the creaky house that cheap credit built - Posted by John V, FL
Posted by John V, FL on October 27, 2003 at 18:39:19:
The creaky house that cheap credit built
’These numbers are scary’
Monday, October 27, 2003
At least until yesterday’s wildfire, San Diego real estate prices were being described as insane.
Now that we’re all happily expecting lift-off for the United States after a 6% growth surge in the third quarter, it seems the perfect time to revisit the skeletons still lurking in the closet of the world’s biggest economy.
In honour of Halloween then, and the most ghoulish time of the year for stock markets, herewith is a house of horrors rundown.
Credit card debt, mortgage debt, bulging lines of credit, state debt, a staggering federal deficit. The main worries for those who don’t quite believe everything is coming up roses for the U.S. economy can all be traced back to debt.
Sure credit is cheap and the surge in house prices means all that debt is being supported by an equally impressive rise in equity but yikes the numbers are scary.
Stéphane Marion, assistant chief economist at National Bank in Montreal, said the Federal Reserve has come up with a new measure of household liabilities that adds rent, auto leases, house insurance and property taxes to its traditional measurement of the debt-service ratio that consists mainly of mortgage and credit card debt.
Homeowners are now forking over 14% of their disposable income toward servicing debt, up up 16% over the past decade. The picture is darker for renters where the Federal Obligation Ratio has jumped 32% to 30%.
The explosion of creative new credit products has been embraced with relish.
U.S. renters can now charge their monthly rent to their credit cards. Bank of America offers a Visa card tied to home equity. Since some mortgage interest is tax deductible in the U.S., the card offers allows some homeowners to deduct their Visa card interest against their taxes.
Myvesta, a U.S. credit counselling service, said a recent internal survey of its clients shows average credit card and unsecured debt rose 50% to US$77,036 in 2003 from 2002. Mortgage debt rose 25% to US$207,958.
Individuals aren’t the only ones borrowing like crazy. California is in a US$38-billion hole, while the federal deficit shot to a record US$374-billion in fiscal 2003.
Many are nonplussed. The debt bubble can be easily explained away: Borrowing is what makes the U.S. economy tick. Consumer credit has been on an upward trajectory ever since it was invented. The rise in credit-card debt may be due to consumers trying rack up reward points. The surge in mortgage debt means more people are owning homes – a good thing. The federal budget deficit may be large, but it is still only 3.75% of GDP.
That may all be true, but what ever-rising debt does mean is that economy will be vulnerable to shocks – a stock market retreat, for example. If the orderly decline in the U.S. dollar turns into a full-blown rout, the Fed may have to raise interest rates to lure foreigners back in. The cost of carrying that monthly credit credit card debt would suddenly soars.
That’s the scaremongers’ view. A more rational reading of the situation is that any easing of borrowing – when the tax cuts wear off, for example – could stop the recovery short if job creation doesn’t kick in in time.
“Never before have U.S. households been this leveraged at the start of an economic recovery,” Mr. Marion said. “The Fed will need to manage this cycle with extreme caution.”
Can you spell bubble? There is no housing bubble in the United States, except in a few pockets, the current wisdom goes. Trouble is, many of those pockets just happen to be major metropolitan centres.
David Moore, a banker and resident of San Diego, has experienced first hand the real estate “lunacy” in California. San Diego has the highest median home price of an city in the country.
In 2000 he bought a 1230 square foot condominium for US$188,000. Three years later this April, a similar condo in his complex sold for US$242,000. In May one sold for US$246,000, in July one went for US$295,000, and August one sold for US$305,000.
Having watched prices rise 26% in five months, Mr. Moore couldn’t take it any more and sold his condo for US$306,000 this fall – for a US$100,000 profit.
He profited handsomely, but will the new owners be so lucky? He outlines the monthly outlays for the new owners compared to his own.
Mr. Moore put US$45,000 down and financed the remainder plus upgrades for a total mortgage of $151,000. With an 8%, 30-year mortgage, his monthly outlays, including condo fees and property taxes, came to US$1,474 – or US$961 when adjusted for the tax deductibility of mortgage interest in the United States.
The new owners, meanwhile, put US$61,000 down, leaving a mortgage of US$245,000. Even with the a lower mortgage rate of 6.5% for 30 years, their monthly outlay, including the same costs, is US$2,050, or US$1,450 tax-adjusted.
So these ultra-low interest rates may have made home ownership affordable for many, but the rise in prices has shouldered them with an awful lot of debt.
Mr. Moore says his experience is not unique, at least in California, a state which for all intents and purposes should have seen its property market cool after the tech wreck decimated jobs and earnings.
“It is routine as eating breakfast in the morning,” Mr. Moore said. “It’s insane. It’s completely totally out of this world.”
Fannie Mae and Freddie Mac Freddie Mac and Fannie Mae, have facilitated this great new U.S. house boom. These giant government-sponsored corporations buy mortgages from lenders and securitize them. They make money on the difference between the cost of the debt they issue and the return on the mortgages they buy.
They now own or guarantee about 42% of the U.S. mortgage market. Many assume these quasi-governmental organizations would be bailed out if there was a major upset – such as a property crash – that threatened their survival. So the fact that nearly 50% of the U.S. mortgage market is run by just two companies – whose arcane hedging strategies are a mystery to most – doesn’t seem to faze many.
Did we say bubble? There is no stock market bubble, most analysts say, except perhaps among a few high-tech stocks.
Bloomberg’s U.S. Internet index has gained 116% from a record low on Oct. 8, 2002. True, it was rising from a very low bottom, but there’s some crazy numbers out there in the market again.
For example, NASD margin debt is 21% greater than it was when the Nasdaq was at its peak in March 2000, according to Grant’s Interest Rate Observer.
There’s those low interest rates at work again.
A vigorous and sustained recovery should put all the demons back in the cupboard – at least until the next slowdown.