It
has been widely reported that housing has been holding up the economy
during the recent period of weakness, and that were it not for the
consumer's ability to keep spending by extracting equity from their
home, the recession would have been much worse.
However,
few commentators realize that these reports are evidence that the
US economy is undergoing a secular shift. The emerging reality,
slowly being recognized by economists, is becoming known as the
Housing Economy. This term recognizes the emergence of residential
real estate as the driver of economic activity.
Some
experts believe that the current changes will be comparable in their
scope to the major shifts of the past two decades, such as the change
from the Old Economy (based on manufacturing) to the Service Economy
(based on the import of consumer goods), that took place in the
80; or the transition from the Service Economy to the New Economy
(based on computers and the Internet) that took place in the 90s.
The
changing composition of the labor force illustrates the transition
that is taking place. The Wall Street Journal and other
papers have recently reported that many unemployed professionals
from fields such as information technology, management, and finance,
are now leaving
their old line of work to become real estate agents as they
realize that their old job has moved offshore or is not coming back.
Eventually,
most of the US labor force will be employed in one of a few types
of work: real estate developer, building contractor, appraisers,
real estate broker, and real estate agent. Their work will consist
of the construction, financing (and re-financing), purchase, and
sale of residential real estate. Day traders who now trade NASDAQ
issues may be able to day trade residential real estate if sufficiently
liquid markets and continuous price quotes are available.
Housing
will be more than the driver of the Housing Economy: it will be
the only form of economic activity. Other types of production, now
seen to be unnecessary, will be converted or diverted to residential
real estate, as the New York Times has reported in a
recent story:
Gregory
J. Nickels, the mayor of Seattle, is battling the Port of Seattle
and the longshoreman’s union to close one of the city’s three
port terminals in a few years, saying it makes more sense to use
the spectacular mountain-framed waterfront property for condominiums
than cargo ships going back to Asia without full loads. He argues
that even the $700 million of recent renovations on the port will
not increase cargo traffic.
“The
land values are such that when the port is only creating 13 jobs
per acre, there may be a better way to create jobs,” Mr. Nickels
said.
The
conversion of factories, transportation networks, and other capital
goods, to residential real estate will yield significant economic
benefits. A Seattle real estate developer contacted by this publication
explained the thinking behind this, "We used to need shipping
terminals because we used to have to produce goods to trade with
foreigners to get things from them in return. But production is
a lot of work, and you have to save and invest. Now how much fun
is that? Why not just build houses and condos?"
One
challenge that has been issued by critics is the likelihood of an
excessive
accumulation of debt. Only hard-core skeptics question that
home owners can perpetually refinance and extract home equity from
their rising home prices. However, a growing chorus of doubters
has raised the issue that increasing
debt levels will limit the long-term growth of the economy.
Past
generations of home owners looked forward to the final payment of
their mortgage debt prior to their exit from the work force. Of
concern are the following trends: in recent years, home equity as
a percentage of home values has sunk to an all-time low, in spite
of the aging population of baby boomers nearing retirement, several
consecutive years of strongly rising home prices, and a period of
record-low interest rates.
The
total amount of mortgage debt outstanding, now around six to seven
trillion dollars, is at an all-time high. Critics are increasingly
alarmed that the fraction of income devoted to mortgage payments
is also at historically high levels, and has been growing.
While
some have argued that the fraction of income spent on mortgages
must remain under 100%, not all economists agree. A mainstream economist
asked to comment on the issue, defended the Housing Economy.
"Using
the most modern econometric techniques, we can project where the
mortgage payments of all home owner reaches 100% of national wage
income. Basically what we do is draw a graph of the percentage over
time, lay a ruler over it, and draw a straight line. The point where
the line crosses 100% is our forecast," he stated.
Some
have charged that this type of forecasting is devoid of any economic
reasoning, and even that it violates common sense. How, for example,
could mortgage payments reach or exceed 100% of income?
