Yet the parabolic climb of home mortgage debt outstanding, which rose from just over $5 trillion to $11 trillion between 2000 and 2007, is actually the subdued part of the home mortgage story; it does not begin to capture the explosive churning which was going on underneath in the form of a refinancing boom.
THE EPIC CHURN OF HOME FINANCE: HOW $20 TRILLION OF MORTGAGES FUELED THE HOUSING PRICE BUBBLE
The refinancing boom meant that massive amounts of existing mortgages were being replaced by new ones. As a result, the figure for “gross originations” was many times larger than the net gain in mortgage debt outstanding cited above. In fact, it was literally off the charts by the standard of any prior experience.
During 2002, gross home mortgage originations totaled $3.1 trillion, or 4.1X actual new home purchases. The Fed’s interest rate repression policy and the rapid spread of floating rate and teaser mortgages which were priced off short-term money rates thus conferred on homeowners a massive windfall of mortgage savings.
As the Fed manically pursued what amounted to an interest rate destruction campaign and brought short-term interest rates down to 1 percent in June 2003, the mortgage financing system literally came off the rails. Gross home mortgage originations for the full year totaled $4.4 trillion. This meant that in a single year, the red-hot machinery of home finance generated gross proceeds amounting to nearly 40 percent of GDP. By contrast, prior to 2001 gross home mortgage financing had never exceeded 17 percent of GDP and normally averaged about 12 percent.
During the second quarter of 2003, mortgage financings literally shot the moon: gross origins clocked in at a stupendous $5.4 trillion annualized rate. Yet during the same period, the Fed poured kerosene on the fire, cutting interest rates yet again. The minutes of the June meeting at which it ratcheted the federal funds rate to the near free money level of 1 percent made no mention whatsoever of the raging mortgage boom. Instead, the Fed’s statement justified the rate cut as necessary to “provide additional insurance that a stronger economy would in fact materialize.”
Nor did the frenzy abate after 2003. Gross originations remained above $3 trillion annually and totaled nearly $20 trillion over the housing boom period of 2002–2007.
The cascade of negative repercussions on the Main Street economy from this deluge of cheap mortgage money started with the unprecedented and manic surge of housing prices, as detailed in chapter 19. These kinds of gigantic price increases in short time intervals can occur for nonmonetary reasons in commodity markets owing to big supply disruptions; for example, a drought in the corn belt or a major copper mine strike. But in a decentralized asset market with low turnover and high transaction costs like residential housing, such huge, sudden price gains were possible only due to the aberrationally cheap mortgage financing enabled by the Fed. The housing price spiral most certainly did not reflect the opposite; namely, organic demand owing to meaningful gains in the earned income of the American households. In fact, while housing prices were soaring by 50 percent during 2000–2003, wage and salary incomes rose by only 6 percent in nominal terms during that three-year period, and actually declined after adjusting for inflation.
Needless to say, this initial price spiral accelerated when house flipping became a national pastime, accounting for up to 35 percent of activity in many overheated markets. Flippers were willing to pay higher and higher prices, believing that they could quickly capture the gains and then reload for another go-round. Whether intended or not, the Fed’s money-printing spree effectively transplanted the gambling mania from dot-coms to residential housing.
THE MEW MADNESS: LINCHPIN OF THE FED’S PHONY PROSPERITY
Not everyone wanted to sell the family castle, of course, so refinancing became the alternative of choice. In an environment of rapidly escalating prices, this gave rise to the infamous MEW trade; that is, mortgage equity withdrawal from owner-occupied properties. MEW represented the excess proceeds from a new mortgage at current housing prices after paying off an older mortgage which had been financed at lower property values and, frequently, at a much lower loan-to-value ratio.
The amount of cash that could be extracted from ordinary homes in this manner amounted to a stupendous windfall. Nothing like it had ever before been seen on Main Street.
