(September 25, 2009)
Leverage is great on the way up and catastrophic on the way down.
Astute reader Scott pointed out that comparing housing to gold on a cash basis
missed real estate's key feature to the average homeowner: the leverage provided
by a mortgage.
(When Housing Is Priced in Gold
September 23, 2009)
That is indeed a critical advantage when housing is rising--and
a freight train slamming equity on the way down.
Here are Scott's insightful comments:
I enjoyed your article and I’m all for checking prices in terms of gold, and I hold gold
and hope that house prices get even cheaper, BUT, your article has a couple of key missing
aspects. (Not flaws, just uncovered relevancies.)
First: your article seems to presume that everyone buys homes in cash and never has a
mortgage. Almost no one can do that. Most people have a mortgage, and therefore they
have LEVERAGE (against the bank)—the homedebtor gets all the gain (or suffers all the
loss, normally) of any house price change.
So when I bought a house in 2002 and sold in 2007, did I lose money because the valuation
went down in terms of gold? NO! When I bought a house for X and wrote a check for about
.05X and paid in about another .10x and then sold it, I came out with a check for about
.7X, a 360% gain. Did gold nearly quintuple? No, I think it about tripled. Could I
have put X into gold and gotten .7X in gain? No, I only had .05X (and later another .10X)
to put in, had I not bought a house. (And, I’d still have to live somewhere.)
Would a bank have loaned my a full .95X so I could put it with my .05X and buy 1.0X of gold?
So even though my house price fell in terms of gold, I didn’t much better in the house.
(If houses get cheap enough, and gold holds, perhaps I will be able to exchange my gold
for a cash-house, in which case the direct price ratio may have direct relevance. Yay!)
(Precisely the reason why all the banks nearly failed, and some are still failing, is
because all this leverage in favor of homedebtors was AGAINST the banks (and banks’
future homedebtor customers)—ESPECIALLY when homedebtors started to foist the leveraged
LOSSED off themselves and onto the banks through default.)
The second problem with the topic of the article is that gold is a volatile commodity,
NOT a measure of basic purchasing power. Is gold at the “right” price now, relative to
something we all NEED, say, food or energy? Was it the right price in 1988? 2002?
2006? You only “make” money in gold if its price is rising RELATIVE to things you’ll
someday need to buy. If it only tracks such prices, it’s just a store of value, not an
investment. If it lags such prices, even if it is also rising, you are losing wealth.
No one NEEDS to own a house, or gold. They do need food and energy.
So if you put together a graph that takes into account the leverage of home loans
(mitigated, perhaps by the tax and maintenance expense) and another graph or the same
graph that takes into account prices of vital goods and services (not just the
flawed/understated CPI) I would be truly enthralled.
Thank you, Scott. While I cannot conjure up that particular chart, I do have a few
others which might be relevant. Let's start with a chart of nominal U.S. housing
prices, 1970 to 2009:
Judging by the substantial rise during the bubble and the modest decline from
bubble heights, we might conclude that homeowners still had plenty of equity:
Oops--household equity has dropped to levels not seen since the mid-1970s. So
the net result of the housing bubble on actual household wealth has been negative--unless
you count the $5 trillion extracted in mortgage re-fi's and home equity lines of credit.
And what did homeowners get of lasting value for that $5T?
I don't have the answer to that, but this chart reveals that homeowners with
negative equity ("underwater") are rising dramatically. Studies have supported
the common-sense idea that people with negative equity walk away from their mortgages
at a far higher rate than those with substantial equity.
Indeed, the "cure rate" of those who fall behind in their mortgages and then get
current again is an abysmal 3-6% for all mortgages--including prime.
Next up: what plentiful leverage has wrought:
The red box highlights historic averages of total debt to GDP from the end of the
Great Depression to the mid-1980s when the Reagan Era ushered in vast increases in
deficit spending, financial "innovations" and increased leverage (the S&L debacle, etc.).
As for gold being a volatile commodity: all commodities are volatile.
There is no one trade, store of value or metric which will retain purchasing power in
the face of fluctuating commodity, currency and asset prices. Housing has done no
better or worse than gold, depending on the time-frame you select.
As an exercise, let's price oil in gold:
As gold rose in value this year and oil dropped, the ratio fell to levels not seen
since the bottom in oil prices in the late 1990s. My point is simply that there is
no asset--housing, gold, oil, dollars, wheat, etc.--which is guaranteed to retain purchasing
power in a world of volatile assets, commodities and currencies.
If there is one conclusion to be drawn from the above charts, it's that leverage is
deadly once the bubble pops, and housing has been a disastrous "investment" for
tens of millions of households who have seen their equity destroyed by a leveraged
bet that "housing only goes up." True--until it doesn't. The same can be said of every asset.
Next up: Walt H. on the dollar:
Gold bugs like to think that the dollar must be backed gold. In other words, they want
South Africa, Australia and Russia to be the richest countries on Earth.
Our current money system is much better. It allows any asset to back the currency. When
money is "created" out of thin air by banks, and lent against collateral, that money
is essentially backed by the collateral. The debtor must obtain dollars, or lose his
collateral. Thus, we get a demand for the currency, all because of the millions of civil
contracts like mortgages, commercial loans etc. that keep demand for the currency high.
Amazing. Amazing that no one seems to understand this, yet, it's a perfect, and only
explanation for why the dollar is not already waste paper.
Like any system, it can be mismanaged, and by allowing lending in excess of the value
of the collateral (accounting for risk) the system has broken down. But this could occur
with a gold backed currency just as easily. Who is going to be doing the accounting on
the gold vaults? On the amount of currency in circulation? That's right, the same corrupt
politicians, regulators and bankers who caused the current mess.
I close with a comment by Harun I. on the intrinsic difficulties of managing
capital assets to retain purchasing power. "We have met the enemy, and he is us."
Hedge Funds and The Pareto Principle (February 19, 2007) for context.
Pareto's curiosity was sparked by the fact that the greatest amount of wealth was in the
smallest number of hands. His observation boiled down to: If you gave everyone in a society
one dollar, eventually 80% of those dollars would wind up in the hands of 20%. And of
course out of that 20%, 4% would hold 64% of the dollars. In this sense Nature's capitalism
is always at work. Money moves from poor managers to strong managers. Strong managers put
that money to use by investing in plant and capacity which puts people to work. Albeit
imperfect and prone to greed, when left alone it works better than socialism.
It has been my experience that nearly all of the people I know and have met have no idea
what to do with their money. Doctors, lawyers, engineers, government officials and even
money managers, all have no clue what to do with their money. Multi-million dollar lottery
winners are broke in short order. People in entertainment routinely die broke. Bubbles
come and go as they all chase the dream of something for almost nothing.
It is not under-education or an inability to think critically which part people from their
money, it is their uncontrolled emotions. Faced with purchasing a house which they know
is unaffordable or choosing to rent they will not bother to run the comparison as long
as it is their dream and "someone" told them they could. Had grumpy old Mr. Critical
Thought been allowed to show up and run a spread sheet or put the numbers into Quicken
they (the cold, emotionless reality of the numbers) would have irrefutably deprived
them of their "dream".
This drama plays out everyday at different levels across the spectrum of human psychology,
the food you should not eat because you are morbidly obese, the years-old but never
used exercise equipment in the garage, the spouse or partner who is abusive but you
can't leave, the dress, shoes, house, boat, car you have to buy but cannot afford,
the candidates we vote for because we like the way they part their hair. The
inconsistencies, contradictions and convolutions are endless and mind-boggling to the
point of madness to the observer.
Permanent link: Housing, Leverage, the Dollar and Purchasing Power
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