above, compliments of a San Francisco Fed's Asset Price Declines and Real Estate Market Illiquidity: Evidence from Japanese Land Values January 2005. They found that if you bought a condo in Japan’s version of NYC in 1992, ten years later the market valued it at around 80% of what you paid. Ten years of flat prices. Maybe this is the report that has given the Fed the confidence to issue the calming view repeatedly expressed in public that housing prices will not “collapse” after the U.S. boom ends but merely “flatten out.” Say you're 50 years old. Are the optimists saying that -- best case -- a house may be worth nominally (price adjusted for inflation) in 2016, when you are 60, what you paid for it in 2006? Let's hope they're right and prices don't regress to the mean. Back to our hero, the Frankenstein Economy. Just as he's convinced North American's of the inevitability of home price appreciation, he has convinced them that they do not need to save. He’s been highly influential on this point, as the chart above from iTulip.com’s previous life shows: the U.S. savings rate from 1960 to 2000. Once again, we note a distinct change in trend in the year 1995. Of all the outlandish features of the Frankenstein Economy, his most outstanding is his enormous head relative to his brain. When he’s thinking at all, he imagines that the world outside the USA finds him as attractive as his previous incarnation, Mr. U.S. Economy. Like an aging Hollywood actor who's suffered one plastic surgery after another in the hope that he can keep getting the star role of the 30-something action hero even though he’s pushing sixty, he expects to keep getting paid a movie star salary premium. So far the ruse seems to be working. He’s taking in $2 billion in foreign investments every day, enough to fund the country’s massive budget and trade deficits. But mostly it’s Asian central banks that are paying; private and institutional investors baled years ago. The Asian central banks only do it to keep the U.S. consumer borrowing and their exports flowing until they can find a better customer. His trade deficits are shown in the chart above selected from the highly recommended site Grandfather Economic Report. As you can see, Economic Frankenstein started to work his magic around 1995 as North Americans began to buy a lot more stuff from overseas than they sold. To see exactly how North Americans paid for all this, see our Chart of the Week, Purchases of U.S. Financial Assets. The crux of our investigation here at iTulip.com going forward is to understand what led to an apparent abrupt change in many long-term economic trends that coincided with the creation of the Frankenstein Economy around 1995. We expect that if we understand that, we’ll understand how, why and when these trends are likely to reverse and the impact that will have on our readers. Actually, we believe we already know, but learned from our previous 1998 iTulip.com experience that you can’t just give up the answer -- no one will believe us. Readers have to develop an understanding on their own. In the end, Dr. Frankenstein's monster does not find peace until his creator dies. The monster then departs for the northernmost ice to die. In the case of the Frankenstein Economy, the sooner the better. Discuss this Commentary Back to Top
	Housing Bubbles Correction Update Geographic Regions Cascade We’ve written three articles on the housing bubble since 2002. In Yes. It’s a Housing Bubble in August 2002, we made the case that the U.S. housing market was comprised of a number of regional real estate market bubbles. At the time, there was still controversy on the topic of whether or not a bubble existed. Now that many housing bubble markets around the country are in decline and are getting covered on NPR and the front page of the business section of your local newspaper, only the most dedicated mortgage or real estate broker still claims that no bubbles existed. The Fed took the strictly accurate but misleading position at the time that no national housing bubble existed. True, real estate bubbles occur within regions – areas of concentration of jobs or especially desirable areas where land is scarce, such as water-front property -- not across the nation as a whole. Housing bubbles happen wherever there are good paying jobs and monthly mortgage payments are declining, not just low. With mortgage rates at 40 year lows, housing bubbles were happening in nearly every populated area of the nation that had not experienced unusual sudden job losses, as occurred for example in manufacturing industry regions of Ohio. Housing bubbles may not be “national” but that doesn’t make them any less dangerous for the national economy. Contrary to the Fed’s predictions, we expected that the decline of these regional real estate bubbles was going to put a significant hurt on the U.S. economy, especially at the point many regional bubbles decline simultaneously. We argued that a housing bubble creates its own fuel: employment within the housing industry itself. Many high tech workers left unemployed by the collapse of the technology stock bubble, for example, moved into the real estate or financial services industries. In fact, 43% of all private sector jobs created since 2001 were related to real estate.
In an update Housing Bubbles are not like Stock Bubbles in 2004, we explained that when a regional real estate bubble ends, it does not “pop” the way stock market bubble does, with a sudden collapse in prices. Instead, the region experiences a collapse in real estate transactions. The reason is that stock markets are very liquid. When investors head for the exits, transaction volumes rise and prices can fall rapidly. Bubbles in housing markets, on the other hand, become illiquid when they correct. For a town or other region that experienced significant real estate price inflation, long periods can pass when there are no transactions at all. The more time that elapses between transactions, the more uncertainty buyers feel about the “market” price for comparable properties. Certainty about price gains is replaced by uncertainty. This motivates further delays in buying decisions. Market psychology shifts to the classic deflationary “I’ll wait to buy because the price is likely to fall” decision process, the reverse of the inflation cycle psychology of “I’d better buy it now before the price gets further out of reach.” Deflationary psychology is especially self-reinforcing in declining property markets because a home usually represents the largest purchase a household will make and involves the greatest leverage as well. The stakes are high. Our last piece on the housing bubble Housing Bubble Correction January 2005, we projected the trajectory of a price decline in U.S. real estate markets. Using historical rates of home equity extraction as a yardstick, we projected a ten to 15 year reversion to the mean for housing prices, using the rate of equity extraction as our guide.