For instance, when a $100,000 home which carried a partially paid-down mortgage of $60,000 was refinanced at a doubled appraisal of $200,000 and a 92 percent loan-to-value ratio, the cash takeout after closing costs would have been $120,000. Accordingly, during the peak of the MEW boom in 2003–2007, thousands of Main Street households walked away from mortgage settlement conferences every day with $50,000, $100,000, and even $200,000 of found money.
MEW thus generated a powerful sense of instant riches along the length and breadth of Main Street because it brought unexpected and undreamed of dollops of hard cash, not just the paper gains of the dot-com stocks. Needless to say, it also resulted in massive increases in contractually fixed household debts, propped up for the moment by wildly inflated asset prices which were bound eventually to come back to earth.
MEW was one of the worst economic poisons ever fostered by a central bank, but the Greenspan Fed actually embraced it as an important tool of prosperity management. The minutes of the same June 2003 meeting in which the FOMC voted to goose the economy with a 1 percent federal funds rate also claimed a double-barreled wealth effect.
In the first instance, improved economic growth would result from “the effects of rising stock market wealth on consumer balance sheets.” Not done with the wealth effect elixir, the Fed minutes also anticipated an economic lift from “continued opportunities for many consumers to extract equity from the appreciated value of their homes.”
Widespread home equity extraction through borrowing would have horrified sound money men only a few decades earlier. But the Fed’s debt-pusher-in-chief urged that there was no cause for alarm about the massive raid on home ATMs being triggered by rising housing prices and easy mortgage credit. Indeed, by issuing a “do not be troubled” advisory, the future Fed chairman proved he didn’t know the difference between honest GDP growth earned by labor and productivity and a “higher print” reflecting speculative borrowing.
“Higher home prices have encouraged households to increase their consumption,” Bernanke noted in March 2005, and that was “a good thing.” Bernanke further allowed that living high on the hog was well justified because it reflected “the expansion of US housing wealth, much of it easily accessible to households through cash-out refinancing and home-equity lines of credit.”
What the monetary central planners didn’t explain, however, was why there should be so much “appreciated value” to be harvested from owner-occupied residences in the first place. That fact is, there is no reason for residential real estate to appreciate under conditions of sound money where inflation is minimal. In fact, the pioneering work of Professor Robert Shiller of Yale showed that there had been no increase in the inflation-adjusted value of the typical American home for the entire century ending in the early 1980s.
The reason is straightforward economics. There is no scarcity of land in the United States, so there is no reason for real prices to rise over time. Indeed, public policy tends to heavily subsidize housing development on the urban periphery, thereby enhancing the free market’s built-in price flattener: namely, the process by which land prices in urban centers are capped as residential construction invariably moves to cheaper land on the urban periphery.
Soaring housing prices were thus a monetary phenomenon owing to an artificial bid from the explosion of cheap mortgage money. Indeed, during the peak of the Greenspan mortgage party, the true economic interest rate on subprime and Alt-A mortgages—which were the marginal sources of housing demand—was often negative after adjusting for probable default losses and inflation.
THE $5 TRILLION TIDAL WAVE OF MEW
It is not surprising, therefore, that low and even negative effective mortgage rates, coupled with the long-s
tanding tax subsidy for mortgage interest payments, unleashed a tidal wave of MEW. When this wave crested during the second quarter of 2005, households were extracting equity from their homes through mortgage financings at a $1 trillion annualized rate. This amounted to an astounding 10 percent of disposable personal income and represents a telltale measure of the financial deformation that had emerged from the Fed-sponsored mortgage bonanza.
In all, the cumulative MEW over 2001 thorough 2007 was nearly $5 trillion. The government statistical mills duly reported the fruits of this giant deformation as evidence of rising prosperity. Thus, the spend-out of MEW materialized throughout the nooks and crannies of the American economy as personal consumption expenditures for wide-screen TVs, vacations, restaurants, maids, and landscaping services, among countless others.
But MEW was also heavily channeled into home improvement and remodeling expenditures, which gets recorded as (housing) investment spending. According to the Fed’s own data, MEW-based spending on granite countertops, new bathrooms, outdoor decks, and the like amounted to 100 percent of reported “residential improvements” in the GDP accounts during much of the housing boom period.
