Monday, May 18, 2009

Mortgage Bubble About to Burst?

Millions of Americans are heavily burdened with first and, in many cases, second mortgages. People reached for "the American dream" of owning their home-but often a home somewhat beyond the reach of their incomes. Additionally, they pulled needed cash out of home equity through refinancing. Who controls these loans? What do creditors receive in return for their money? Are we about to experience a financial restructuring on a world scale with shocking consequences for the United States?
by Melvin Rhodes

The Old Testament book of Deuteronomy warns Israel of the consequences of disobedience to God's laws. The Israelites were given a choice-they could obey God and be blessed or disobey God and suffer the inevitable consequences.

One of the blessings for obedience was that Israel would "lend to many nations, but...not borrow" (Deuteronomy 28:12). The reverse would happen if the Israelites disobeyed: "The alien who is among you shall rise higher and higher above you, and you shall come down lower and lower. He shall lend to you, but you shall not lend to him; he shall be the head, and you shall be the tail" (verses 43-44).

America is clearly starting to reap the negative financial consequences of disobedience, as a recent article in The American Conservative shows. Written by San Francisco financial analyst Robertson Morrow, the article is titled, "Living With the Bubble" (Feb. 10, 2003).

"As a percentage of personal income, mortgage debt has risen from 51 percent 25 years ago to over 100 percent today," points out Mr. Morrow. "In the last 5 years, mortgage debt has risen by 60 percent, or $2.2 trillion, an amount roughly the same as the profits of every American corporation for the last five years and twice China's exports to the entire world."

In a society where debt has become a national way of life, does this really matter?

Mr. Morrow says it does. "One problem with borrowing all this money is that people might not be able to pay it back. Another is that, for the foreseeable future, Americans will be spending a large proportion of their income on debt service. This will constrain consumer spending-two thirds of the economy-which will retard economic growth for the remainder of the decade. Slow economic growth will inhibit income growth, preventing us from earning our way out of the hole into which we have dug ourselves."

Housing has been one of the few sectors of the U.S. economy that has been doing well.

Lower interest rates have encouraged new homebuyers, while at the same time those already owning their own homes have refinanced their mortgages, often enabling them to get further into debt with new purchases. This cannot go on, as Mr. Morrow shows.

Refinancing has its limits

"Moreover, at some point, we will exhaust the supply of money available using homes as collateral. In 2001 and 2002, Americans extracted $300 billion in cash from their existing homes through refinancing and home equity loans. This infusion of cash is what has fueled rising consumer spending in the face of recession.

"Why did a rational capitalist society choose to lend people too much money, and why did rational capitalist Americans choose to borrow more than was good for them?

"Three reasons: The first is that the federal government dominates mortgage borrowing. The second is that modern finance has made it easier to succumb to the human temptation to borrow now and worry later. The third is that foreigners have-perhaps naively-been willing to lend Americans whatever we wanted. In short, American capitalism has been corrupted by government subsidies, value-free modern finance, and globalization."

Ominously, Mr. Morrow adds: "As Americans have increased their debt to finance the greatest consumer spending spree in the history of the world, we have become one of the most indebted people on the planet. Near the center of this degeneration is the transformation of the home mortgage from a means of savings to a means of spending."

When the bubble bursts and house values fall, millions of Americans will be in deep trouble. Much of their debt will be owed to foreign nations, America's former debtors turned creditors.

"An indispensable aspect of the debt binge is the willingness of foreigners to lend us the money. Not only is 20 percent of mortgage debt sold to foreign banks and other foreign buyers outright, but modern finance has made all liquid instruments de facto fungible. Even when foreigners buy other American financial assets, they are propping up a market of which mortgages are a part. Take the foreign buyers out of the equation and the whole thing collapses, and plentiful, cheap mortgage debt is no longer available to Americans."

In other words, Americans have become dependent on the willingness of foreign banks to continue their lending to a people already awash with too much debt. Well, Mr. Morrow did say that they were "perhaps naively" continuing to lend.

"Without foreign buyers, the wave of cash-out refinancing and home equity loans would reverse, and we would return to the normal mode of gradually paying down mortgages."

The banker has become the borrower

There was a time when the United States loaned to other nations. During both world wars American banks loaned money to the British and others when they most needed it to continue their war effort. After 1945, the American Marshall Plan helped Europe to recover from the ravages of war. America continued to invest in and loan to other countries.