Housing Bubble Correction predicts that in housing markets where bubbles occurred, prices will go through seven stages of decline, Stage A through Stage G as shown above, over a ten to fifteen year period. So far, anecdotal evidence indicates that this prediction may have been optimistic with respect to the rate of change, and we will not know for many years if our estimate of the duration of the correction is accurate. Today, certain markets are at the latter part of Stage A of bubble growth while others are at Stage B of decline and yet others are at Stage C or further. Here we offer a theory that explains the variations in regional housing bubble declines and how they are likely to unfold geographically over the projected ten to fifteen year period. This applies the housing bubbles centered in metropolitan areas versus resort areas. Bubble pricing in the latter is largely driven by money generated by participants in the U.S. Speculative Financial System (see The Big Bet) and will decline in line with the decline of The System, of which, adding to the complexity of an analysis, real estate is itself a part. Here we will focus on housing bubble markets tied to metropolitan areas. During the early growth stage of various regional housing bubbles, housing prices increased first in metropolitan areas, then in the suburbs and finally in rural areas. (These are admittedly crude geographic designations designed to simplify the explanation of the theory without invalidating it.) Prices cascaded geographically outwards from areas of high employment (income) and population density (housing demand) in metro areas to areas of lower employment and population density in the suburbs surrounding metro areas and finally, once demand pushed housing affordability to extremes there, to areas of low employment and low population density beyond the suburbs. This process of geographic price cascading took approximately ten years, from around 1995 to 2005. The dynamic that drove prices outward was the need for workers in the cities and later the suburbs to escape high real estate prices, to move to where real estate was relatively cheaper and the cost of living lower, but still within an “affordable” commute. As homebuyers traveled farther from metro areas, they encountered lower real estate prices. At the extreme top of the market in late 2004 and early 2005, some home owners who bought property in the mid 1990s in market bubble areas before a housing bubble reached their region, sold their property at a huge profit, purchased equivalent property in size and quality in a rural area, and retired on the profit with perhaps a low wage retirement job. For example, home owners from Boston and nearby suburban towns, as well as from new York and Connecticut, sold their homes and purchased homes in Amherst and surrounding towns, 90 minutes from Boston and have retired using the profit on the transaction. However, most rural homebuyers who purchased at the top of the rural market in mid 2005 did so to have a chance to buy an affordable home. Of course, as more and more homebuyers searched farther away from metropolitan areas, prices increased in outlying areas as well until property values in rural areas reached historical peaks and experienced bubbles of their own. Living in rural areas and working either in the suburbs or metropolitan areas increased commute time and expense, but this was affordable with gasoline under $1.50 per gallon as it was before hurricane Katrina. But combined increases in gasoline, heating oil, natural gas and propane prices plus higher interest payment on ARMs combined in mid 2005 to pushed many household budgets past the tipping point for those living in homes purchased in rural areas at or near the top of rural market housing bubbles. Housing bubbles are driven by the same psychological factors that drive all late stage asset bubbles, the popular assumption that prices only rise. A steady drumbeat of negative press today, as evidence mounts that the boom is over, reinforces the negative price expectations, but nothing gets the fear juices flowing like watching home prices collapse in a neighboring town, or watching one’s neighbor lose his or her home. This change in psychology will start to cause housing bubbles around suburban then metro areas to decline in a reversal of the process that drove prices from metropolitan markets outward to suburban and rural markets. The trigger, it should be remembered, was rising gasoline and energy prices and their impact on rural homeowners who purchased at the top of the market.
After a year or so, broad regions covering metropolitan areas out to rural areas that experienced real estate bubbles will experience simultaneous price declines. The extent of price decline in any area will depend on several factors, but most importantly the diversity of the local economy. A local economy that is dependent on one or two industries, and especially one or two employers, is vulnerable to significant housing price declines. An unusual characteristic of this housing boom is the extent to which it was self-reinforcing by producing jobs that in turn drove up prices. Declining demand for housing related employment will further add to the self-reinforcing housing price deflation dynamic. On the top of our list are areas at risk are those that depend heavily on employment from: Housing Related Industries (e.g., construction, realty services, landscaping, building supplies, etc.) Financial Services (e.g., mortgage lending) Venture Backed High Technology Venture Backed Biotechnology Our best estimate is that eventual price stabilization will be transmitted from the outside in, just as price declines were. This does not mean that prices will stabilize at the same levels relative to their peak prices in all areas, however. Prices will tend to fall dramatically from their peaks in rural areas, less so in suburban areas, and even less so in metropolitan areas, largely as a result of the relative lack of employment opportunities in rural versus metro areas and relatively high commuting and energy costs. Over time, prices will, or course, stabilize and recover to their mean rate of growth, at more or less the same rate as the rate of inflation. Discuss this Commentary Back to Top

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