Housing Boom, Bubble and Bust

Posted by PITHOCRATES - April 15th, 2013

Economics 101

Building and Furnishing Houses creates Great Economic Activity

Central to any booming economy are healthy home sales.  For home sales unleash great economic activity.  From the first surveys of a new subdivision.  To the new sewers and water systems.  Gas and telephone.  Cable television and broadband Internet.  Concrete for basements, driveways and sidewalks.  Structural steel (that beam in the basement and steel poles holding up the house).  Rough carpentry.  Electrical work and plumbing.  Drywall, windows and roofing.  Painting, flooring, doors and hardware.  Heating and air conditioning.  Lighting and plumbing fixtures.  Brick, siding and landscaping.  Etc.

All of this takes manufacturing to make these construction products.  All these manufacturers need raw materials.  And raw material extraction needs heavy equipment and energy.  At all of these stages of production are jobs.  Extracting raw materials.  Processing raw materials.  Manufacturing products out of these raw materials.  Building this production equipment.  Interconnecting these stages of production is every form of transportation.  Rail, Great Lake freighter, river barge and truck.  Requiring even more jobs to build locomotives, rolling stock, ships and trucks.  And jobs to operate and maintain them.  And build their infrastructure.  Filling all of these jobs are people.  Earning a paycheck that will let them buy a house one day.

Then even more economic activity follows.  As people buy these homes and furnish them.  Washers and dryers.  Refrigerators, stoves, microwaves, food processors and coffee makers.  Furniture and beds.  Light fixtures and ceiling fans.  Rugs, carpeting and vacuum cleaners.  Telephones, televisions, music systems, modems and computers.  Curtains, drapes, blinds and shades.  Shower curtains, bath mats, towels and clothes hampers.  Mops, buckets, cleaning supplies and waste baskets.  Lawnmowers, fertilizers, hoses and sprinklers.  Snow shovels and snow blowers.  Cribs, highchairs, diapers and baby food.  Etc.  All of these require manufacturers.  And all of these manufacturers require raw materials.  As well as transportation to move material and product between the stages of production.  And to our wholesalers and retailers.  More jobs.  More people earning a paycheck.  Who will one day buy their own home.  And create even more economic activity.

Bill Clinton pressured Lenders to Lower their Requirements and Subprime Lending took Off

This is why governments love housing.  And try to do everything within their power to increase home ownership.  Which is why they changed the path to home ownership.  After World War II when the building of subdivisions took off there was the 3-6-3 savings and loan.  Where savings and loan paid 3% interest on savings accounts.  Loaned money to home buyers at 6%.  And were on the golf course by 3 PM.  And the mortgage was the 30-year conventional mortgage with a 20% down payment.

The conventional mortgage was the mortgage of our parents.  Who had no problem putting off their wants to save money for that 20% down payment.  They prioritized.  And planned for the future.  But the conventional mortgage has an obvious drawback.  It limits home ownership to those who can save up a 20% down payment.  Pushing home ownership further out for some.  Or just taking that option away from a large percentage of the population.  So the government stepped in.  To help those who couldn’t save 20% of the house’s price.

Mortgage Qualification Decreasing Down Payment

As we lowered the down payment amount it allowed lower-income people the opportunity of home ownership.  But it didn’t get them a lot of house.  That is, those who could afford a 20% down payment could buy more house for the same monthly payment than those who couldn’t afford it.  And a house in a better neighborhood.  Which some said was unfair.  Some in government even called it discriminatory.  As Bill Clinton did.  Who pressured lenders to lower their lending requirements to qualify the unqualified.  His Policy Statement on Discrimination in Lending helped to fix that alleged problem.  And kicked off subprime lending in earnest.  Leading to the subprime mortgage crisis.  And the Great Recession.

Conventional Wisdom was to Pay the Most you could Possibly Afford when Buying a House

But lowering the down payment wasn’t enough.  Even eliminating it all together.  The people needed something else to help them into home ownership. And to generate all of that economic activity.  And this was something the government could fix, too.  By printing a lot of money.  So banks had a lot of it to lend.  Thus keeping interest rates artificially low.  And we can see the effect this had on home ownership combined with a zero down payment.  It allowed people to buy more house for the same given monthly payment.  Even more than those buying with the 3-6-3 conventional mortgage.

