Tuesday, May 05, 2009

Cracked Foundations

Good Charles Hugh Smith piece.

It begins:

Homeownership and Wealth Accumulation/Destruction (May 5, 2009)

The nature of "homeownership is the foundation of middle class wealth" has changed from accumulating wealth by paying off a mortgage to speculating in housing by taking on more debt.

Once upon a time people spent decades paying off their home mortgages. That reduction in debt to zero left them equity. Those who paid rent for 30 years may have had lower costs of living (no maintenance costs or property taxes) but unless they saved religiously then they did not end up with the equivalent wealth of a typical homeowner who paid off the mortgage.

Throughout the 1950s and 60s, homes prices and mortgage rates were remarkably stable. The idea that one's house could double in value in a few years was as nonsensical as the price falling in half. Houses cost about two or three times' average income, and over time they drifted higher (adjusted for the era's low inflation) at about 1% a year.

As a result, speculation was nonexistent. Some enterprising handyperson might buy a rundown house for say $22,000, invest some money and sweat equity, and then be delighted to sell it for $25,000 some time later.

The key to housing being the foundation of middle class wealth was not the rise in value--it was the reduction of debt to zero. Removing equity from one's home was unheard of--there were no HELOCs (home equity lines of credit) and second mortgages were modest; people took a second mortgage out to pay for major home improvements or a new roof, not for vacations, new cars, college, etc.

Needless to say, the entire concept of "homes as the foundation of middle class wealth" has been radically modifed--and perhaps refuted. What was once rare--aging homeowners nearing retirement still holding large mortgages and modest equity--is now commonplace.

The inconceivable has happened to homeowners in locales such as Detroit: paying off the mortgage did not build wealth, as the value of the home diminished to near-zero.

In left and right coast locales, the inconceivable also happened: simple bungalows tripled in value in less than a decade, creating leveraged wealth far beyond any historical precedent.

Under the influence of sharply rising inflation and the massive Baby Boom generation entering its prime homebuying years, housing shot up in the late 70s. This rapid rise in value was repeated in the late 80s as well, further priming the expectation that housing had changed from a rising-at-1%-per-year asset of slowly accumulated equity to a speculative vehicle in which a 20% down payment could be leveraged into 100% or even 200% gains in a few years.

This changing character of "housing as wealth accumulation" thus set the psychological stage for the Great Housing Bubble of the 2000s, in which even the 20% down payment vanished and leverage approached infinity as "no down payment, no document verification" loans flourished.

The "rational" response to low interest rates, easy credit and wildly climbing housing prices was to increase one's debt to the maximum and throw it all into real estate speculation. Thus we saw low-income households buying one or two McMansions to flip for quick profits, speculators putting a few thousand down on homes which had yet to be built and then selling the right to the house for stunning profits, and so on: a full speculative mania.

This change in the nature of wealth accumulation from home ownership was profound. With interest rates low and real estate skyrocketing in value, paying down one's mortgage was considered backward and foolish; the rewarding strategy was to extract all of the new equity and use it for fun or further speculation in real estate (or collectibles, cars, stocks, etc.)

But once housing prices began falling to earth, the perverse consequences of leveraged debt became evident...

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