The
mainstream economist responded to these charges. "Home owners
can simply extract equity from their home by refinancing and use
the cash they take out to pay the difference between their income
and their mortgage." Home owners extracted
$491 billion of equity from their homes last year according
to the Wall Street Journal. "Home owners are already
using home equity from refinancing to meet ongoing monthly expenses,"
he continued, "It is a small step forward to start using these
funds for the mortgage itself."
He
continued, "Those worry-mongers who are always complaining
about debt are laboring under the quaint notion that debt is supposed
to be repaid. The purpose of going into debt is so that you can
acquire more debt in the future. Governments have known this for
a long time, but in a democracy, why shouldn't ordinary people be
able to take advantage of this as well?"
Fed
Chairman Alan Greenspan, one of the leading thinkers in this new
paradigm, has generally endorsed
these changes, as the Wall Street Journal reported:
WASHINGTON
– Federal Reserve Chairman Alan Greenspan said Monday the
finances of U.S. households are in “good shape” despite a steep
rise in household debt and national bankruptcy rates over the
last few years, suggesting that consumer spending isn’t likely
to fizzle out.
In
a speech, Greenspan said that although nonbusiness bankruptcy
filings have risen steadily over the last few years, they don’t
reflect the true state of household finances. Household debt,
he said, has climbed in tandem with rising homeownership rates
and rising home prices, allowing most households to carry the
debt without stress.
“Overall,
the household sector seems to be in good shape, and much of the
apparent increase in the household sector’s debt ratios over the
past decade reflect factors that do not suggest increasing household
financial stress,” Greenspan told the Credit Union National Association
in prepared remarks.
If
the use of debt to fund current consumption is to be sustainable,
continually rising housing prices are required so that a plentiful
supply of home equity to be cashed out is always available.
This
might sound like a perpetual motion machine to old-school economists,
who have argued that wealth creation required savings and investment.
But thanks to recent developments in economic thinking, the use
of permanently rising asset prices as a means of wealth creation
now has a sound basis in economic theory.
Fed
Chairman Alan Greenspan was one of the first to see how rising
home values could be a source of economic growth:
As
an economic consultant in the 1960s, Alan Greenspan had a novel
insight about buying and selling homes. He noticed that when a
house changed hands, the mortgage the buyer took out almost always
was bigger than the one the seller was retiring.
Mr.
Greenspan went on to conclude that this borrowing played an unexpectedly
large role in consumer markets, by generating extra spending power
backed by the value of homes. At the time, it was an arcane thesis
that few other economists accepted or even understood.
[...]
Mr.
Greenspan’s analytic interest in housing dates to his days as
a consultant at Townsend-Greenspan & Co. He noticed that total
mortgage debt was increasing each year by more than could be explained
by mortgages taken out on newly built homes, after he subtracted
scheduled repayment of existing loans. The difference, he concluded,
had to be mortgage borrowing secured by the equity in existing
homes – borrowing that consumers used for other purposes, from
buying cars to investing in stocks.
Mr.
Greenspan called this the “monetization,” “liquefication” or “extraction”
of home equity. He believed it could explain a lot of things –
stock prices, home prices and consumer spending – better than
other economic models did. “Capital gains from home sales are
a potent force in consumer markets, far greater than … stock-market
gains,” he told the National Association for Business Economics
in Philadelphia in 1977.
[...]
“In
the old days, housing wealth was relatively illiquid and the only
way to realize it was to sell and move to smaller house,” said
Fed researcher Andreas Lehnert at a recent academic conference
in Washington. “Now you can borrow against housing wealth.” He
calls this increased role of the home as a source of cash the
“ATM effect.”
In
a groundbreaking 1996 article, the concept of using rising prices
to create wealth was extended from rising home prices to rising
asset prices in general. Economist Dr. Kurt Richebächer summarizes
this article:
For
the first time ever in the history of economic thinking, economists – that
is, American economists – are claiming that growing asset
prices represent fully valid wealth creation. In 1996, an article
in Foreign Policyentitled Securities: The New
Wealth Machine effectively explained that the financial markets
have become the most powerful generator of wealth.