Mortgage Qualification Decreasing Mortgage Rate

Falling interest rates bring in a lot more people into the housing market.  Which is good for sellers.  And good for the economy.  A lot more people than just those who could afford a 20% down payment can now buy your house.  As people bid against each other to buy your house they bid up your price.  Raising home prices everywhere.  Increasing the demand for new housing.  Which builders responded to.  Creating a housing boom.  As builders flood the market with more houses.  At higher prices.  That new homeowners move into.  And max out their credit cards to furnish.  Creating a lot of debt people are servicing at these artificially low interest rates.  But then the economy begins to overheat.  And other prices begin to rise.  Leaving people with less disposable income.  The housing boom turns into a housing bubble.  House prices are overvalued.  Those artificially low interest rates created a lot of artificial demand.  Bringing people into the market who weren’t planning on buying a house.  But decided to buy only to take advantage of those low interest rates.

Conventional wisdom was to pay the most you could possibly afford when buying a house.  For all houses gained value.  You may struggle in the beginning and have to make some sacrifices.  Say cut out steak night each week.  But in time you will earn more money.  That house payment will become more affordable.  And your house will become more valuable.  Which will let you sell it for more at a later date letting you buy an even bigger house in an even nicer neighborhood.  But when it’s cheap interest rates driving all of this activity there is another problem.  For printing money creates inflation.  And inflation raises prices.  Gasoline is more expensive.  Groceries are more expensive.  As prices rise households have less disposable income.  And have to cut out things like vacations.  And any discretionary spending on things they like but don’t need.  Which destroys a lot of economic activity.  The very thing the government was trying to create more of by printing money.  So there is a limit to the good economic times you create by printing money.  And when the bad consequences of printing money start filtering through the rest of economy the government has no choice but to contract the money supply to limit the economic damage.  And steer the economy into what they call a soft landing.  Which means a recession that isn’t that painful or long.

The Price of Artificially Low Interest Rates is Inflationary Booms, Bubbles and Great Recessions

As interest rates rise home buying falls.  Leaving a lot of newly built homes unsold on the market.  And that housing bubble bursts.  Causing home values to fall back down from the stratosphere.  Leaving a lot of people owing more on their mortgage than their houses are now worth.  What we call being ‘underwater’.  And as interest rates rise so do the APRs on their credit cards.  As well as their monthly payments.  And those people who paid the most they could possible afford for a house with an adjustable rate mortgage saw their mortgage interest rates rise.  As well as their monthly payment.  By a lot.  So much that these people could no longer afford to pay their mortgage payment anymore.  As a half-point increase could raise a mortgage payment by about $50.  A full-point could raise it close to $100.  And so on.

Increasing Monthly Payment dur to Increasing Mortgage Rate

With the fall in economic activity unemployment rises.  So a lot of people who have crushing credit card debt and a house payment they can no longer afford lost their job as well.  Causing a rash of mortgage foreclosures.  And the subprime mortgage crisis.  As well as a great many personal bankruptcies.  Causing the banking system to struggle under the weight of all this bad debt.  Add all of this together and you get the Great Recession.

This is the price of artificially low interest rates.  You get inflationary booms.  And bubbles.  That burst into recessions.  That are often deep and long.  Something that didn’t happen during the days of 3-6-3 mortgage lending.  And the primary reason for that was that the U.S. was still on a quasi gold standard.  Which prevented the government from printing money at will.  The inflationary booms and busts that come with printing money.  And Great Recessions.

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Two Consecutive Negative Quarterly Growth Rates in Business Earnings say we’re in a Recession

Posted by PITHOCRATES - March 9th, 2013

Week in Review

Business earnings drive everything in the economy.  Every dollar a person spends in the economy came from a business.  From someone spending their paycheck.  To someone spending their government assistance.  Because business provides every tax dollar the government collects.  Whether from the business directly.  Or from their employees.  So business earnings are everything.  If they’re not earning profits they’re not creating jobs.  And the fewer people that are working the less tax revenue there is.

Lakshman Achuthan with the Economic Cycle Research Institute (ECRI) looks at business earnings and has found a direct correlation between the growth rate of business earnings and recessionary periods.  Finding that whenever there were 2 or more consecutive quarters of a falling growth rate in business earnings we were in a recession.  Business Insider has reproduced his chart showing this correlation as well as quoting from his report (see CHART OF THE DAY: A Stock Market Trend Has Developed That Coincided With The Last 3 Recessions by Sam Ro posted 3/6/2013 on Business Insider).

This is a bar chart of S&P 500 operating earnings growth going back a quarter of a century on a consistent basis, as we understand from S&P. Others can choose their own definitions of operating earnings, but this is the data from S&P. In this chart, the height of the red bar indicates the number of consecutive quarters of negative earnings growth.

