THE MORTGAGE TIME BOMB

      The financial media has regularly reported that housing has held up well during this economic downturn, and the refinancing of mortgages continues to run at very high levels. The follow-on logic is that, unlike investments in the stock market, American's net worth as measured by their investment in their homes is intact; and lower interest rates (which allow the favorable refinancing of mortgages) provide additional resources for the consumer to keep spending. While most people accept this information at face value as a positive event, it is misleading in its simplicity and hides a serious structural flaw in our economy.

      First of all, housing is a lagging indicator. To say that housing starts and housing prices are holding up well says nothing about the immediate or long term future. Only after business slows down and companies start to experience an earnings shortfall do we see a cut in capital spending, a freeze on hiring, and then ultimately layoff announcements. And only after layoffs have taken place, and people have used up their severance benefits and emergency savings, do we see pressure on housing because of mortgage foreclosures. But beyond the normal lag in the cycle of pricing that occurs with the fluctuation in demand (that is a direct result of the fluctuation in general economic growth), there has been a structural shift in the use of mortgages that has created a time bomb for housing and the broader economy.

      For the generations prior to World War II, mortgages were not as readily available as today. A 50% down payment was often required in order to obtain financing, and the terms and conditions of the note of indebtedness were draconian. The misery of those who lost their homes during The Great Depression taught a generation of Americans that debt is bad.

      After World War II, with the creation of the Federal Home Loan Administration, loans to veterans, and other government programs, mortgages became easier to obtain, less severe in their foreclosure provisions, and more desirable in an environment of high income taxes. But the generation of homeowners in the 1950's and 1960's still treasured the goal of being able to pay off the mortgage and ultimately own their property free and clear. It wasn't until the 1970's and 1980's, when inflation was at its peak, that having a mortgage became almost a prerequisite to owning a house. The concept of financing home ownership has become so institutionalized (much the same way that financing an automobile purchase has become the norm), that little thought is given to actually paying off the mortgage. House payments, car payments, and credit card payments are simply the American way of life. Current generations have been brainwashed into a "buy now, pay later" mode of operating. Instead of the traditional goal oriented savings programs of our forefathers, modern financing promotes instant gratification. This is not necessarily a bad thing in a stable or growing economy, but it has the potential for disaster in a recessionary economy or a depression.

      Homeowners no longer own their property. They only have a claim on the remaining equity in their property after all debts and taxes are paid. The ease of obtaining high loan-to-value financing has both reduced the general level of equity in people's houses and helped inflate the cost of housing. In the competition to purchase, it is much harder for the average person to come up with additional cash out of pocket than for someone to pay a little more each month on a mortgage. The seller will always sell to the highest bidder, and that person will usually be the person with the best access to financing. The viability of this structure for home ownership is clearly dependent on two factors: 1) The ability of the homeowner to continue to make mortgage payments, and 2) The price of the property staying at a level that is higher than the total indebtedness on the property. Because financing introduces leverage into the system, the danger is at the margin where demand and ability to pay meets supply and price. A very small shift at the margin can cause a sudden collapse of the entire structure.

      As a growing population and a growing economy has met with a finite amount of land and increasing restrictions due to zoning and environmental concerns, the net result has been upward pressure on the cost of housing. However, we have reached the point where demand has started to diminish because the cost of housing has moved beyond what is affordable for many people. As the economy slows down, demand will decrease further as fewer people have the economic strength to purchase a house. In the meantime, some of those people who already own homes will lose their job and ultimately lose their house. As desperation sales hit the market and mortgage foreclosures increase, there will be downward pressure on prices. Unfortunately what would normally be only a small event at the margin can rapidly escalate into a major collapse because of the downward spiral that is created by the inverse leverage of falling house prices. A 10% drop in property prices would be a very survivable event if all residences were owned free and clear. But in this era of financing, a 5% or 10% drop in property price may mean a 100% loss of homeowner's equity. Home ownership today is similar to stock ownership in 1929 when many purchases were made on 95% margin. A slight drop in prices can start a devastating downward spiral.

      Thus, when you hear that mortgage refinancing is running at record levels, do not assume that this is a good thing. When the reports show that a high proportion of refinancing involves the homeowner taking additional equity out of his property, this is an indication that a time bomb is being put in place that has the potential to destabilize the economy to a much greater degree than anyone in the popular media is currently forecasting.