Californians have become masters of the personal finance Ponzi Scheme. Today we will examine how it happened and how it works.
Asking Price: $399,000
Address: 51 Cartier Aisle, Irvine, CA 92620
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This Way — Dilated Peoples
This time I made up my mind
This time I’m back on my grind
I know there’s things in my life
That I’ma let go startin tonight
I can’t live my life this way
Imagine living in a world without consumer debt. The first credit cards did not appear until after WWII. Prior to WWII, if you wanted to buy something, you needed to save money from your wage income until you could afford to pay cash for it. There was an absolute dependency upon wage income to provide a lifestyle; living beyond your means was not possible unless you had previously saved money, and it could not continue beyond the day you went broke. Times have changed.
With the invention of credit cards, it became possible to borrow from future earnings to live better today–better than people can currently afford. Credit cards make it possible for people to live beyond their means. However, there comes a point when the future is now and the bills come due, and when that happens, people must live within within their means, minus the payments on the debt. Or does it?
If a new creditor is willing to loan even more money to the debtor, the debtor can use the borrowed money to pay back the previous creditor and continue to live the good life. Borrowing from one party to pay back another is the essence of a Ponzi Scheme. This can go on for a very long time if new creditors can be found and if the debtor can afford the debt service payments (Federal Government financing is a great example of a long-term Ponzi Scheme).
The creditors have to walk a fine line. Like any drug dealer, creditors want to give them enough product to keep them hooked, but they do not want to give them too much product to cause an overdose and death. In the credit world, an overdose leads to insolvency and an inability to service the debt. Insolvency often leads to bankruptcy and the loss of lender funds. The goal of every credit card vendor in the modern era is to maximize the debt service they can extract from each addict without killing them with insolvency.
Many spenders in California have entirely abandoned the idea of saving in favor of personal Ponzi Scheme financing. The idea seems to be that if you can keep borrowing long enough, you can die before the bills come due and avoid the inevitable period where the debts must be repaid. Some even come to believe this is a sophisticated method of financial management; Ponzi Scheme borrowing is lunacy of the highest order.
The system might have gone on longer if creditors had not completely lost their minds. New creditors entered the consumer finance arena by tapping the source of consumer savings securely trapped in the equity of their homes. This permitted consumers to pay off their previous credit card vendors as well as find an enormous source of new spending money. The impact of this new source of spending money created a set of circumstances where home ownership became extremely desirable thereby causing consumers to bid up the prices of homes. The higher home prices meant even more equity was available to spend, so creditors increased their lending to consumers. This made houses even more desirable. This feedback loop is part of the cause of the inflation of the Great Housing Bubble, and it explains much of the residual kool aid intoxication still present in our real estate market (buyers incorrectly believe appreciation and HELOC spending are coming back soon).
The Great Housing Bubble was a grand experiment in financial innovation. Lenders sought to find ways to loan even more money to people through crazy manipulations of loan repayment terms with loan programs like the Option ARM. Unfortunately, The Fallacy of Financial Innovation demonstrates that the loan programs developed during the bubble were not sustainable, and the entire Ponzi Scheme collapsed in a massive credit crunch. The collapse of this Ponzi Scheme is the source of our current financial woes.
Examine the graphic above. The first column shows a graphical breakdown of the income of a typical homeowner. Total home related debt (including taxes, insurance, HOA and other monthly expenses) is limited to 28% of gross income. Consumer debt including all other debt service payments is limited to 8%. Taxes take up about 24% (depending on income and tax bracket), and the remaining 40% is disposable income to cover the other expenses of daily life.
The second column shows what happens as people start to stretch to buy a home in a financial mania (charts are below). The increasing home debt reduces the tax burden a little, but the increased consumer spending and home debt takes a big chunk out of disposable income. The recession of the early 90s lingered for so long here in California because the people who bought in the frenzy of the late 1980s found themselves with crushing debts and greatly reduced disposable income. Prior to the increase in housing debt, this disposable income would have been spent in the local economy; instead, this money was sent out of state to the creditor who made the loan.