It is interesting that, historically, there have never been two or more quarters of negative earnings growth outside of a recessionary context. On this chart, showing the complete history of the data, the only times we see two or more quarters of negative growth are in 1990-91, 2000-01, 2007-09 and, incidentally, in 2012. This data is not susceptible to the kind of revisions one sees with government data. The point is that this type of earnings recession is not surprising when nominal GDP growth falls below 3.7%. So, even though the level of corporate profits is high, this evidence is also consistent with recession.

Follow the above link to see this chart.

The stock market is doing well now thanks to the Federal Reserve flooding the market with cheap dollars.  Investors are borrowing money to invest because of artificially low interest rates.  So the rich are getting richer in the Obama recovery.  But only the rich.  For an administration that is so concerned about ‘leveling the playing field’ their economic policies continually tip it in favor of the rich.  Who can make money even if the economy is not creating new jobs.  Which it isn’t.

All of these recessions can be traced back to John Maynard Keynes.  And Keynesian economics.  Playing with interest rates to stimulate economic activity.  The 1990-91 recession was made so bad because of the savings and loan (S&L) crisis.  Which itself is the result of government interventions into the private economy.  First they set a maximum limit on interest rates S&Ls (and banks) could offer.  Then the Keynesians (in particular President Nixon) decoupled the dollar from gold.  Unleashing inflation.  Causing S&Ls to lose business as people were withdrawing their money to save it in a higher-interest money market account.  Then they deregulated the S&Ls to try and save them from being devastated by rising inflation rates.  Which the S&Ls used to good advantage by borrowing money and loaning it at a higher rate.  Then Paul Volcker and President Reagan brought that destructive high inflation rate down. Leaving these S&Ls with a lot of high-cost debt on their books that they couldn’t service.  And while this was happening the real estate bubble burst.  Reducing what limited business they had.  Making that high-cost debt even more difficult to service.  Ultimately ending in the S&L crisis.  And the 1990-91 recession.

Fast forward to the subprime mortgage crisis and it was pretty much the same thing.  Bad government policy (artificially low interest rates and federal pressure to qualify the unqualified) created another massive real estate bubble.  This one built on toxic subprime mortgages.  Which banks sold to get them off of their books as fast as possible because they knew the mortgage holders couldn’t pay their mortgage payment if interest rates rose.  Increasing the rate, and the monthly payment, on their adjustable rate mortgage (ARM).  Fannie Mae and Freddie Mac bought and/or guaranteed these toxic mortgages and sold them to their friends on Wall Street.  Who chopped and diced them into collateralized debt obligations (CDOs).  Sold them as high-yield low-risk investments to unsuspecting investors.  And when interest rates rose and those ARMs reset at higher interest rates, and higher monthly payments, the subprime borrowers couldn’t pay their mortgages anymore.  Causing a slew of foreclosures.  Giving us the subprime mortgage crisis.  And the Great Recession.

In between these two government-caused disasters was another.  The dot-com bubble.  Where artificially low interest rates and irrational exuberance gave us the great dot-com bubble.  As venture capitalists poured money into the dot-coms who had nothing to sell, had no revenue and no profits.  But they could just as well be the next Microsoft.  And investors wanted to be in on the next Microsoft from the ground floor.  So they poured start-up capital into these start-ups.  Helped by those low interest rates.  And these start-ups created a high-tech boom.  Colleges couldn’t graduate people with computer science degrees fast enough to build the stuff that was going to make bazillions off of that new fangled thing.  The Internet.  Even cities got into the action.  Offering incentives for these dot-coms to open up shop in their cities.  Building expansive and expensive high-tech corridors for them.  Everyone was making money working for these companies.  Staffed with an army of new computer programmers.  Who were living well.  The brightest in their field earning some serious money.  So they and their bosses were getting rich.  Only one problem.  The companies weren’t.  For they had nothing to sell.  And when the start-up capital finally ran out the dot-com boom turned into the dot-com bust.  As the dot-com bubble burst.  And when it did the NASDAQ crashed in 2000.  When it became clear that all of President Clinton’s prosperity in the Nineties was nothing more than an illusion.  There would be 4 consecutive quarters of negative growth in business earnings before the dust finally settled.  One quarter worse than both the S&L crisis and the subprime mortgage crisis recessions.

And now here we are.  With 2 consecutive quarters of negative earnings growth under our belt.  Based on this chart this has happened only three times in the past 3 decades.  The 1990-91 recession.  The 2000-01 recession.  And the 2007-09 recession.  Which if his theory holds we are in store for another very nasty and very long recession.  No matter what the government economic data tells us.

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