Real estate appreciation is religion in California. Ever since the first bubble in the 1970s enriched a generation, everyone in California sees owning a home as a short cut to riches. The bubble of the 1970s saw dramatic price reductions in some areas and a lingering stagnation in others. Prices did not fall to previous levels of affordability, and learning nothing from that downturn, Californians quickly inflated another bubble in the late 1980s that peaked in 1990. The downturn from that bubble was a little deeper and a little longer, but Californians were undeterred in their faith in real estate wealth. When prices finally bottomed out in 1997, Californians waited a few years, but they they inflated a truly massive housing bubble. The resulting crash saw prices drop 30% to 50% or more and devastated an entire generation. You would think after repeated crashes, Californians would lose their faith in real estate as a path to unlimited wealth and spending power. Perhaps the wiser and more prudent saw the Light, but for California Ponzis, the cycle of boom and bust presents opportunities for free money they don’t want to miss out on.

U.S. Homeowners Are Repeating Their Mistakes

By Brendan Greeley on February 14, 2013

If there’s one thing Americans should have learned from the recession, it’s the importance of diversifying risk. Middle-class households had too much of their net worth tied up in their homes and were too exposed to stocks through 401(k)s and other investments.

If there’s one thing Americans should have learned from the crash after the Great Housing Bubble is that real estate cannot appreciate at sustained rates greater than the growth in wages, usually less than 4%, and that money shouldn’t be extracted and spent like income. Californians believe house prices can rise 10% to 15% or more per year, and it’s free money they can spend. They don’t know how or why, they just have faith that it does. While prices certainly can rise that high in any given year, it cannot possibly sustain such rates of appreciation because people can’t afford it. And now with regulations in place banning most “affordability” products, it will be much more difficult to inflate another unsustainable bubble with rapid rates of appreciation. However, memories of rapid price rises are strong, and memories of the crash are quickly forgotten, particularly by those Ponzis who live on the free money during the rise and leave the bills to others during the crash.

Despite the hit many Americans took, there’s little sign they’ve changed their dependence on homes as the mainstay of their wealth. Last year, Christian Weller, a professor at the University of Massachusetts, looked at Federal Reserve data for households run by those over 50. The number of families with what Weller calls “very high risk exposure”—a low wealth-to-income ratio, more than three-quarters of their assets in housing or stocks, and debt greater than a quarter of their assets—

These are Ponzis. The euphemism “very high risk exposure” is looking at these people’s behaviors through the eyes of a prudent person. Ponzis don’t care about risk. They don’t consider it because they know they will avoid the consequences for their actions. The fringe buyers during the peak of the housing bubble that drove prices up the most were largely Ponzis. They saw housing as a chance for free spending money, so it didn’t matter what price they paid as long as someone else came along to bid more, raise prices, and allow them to qualify for more HELOC money. As long as the possibility existed, they were going to play the game.

had almost doubled between 1989 and 2010, to 18 percent.

It shouldn’t be surprising the the number of Ponzis went up during a period of declining interest rates. If there’s anything that encourages Ponzi borrowing it’s falling rates which allow borrowers to increase debts significantly without large increases in debt service.

That number didn’t decline during the deleveraging years from 2007 to 2010; its growth just slowed to a crawl.

The numbers haven’t declined because Bernanke continues to lower interest rates. Despite the obvious fact that we need to deleverage as a society, the banks don’t want to see it and can’t afford the write downs, so they respond by lower interest rates to near zero. Everything possible has been done to prevent deleveraging, but it’s still going on. It’s the main reason we haven’t seen much inflation from our sustained period of very low rates.

The Fed will conduct a new wealth survey in 2013, but don’t look for a rational rebalancing. The same pressures that drove families to save less before the recession are still in place: low income growth, low interest rates, and high costs for health care, energy, and education. Families have been borrowing less since 2007, but the rate of the decline has slowed. As soon as banks start lending again, Weller says, people will put their money back into housing. “The trends look like they’re on autopilot,” he says. “They don’t suggest that people properly manage their risk.”

