Postcards from Old Europe – Consume your house!
Note: due to extensive traveling without access to the web this postcard is a day early.
As the past columns have been very Euro-centric I guess that it is high time to shift my view back to the goings-on in the US. While household demand has been flagging in Europe the US consumer has been a bastion of strength over the past couple of years. This is pretty astounding if you consider that the most recent past has seen a stock market crash and rising unemployment. One would think that these negatives would have led many households to retrench and start to consolidate their personal finances. This didn’t happen. Consumers kept their wallets open – the only question is: “where did the money come from?”.
Let’s take a quick look at the numbers to set the stage: Household wealth saw massive equity-driven gains up to the year 2000. Holdings of equities and mutual funds peaked in 2000 at around 12 trillion dollars and then fell by around 25% before making a come-back over past couple of months. The year 2000 is also significant because it saw equity wealth overtake real estate wealth for the first time. The subsequent reduction in value of stocks (i.e. bubble-bursting) served to push houses back on top of the household wealth heap by 2001.
In the years after 2000 US households saw two things: their stocks were racing for the bottom while the value of their homes started taking off. This rise in real estate wealth took some of the sting out of looking at the diminishing value of the investment portfolio. For many families rising house-prices meant rising household wealth – even after taking into account the losses in other investments.
But while a single call to your broker will release the gains (losses) in your trading account selling a home isn’t that easy. But wait, why sell? The financial service industry provides you with a host of possibilities to release all that equity locked up in your home! But that’s not all – there’s more! You can even deduct interest paid on home equity lines of credit (and mortgages) from income for tax purposes!
Let us take a step back here and look at what used to happen: a family would identify a home it wanted to buy and then make a down payment and finance the balance. The next couple of years would see the equity in the home increase primarily by the act of the family paying down the debt. If the family was lucky they would see interest rates fall which would then lead them to refinance their mortgage, thereby saving money. If the family was really lucky they would also see the price of their home rise.
This is what has been happening on a massive scale over the past couple of years. Rates have been falling while prices have been shooting upwards. This confluence of positive forces ignited a rocket in home equity which consumers have been riding hard.
A look at the Fed’s Flow of Funds reports gets us the data. The carving out of home equity can be calculated by subtracting the growth in residential investment from the growth in mortgage debt. The amount of equity extraction has been staggering over the past two years! The past has only rarely seen phases of equity extraction at all! The last 20 years were characterized by homeowners paying down debt – i.e. investing equity!
Equity extraction peaked in the middle of 2003 at a time where the FOMC saw deflation just around the corner and interest rates on mortgages were at near-record low levels. These equity take outs boosted consumer disposable incomes by up to 3% – at a time when wages and salaries remained mostly flat. No wonder that the growth in consumption managed to outstrip the growth in “real” income.
But real income via wages is coming firmly back into focus. Interest rates are creeping up and most everyone who has wanted to refinance has refinanced by now. Momentum in existing home sales is moderating as record-high prices will probably see affordability drop and turnover moderate. Any slowdown in home equity extraction could lead to less consumption if disposable income doesn’t get a boost via rising wages or from other sources. The missing tax refunds are not helping either!
To sum it up: consumers have been spending all through the recession and the following phase of economic weakness. As wages and salaries have been flat while the stock market has been sputtering, consumers have tapped into home equity to sustain their spending binge. As this possibility is becoming less attractive, consumers need other sources of income to compensate. Just one more reason why everyone is so focused on the payroll data.
Just a thought to finish off with: what happens if house prices fall?
Thank you for reading. If you’d like to read more of my ramblings, be sure to visit CurryBlog.