Not coincidentally, the powerhouse home improvement retailers which arose to meet this fulsome demand—Home Depot and Lowe’s—had spectacular gains in financial results. Between 2000 and 2007 their combined sales doubled from about $65 billion to $130 billion, thereby providing a perfect tracker beam on the borrowed prosperity emanating from the Fed’s financial repression.
A half decade later, by contrast, the combined sales of Lowe’s and Home Depot are nearly 8 percent below the 2007 peak. What the striking shrinkage of powerful free market enterprises like these two firms dramatizes is not the loss of business acumen or market share, but the evaporation of artificial demand from both contractors and do-it-yourself customers who depended upon MEW.
At the end of the day, the post-2001 recovery generated by the Fed’s prosperity management stratagem was a hothouse concoction fueled by waves of credit expansion over its six-year run. The foundation was $20 trillion of gross mortgage financings and $5 trillion of MEW.
The credit money spending which resulted from these borrowings produced one-time sales which flattered the reported GDP, but did not generate permanent economic growth or higher sustainable wealth. In fact, what it actually generated was a permanent overhang of vastly expanded household mortgage debt that would subtract from economic growth in the more distant future.
WHEN THE FED’S “INVISIBLE” HOUSING BUBBLE CRASHED: FINANCIAL CLIFF DIVING
The residential investment component of the GDP accounts illustrates in spades the manner in which reported economic growth funded by the mortgage boom amounted to little more than stealing from the future. During the prosperity of the 1990s, housing had gotten its fair share, but it had not experienced an outright boom.
New housing construction starts drifted up from about 1 million units annually after the 1990 recession to about 1.5 million by the end of the decade. Likewise, the residential investment component of GDP rose at a circumspect 4–5 percent annual gain after inflation.
Once the Fed got interest rates down to 1 percent and kept them there for an extended period, however, the fur began to fly. Residential housing investment grew by 7 percent in 2001 and then by 10 percent the next year, followed by 17 percent in 2003 and then another 15 percent each year in 2004 and 2005.
Altogether, the annual rate of residential housing investment, which includes both new construction and renovation, surged from $450 billion at the end of 2000 to $810 billion by the fourth quarter of 2005. Reported housing starts attained liftoff as well, rising from a 1.5 million annual rate to a peak rate of 2.3 million annualized units in January 2006.
The significance of these figures lies not merely in the steepness and speed of their climb, but in the proof implicit in their subsequent total collapse that the reported prosperity during 2002–2007 was largely an artifact of Greenspan’s bubble finance. The sad facts of the housing crash are well known, of course, but it is the sheer vertical drop which is the smoking gun.
From the January 2006 peak, new housing starts dropped by 80 percent before hitting bottom forty months later in May 2009. Even more pointedly, when total residential investment rolled over at its $800 billion top in late 2005, it seemingly never stopped plunging—until it finally found a bottom at $330 billion annualized rate at the end of 2010.
Activity rates which deflate by magnitudes of 60–80 percent in a major sector of the national economy do not represent free market capitalism succumbing to a bout of cyclical instability. Instead, this kind of economic violence—100 percent up and 70 percent down—attests to the visible hand of the central bank attempting to administer prosperity through the blunt instrument of interest rate pegging and the avaricious machinery of the Wall Street dealer markets.
In this respect, it is not coincidental that at the very moment the Fed-induced housing mayhem reached its 2004–2005 apex and was on the cusp of a violent plunge, Bernanke was issuing his paean to the Great Moderation. The arrogant foolishness of it needs no elaboration.
In truth, the central planners in the Eccles Building never troubled themselves with the actual health or the real wealth of the Main Street economy. They were strictly paint-by-the-numbers monetary plumbers. Their focus was not on the sustainability of fundamental trends, but simply on keeping the GDP game going one quarter at a time, and on enabling Wall Street to keep pumping up the price of equities and other risk assets based on the flavor of the month.