The big financial innovation–if you want to call it that–of the Great Housing Bubble was the nearly unrestricted use of cash-out refinancing and HELOCs to tap into home price appreciation. The third column shows the impact this new source of credit had on personal income statements. HELOC money allowed people to pay off their consumer debt while only modestly increasing their home debt. Since this income was untaxed (borrowed money is not truly income), the extracted money was entirely converted to disposable income. This incredible influx of disposable income caused our economy to explode.
Unfortunately, as is documented in the post Our HELOC Economy, the loss of this HELOC income is having devastating effects on local tax revenues and our economy. When you examine the personal income statements of borrowers in column four, you see that home debt and consumer debt have now become so burdensome that there is no longer enough disposable income to cover life’s basic needs; borrowers are insolvent.
The only solution to the problem of borrower insolvency is a monumental restructuring of both home and consumer debt. Realistically, the only way this is going to occur is through foreclosure and bankruptcy. We are not going to re-inflate this Ponzi Scheme because when sustainable loan terms are applied to real incomes, people cannot raise bids to sustain or inflate home prices–even with 4.5% interest rates. Without home price appreciation and subsequent HELOC borrowing, the Ponzi Scheme does not work.
The implications of this are clear; we are going to experience an extended recession bordering on depression here in California that is going to linger for many, many years. During this extended crisis, a significant percentage of California homeowners are going to face foreclosure and personal bankruptcy.
The collapse of a Ponzi Scheme is never pleasant, and that is what we are facing. According to Arthur Miller, “An era can be said to end when its basic illusions are exhausted.” The unsustainable lifestyles and illusions of wealth created during The Great Housing Bubble are exhausted; the era has ended.
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You have seen these charts before, I want to remind you of just how burdensome home debt became as a percentage of personal income during our last two bubbles.
Debt-To-Income Ratio, California 1986-2006
From 2001-2006, the median home price in Irvine increased by an amount equal to the median income. I want to remind you what a massive economic stimulus this was:
Mortgage Equity Withdrawal 1991-2007
And Calculated Risk has a chart tracking the rising personal bankruptcy rate since the new bankruptcy law was passed in 2005:
This trend will continue. In fact, it will likely get much, much worse as the recession, unemployment, and foreclosures take their toll.
Asking Price: $399,000
Income Requirement: $99,750
Downpayment Needed: $79,800
Monthly Equity Burn: $3,325
Purchase Price: $403,000
Purchase Date: 9/2/2003
Address: 51 Cartier Aisle, Irvine, CA 92620
| Beds: | 3 |
| Baths: | 2 |
| Sq. Ft.: | 1,450 |
| $/Sq. Ft.: | $275 |
| Lot Size: | – |
| Property Type: | Condominium |
| Style: | Contemporary |
| Stories: | 1 |
| Floor: | 1 |
| View: | Park or Green Belt |
| Year Built: | 1990 |
| Community: | Northwood |
| County: | Orange |
| MLS#: | S566730 |
| Source: | SoCalMLS |
| Status: | Active |
| On Redfin: | 46 days |
Fabulous ground level end unit three bedroom, two bath condo. Large eat
in kitchen with sliding doors out to a tranquil patio. Light and bright
home with neutral colors. Inside laundry and attached garage. All
pictures on the MLS are current.
Today’s featured property is a 2003 rollback.
- The property was purchased on 9/2/2003 for $403,000. The owner used a $322,400 first mortgage, a $80,600 second mortgage, and a $0 downpayment.
- On 6/22/2005 the property was refinanced with a $412,000 first mortgage.
- On 4/21/2006 the owner opened a HELOC for $148,000.
- Total property debt is $560,000.
- Total mortgage equity withdrawal is $157,000.
If this property sells for its current asking price, and if a 6% commission is paid, the total loss will be $184,940.
For this owner, the Ponzi Scheme is officially over.
BTW, I would like to call your attention to the newest blog in town: Irvine Homes. Erika Chavez of the OC Register is now writing a daily blog on Irvine real estate, and she has an interview with me posted today. Go check it out.
