Transformation

If Real Estate is to keep it's bubbly levels, the economy MUST recover and recover quickly.

But as faithful readers of this blog know, I am not optomistic about that occurring.

One of the main reasons is that fact that I believe our economy is going to be forced to undergo a major, painful transformation.

Currently 70% of our economic output depends on consumer buying. No buyers, no recovery.

Which is why the Canadian and American federal governments have been pumping 'stimulus' into the economy at a furious pace. Historic low interest rates are designed to encourage Canadians and Americans to get back into buying.

The problem is that we are at the end of the credit boom – certainly the nine-year boom and maybe the 60-year boom. Has any society ever created so many ways for people to go into hock?

In 2003, Americans had 1.46 billion credit cards, or five per person. Home mortgages total $9 trillion, and some initially don't require borrowers to repay all their annual interest. In 1946, households had 22 cents of debt for each dollar of disposable income. Now they have $1.26.

Behind these numbers lies a profound social upheaval: the “democratization” of debt. Everyone gets to borrow. But this process may now have reached its limits.

The biggest boon has been the expansion of homeownership, up from 44% of households in 1940 to 69% today. (Three-quarters of household debt consists of mortgages.) At heart our appetite for credit reflects a continental optimism. We presume that today's debts can be repaid because tomorrow's incomes will be higher.

The origins of today's credit culture date to the 1920s with the advent of installment lending for cars and appliances (stoves, refrigerators, radios), says economist Martha Olney, author of “Buy Now, Pay Later.” Attitudes changed. In the 19th century, “it was thought that only irresponsible families bought on credit,” she says. “By the 1920s, it was only foolish families that didn't buy on credit and use it while they were paying for it.” In the mid-1920s, 60% to 70% of cars were sold on one-to two-year loans.

After World War II, credit became part of the mass market. In 1958, Bank of America introduced a credit card that (in 1976) was renamed Visa. The combination of aggressive merchandising and government laws prohibiting racial and ethnic discrimination in lending led to a huge expansion of borrowers. One reaction to the anti-discrimination laws was the use of impersonalized computer-driven credit scores to determine loan eligibility. Now, U.S. businesses buy 10 billion FICO scores annually.

Credit is about more than selfishness and impatience. “Once consumers step onto the treadmill of regular monthly payments, it becomes clear that consumer credit is about much more than instant gratification,” writes historian Lendol Calder in his book “Financing the American Dream.” “It is also about discipline, hard work” – the attributes necessary to repay the debt and borrow more.

Ironically, our optimism feeds our stress.

The trouble is that no society can forever raise its borrowing faster than its income – which is what we've been doing. Sooner or later, debt burdens become oppressive. One reason for thinking we've passed that point is that the last spasm of credit expansion was partly artificial. To soften the 2001 recession the Federal Reserve embarked on an audacious policy of easy credit. From December 2001 to November 2004, it held its key short-term interest rate under 2%.

A real-estate bonanza ensued. From 2000 to 2005, sales of new and existing homes increased by nearly 40%. In hot metropolitan markets, prices more than doubled over five years. Nationally, the increase was 57%.

The frenzy depended heavily on low interest rate mortgages. In 2005, about half of new home loans had variable interest rates (often with low, introductory teaser rates) or required only interest payments.

What the Fed giveth, the Fed taketh away. And between June 2004 and 2006, the US Federal Reserve raised short-term interest rates from 1% to 5.25%.

And that's what caused the bubble to break in the most bubbly US cities. This forced real estate prices to drop a bit, which triggered the first subprime mortgages to default, and the dominos started to fall.

This turn of the credit cycle could signal signals a dramatic change.

The end of the decades-long rise of personal debt to income is going to have profound reprecussions.

It's not just that debt service (which is at aa historic high, nearly 19% of disposable income) has been stretched too far, credit standards have been stretched too far as well. And those standards are in the process of being pulled back.

In additiona much recent debt has been contracted at artificially low interest rates. As rates rise, buying will drop.

Toss in rising unemployment, and a contraction of the credit cycle in unavoidable.

For an economy that is 70% dependent on consumer buying, that becomes a death knell. Without that prop, the current economy cannot function and it cannot be resuscitated.

And if it can't be resuscitated, it must be restructured. A major, painful transformation may be our only option.

It won't be pretty.

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Email: village_whisperer@live.ca
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