Most people buy a house based on monthly payment. Further, most people assume that whatever they can finance they can afford. For as distasteful as I find paternalism in government, when it comes to mortgage finance, it’s necessary. As we saw during the housing bubble, people have no clue the risks they are taking on. People will take on interest rate risk, refinance risk, collateral risk, income loss risk, and any other risk you can think of to buy a house, particularly if they believe free money will follow or that they will be bailed out if things go awry. In fact, the moral hazard of assured future bailouts makes government paternalism even more imperative otherwise taxpayers will be bailing out the next generation of Ponzis.

In a 2012 paper for the National Bureau of Economic Research, economist Edward Wolff concluded that from 2007 to 2010, the median American household lost 47 percent of its wealth. Average wealth—a number that includes the richest Americans—declined only 18 percent. Houses make up a smaller share of the wealth of a rich family. The wealthy also benefit from better financial advice, Weller says.

A home is what economists call a consumption good; you have to live somewhere. It’s also a store of wealth.

It’s a leaky store of wealth at best. In places like Texas, which didn’t participate in the housing bubble, HELOCs are legally restricted to no more than 80% of a property’s value. This puts some restriction on a loanowners ability to raid the housing piggy bank, but in places like California, which heavily participated in the housing bubble, there are no such restrictions, and whatever “wealth” appears through appreciation is almost immediately converted to spending money by Ponzis.

Unlike other assets, you can’t buy a portion of a house. “You want to consume a big home,” says Sebastien Betermier, an assistant professor of finance at Desautels Faculty of Management at McGill University. “But if you want to buy that home, it’s a huge investment—probably more than you really want.”

This guy obviously doesn’t live in California.

Betermier, who studies consumers’ financial decisions, says homeownership makes it harder to diversify risk. Since 1983, for the richest 20 percent of U.S. households, the principal residence as a share of net worth has been around 30 percent. For the next 60 percent—most of us—housing has risen from 62 percent to 67 percent of total wealth.

To compound the problem, home equity dropped for this middle group even as home values rose.

This was one of the most shocking facts I turned up when researching the housing bubble. Think about that. Home equity actually declined during the housing bubble.

Most people assumed that when prices doubled or tripled in about eight years that everyone was sitting on mountains of equity. The prudent owners who didn’t tap their equity were, but the Ponzis were not. They extracted and spent it. And it wasn’t just a few. 88% of refinances in 2006 had cash-out refinancing in excess of 5% of the property’s value. As the daily debtor debacles I’ve featured every day for the last six years testify to, it was a very widespread practice.

Rising house values, low interest rates, and easy refinancing encouraged property owners to take out home equity loans.

No kidding.

The graphic above is not one of my cartoons. It’s a real ad from 2006. Look at the vaguely happy people thrilled that some lender was willing to enslave them with a stupid loan you and I will end up paying for with our tax dollars when they can’t pay it back.

And Wolff’s analysis shows the middle class reducing their cash cushion from 21 percent of assets, starting in the early 1980s, to 8 percent just before the recession. Cash is bad luck insurance; you pay a premium because you don’t earn a return on it, but it’s available in case of an emergency. Americans borrowed against their homes, spent the cash, and were left only with risk. …

Which is why so many got wiped out during the recession.

Weller, Betermier, and Mitchell agree that the mortgage interest deduction contributes to the problem, as it encourages families to move their assets into housing. “When people think about renting vs. buying, the tax subsidy looms large,” says Wharton’s Mitchell. Weller endorses an approach suggested by Senator Barack Obama in 2008: Turn the deduction, which lowers taxable income, into a flat credit, which cuts your tax bill by a fixed amount. That would lead to slower growth in house prices, says Weller, since the credit wouldn’t rise even if people took on a bigger mortgage to buy a more expensive house. As the price of housing climbs more slowly, the shift of a family’s savings into housing would slow.

The home mortgage interest deductions should be eliminated. Taxpayers, which includes renters, have no business subsidizing a loanowners mortgage. However, since it won’t likely be repealed, ideas for reform are welcome.

