Mr. Moderate

In the first two essays of this series we looked at the basics of the Law of Supply and Demand and we examined the concepts of Inflation and the Money Supply. Now, we will put all those concepts to use by looking at the disaster created within the US housing market by government-sponsored easy credit for home buying.

I will begin with a personal story to put all this into some real context. I was born before my father finished building, by his own hands, the first home I would live in. A few years later, my sister came along, and the little bungalow that dad built was suddenly way too small for a growing family of four. My dad had a good job, making roughly $8,000 or $9,000 per year, so he was able to apply to a Savings and Loan for a home mortgage loan. This allowed him to buy a house whose list price was $10,500, or roughly fifteen (15) months of income. He had to put down about $2,500, or a little more than the standard 20% down payment (which was borrowed from my grandparents as he didn’t sell the little bungalow for several years). The mortgage payment was about $80 per month, which was about 11% or 12% of his monthly gross earnings. Even with that small of a payment, the mortgage was scheduled to be paid off in about 18 years, and of course my parents did manage to pay it off on schedule. When this all happened, about five decades ago, this was typical of the kinds of home loans that people got themselves involved with. Such stories are called “the American Dream” because, after my parents died, my sister and I sold that home for roughly $650,000.

To purchase a home these days, both the husband and wife have to be working, and they need a somewhat above average gross family income of at least $60,000 per year to be able to just barely qualify for a slightly-below-average home costing $200,000. This is now a housing price which represents about 60 months of income for both the husband and wife, or five times annual earnings. Not too long ago, you needed to have annual income of at least one third of the loan amount to qualify for a loan, but those limits were waived as interest rates went down and home prices went up. In order to sell anything now, the only real question is whether there is any hope at all you can make the payments. That is what “sub-prime” lending is all about. So, in cases like these, the 20% ($40,000) down payment will be creatively-financed, with the buyers required to come up with only about $10,000 in cash and the rest ($30,000) rolled over into a second mortgage with horrid terms and conditions. The mortgage term will be for a minimum of 30 years, and may involve other creative terms and conditions to be able to qualify this “low income” couple for the purchase of this “very expensive” (but totally average) home. If the couple successfully manages to make it through the first five to seven years of a creative deal, they will then be expected to refinance the remaining debt into another mortgage of 30 or more years, but this time with more equity in the property and a hopefully higher income level they should qualify for better terms and conditions. Meanwhile, the folks who financed the original deal have made a mint of money off of the interest and various fees associated with the origination and termination of the first loan(s). Under these circumstances, there is very little real probability of ever paying off this kind of mortgage. If it is paid off, the lender makes a fortune over the term of the loan, all due to the wonders of compound interest. And of course, with “reverse mortgages” to pay for the costs of getting old, it will be a wonder if there is anything at all left over for the kids of recent home buyers.

What is obvious from this picture is that wages have not gone up anywhere near as much as home prices have gone up. Using the GDP deflator for calculations, my father’s $8,500 income is worth about $49,000 in modern terms and the $10,500 home price is worth about $60,000 in modern terms. If you could still buy an average home today for $60,000, we would not have a problem. But the inflation numbers that the government produces average out a huge number of factors without disclosing that average wages do not ever go up as fast as price inflation goes up, and home prices suffer inflation at a much higher rate than do other prices in the overall consumer marketplace.

Why is this so? Well, the answer that nobody wants to admit is that the easy credit of modern mortgage lending has caused tremendous inflation in home prices by vastly increasing the amount of money available for home purchases. And this was all done with the active cooperation of the US government, which even went so far as to set up several different corporations (such as Fannie Mae and Freddie Mac) to facilitate the market for mortgage loans made to average consumers. Lost in the mists of history is the entire idea of a “Savings and Loan” which specialized in helping people save money for a down payment and then giving them mortgage loans once they could qualify for “conventional financing.” President Reagan destroyed the Savings and Loan industry with deregulation that made it attractive for con men to take over Savings and Loan companies as captive lenders to their own grand land development schemes (see Charles Keating).

Anybody with a decent background in the Law of Supply and Demand could easily anticipate what would happen. Easy credit for the specific purpose of home buying will tend to drive up the prices of homes and home-related products. It does this by encouraging consumers to over-extend themselves by taking on larger and larger loans with respect to their income. Everybody needs a place to live, and the government offers strong encouragement to home buyers through income tax deductions and easy credit mortgages. Meanwhile, the banks and other lenders profit tremendously from the interest payments (primarily “points”) and fees for financing (and refinancing) these mortgages. Fannie Mae and Freddie Mac repackage these loans into pools that are funded through issuing bonds to Wall Streen investors. And if Wall Street ever slows down in its purchases of these “mortgage-backed securities,” then the Federal Reserve will step in as the lender of last resort and buy the bonds for its own portfolio, injecting whatever cash is needed to keep the economy liquid and give the illusion of real health.

But things are to the point now where consumers are at the financial breaking point. A crisis was largely averted before through encouraging wives to become “second income” sources, and using that extra income to qualify couples for larger and larger loans (which were not used to purchase larger and more valuable homes, but which were instead used to bid up the prices of homes to unrealistic levels, causing the cycle to keep spinning on and on, out of control). Census figures show that the average family with an income of $58,000 per year or more has two wage earners. But where can a family get extra income now that both parents work? And what has become of the typical American family when neither parent is around during working hours and the kids are left with babysitters and day care? There is a point of diminishing returns, and it appears to me that we are close to it, if not already past it.

The recent crisis with “sub-prime” lenders has prompted talk of the “housing bubble” possibly “bursting.” Well, that is a very real possibility, and a dramatic upset in the whole US economy will certainly result if that happens. Such a “bursting” would be an occasion where increasing numbers of defaults and foreclosures force prices down, and lower housing prices lead to greater and greater numbers of defaults and foreclosures as people abandon homes where they are financially “upside down” (they owe far more than the home is worth).

However, the basic mind-set has not changed in Washington, DC so I suspect that the beginnings of a “bursting” of the “housing bubble” would prompt the creation of yet-another “easy credit” program to help people hold onto the homes they already have. But of course, like all such “easy credit” programs, the net result is bound to be another jump up in home prices, which in the long run is merely delaying the inevitible.

The question for you all out there: can we really afford more “easy credit?”

Or better: can we ever afford to allow consumers to fail at home ownership by abandoning “easy credit” for home buying?