Why isn’t the economy improving with higher house prices?
Higher house prices were supposed to stimulate spending, but instead the increased debt service has taken money out of consumers pockets, reducing spending.
The bailouts of banks and the housing market were sold to us on the premise that rising house prices would stimulate the economy through the wealth effect. In theory, as people saw their personal balance sheets improve, they would stop saving so much and begin spending money again, and that additional spending would cause all economic activity to increase. Rising house prices was supposed to be a panacea curing all our economic woes.
Well, house prices are up, yet the economy still sputters. Were the economists and politicians who touted this idea wrong?
Exactly a year ago from today, one of us wrote a short piece entitled “Will Housing Save the U.S. Economy?” The conclusion was pessimistic:
“we need to temper our optimism on what a housing recovery can do. I agree that house prices will continue to rise and new residential construction will steadily increase from its current very low level … But we will not be returning to the boom years that preceded the Great Recession. The days when housing was the predominant force driving economic activity are gone…”
Rising house prices could potentially boost economic activity through two channels. First, and most importantly in our view, it could allow lower income, lower credit score households to borrow and spend. This has been historically called the “housing wealth effect,” but the “home equity withdrawal effect” is a more appropriate term. As our latest research shows, the housing wealth effect is driven entirely by lower income households who borrow against rising home equity to spend. This channel was huge during the 2002 to 2006 period, something our research quantifies.
Rising home prices is what economists and politicians wanted because they subscribe to the belief in the wealth effect, the most dangerous euphemism in economics. The conventional interpretation is that rising house prices make people feel more confident than rising stock prices, so rising house prices have a greater impact on people’s desire to spend, a partially true interpretation because prior to the housing bubble, house prices had never gone down while stock prices had crashed repeatedly. A rising house price appeared more stable; however, that isn’t what’s really going on.
If stock prices go up, people don’t have ready access to that money, as they would have to sell some of that stock and pay taxes on the gains in order to obtain the money. That’s work; that’s a hassle; that’s why the correlation between stock price gains and consumer spending is so weak.
If house prices go up, it’s a different story. When credit is loose, lenders will loan 100% of the value or more of a house with a HELOC or second mortgage, giving homeowners immediate access to cash, and it doesn’t have any tax implications — and the owner doesn’t have to sell the house, so they may be offered even more free money in the future. That’s easy; that’s convenient; that’s why there is a strong correlation between house price gains and consumer spending.
We can test whether we are getting a big kick from house price growth by comparing the last two years to the two years prior to the Great Recession. House price growth in both periods was similar. In fact, as the chart below shows, house prices grew even faster over the last two years relative to the earlier period:
So house prices grew strongly from 2011 to 2013. Did it boost household spending through the home equity withdrawal channel? Here is a comparison of the total amount of cash-out refinancing done in 2005 and 2006 versus 2012 and 2013. A cash-out refinancing is when a homeowner refinances her mortgage with a larger principal balance, hence taking cash out of the home:
In 2005 and 2006, homeowners refinanced over $600 billion in mortgages where cash was taken out. The chart above actually understates the 05-06 total amount considerably, because we are using Freddie Mac data that includes only prime conventional mortgages. The most aggressive borrowing took place in Alt-A and sub-prime markets.
What about the 2012 and 2013 period? There was a much smaller volume of cash-out refinancing. Despite home values rising more from 2011 to 2013 than from 2005 to 2006, homeowners took much less equity out of their homes compared to the earlier period. While this doesn’t directly measure spending, our research shows that almost all spending during the 2005 and 2006 period came out of active home equity withdrawal. So the fact that there has been very little cash-out refinancing in 2012 and 2013 tells us that there is likely very little spending out of housing wealth currently.
There are two reasons mortgage equity withdrawal was so much less in 2012 and 2013. First, with many homeowners underwater, the increase in value on their homes didn’t accrue to them — it went to the banks; in fact, that’s the main reason banks want to see higher house prices because it restores collateral to their bad bubble-era loans. Second, for now, banks are only willing to loan 80% of the value of the property on a refinance. Without 100% or higher HELOCs and refinanced, borrowers simply don’t have access to the increase in property value.
Ironically, the fact that house price growth has not contributed much to overall economic activity over the past few years implies that the economic consequences of stalled house price growth may be small. Slower house price growth will lower new residential construction, but it has been pretty weak anyway. And cooling the rapid rise in rents may actually help boost spending on other goods. The bottom line is that the U.S. economy will have to look for an engine other than housing to drive growth going forward.
Why is the fact that rising house prices didn’t improve the economy ironic? IMO, believing otherwise was moronic. Rising house prices only contribute to the economy when lenders enable personal Ponzi schemes with millions of borrowers. There is no wealth effect; there never was. In their own words, it was better described as a “home equity withdrawal effect”. Perhaps it’s time for them to question their old dogmas.
We think it is officially time to stop cheering for higher house prices. They aren’t having much of an impact on the economy anyway, and the resulting higher rents are hurting many.
I’ll agree with that conclusion 100%.
From theory to reality
Writing about big-picture concepts like moral hazard and Ponzi schemes is only useful if readers can translate these concepts to real-life concrete decisions of real people they see every day. Fortunately, anyone who reads this blog regularly already knows how common and pervasive the Ponzi borrowing lifestyle is here in Orange County. There’s nothing special about people in Orange County, except perhaps the scale of the Ponzi borrowing was much larger here because the homes they borrowed against were more inflated in value.
I have documented more than a thousand cases of HELOC abuse right here in Orange County, with the majority of them in one city, Irvine, California. These people all had one thing in common; based on the rising value of their homes they took on debts they couldn’t afford to service. Each of them became dependent upon future infusions of debt to sustain the service on the debt they already had. In other words, they were all running personal Ponzi schemes. They were small versions of Bernie Madoff.
Ponzi schemes are inherently unstable for one simple reason; borrowers get cut off. Once a borrower becomes dependent upon future infusions of debt to sustain existing debt, the last lender is a bagholder destined to lose money. Once lenders realize this, they stop lending, a credit crunch ensues, bills come due and people can’t pay them, and all discretionary spending in the economy grinds to a halt (today’s article confirms that). The circumstances and behaviors of the individual borrowers drives large economic events. If you give millions of people free money to spend — as we did during the housing bubble — the economic stimulus is huge. If you cut those borrowers off — as we did during the recession of 2008 — the economic collapse is equally as huge.
Economists and academics seem to think we don’t need to cut off this flow of money. Perhaps if lenders just keep on loaning money, then everything will be okay, right? Credit crunches are viewed in academia as an unnecessary impediment to economic growth rather than a rational response when lenders realize they are supporting millions of parasitic Ponzis.
For now, the Ponzi gravy train isn’t serving up free money. I believe HELOC abuse won’t be as common in this cycle, partly because lenders won’t be anxious to enable millions of personal Ponzi schemes, and partly because rising interest rates makes borrowing this money much more expensive. During the housing bubble, lenders offered borrowers the ability to refinance at lower interest rates. This allowed borrowers to extract their equity often without increasing their monthly payments. From a borrower’s perspective, this really was free money. Since we are at the bottom of the interest rate cycle, borrowers won’t get lower interest rates to refinance and keep the same monthly payment. That means HELOC booty will have a cost this time around. If the borrowed money has a real cost, far fewer people will take it.