{book1}
This time I made up my mind
This time I’m back on my grind
I know there’s things in my life
That I’ma let go startin tonight
I can’t live my life this way
This Way — Dilated Peoples
Excellent post IR
Sorry to nit-pick, but the sizes of your color bars in your graph don’t match the numbers. In particular the “disposable income” category in the left-most bar is 40% which therefore should be larger than the 28% home debt. Likewise in the last one, the 15% disposable income should be larger than the 12% “other debt”.
Now, of course not all that income is really “disposable”, because food, transportation costs, health-insurance, etc are not exactly optional.
Yes, they are approximations. I couldn’t shrink down the consumer debt one to be small enough and make the type readable. Also, breaking down the disposable categories would have been more accurate, but I thought it would create more clutter than clarity.
Privately-owned condos and SFRs are trimming rental rates, as well.
Closed leases for Irvine per the SoCalMLS feed are tracked here:
Irvine Leases (Excel Spreadsheet)
Average closing $/sqft for Jan, Feb, and March 2009 were $1.61, $1.62, and $1.58 respectively. This was down from 2008’s numbers of $1.65, $1.67, and $1.63 for the same months.
Closing [b]sales[/b] numbers, with mortgage info, will be updated after the first few days of May.
Thanks, and good luck,
-IR2
trying again:
http://irvinerealtorsite.com/IrvineLeases2008.xls
I fixed the link. Thank you for the update.
Thank you for this!
Wow, that is like gold to me right now, thanks so much IR2!!!!
There is another part of the credit addiction which isn’t commonly mentioned. It’s the addiction of the shareholder of lenders, and those who invest in certain types of bonds.
Without investors providing capital, there wouldn’t have been a subprime problem. Without investors buying shares of now-insolvent lenders, they wouldn’t have existed.
Investing is typically a pursuit of the best returns, or of a particular mix of expected risk and returns. Investing is much different than choosing where to work. Many people don’t pay attention to what firms their pension fund or mutual fund invests in. They pay attention to returns.
Even worse, company shares come with voting rights. Shareholders have the power to: fire management they do not like; nominate management they do like (a very underappreciated but valuable power); vote on propositions; and submit propositions. Even the threat of certain types of ballot propositions sometimes change behavior. If Bank X had some vocal shareholder in 2005 saying “get out of subprime”, or even better “all loans require documentation of income and a downpayment”, Bank X might have changed its policies before this even made it to a shareholder vote.
Management and the press get a very clear signal if such a proposition passes: shareholders really care about this issue, if you get in their way you will probably get overruled or fired. The management of Banks V, Y, and Z will also take note, “Avoid no doc loans so I don’t get publicly embarassed, have my bonus cut, and may get fired”.
I have become cynical about the power of shareholders to influence management. Don’t most management teams have more than 51% of the vote tied up through proxies? I have always assumed management controls the board thus enabling them to pay themselves ridiculous sums and do whatever they please.
Here is an example of a proxy fight involving 5% ownership. http://www.complianceweek.com/article/2713/heinz-battle-offers-primer-on-proxy-fights
If you can get onto the agenda or into the press, often management starts making changes. Especially when you are focusing on something which is quite dangerous for the long term prospects of the company, you get a lot of attention. It removes plausible deniability for stupid ideas like no doc negative amortization loans.
If you have a student loan would that be considered Consumer Debt?
It would be as far as a lender is concerned. All debt service payments are included in the back-end DTI that a lender considers. Many people find they cannot get a large front-end DTI because they are carrying too much other debt.
Fleckenstein over at MSN expressed a sentiment I think the IHB community shares, but we often forget:
“…Poker as teacher
The patience required in investing is not so much the patience for sitting with a position after you establish it but the willingness to be patient beforehand. To quote my friend Jack McHugh (using a Texas Hold ‘Em analogy): “Waiting for more information allows a patient gambler to better know when to commit his or her chips. . . . There’s always another hand to be played, just as there will always be a new set of investment opportunities to consider”…” http://articles.moneycentral.msn.com/Investing/ContrarianChronicles/thank-uncle-sam-for-the-rally.aspx
Caveat – I don’t consider buying a home “investing,” but you can “lose” money by lacking patience when considering buying a home.
