US Household wealth: where did it go?

Where did all that housing wealth go?

In the last four years, US home equity - the difference between the market value of homes and the outstanding stock of mortgage debt - has fallen by half. In terms of wealth destruction, there have been few parallels outside of war. The nominal value of housing wealth today is now at the same level it was back in the late 1990s. In terms of wealth accumulation, it is as if the US housing bubble had never happened.

This chart tells the deeper story than just simple post-bubble wealth destruction. During the bubble years, US homeowners remortgaged and extracted billions of dollars that was spent to sustain personal consumption. Lurking beneath the crazy house price appreciation of the last decade was a lethal accumulation of household indebtedness.  Households might have thought they were becoming richer. In reality, they were promising away their future incomes.

Here lies the treacherous asymmetry between home valuations and mortgage loans. House prices are ephemeral, flighty and fundamentally subjective. Debt, on the other hand, is merciless and exact. It must be paid.

Crashing household wealth also goes a long way towards explaining the ferocity of the recent US recession. There is a rough and ready empirical rule relating household consumption to wealth. Most economists agree that if wealth increases by one dollar, personal consumption increases by three or four cents.

If household wealth isn't fluctuating by much, then this wealth effect is quite muted. If, on the other hand, household wealth crashes by 50 percent, then GDP is going to take an almighty hit. So when house prices are racing upwards, the economy booms as everyone thinks they're getting richer. But when they crash, a recession is inevitable.

There is nothing new in any of this. Economists have understood the relationship between economic fluctuations and household wealth since the 1950s. The really interesting question is why would policymakers, in particular the Fed and the Bank of England, allow house prices to continue to rise, knowing the risks inherent when they inevitably crash? They can not plead ignorance.

Stopping a housing bubble isn't difficult. It can be done in one of two ways; raise interest rates or impose lending restrictions on banks, preventing them from writing mortgages to fuel the bubble. All that is needed is the will to do so.  However, bubbles are great while they last, and the pain they create is marked down for payment somewhere in the distant future. 

If this restatement about the dangers of asset bubbles seems a little too retrospective, take a look at food or oil prices today, which are now beginning to rise sharply. Also, examine recent developments in certain property markets in continental Europe, for example, Paris or Vienna. We still live in a world of asset price bubbles. Interest rates are too low, and we're bouncing from one crisis to another. We never seem to learn, or rather they would prefer to accrue the short run benefits of asset appreciation, and leave the consequences to the future.

The great mortgage payback continues

Here is another reason why first quarter GDP turned violently negative. Home owners paid back record amounts of their home equity and mortgage loans. During the first three months of this year, the payback amounted to 3.5 percent of post tax income. A cool ₤8 billion was repaid to the banks.

Before the crash, home equity withdrawal was the engine of the UK economy. House prices went up, home equity increased and banks handed out loans to anyone who owned a home. These loans financed a consumption binge which kept taxes high and the rest of us in employment.

House prices are again picking up, and as they do, home owners gain equity, allowing them to take out loans. If prices fully recover, then the bubble back on. Banks can turn the tap back on and we can return to the good old days of asset appreciation and a consumption loaded lifestyle built on debt.

Bring it on; I can't wait.

The end of the big LTV mortgage

Anyone who wants to buy a house today needs to come to the market with a huge deposit. A year ago, around 60 percent of mortgage products offered customers the opportunity to borrow 90 percent or more of the house price. Today, that figure is a litte over seven percent.

The housing equity economic cycle

There is something sad about our dependence on home equity withdrawal. When it goes up, the economy booms; when it goes down, the economy dives into a recession. Our economic fortunes have become utterly dependent on whether house prices rise sufficently quickly for home owners to borrow and consume against their imagined increases in housing wealth.

However, under New Labour this dependence on home equity withdrawal reached grotesque proportions. The government and the Bank of England have risked everything on stabilising house prices and re-establishing household sector credit growth. They have forsaken fiscal stability, cut interest rates to almost zero and started to print money. Yet despite every crazy policy gesture, home equity withdrawal has not recovered.

Mortgage equity withdrawal - UK homeowners go cold turkey

Mortgage equity withdrawal was the engine of the UK economic miracle. Without it, UK households could not have kept spending. They needed the extra boost that came from borrowing money against the imaginary capital gain in their homes.

Between the summer of 1997 and March 2008, UK homeowners borrowed ₤325 billion against the value of their houses. In the last nine months of last year, households started to pay down this extraordinary debt. So far, households have repaid ₤15.6 billion, representing about 5 percent of the borrowing binge accumulated during the previous 10 years.

This is, of course, the insurmountable problem that Brown and Darling face. During the glory days of New Labour, the UK economy had become totally addicted to mortgage equity withdrawal. Brown and Darling would like to revive the habit, but UK homeowners are determined to go cold turkey.

The home equity housing bubble

(click on the chart for a sharper image)

The recent housing bubble was strange. The volume of sales didn't increase much, yet prices shot up. This lack of activity also features in gross mortgage lending data. Loans for house purchases remained comparatively flat throughout the bubble (see the chart above).

In contrast, home equity lending exploded. By 2007, it accounted for almost 40 percent of all mortgages. Of course, these loans fed straight into consumption. Homeowners, who are mostly middle aged, borrowed and spent, based on the illusion that they were rich because house prices were inflating. In the post-bubble world of 2009, this idea seems truly bizarre, but that is how things worked in early 2007.

Buy-to-let was the other major growth area for mortgage lending. By 2007, around a quarter of loans were financing small time property investment. Many of these investors were already home owners, who used the equity in their homes to provide collateral to dive into fully fledged speculation via the BTL market.

There is an interesting implication here. While the housing bubble generated a huge amount of personal debt, it is heavily concentrated among home owners. Renters never found it easy to get access to credit. Apart from college loans and some heavy credit card balances, young people are also comparatively free from debt.

So behind the government's banking sector intervention lurks a homeowner bailout. Brown wants banks to increase their lending, in the vague hope that house prices will stabilize and the home equity bubble can resume.

This bailout works against the interests of both renters, and the young. Higher house prices shuts out renters from home ownership, while huge bailouts puts the burden of paying for this mess on young taxpayers.

There will be some pay-back for this mess. One day, those young taxpayers will have to pay for the pensions of heavily indebted homeowners. I wonder how generous they will be?

(The chart comes from the FSA's Turner report)

The party is over

It isn't hard for an economy to grow when homeowners are supplementing their income by 5-8 percent with loans collateralized on rising housing values. However, that scam is over. Property prices are crashing, home equity is evaporating and the banks have turned the tap off.

For far too long, the UK depended on home equity loans to sustain consumption. The party is now over. The hangover has just begun.