Rodney Johnson | Monday, November 12, 2012 >>
We, as homeowners and consumers, are guilty.
For years I’ve railed against the Bureau of Labor Statistics (BLS) for including the change in home prices, through their convoluted formula, in the Consumer Price Index (CPI).
My point was that, beyond its incomprehensible Owner’s Equivalent Rent approach, a change in the value of your home does NOT mean you immediately change your spending, therefore including housing in a measure of short-term inflation is simply wrong.
Think about this in relation to the price of gas…
If your house goes up by 5% this month, beyond popping champagne and dancing a jig, nothing much will change for you. If, however, gasoline goes up by 5%, then chances are you will feel the pain within a week when you fill up your car.
However, over the long term, housing has a profound effect on the inflation/deflation trend in the economy.
When houses go up in value then the next buyer, the marginal consumer, must pay more. Given that home ownership is still over 60% in the U.S., it is true that most Americans will not be buying a new home tomorrow or even this year. But the rise in prices does materially affect how much new home buyers must spend.
Also, there is the “home-as-an-ATM” factor to consider…
The more equity homeowners had in their homes, the more they could borrow against that home. This led to a wild run up in home equity lines of credit (HELOCs) in the years leading up to 2007/08, which put hundreds of billions of new dollars (funded by debt) into the economy to be spent.
Obviously this funded inflation. After all, this was how consumers continued to ride the buy-everything wave during the 2000s, even though incomes were flat or falling in real terms.
So, when housing prices fall, that creates deflation by removing the ability of homeowners to continually borrow and spend.
Given that what consumers pay for shelter is the largest expense of the household, as prices drop, the next buyer has a lower cost. Obviously, this is great for him, but it is definitely bad for existing owners.
As prices fall, not only are HELOCs harder to get and smaller, but the overall loan-to-value ratio goes up. In short, there is less equity. So the homeowner gets squeezed.
If the value of the home falls below the value of the mortgage, then the homeowner finds himself underwater, working to pay off a loss.
This trend of falling asset prices while debts remain the same is a hallmark of deflation… and we have it in spades in the U.S.
That Leaves Just One More Question…
How does this inflation/deflation play into the long-term finances (like retirement) of the homeowner?
Most people think of retirement savings as their 401k, IRA or some other investment vehicle. This is true of course, but most Americans do not achieve great savings in these vehicles. Instead, most of their savings or accumulated wealth is in their home equity.
In 2010, the Federal Reserve reported that the median drop in financial assets since 2007, for middle income earners, was 40%… from $62,500 to $37,500. That’s a big percentage hit.
Meanwhile, the same middle income earner lost 22% of his home value… from $225,000 to $175,000.
Now, the percentage loss on the home doesn’t seem as much, but the real dollars lost are more than twice as large.
Which would you rather have? A smaller percentage loss? Or the loss of fewer actual dollars?
Exactly… give me the dollars any day.
At the same time, most investments like stocks and bonds are not leveraged. So that drop in value from $62,500 to $37,500 was painful, but it was clean. Meanwhile, the same homeowner above had a mortgage of $120,000 in 2007 and a mortgage of $116,000 in 2010. This means the homeowner’s equity fell from $105,000 in 2007 to $69,000 in 2010. Ouch.
I’m pretty sure that homeowner was counting on the equity to keep rising, not fall. That means he must now adjust whatever plans he had for the equity. Presumably he’d save more from other sources. Greater savings is the twin of lower consumption, which of course fuels deflation.
For many years we have pointed to a consumer-led deflationary season that would begin around 2008. Our point was that the Baby Boomers would pass their peak spending years and move into their peak saving years.
The housing boom fueled a credit bubble that allowed this group to spend well beyond their income and other earnings. Now the backside of this credit bubble is here. And bubbles don’t deflate gently. They pop.
The Fed has moved mountains to hold off this eventuality, but it can’t fight the tide forever. The deflationary forces in our economy today are here to stay for a number of years.
P.S. You can prepare in many different ways. One is to build streams on income. Another is to seek out yield. On the former, we have several plays in our Boom & Bust portfolio designed to accomplish just that (with the bonus of equity gains). On the latter, more on Wednesday.
A third is to pre-order your copy of the Demographics School Audio, before midnight tonight.
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