A flat credit for the deduction would be far more effective in promoting home ownership than our current policy. The current deduction merely encourages high wage earners to take on larger debts and inflate prices in places like Coastal California. It does nothing to encourage home ownership because this group would own anyway. The stated purpose government housing policy is to encourage home ownership among low- to mid- wage earning families, but since most of these families don’t itemize, they don’t gain from the HMID. A flat deduction would encourage low- to mid- wage earners to buy homes because they would gain the deduction. Of course, like any subsidy, the effect would be short lived as the market would find a new equilibrium, and entry level pricing would go up just like we witnessed during the bubble when subprime loans proliferated.

In 1999, Robert Shiller of Yale University proposed a way to hedge house values. New owners would buy an option with their mortgage, tied to an index of house prices (such as the one developed by Shiller and Karl Case). The option would function as home value insurance. But “when you buy insurance and you don’t die,” says Shiller, “you think how I spent all this money and got nothing. It takes sophistication.” The problem with his idea, he says, as with similar approaches by the Bank of Scotland and Bear Stearns, was that house prices were rising. People don’t buy insurance for a risk they don’t see.

The problem with this idea goes way deeper than “sophistication.” I really like Dr. Shiller’s work, but this idea was flawed from the start. First, as he pointed out, nobody used this insurance. Most didn’t know about it, and those that did know it existed didn’t think such insurance was necessary. But let’s reflect on this idea a bit further, and the true folly becomes apparent. In a future’s market, you can bet on prices going up or down. Dr. Shiller envisioned millions of Americans buying the bet on downside price movement to hedge themselves against a loss. But what would people really do? Most people rather than hedging their risk by buying the “put” would instead magnify their risk and buy the “call.” People are buying the house because they believe prices are going up. They don’t want insurance. They want to make more money when prices go up. If Dr. Shiller’s futures contracts on house prices ever became widely traded, most people would do the opposite of what he envisions, buy the contract betting on upside appreciation, and make their circumstances even worse when things go bad.

This leaves Shiller, like Wharton’s Mitchell, pushing for education. At the Obama Treasury several years ago, he suggested the White House hold conferences on housing risk. “They would invite top financial organizations,” he says, “and ask them ‘What are you doing about this?’ ”

Educating people sounds great and noble. I hope I provide an education service with the writing of this blog. However, education only reaches those who care to be educated, and that’s a very small fraction of the homebuying public. Most people who buy a house consider themselves experts on real estate already. After all, they’ve watched a few TV shows on flipping or house hunting, and they’ve lived in a house for years. The vast majority will not be receptive to education on housing risks, particularly if the message is don’t take on too much debt, don’t buy too much house, and don’t abuse HELOCs. Even if the government put out this message, the prospective homebuyer’s real estate agent and mortgage broker will be telling them the opposite, and people will listen more to the agents they mistakenly trust than they will to a paternal message from the government. in short, government education won’t work.

At the time, Treasury and the banks had more pressing things to do. The federal government could also resort to regulation. Shiller points to the example of Franklin D. Roosevelt, who mandated that homeowners buy fire insurance with their mortgages. “I think it could be expanded to home value insurance,” he says.

Government mandated home value insurance? That’s a form of paternalism I can do without. If this were a really good idea, banks would simply require private mortgage insurance on every loan. It would have the same effect.

The best remedy of all would be a higher savings rate. Mitchell tells her daughters, who are in their twenties, to hold off buying a house and save 25 percent of what they earn. But, she says, “They don’t find this very helpful.”

LOL! That would cut into their entitlements.

The bottom line: Americans still have too much of their net worth tied up in their homes. There are limited options to encourage diversification.

Owning a primary residence is a solid part of a good financial plan. Eliminating a mortgage payment goes a long way toward stretching retirement dollars. Unfortunately, most people never pay off their primary residence, and many others foolishly take out reverse mortgages or HELOCs with hopes of borrowing their way to a prosperous retirement.

Real estate can still be part of a retirement plan. My family has purchased a number of rental properties that I plan to live on in my own retirement. I didn’t buy these properties with any expectation of appreciation; I bought them for the rental cashflow. Most people don’t get that concept, and they put all their faith in obtaining a lump sum through appreciation on their primary residence. I won’t envy their retirement lifestyle. It won’t be what they hope it to be.