Apr222013

Did stopping HELOC abuse kill the economy?

Economists are busy studying the “wealth effect” to determine how important it is to the country’s economic health. Unfortunately, they don’t really understand the mechanics behind what they are studying. The basic assumption economists make is the people spend more of their liquid savings when assets they own increase in value. This basic assumption is flawed. In my opinion, The “wealth effect” is the most dangerous euphemism in economics. What happens in the real world is not an increase in spending of savings, but an increase in Ponzi borrowing based on inflated asset values. It’s the behavior that lead so many to foreclosure as I document daily. The wealth effect is help the economy doesn’t need.

Carl Case and Robert Shiller are pioneers in the study of the wealth effect. They noted that stock prices had little effect on people’s propensity to spend; however, house prices have a strong correlation to people’s spending habits. The conventional interpretation is that rising house prices make people feel more confident than rising stock prices, so rising house prices has a greater impact on people’s desire to spend. That interpretation is partially true 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. 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. This gives homeowners immediate access to cash, and it doesn’t have any tax implications. That’s easy. That’s convenient. That’s why there is a strong correlation between house price gains and consumer spending.

There’s only one problem. It’s a Ponzi scheme! It’s theft! (See: Neighbors stealing from neighbors: HELOCs make a comeback). Don’t let the euphemism, wealth effect, distract you from the more accurate dysphemism, Ponzi effect. The boost to the economy is real and quite visible. The economic instability and outright theft is hidden.

The federal reserve nurtures moral hazard

The federal reserve seeks to make recessions less painful. If they print enough money, and steal from anyone with stored wealth, they can buoy nominal prices of most asset classes and make the recession less economically painful for those who deserve to feel the most pain — stupid speculators.

With each round of economic intervention, the people who are bailed out learn that the consequences for their wild and irresponsible risk taking isn’t as bad as they thought. In fact, after a few cycles, it becomes widely known that any irresponsible risk taking will be bailed out by the federal reserve (anyone remember the “Greenspan Put?”) People respond to incentives, and if people realize they have huge potential rewards for wild risk taking and limited potential for downside risk, people take ever wilder and more irresponsible risks. That is the essence of moral hazard, and every policy of the federal reserve nurtures moral hazard into larger and larger financial catastrophes.

The real purpose of recessions

Most people don’t understand the economic cycle. After the deep double-dip recessions of 1979 and 1980, people really believed the federal reserve conquered inflation and made our economy immune to recessions. We all existed in a state of delusion and false security. Hyman Minsky noted that long periods of economic stability become characterized by increasing levels of Ponzi finance that introduces instability to the system and promotes the misallocation of resources. The purpose of a recession is to wipe out Ponzi schemes and correct these poor resource allocations. This restores the economy to health and promotes efficient use of resources in those areas where they provide the most benefit.

The federal reserve in its policies to lessen the impact of recessions prevents this natural cleansing from taking place. The Ponzi schemes of the bubble survive, people don’t learn their lessons about the dangers of Ponzi schemes, and the inefficient use of resources and outright theft of money continues.

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.

Did underwater mortgages kill the economy?

Posted by Zachary A. Goldfarb on April 18, 2013 at 1:03 pm

…A recently revised paper by Atif Mian of Princeton, Amir Sufi of the University of Chicago Booth School of Business and Kamalesh Rao of MasterCard Advisers suggests that underwater mortgages have played a significant role in holding back the recovery. The paper, “Household Balance Sheets, Consumption and the Economic Slump,” was first released several years ago, but it has been revised to include an important new calculation.It is widely recognized that the fall in housing prices had a “wealth effect” that led homeowners across the country to cut back on spending.

It is completely unrecognized that this was largely due to the shutting down of the housing ATM machine.

In the updated paper, Mian, Sufi and Rao measured how much more underwater borrowers probably  cut back on spending compared to borrowers without an overhang of mortgage debt. (More precisely, they measured how much homeowners cut back on auto spending for each dollar loss of housing wealth. But that’s important; the decline in auto sales was a significant part of the economic contraction.)

The authors found that being underwater makes a big difference. … Zip codes with fewer than 15 percent of homeowners only cut back only a little – spending only half a cent less for every dollar their home fell in value. But in Zip codes where more than 50 percent of homeowners were underwater, borrowers cut back five times as much – spending 2.5 cents less on car purchases for each dollar of reduced housing wealth.

This affirms the basic hypothesis that people were borrowing from their homes to buy cars. This study erroneously implies that people were cutting back on discretionary spending by choice. That’s not what happened. These people were cut off from the housing ATM by lenders who didn’t want to lose any more money on Ponzis. There is a huge difference between the two reasons, and these guys, like most other economists, completely missed it.

In an e-mail interview, Sufi says he and his co-authors believe the paper is the first to show that borrowers with very high leverage – which would include people who are underwater – are likely to cut back significantly on spending in a housing decline.

“This shows that a decline in household wealth will have larger consequences for housing spending if losses are concentrated on high leverage, low net worth borrowers,” he says. “The distribution of losses matters, not just the level.”

Sufi says the findings underscore the notion that principal reductions – reducing the overhang of mortgage debt left by the financial crisis – should have been more widely embraced as part of the policy response to the housing bust.

