Imagine living in a world without consumer debt. The first credit cards did not appear until after WWII. Prior to WWII, if you wanted to buy something, you needed to save money from your wage income until you could afford to pay cash for it. There was an absolute dependency upon wage income to provide a lifestyle; living beyond your means was not possible unless you had previously saved money, and it could not continue beyond the day you went broke. Times have changed.
With the invention of credit cards, it became possible to borrow from future earnings to live better today–better than people can currently afford. Credit cards make it possible for people to live beyond their means. However, there comes a point when the future is now and the bills come due, and when that happens, people must live within within their means, minus the payments on the debt. Or does it?
If a new creditor is willing to loan even more money to the debtor, the debtor can use the borrowed money to pay back the previous creditor and continue to live the good life. Borrowing from one party to pay back another is the essence of a Ponzi Scheme. This can go on for a very long time if new creditors can be found and if the debtor can afford the debt service payments (Federal Government financing is a great example of a long-term Ponzi Scheme).
The creditors have to walk a fine line. Like any drug dealer, creditors want to give them enough product to keep them hooked, but they do not want to give them too much product to cause an overdose and death. In the credit world, an overdose leads to insolvency and an inability to service the debt. Insolvency often leads to bankruptcy and the loss of lender funds. The goal of every credit card vendor in the modern era is to maximize the debt service they can extract from each addict without killing them with insolvency.
Many spenders in California have entirely abandoned the idea of saving in favor of personal Ponzi Scheme financing. The idea seems to be that if you can keep borrowing long enough, you can die before the bills come due and avoid the inevitable period where the debts must be repaid. Some even come to believe this is a sophisticated method of financial management; Ponzi Scheme borrowing is lunacy of the highest order.
The system might have gone on longer if creditors had not completely lost their minds. New creditors entered the consumer finance arena by tapping the source of consumer savings securely trapped in the equity of their homes. This permitted consumers to pay off their previous credit card vendors as well as find an enormous source of new spending money. The impact of this new source of spending money created a set of circumstances where home ownership became extremely desirable thereby causing consumers to bid up the prices of homes. The higher home prices meant even more equity was available to spend, so creditors increased their lending to consumers. This made houses even more desirable. This feedback loop is part of the cause of the inflation of the Great Housing Bubble, and it explains much of the residual kool aid intoxication still present in our real estate market (buyers incorrectly believe appreciation and HELOC spending are coming back soon).
The Great Housing Bubble was a grand experiment in financial innovation. Lenders sought to find ways to loan even more money to people through crazy manipulations of loan repayment terms with loan programs like the Option ARM. Unfortunately, The Fallacy of Financial Innovation demonstrates that the loan programs developed during the bubble were not sustainable, and the entire Ponzi Scheme collapsed in a massive credit crunch. The collapse of this Ponzi Scheme is the source of our current financial woes.
Examine the graphic above. The first column shows a graphical breakdown of the income of a typical homeowner. Total home related debt (including taxes, insurance, HOA and other monthly expenses) is limited to 28% of gross income. Consumer debt including all other debt service payments is limited to 8%. Taxes take up about 24% (depending on income and tax bracket), and the remaining 40% is disposable income to cover the other expenses of daily life.
The second column shows what happens as people start to stretch to buy a home in a financial mania (charts are below). The increasing home debt reduces the tax burden a little, but the increased consumer spending and home debt takes a big chunk out of disposable income. The recession of the early 90s lingered for so long here in California because the people who bought in the frenzy of the late 1980s found themselves with crushing debts and greatly reduced disposable income. Prior to the increase in housing debt, this disposable income would have been spent in the local economy; instead, this money was sent out of state to the creditor who made the loan.
The big financial innovation–if you want to call it that–of the Great Housing Bubble was the nearly unrestricted use of cash-out refinancing and HELOCs to tap into home price appreciation. The third column shows the impact this new source of credit had on personal income statements. HELOC money allowed people to pay off their consumer debt while only modestly increasing their home debt. Since this income was untaxed (borrowed money is not truly income), the extracted money was entirely converted to disposable income. This incredible influx of disposable income caused our economy to explode.
Unfortunately, as is documented in the post Our HELOC Economy, the loss of this HELOC income is having devastating effects on local tax revenues and our economy. When you examine the personal income statements of borrowers in column four, you see that home debt and consumer debt have now become so burdensome that there is no longer enough disposable income to cover life’s basic needs; borrowers are insolvent.
The only solution to the problem of borrower insolvency is a monumental restructuring of both home and consumer debt. Realistically, the only way this is going to occur is through foreclosure and bankruptcy. We are not going to re-inflate this Ponzi Scheme because when sustainable loan terms are applied to real incomes, people cannot raise bids to sustain or inflate home prices–even with 4.5% interest rates. Without home price appreciation and subsequent HELOC borrowing, the Ponzi Scheme does not work.
The implications of this are clear; we are going to experience an extended recession bordering on depression here in California that is going to linger for many, many years. During this extended crisis, a significant percentage of California homeowners are going to face foreclosure and personal bankruptcy.
The collapse of a Ponzi Scheme is never pleasant, and that is what we are facing. According to Arthur Miller, “An era can be said to end when its basic illusions are exhausted.” The unsustainable lifestyles and illusions of wealth created during The Great Housing Bubble are exhausted; the era has ended.
You have seen these charts before, I want to remind you of just how burdensome home debt became as a percentage of personal income during our last two bubbles.
Debt-To-Income Ratio, California 1986-2006
From 2001-2006, the median home price in Irvine increased by an amount equal to the median income. I want to remind you what a massive economic stimulus this was:
Mortgage Equity Withdrawal 1991-2009
And Calculated Risk has a chart tracking the rising personal bankruptcy rate since the new bankruptcy law was passed in 2005:
This trend will continue. In fact, it will likely get much, much worse as the recession, unemployment, and foreclosures take their toll.