Monday, September 12, 2011

The Oldster's Debt Dilemma

Debt Hobbles Older Americans deals with the worsening debt picture of Americans in their 60s relative to earlier generations of the same age group. A few tidbits from the article worth mentioning are related to housing:
"All kinds of debt held by this age group have risen, but the big problem is mortgages. Thirty-nine percent of households with heads aged 60 through 64 had primary mortgages in 2010 and 20% had secondary mortgages, including home-equity lines, according to research group Strategic Business Insights' MacroMonitor. That was up from just 22% and 12%, respectively, in 1994."
It goes on, "The housing crash has made things worse. A few years ago, homeowners in their 60s with big mortgages could sell their homes for a profit and buy smaller places or rent. But the drop in housing values means that many homeowners have little equity, and some now owe more than their houses are worth."
Later the article deals with causation, "The combination of easy credit, low interest rates and a consumption-oriented culture helped fuel a spending binge for Americans until the financial crisis. People with problems aren't just those who took subprime loans or spent foolishly on lavish lifestyles. They are people from all backgrounds, including some with six-figure incomes."
I recommend that you consider taking the time to read and reflect on what the relatively brief article says about our American consumption-oriented culture, including the paucity of savings available for the retirement needs of older Americans.

My take on this unfortunate situation is simple and straightforward. Housing has long been viewed and even "sold" in our society, albeit incorrectly, as a one-way-can't-miss-bet. Borrowing all we could borrow to buy all the house we could buy was only the "smart" thing to do.

And when the asset/housing easy and cheap credit bubble eventually burst, as it certainly did, the oldsters were often caught with much more debt than their newly depreciated home was worth. And the problem isn't getting any easier with the passage of time.

Let's face facts. Virtually "everybody" was encouraged to "buy and own" a home asap upon reaching adulthood. The family, the friends, the government, the teachers, the banks, the builders, the realtors and all others preached the home ownership gospel.

So what happened this time to make it all end up so wrong? Sadly, despite all that was said about how great home ownership would be, the bursting of the home pricing asset bubble was nothing new when viewed in the context of history.

Financial debacles, such as the current one, are not new. They happen periodically and are predictable, even though we can never know exactly when the bubble will burst.

As an analogy, they can be likened to the 100 year flood syndrome. If a 100 year flood by definition occurs only once each century, that means it will only take place in one out of four twenty five year time periods.

Thus, like the flood, housing was a "can't miss" investment until it wasn't. Stated another way, as with the risk of precipitous housing price declines, we didn't need flood insurance for three of the four 25 year time periods during the prior 100 years.
Here are some basic facts about housing prices over time. Real home prices (adjusted for inflation) rose only a cumulative total of 27% in the 106 years ended 1996. In the subsequent 10 years ended 2006, however, they rose by 92%. At the peak real prices rose by 12% in 2005 alone.

In hindsight, that ten year 92% increase, let along the 2005 12% performance, clearly was not sustainable. Still, at the time the conventional wisdom was that home prices would always increase, so why worry about how much the mortgage debt was, since a buyer could always get his money out simply by selling the house.

That is, unless home prices went down, which of course they did, and like a rock, too. Now prices are roughly one third lower than five years ago. How much farther and how fast they will decline from here is the only remaining question. Stay tuned.
Why was the housing "flood" predictable? Here's why.

(1) Asset based inflation (homes in our example) financed with (2) cheap and readily available borrowed money (no/low money down mortgages in our example) combine with (3) current account deficits (heavy borrowing from the Chinese to buy the manufactured goods or homes) to (4) bring about a slowing economy (as developed in 2007), thereby resulting in a debt deflation scenario, which generally results in a severe financial catastrophe.

In a nutshell, this is what happened. This and many other similar examples are dealt with in the timely book "This Time Is Different" by Reinhart and Rogoff. Of course, the book's real message is that, unlike the book's title, this time really isn't different at all. In historical terms, it happens frequently and is quite predictable.
To quote the authors, "If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is. Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable than they really are. Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and needs to be constantly refinanced. Debt-fueled booms all too often provide false affirmation of a government's policies, a financial institution's ability to make outsized profits, or a country's standard of living. Most of these booms end badly. Of course, debt instruments are crucial to all economies, ancient and modern, but balancing the risk and opportunities of debt is always a challenge, a challenge policy makers, investors, and ordinary citizens must never forget."
Accordingly, today's oldsters and near-oldsters are largely victims of circumstance. Since "everybody" knew housing was a no-lose situation, why not load up and then sell out when the time came to downsize for the golden retirement years? And that was the main idea, at least until the "flood of the century" hit.
In brief, we can summarize the debt dilemma of the oldsters compared to that of younger generations as follows: The principal difference between the debt dilemmas of old and young is simply date of birth.

In other words, the old have less and the young have more time for recovery when the periodic floods inevitably occur. Nothing at all complicated about that.
Thanks. Bob.

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