Verbatim:
“Historically, manufacturing, exporting, and direct investment
produced prosperity through income creation. Wealth was created
when a portion of income was diverted from consumption into investment
in buildings, machinery and technological change. Societies accumulated
wealth slowly over generations. Now, many societies, and indeed
the entire world, have learned how to create wealth directly.
The new approach requires that a state find ways to increase the
market value of its stock of productive assets. Several countries
have successfully directed their economic policies toward that
goal, achieving and sustaining faster growth rates than were once
thought possible…”
The
Housing Economy brings concept of extracting wealth rising asset
prices full circle: rising housing prices will drive not only the
entire economy, but also ensure the further increase in housing
prices. The Wall Street Journal noted
that the net worth of households recently "surpassed the
peak of $43.58 trillion reached in the first quarter of 2000,"
due to "a rebound in the stock market as well as the rapid
appreciation in home values in the past few years."
Proponents
of the Housing Economy have argued that it will be more resistant
to business cycles. One case in point is that it will be immune
to offshore movement of jobs to India or China. Real estate agents
must be local in order to be familiar with the neighborhood conditions.
However,
some social justice activists have raised concerns about what will
happen to those individuals who fall through the cracks — those
unable to get a mortgage or to find work as real estate agents or
brokers.1
One
community-based development activist recently spoke out: "We
are in danger of an unequal society, one of real-estate haves and
real estate have-nots." Indeed, this would mirror the experience
of Japan's bubble economy, in which modest homes fetched millions
of dollars. Only those who already owned a home had the means to
purchase real estate. Those who had not purchased before the bubble
were left behind.
To
avoid the specter of housing inequality, the Housing Economy will
require additional social safety net programs to ensure that everyone
can obtain a mortgage of any size, no matter what their credit-worthiness.
Recent financial innovations such as zero-percent (no down payment)
mortgages2, interest-only mortgages3,
negative amortization4, and mortgages
written for greater than 100% of the value of the home5
will provide a basis for these new programs.
Here
the Housing Economy may borrow from recent financial innovations
in auto financing. Car owners who are "upside down," that
is, owe more on their car than it is worth, can roll
the old debt into a loan on a new car. The new loan is often
for more than the value of the new car.
The
housing GSE Fannie Mae will continue to provide an important service
to home buyers by purchasing mortgages that are issued to finance
homes, securitizing them, and selling them to the Chinese and Japanese
Central Banks.
Fannie
Mae CEO Franklin Raines has emphasized the important role of the
GSEs in ensuring continually rising home prices. In a
speech to the SIA, Raines calculated the supply of credit that
would be available for mortgages. Raines then made an independent
calculation for the demand for mortgage loans, based on the entirely
reasonable assumption of continued home price appreciation.
According
to Raines, credit demand would have exceeded credit supply by a
significant margin. This would undoubtedly lead to a complete shutdown
of the housing market, as home prices remained stuck at high levels
that buyers could not afford. Fortunately, Fannie Mae was able to
step in and provide the additional credit that was needed to make
up the difference between supply and demand.
It
was thought by older economists that supply and demand could not
be permanently out of balance because the movement of prices would
occur until supply and demand were matched. In this mode of thinking,
supply, demand and price were seen as interdependent phenomena.
Indeed, without Fannie Mae, the price system would have been required
to bear the full burden of bringing supply and demand into balance.
This would have meant either higher interest rates, lower home prices,
or some combination of the two.
One
home owner, who has retired from their line of work and now lives
entirely off their home equity, summarized the impact of the Housing
Economy on his own life: "Is this a great country, or what?"
Notes
- Some people
will always find something to complain about.
- I'm not
making this up.
- Or this.
- Or this,
either.
- Or this.
March
8, 2004
Robert
Blumen (send him mail)
is an independent software consultant based in San Francisco, where
he rents an apartment.
