Addicted To Debt / Household Formation Slowing

Posted by urbandigs

Fri Mar 13th, 2009 12:50 PM

A: It should be no surprise to anyone that Americans were addicted to debt well before the housing bubble even began. Buy now and worry later was a way of life. But when the debt piling started to come from home equity extraction, we went from dangerous to nuclear. I discussed Mortgage Equity Withdrawal (MEW) over twenty times since mid 2006 here, but Calculated Risk should get top honors for showing why we had a debt problem on our hands and the role MEW played. The main point to take from all this is that while asset prices fall due to deflationary pressures, the debt remains! Understanding this reality should put your near term future view on this consumer driven economy into perspective. The drugs (new debt through extension of credit without savings/equity to back it up) are being taken away from us, and the withdrawal (asset price declines) is here. In the end, this is a necessary part of the process of becoming clean. For now, let us understand the addiction to debt first.

Over time the population grows, that we know. As the population grows, there is usually rising household formation that tends to have a positive trickle effect on the overall economy as the house is outfitted with products/services. First time home buyers generally have put 20% down on their homes, but for the period of the boom that reached 0% down in part because of the theory that home prices never go down. Those who have been in their homes for longer periods of time, built up substantial equity, which is why the average % of homeowner equity has tended to be above 50%. Not any longer. Rolfe at OptionARMageddon.com shows us the following chart on "% Homeowner Equity":

mew-homeowner-equity.jpg

Because of the rising home prices, owners extracted equity (MEW) from their asset to be used for consumption - and banks were more than willing to offer their fee based re-financing/HELOC services. Now the asset's value is about to plunge! Consider what happens to percentage of homeowner equity in the home when the VALUE of that home falls, yet the debt remains or worse, rose higher. That is what the above chart tells us and it is not a strong foundation to build a new, sustainable consumer driven economic recovery on. But don't take my word for it, Rolfe adds a 2nd chart on "Outstanding US Debt by Sector":

slide18.jpg

That's a debt problem! The consumer balance sheet must correct itself through saving, frugality, bankruptcy, rising income, paying down or outright elimination of the debt; just like a corporation would. Think this is a quarter to quarter adjustment?

In the parabolic period, we had an easing of lending standards, cheap & easy money, and an increase in exotic loan products which allowed home transactions to take place with substantially lower up-front down payment requirements. Buyers were starting out with little to no equity in their homes, and that was basically unheard of prior to the early 1990s; before PMI insurance became widely available. It's amazing how government sponsored programs may catalyze the development of new free market products, for better or worse - in this case, the FHA low down payment programs for new homeowners leading to a broader free market solution to buy a home with bad credit and little to no income history. Of course, wall street took it too far proving once again that we are demons of our own design.

As the housing downturn matured (its getting close to being a 3-yr veteran by now), we are finding that household formation is slowing. Why? Let us not forget the level of immigration that had occurred as a direct result of the housing/credit boom, and the surging need for construction workers to build those new homes. The main drivers for household formation is jobs, demographics, and immigration trends; and we got two strikes right there between jobs & immigration trends. According to a recent US News & World Report article, "Household Formation: 2009 Housing Head Wind":

Slowing Household Formation: At the same time, the pace of new household formation is slowing, which further chips away at housing demand. Richard Moody, chief economist at Mission Residential, says the development is linked to three factors: More singles are moving in with each other, young adults are returning to live with their parents, and fewer immigrants are entering the country. "For those three reasons, you are seeing a slowdown in the rate of household formation," Moody says. "And to the extent that the economy and the labor market remain weak this year—which I think they will—then that's going to continue."
Now the process is in reverse. It reminds me of the fiber optics craze of the dot com boom/bust - when bandwidth demand was perceived to be exponentially growing with no end in sight for the exploding internet.

Back to housing, the desire to own a home went up with rising prices/ez-money/no money down, and the desire to own a home is declining with falling prices/tighter lending standards/elimination of exotic loan products. Add in those that forcibly lost their homes due to foreclosure, and we get a dose of what is really going on out there. We were operating under the assumption that household formation was growing at 'X' pace (I believe 1.2-1.5 million homes annually for the US is normal under growth conditions), when that number was a fantasy number boosted by the euphoric boom. This is why when a market tops, it always goes down more than you think! Think back to the rise & fall of JDS Uniphase and Ciena in 2000 - 2002, for the fiber optics analogy - it was a doozy for those playing the game back then.

Slowing household formation is one lagging indicator showing the core of this crisis. The series of purchases that occurs with rising household formation, should ripple through the economic system; yet now we see the reverse effect. Using debt for consumption rather than for productive means has its disadvantages, and unfortunately the corrective phase is not anywhere near as fun as the debt driven party. The pain will run deep for those that mis-used debt and their home as an ever-lasting ATM machine, which is why I think the household deleveraging phase will last far longer than the financial sector one.

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