WTF? We need to embrace irresponsible borrowing by Ponzis by forgiving their debts so they can restart their Ponzi schemes? Do these guys give any thought to what they’re saying?

Do you see the complete disconnect between reality and what these academics believe? These misconceptions drive public policy, and if we implement the wrong responses — and principal reduction would have certainly been the wrong response — then we ensure more problems in the future as more people embrace the Ponzi lifestyle.

“Facilitating mortgage debt write­-downs would have softened the blow to household spending. A dollar lost by a creditor has less of a negative effect on consumption than the positive effect on consumption from a dollar gained by an underwater homeowner,” he says. “But some caution is warranted from a policy perspective: there may have been other costs of mandatory write­-downs that our estimates don’t capture. For example, faith in contracts may have been undermined.”

No kidding? Moral hazard has given every borrower faith that the words of the contract they signed will not matter. If they get into trouble, they expect to be offered a unilateral concession from the bank in the form of a loan modification, and if they decide to quit paying entirely, they are entitled to game the system and squat for long periods of time. They’re loanowners. They’re a favored class of people.

Perhaps the academics “sophisticated” financial models failed to capture the impact of moral hazard.

Some critics argue that the overall decline in housing wealth easily explains the economy’s subpar performance from 2007 through much of 2012, and that you don’t need effects from underwater mortgages to account for the drop in consumer spending.

That’s right. All that’s required is turning off the housing ATM machine for the economy to sputter.

And while debt may have had an impact, the real problem was that housing values declined dramatically across the country. Writing down mortgage debt, this argument goes, would not have had a significant impact on the overall economy as long as home values were depressed.

“There was a big negative housing wealth effect,” said Dean Baker, co-director of the Center for Economic and Policy Research. “It might be somewhat stronger for people who are underwater and for lower-income people compared to higher-income people, but the story is that we lost $8 trillion in housing bubble wealth and that was going to have a huge impact on consumption even if no one was underwater.”

But Sufi maintains that critics too often assume that the decline in housing wealth was uniform across all borrowers. The reduction in consumption, he points out, was much greater for the most indebted people. …

That’s because they were Ponzis!

Who are the people with the most debt? Those that run personal Ponzi schemes.

Who are the people first to be cut off during a credit crunch? The Ponzis who the banks know will cost them the biggest losses.

No lender wants to be the last one to give a Ponzi a loan because they will be the bagholder. Lenders are not completely stupid. They know this, so when a credit bubble bursts, lenders seek to weed out the Ponzis first and pray some other lender, a lender even more stupid than they were, steps up to absorb the losses. When a credit crunch ensues, there is a rational panic as every lender rushes for the exit.

The danger of reflating the housing bubble

As I’ve described in great detail, lenders are keen to reflate the housing bubble to restore collateral value behind the Ponzi loans they made during the housing bubble. They have the backing of the federal reserve, who engineered low interest rates, and government policy makers who want to see the economy improve. As the bubble reflates, homebuilding will come back, and the economy will enjoy some stimulus from the reduction in unemployment, but what everyone is waiting for is the restarting of millions of personal Ponzi schemes to really juice the economy.

If we restart the dormant Ponzi schemes of millions of borrowers — and that certainly is their intention — then banks will again expose themselves to trillions of dollars in bad loans. But this time, there is one key difference; both banks and borrowers know the US taxpayer will bail them out. This is moral hazard on steroids.

The flow of money from Ponzi theft

If a homeowner held you up at gunpoint, you would know you were robbed.

If a homeowner hired a burglar to clandestinely steal your money, you would still know you were robbed. It might take a little investigation to uncover, but the fact that your money went through a middle-man to the homeowner would still be theft, irrespective of whether it was direct or indirect.

If a homeowner takes a loan from a lender and doesn’t pay it back, the homeowner robbed the lender. However, if the lender then turns to Uncle Sam and gets a bailout, then the homeowner robbed Uncle Sam. And since YOU fund Uncle Sam with your tax dollars, the theft of the homeowner went through the lender, through Uncle Sam, and directly in to your pocket. In other words, the homeowner was stealing from you.

Most people don’t follow this chain of events and realize homeowners who take out Ponzi loans they don’t repay are stealing from them personally. The too-big-to-fail lenders and the government are merely middle-men facilitators who sanction this theft because they profit from the activity. Lenders profit on fees, and government profits from the economic activity of the thieves. The losses are directly passed to you as taxpayers.

What’s worse is that there is nothing you can do about this. This is state-sanctioned theft. An arrangement were people entering into largely unregulated private transactions have developed a way to pass the costs of their nefarious deeds on to you.

Perhaps cutting off the HELOC abuse did hurt the economy. Perhaps we all suffered for the last five years for the excesses of Ponzis during the bubble. If so, It’s a price I would gladly pay if I thought the Ponzi borrowing and subsequent theft was over. Unfortunately, with the federal reserve and the government cheering for more stimulus from the “wealth effect,” it’s apparent that they want the personal Ponzi borrowing to resume. Why not? They’re not the ones who are going to pay for it.

You are.

Sucker.