It was the Vietnam War that began the big debt problem. The unpopular Vietnam War was fought without any increase in taxation at the same time as expanding social programs were introduced by the federal government. The rising costs of both put pressure on the dollar and, by 1971, the United States had to forego the link between the dollar and gold. No longer could people around the world rely on America to back up the dollar with gold on demand at $35 an ounce. For the last 30 years the U.S. dollar has been unredeemable currency, relying solely on confidence to maintain its value, its real worth unsupported by the precious metal.

In recent years, America's foreign debt has increased rapidly, receiving very little attention at home. While concern is expressed about the federal budget deficit-the difference between the amount the federal government receives in taxation and the amount it spends-the growing trade deficit has hardly been noticed. Yet, December's trade deficit was over $40 billion, the highest on record and the biggest trade deficit of any nation in the history of the world.

Ideally, a nation will balance its total trade with other nations. That means it will sell to others goods to the same value as what it buys. Selling more equals a trade surplus, selling less is a trade deficit. As Americans overspend on foreign goods, the money used has to go somewhere. Some is used to buy up American companies or land while a great deal of the rest is simply loaned to Americans, ironically enabling them to refinance their mortgages, spend the money saved and get even deeper into debt.

As Mr. Morrow puts it: "The foreign-debt bubble, and therefore the mortgage bubble, is a necessary consequence of our trade deficits. When we run a trade deficit, foreigners are giving us their goods not in exchange for our goods but in exchange for something else of value. Subject to trivial quibbles, this can only be two things. The first is foreign investment: when we give them a factory in America or a claim on a factory in America. The second is debt."

Simply put: "One necessary consequence of the present trade mess is that America is inexorably becoming a nation of debtors and other nations-principally Japan and her Asian imitators-nations of creditors. What this really means is that an entire society (ours) has become biased in favor of consuming things, while others have become biased in favor of owning things."

This also means that other countries have the power to pull the plug on the U.S. economy. What would be the consequences of this?

Potential global financial restructuring

"The global money market is a fickle lover. Once money stops blowing into a debt bubble, the bubble bursts, and no financial intervention can restore it. Just ask the Malaysians, the Russians, the Argentineans, or the U.S. telecommunications industry."

Bringing it down to the consequences for American homeowners, Mr. Morrow states: "What does this mean for the individual homeowner? The imprudent will suffer. Debt will become harder to assume, housing costs will fall, and consumer spending will sag. Those who refinanced to extract cash, took out a second mortgage, bought more house than they could afford, or failed to save, risk deep financial pain when the housing bubble bursts. Homebuyers depend on their jobs to make their mortgage payments, and the economic contraction caused by a squeeze on consumer spending will put those jobs in jeopardy. Even the prudent will suffer due to the irresponsibility of others: one's financial mistakes are not solely one's own business.

"Risk to the global financial system is even greater. For the first time in financial history, a major debtor nation owes its debt in its own currency. This means that rather than exporting goods to buy foreign currency to repay that debt, we can just print the money. We inflate the dollar to pay off foreigners in money that is not worth very much. Creditors will oppose destroying the dollar, but they lack the political clout of millions of American debtors. This opens the possibility of major inflation or polarization of the American political system between those serving the interests of foreign creditors and those representing American mortgage-holders. Neither is an attractive possibility, for either means the U.S. economy should be prepared to take a bubble bath."

Mr. Morrow may be overly optimistic when he writes, "creditors will oppose destroying the dollar." Since World War II, the U.S. dollar has been the preferred currency of international trade and finance. However, the dollar's recent slide in value against other currencies reflects a lack of confidence in the U.S. currency, partly due to the trade deficit and war jitters. At the same time, the increased value of the euro, the one-year-old European currency, shows increased confidence in the new currency, increasingly in demand around the world.

The bursting of the American debt bubble will impact the major creditor nations adversely along with the United States itself. The creditor nations are "Japan and her Asian imitators." A major reversal in the American economy would naturally affect these other countries first and foremost.

All nations would be affected, but the nations of the European Union would be impacted least. The euro could easily take over from the dollar as the world's major trading currency. By default, Europe would become the only engine capable of pulling the world economy out of recession.