Today, we return to our courtroom drama.
You will recall, dear reader, we are arguing that the typical house is not what it appears to be. It pretends to make its owner rich; instead, it makes him poor.
Practically every sentient being with a U.S. passport believes the opposite - that buying a house is a nearly risk-free/reward-guaranteed proposition. Taking the other side of the argument clearly puts us in a very small minority. We look around, and we are practically alone. So, the burden of proof is on us. Last week we carried the load a short way. Today, we pick it up again and teeter on.
Your editor begins by disclosing a prejudice: he is a sucker for real estate. He likes the feel of dirt beneath his feet and under his fingernails. He is comforted by the notion that - should the world go to Hell as he has been predicting - at least he would have a place to live. He even imagines himself living well - eating the fruits of his own garden. In extremis, he might even slaughter his wifes obnoxious horses and roast them over an open fire while swilling his own homemade hooch out of an old jar. For luxuries and heating oil, he could dig up a gold coin or two when needed.
On the whole, the end of the world might not be so bad.
Since he is making disclosures, your editor might also confess a mixed record when it comes to real estate investing. He has spent the week down in Nicaragua, scouting real estate investment possibilities. But this is not the first time he has been a pioneer in the Third World. Two decades ago, he bought a house in a bad neighborhood in Baltimore. He paid almost nothing for it and restored it himself. Back then, he felt he was building 'sweat equity' in the property. Only later did he discover that his perspiration was not worth very much. He could improve the house, he discovered. But not the city around it. When the final tally was made, he found that he had lost money on an actual cash basis. For all his sweating, he had earned not a penny.
Typically, our experience was at odds with the rest of the world. In a sea of rising property prices, your editor managed to find a leaky boat.
But the real tidal increase in property prices began later...about 8 years ago. In that period, house prices rose 3 times faster than rents. Not since The Flood has there been such a lift. Prices rose nearly 50% in nominal terms, almost 30% more than the increase in inflation. Without lifting a finger, the nation's homeowners found themselves $2.7 trillion richer - about $35,000 extra for every one of them. Where did the money come from, we wondered last week?
In almost every community, the story was much the same. You could toss a congressman out of a helicopter almost anywhere in the country; it was very unlikely he'd fall upon a house that had not gone up in price.
But we contend that houses have not really made people wealthy at all. In fact, they've made them poor. How can that be?
Last week, we established an important point: that the house itself - the physical thing - couldn't possibly increase in value. All its components deteriorate, depreciate, fade and decay - just like everything else.
And now we call our star witness.
"Mr. Alan Greenspan, would you step up to the witness stand, please?
"Mr. Greenspan, you have sworn to tell the truth, the whole truth and nothing but the truth, isn't that right?
"Of course, you wouldn't tell lies, we just wanted to make sure...
"Now, isn't it true you have said many times that your lower interest rates were a big help to consumers? In fact, wasn't it as recently as a few weeks ago that you testified before Congress that consumers were in 'better shape,' since they had been able to refinance their debts at lower rates?
"Now, to tell you the truth, you might as well have gotten down on all fours and barked...it would have made as much sense to us. As near as we can tell, consumers have never been in worse shape.
"Of course, as chief of the Federal Reserve system, you are well aware of the numbers. The old rule was that lenders insisted that monthly mortgage payments not exceed 28% of gross income. They called that the 'back-end ratio.' But as people came to believe that real estate always goes up, both borrowers and lenders began to loosen up. Now, in expensive markets such as Boston and San Diego, the percentage of income devoted to mortgage payments has risen to more than 43%. In San Francisco, the average family spends 47% of its pre-tax income on mortgage payments.
"San Francisco must be the Nasdaq of real-estate markets, wouldn't you agree? The median house there sells for $515,000. Only 14% of the people in the area can qualify to buy a house...and those who do spend 5 to 6 times their annual income on it. Thirty years ago, the median house cost 2.1 times median income.
"Much of the reason for the increase in real estate prices must simply be that it is easier to borrow money, wouldn't you guess? Even very poor credit risks are routinely cleared for mortgages these days, aren't they? Because everyone is so sure house prices will keep going up. As long as prices are rising, why worry? If the homeowner runs into trouble, he can always sell his house for a higher price. Or, the bank can resell it for him.
"But isn't it true, too, that lending to the marginal credit risk is a little like introducing your daughter to a marginal sports star? If you make it too easy for him, there is almost sure to be trouble.
"Thanks to your policies, and the innovations of the financial industry, credit has never been easier to come by. As a consequence, debt has increased for the last 30 years...and it has continued to increase even through the recession of 2001...and right up to the present. In absolute terms, as well as by most relative measures, Americans are more in debt than at any time in history. And after record levels of mortgage refinancing, never before have they owned so little of their own homes.
"In light of all that, would you care to explain what you meant by consumers being in 'better shape'?"
[Unintelligible response.]
"Well, let's approach it in another way.
"Do you read the papers, Mr. Chairman?
"You do?
"Good. Well, have you seen an advertisement offering an equity line of credit? It has a drawing of a house with bags of money under it. 'Go ahead...it's yours...you have a right to it...take it out...spend it...' the ad says, or something like that.