A central bank focused on the fundamentals would not have been celebrating the strength of the housing sector. Instead, it would have been deeply alarmed by a mortgage financing bubble which was visibly out of control, and the fact that household income growth was not remotely sufficient to support the boom-time rate of housing expenditures.
Between 2000 and 2005, for example, nominal wages and salaries grew at only a 3.3 percent average rate, meaning that purchasing power gains were tepid, even before adjusting for inflation. By contrast, during the same five-year period, new housing starts rose at a 7.5 percent annual rate, home improvement spending was up at a 10 percent rate, and total residential investment spending soared at a 12.5 percent annual rate.
The huge gap between modest household income gains and the soaring growth metrics of the housing sector was obviously bridged by the explosion in mortgage lending and MEW extraction. These trends were not remotely sustainable, yet in embracing the housing boom and promising to keep interest rates low and the Greenspan Put reliably in place, the Fed gave the all-clear signal to new speculative deformations.
MORE TREES WHICH GREW TO THE SKY: THE PREPOSTEROUS RISE AND COLLAPSE OF THE HOME BUILDERS
This time the home builders became the flavor-of-the-month in yet another Wall Street chase for easy riches. The publicly traded home builder stocks soon became red hot, particularly the six big nationwide companies which produced standard-plan suburban homes in new tracts called “communities.” As the stocks of these companies rocketed skyward between 2000 and 2005, they became a popular landing pad for speculators jumping out of the still-burning windows of the dot-com edifice.
The stock of the largest of these, D.R. Horton, soared from $4 to $40 per share during this period while the shares of its rival, Hovnanian Enterprises, climbed a vertical wall from $3 to $70 per share. The stock prices of the other four—Pulte Homes, Lennar, Toll Brothers, and KBH Homes—followed almost the identical trajectory, rising tenfold during the five-year period. Not surprisingly, the combined market cap of the six national home builders experienced an impressive advance, rising from a mere $6.5 billion in 2000 to $65 billion by their 2005 peak.
These high-flying home builders powerfully illuminate of the “wealth effect” folly perpetrated by the Greenspan Fed. A stock market that was still in the business of discounting the earnings capacity and prospects of individual companies, rather than trading the monetary dispensation
s of the central bank would never have carried these six economically hollow home builders to the stratospheric levels they obtained during 2004 and 2005.
The massive overvaluation of these home builders was especially grotesque because in truth they were essentially “made for financial TV” storefronts. They generated almost no value added and reported temporarily munificent profits, which mainly represented winnings from gambling on vacant land.
Indeed, the payrolls of these purported home builders included virtually no carpenters, plumbers, or electricians. Likewise, they did not own any power saws, cement mixers, or tape measures. Nor did they have any long-term supply arrangements with lumber vendors, paint companies, or roofing manufacturers.
What they did have was a modest contingent of accountants, salesmen and land buyers—and also a CEO telegenic enough to appear regularly on CNBC to tout the sector. As the housing bubble unfolded, viewers could hear a nonstop parade of the executives explaining the latest uptick in orders, deliveries, new communities, and customer traffic.
Yet the one thing they didn’t explain was crucial; namely, that none of these red-hot home builders made any money at all building homes! Instead, they were land speculators who assembled, developed, and marketed subdivisions, but contracted out everything having to do with the building and selling of homes.
Consequently, the Greenspan Fed was the patron saint of the national home builders. Driving interest rates to the sub-basement, it escalated the value of home builder “land banks” to the rooftops. Then, as housing prices spiraled upward, the home builders hired contractors to turn their inventory of low-cost land into high-priced new homes, booking profits the moment that a local real estate broker delivered a signed purchase contract.
Needless to say, the stock market was capitalizing one-time windfall profits from overvalued land holdings, not a sustainable stream of earnings from building homes. Still, the home-builder stock bubble wasn’t just a ramp job in the trading pits. In fact, the absurd overvaluation of the home builders was merely the next link in the vast chain of deformations and malinvestments which flowed from the Fed’s money-printing spree after December 2000.
The Great Deformation Page 59