The home equity credit system is often looked at as a pyramid scheme. It can also be viewed as a way of printing money.
Printing actual cash bills is old fashioned, but what if you could create money out of thin air, and you weren’t the government? For centuries, there has been a line of thought that banks create money, often without individual banks or bankers realizing it.
The usual explanations of banks creating money involve making loans to people who buy things. The sellers deposit the money at another bank, which then lends most of it. That borrower buys some more stuff, and the process repeats.
However, the process behaves differently if the prices of the items being purchased rise, especially if the prices rise faster than interest rates. In that case, a Bank A lends to Customer B to buy a house. Seller C gets the proceeds and deposits them at Bank D. Then, there is a different thing happening. Bank E makes Customer B a new loan, for the same house. It’s a HELOC.
With a cashout refi or HELOC, the same collateral is now being used for a larger loan. Looser credit terms create more loans, larger loans, and higher prices.
Yes, HELOCs and cash-out refinancing is like printing money. In theory, bank capital is supposed to flow from pooled savings; however, if the “savings pool” is derived from artificially inflated home values, then there is no real savings being loaned. Appreciation is neither income or savings despite the fact that borrowers and lenders treat it that way. The resulting increase in money in circulation is a dramatic increase in money supply and results in stealth inflation and a reduction in value of real savings. Of course, when asset values fall, the process goes in reverse, and you have a contraction in money supply, deflation and an increase in the value of real savings.
I have long been an advocate of watching the cashflows of a potential transaction, or of a company, instead of looking at the accounting implications. As someone who knows accounting rules very well, I can tell you that a lot of them are quite misleading.
I am now experimenting with a different approach: don’t follow anything which is in dollars. Watch real variables like cars produced, how long people live, how many homes are in existence. This provides insights which are hard to get from accounting numbers, or even cashflow.
I’m getting some pretty interesting observations, I’ll share some over the next few weeks. Some of those have to do with what is “real” savings. Savings and investment as a way to “store” value is a longstanding problem in finance.
This post is so important because it touches upon so many deeper issues that led us to the mess we’re in today. I’ve watched as one friend bought a 2br condo for $800k, and they still cling to the illusion that they’ll sell for a profit soon. Other friends make less than half what we make and yet live like they make double. One family member bought a condo in a less desirable neighborhood for $400k with a sizeable down payment and just got laid off. All these people have one thing in common: they’re screwed, but they wouldn’t be if this crazy credit hadn’t been availble to anyone who could sign their name.
I love the drug dealer analogy. Unless we have major monetary policy reform in the world. I don’t see anything changing in the future. Except for more bubbles, more frequently, and more volatile.
Lets face it. Who can really make any significant amount of money unless they play the bubbles?
Re “Prior to WWII, if you wanted to buy something, you needed to save money from your wage income until you could afford to pay cash for it. ”
Actually, that’s not true – the payment plan was created in the 20s, some blame it for helping increase household leverage helping create the Great Depression
http://www.1920-30.com/business/instalment-plan.html
“As America and the world slipped into the depression of the 1930’s, those carrying too much debt were bankrupted, including many of the consumers enticed into debt by instalment purchases. Unemployment increased to unforseen levels and incomes were significantly reduced. It became impossible for many people to maintain repayments and as a consequence people walked away from their homes and farms, or sold their car, or returned goods to retailers. Landlords auctioned off what was left for rent arrears. The market was flooded with cheap items due to oversupply, so it was a buyers market if you had the cash. “
Very true. The fact that the current recession is the first one since the Great Depression created by lack of demand — too many goods had been produced due to phantom demand generated by consumption due to a credit bubble — is one of the things that scared people so much about this crisis. I don’t believe this is the Great Depression Redux but that simalarity was enough to scare the bejeezus out of the governments of the world.
Not to drop names, but I was reading Churchill’s “History of the Second World War” recently, and in his analysis of the causes of WWII the Great Depression was a major factor. His discussion of the causes of Depression itself is almost exactly what you just wrote — a consumer driven credit bubble. Reading the causes of the bubble and the Depression, I could have been reading about the world economy over the past five years.