"Well, now...there wouldn't be any ads like that if rates hadn't been cut so dramatically, would there?
"Of course not.
"And there wouldn't be a refinancing boom, either, right? And if there were no refinancing boom, consumers wouldn't have been able to keep spending, could they?
"Now we understand that you regard all this as a good thing. If consumers had not been able to keep taking the 'equity' out of their houses...the whole world economy would have fallen into recession, wouldn't it? Americans wouldn't have had any money to spend. Foreigners wouldn't have been able to sell their products. Nor would they have been able to accumulate hundreds of billions of dollars or to reinvest them in U.S. Treasury bonds. There wouldn't be such a huge trade deficit...and no way to finance the federal deficit or the war against Iraq...at least not at current interest rates.
"Wouldn't you agree?
"You would? Good.
"So, you would say that the whole world economy depends on the rate cuts and on consumers' willingness to continue taking out 'equity' from their houses, right?
"Yes, it is fairly obvious. But now a more difficult question. Are you ready for this, Mr. Chairman? Here goes:
"What exactly is this 'equity'? We understand money you make from working. Or profits you make in your business. Or money you've saved up. But this no-sweat equity is something different, isn't it? It seems to come out of nowhere, almost magically. Houses are supposed to provide a sort of dividend for their owners; they give them a roof over their heads. But isn't it a bit peculiar that they should produce extra cash, too?
"What is this money? We've put the question to others. No one has had a good answer. We were counting on you, Mr. Chairman. As the best-known central banker since John Law, we thought you might be able to tell us what this money - this money that the world relies upon so heavily - really is.
"Well, let us jog your brain a bit.
"Isn't it possible that there really is no money there? A house is a house is a house, after all. It is a consumer item, not a capital asset. What is really happening is that the house owner is merely borrowing against the inflated value of it. And isn't it possible that the house is subject to the same fits of 'irrational exuberance' - as you put it - as the stock market? Isn't it true that the mortgage industry is merely acting like the brokerage industry in a bubble market - lending money on the inflated value of the asset? And isn't it correct to say that this lending is itself contributing to the bubble in prices?
"You know how it works; you watched the same thing in stocks three years ago. You said you couldn't tell it was a bubble back then. But now that you've seen one up close, maybe you are better able to see the next one? A fellow sees his house going up at 10% per year. He figures he'll buy another one. How can he resist? It's easy money, isn't it? Especially since, as everyone knows, house prices never go down.
"But you remember Hyman Minsky? He pointed out that 'stability produces instability,' didn't he? The idea was that the more people come to believe something is sure, the less sure it becomes. As everyone came to believe that house prices only go up, lenders lent more freely and buyers spent more freely. Naturally, prices rose. This convinced other buyers that they should get in while the getting was good. Before you knew it, real estate prices had taken off, rising far faster than the incomes of the people who were to buy them.
"And isn't that exactly what has happened in America? The average after-tax, after-inflation income is barely rising at all. And yet, house prices are going up at 10% per year and more. Yesterday, we read that house prices in Minnesota have risen 50% in the last 4 years. And last year alone, in places as diverse as Topeka, KS, and Providence, RI, they were up nearly 20%. In Nassau County, NY, they were reported rising at an unbelievable 26%. How long can that last?
"You don't know? Well, we dont know either, but it definitely can't last forever, can it? There must come a time when the average person can no longer afford the average house and when some people need to sell. Then what?
"Of course, we're not blaming you, Mr. Chairman, we're just trying to get to the bottom of it...to understand what is going on.
"Now let me ask you another question. If house prices can stop rising, they can also go down...isn't that correct? And isn't it also correct to say that, in fact, sooner or later, they will go down? Isn't this exactly what happened following every stock market bubble of the last 70 years - in Japan, Korea, Hong Kong, the Philippines, Thailand, Indonesia, Mexico and Brazil?
"And what do you think will happen to homeowners who have taken out the equity in their houses? They will still have to pay interest on it, won't they? In fact, at some point they will even have to put the equity back in...right? When they sell, for example?
"And now, here's something interesting. Even in a bad economy, most people will be all right, of course. Most won't have to sell. So, you might assume that property prices will stay fairly stable. But that's not really true, is it? In Japan, residential properties have fallen 23% since 1991.
"Prices are set by the properties that sell, not by those that don't change hands. In a crunch, all it will take is a few desperate neighbors and your house could decline in value by 10%...20%...or even more.
"Yes, but? What but?
"We're not asking you to predict the future. We are talking about the present. We just want you to admit that a homeowner who takes 'equity' out of his house is actually poorer than the one who does not. And since low interest rates and rising real estate prices are an invitation to 'take out' this 'equity,' it might also be correct to say that the boom in the real estate market has actually made the marginal homeowner poorer. Am I wrong about that?"
[Unintelligible response.]
"You may step down, Mr. Greenspan, we have no further questions for you..."
And now, let us call our final witness: you, dear reader.
Let us begin with the same question we've posed to our other witnesses. What is this no-sweat 'equity' people take out of their homes? Is it really any different from any other promise of something for nothing?
And like every other promise of something for nothing, won't it more than likely end in more nothing than something?
And won't millions of homeowners end up sweating their equity after all?
