The Coming Crash
Whoever wins the US federal election (my money, if I was a gambling man, would be on Kerry) will inherit an economy with a ticking time bomb inside it, soon to go off.
The housing bubble is getting ready to burst. It might happen next week, or next month, or even next year, but it will surely happen. The bubble is a decade in the making, and a trillion dollars will disappear before it's over.
Average incomes have been stagnant for a long time and jobs are disappearing. However, consumer spending keeps increasing. The difference is made up by ever-increasing consumer debt levels and shrinking savings levels (household savings are around 1 percent).
The Fed has endeavoured to keep interest rates as low as possible to spur demand. At the same time, government lenders like Freddie Mac and Fannie Mae have made it exceptionally easy for consumers to get mortgages. This has produced an artificially high demand for houses and pushed up house prices. The perception that homes are a great investment only attracts more home buyers, which further pushes up house prices.
But since consumer purchasing power is stagnant, homeowners are driven to refinance their homes in order to obtain money, which puts them further in debt.
For example, let's say John, who works as a freelance programmer, buys a house for $100,000. After two years, it's worth $150,000, but John finds himself "between contracts". He refinances his home and lives on the $50,000 in equity for several months until he lands another job. Of course, he now has a $150,000 mortgage, but he goes from a fixed term rate to a floating rate, so his monthly payments don't really change.
After another two years, John's credit cards are maxed and he needs a new car. Having nowhere else to turn, he taps back into his home equity, since his home is now worth $200,000. It has, in fact, increased some 35 percent faster than the inflation rate. He gets to pay down some of his cards and buy a nice new SUV.
However, he now owes $200,000 on a house he bought for $100,000. The home hasn't become more productive; it contains no additional rooms or square footage; the view hasn't suddenly improved (in fact, the opposite is probably true as his surroundings fill up with more houses). Quite simply, his house has doubled in price without increasing in value.
John is unlikely to question where the other $100,000 came from. The fact is that the money came from nowhere, and it's only a matter of time until the money returns to the nowhere from whence it came.
This bubble must keep expanding to avoid collapsing under its own weight. For lenders like Fannie Mae, which has a debt to equity ratio of 78 to 1 (that is, it lends out 78 dollars for every dollar in equity it holds), it must draw in an ever-increasing supply of home buyers to keep investors interested.
You don't need to be an economist to see where this is going. Until now, those low interest rates and the promise of capital gains have attracted enough consumers to keep the system expanding, but interest rates are increasing - and that can only spell disaster.
When interest rates go up, it becomes more expensive to make mortgage payments, which discourages homeowners from "buying up" and scares away first-time buyers. As demand for new homes cools, builders must lower their prices. That scares away speculative buyers (people who buy houses and then flip them six months later to reap a quick capital gain), which further pushes down demand.
Then, existing houses start to lose value. At the same time, higher interest rates start to hit those homeowners in the pocketbook, especially since such a high percentage of homeowners are on variable rates. Banks get nervous when homeowners carry mortgages worth more than their collateral properties.
To return to our example, John suddenly discovers that he has a $200,000 mortgage on a $100,000 house. That puts him in dangerous financial terrain. Add in the fact that oil and gas are both at historic highs, and he may well find that he can no longer afford to carry his payments. Even if he sells his house, he will still be in hock to the tune of $100,000 - for which he will have no collateral.
John struggles on heroically until bad luck - a layoff, an illness, you name it - strikes, and he is forced to default on his mortgage and declare bankruptcy.
Now multiply John by several million.
In the meantime, the dollar keeps slipping against foreign currencies (it's lost a third of its value since 2001), foreign investors are losing interest in US T-bonds, the US federal government is running over $400 billion in deficit, most state governments are also in the red, the trade deficit is close to $600 billion, and the federal debt is $4.3 trillion.
Talk about a perfect storm: as American homeowners start defaulting and financial institutions take the hit from bad debts, the US economy will go into a tailspin and Americans will stop buying all the lovely manufactured goods they currently import from Asia. As a result, Asian markets will slow as well (although burgeoning domestic demand in Asia will mollify the effect of the US recession). The falling US dollar will further weaken American consumers' buying power, which will further harm the foreign markets that sell to it.
The result may well be a major worldwide recession. If that happens, it's only a matter of time until the oil producing countries get tired of selling oil for depreciated US dollars and make the switch to Euros, something they would have done already if not for the Iraq war. That will, of course, further devastate the US economy.
Another thing: since America imports almost two thirds of its oil, the price of oil will skyrocket in US dollars. When the price of oil goes up, everyone suffers: manufacturers, transporters, farmers, anyone who wants to stay warm during the winter, etc.
Of course, every cloud has a silver lining. With a massive, worldwide recession, the peak in oil production may be pushed back a few years as America's insatiable demand for oil finally ebbs.
November 2, 2004