The official inflation figures were quite low with the govt monkey business in setting CPI using large weight on home interest rates. From the 1990’s and 2000’s this lead to follow the leader with cooked books. Internet bubble, Enron bubble, housing bubble. Just look at the price of a car battery, gallon of milk, bread, vegetables from 1990 compared to today or last year. By the way regular (non-exectutive) wages have not keep pace with real inflation. Some people (mostly flippers, MEW’s) got rich at least for a time, but most were seeing less opportunity for themself and their children.
I agree that the index was not done properly. They followed a flawed method. My suggestion is to use the Case Shiller numbers and follow the original date of purchase.
This brings up a distinction between “cost of living” and price indexes. Since people do not buy a new house each month, the cost of living for homeowners is a mixture based on when they bought their homes. A similar survey to that used for renters could be followed. “How much are your house payments this month?” “How much is principal and how much is interest?” “How much are your property taxes?” etc.
Cartier Aisle??? Is there also a Tiffany Aisle, and a Louis Vuitton Aisle? How about a Wal-Mart Alley?
“Orange County cultural pathology” on display…
“The only solution to the problem of borrower insolvency is a monumental restructuring of both home and consumer debt.”
Won’t happen. Geithner’s TARP assumes that homes and consumer debt are properly priced. He asserts price declines reflect a liquidity paralysis induced by irrational panic.
TARP is meant to buff up bank balance sheets so the Execs can sell their shares at inflated prices.
The bankers are in complete control. When all is smoldering rubble they’ll fly off to a stable socialist country of their choice.
What we really need is socialism.
don’t worry it’s coming. But the rules of socialism will mostly affect the average, broke, sheeple.
“What we really need is socialism.”
No, what we really need is a revolution where we throw out the ruling Wall St./Washington oligarch which has found a way to enrich themselves at everyone else’s expense.
Perhaps in a couple of years when people are actually hungry and still out of work, we will be ready.
I hope the transition happens peacefully through the electoral process. I don’t recall too much social unrest during the Great Depression. I wonder if we will be as docile this time around.
Yes – [url=”http://www.theatlantic.com/doc/200905/imf-advice”]The Quiet Coup[/url]
I’ve been picking through that article over the last two or three weeks. It seems to hit the mark.
We had a score of socialism in the USA. It was privatization of profit (even if they were vapor, they were paid cash). Then the vapor cleared, the losses were socialized as with the 1990 hedge fund bailouts (Mexico), S&L bailout (remember Whitewater), Insurance (Insurance in the Gulf states – a contribution comes in handy), and now in 2000’s Insurance again (AIG) and retail Banks and Investment banks.
MalibuRenter,
The CPI and COL were rigged to use current drops in interest rate to “adjust for lower leading cost and monthly payments.” I know very few people who refinance yearly to take advantage of this lower monthly cost (only to rack up upfront fees such as points, title insurance, doc fees). During the 1990’s high end computers were used. What is the cost saving of purchase a new computer and software with 4 year old tech vs. cost 4 years ago. Transportation cost were also adjust for “longer life of cars.” I can partially agree with the latter, but the former adjustments were bunk to keep down COL adjustment for pension and wages.
IR,
You might have overestimate the 15% disposable income for the foreclosure candidate. What about food, insurance, transportation cost? They can cut down on clothing cost using Salvation Army Thrift Stores, but it’s very hard to cut down food, insurance and transportation to under 5% income unless you’re Jack Welch.
This post is very informative! every one should think of it.
IR:
I just read part of the interview on the site and i have 2 comments that i like to share with you.
1st, I did like it better when you were anonymus (go, spellingchecker, go! ;)) It had a certain flair to it 🙂
2nd I do like your blog a lot, It’s an unique perception of a housing market thats gone berserk.
And i’m hoping that “we” (house owners in the netherland) can learn from “your” mistakes. (never ever ever erver use your house as an ATM)
Keep it up!
Jump