In the previous post I discussed anchoring and how it affects our personal finance decisions. In this post I’ll look at how anchoring’s is exacerbating the current housing crisis.
Most commentators agree the housing bubble was caused by a combination of factors including speculative fever (prices will only go up), overleveraging (requiring 0% down and no asset verification in the worst cases) and fraud (both by mortgagees who lied about their income and assets and lenders who fraudulently enticed owners to take our first, second and third mortgages with misrepresented terms). Add to the mix that many homeowners drew down their equity in attempting to maintain a standard of living that their incomes could no longer support.
That was then; this is now: Homeowners and banks are both falling victim to anchoring errors. Until these are corrected, the economy will have a difficult time making much forward progress. Homeowners with positive equity (market value less mortgage is positive) are still anchoring on what they paid for their home. When evaluating a job offer in a different area, they decide they cannot afford to sell because they have lost money on their house. They fail to recognize that the money has already been lost whether or not they sell. This makes it harder for geographical imbalances in the labor market to correct.
In every market downturn, anchoring on historic housing prices lengthens the duration of the imbalance between asking prices and selling prices. Sooner or later, the strength of market forces brings the prices together and market stability returns.
The strength and length of the housing bubble means that the adjustment process will be longer than usual. The number of foreclosures that have and will occur has generated another perverse reason for lengthening the turmoil: the company that services the mortgage only earns money while the mortgage exists AND they earn even more money when it goes through foreclosure proceedings. The mortgage itself may have several owners as part of the Collateralized Mortgage Obligation market. The mortgage servicing agents have little incentive to reflect the economic interests of the homeowner or mortgage owner over their own.
A short sale in which the mortgage owner writes down the value of the mortgage to the net sales price might be the best thing for both homeowner and mortgage holder, but it stops the cash flow for the mortgage servicer and is therefore rejected. Even when the mortgage servicing agent and owner are the same financial institution, the employees are from separate departments and their compensation structures are not aligned to overall corporate goals, but to departmental goals.
In the meantime these two anchoring forces have bumped heads and eventually underwater homeowners realize they have already lost all of their equity. They reset their anchor and understand anything they pay to the bank is throwing good money after bad. They stop paying on their mortgage, ultimately being evicted from their house through foreclosure. They also stop paying real estate taxes, and maybe insurance too; both costs provide no benefits to them. The mortgage servicer ends up with increased fees and the mortgage owner doesn’t get his money until the house is eventually sold, usually at a much lower price than market value. By the time a house is foreclosed, the owner is usually over a year in arrears.
I’m a big fan of the blog Calculated Risk. It has frequent posts on the housing market and my extrapolation of their charts and graphs implies that we are still at least three years out from foreclosures returning to “normal” levels. The results of these overhangs are that housing prices continue to slip, and because of the excess inventory (supply greater than demand) new construction is at record lows as a percentage of housing stock.
The good news is that current construction is near all-time lows for housing stock. Continued population growth (and eventual household formation) means that demand will grow to meet supply and the dearth of new construction will hasten that day.
However, construction is usually a key driver of new jobs in economic recoveries. Job growth has been anemic is this recovery, largely (but not entirely) because of the paucity of new construction. New construction employs not only builders, but those who supply building products, appliances, etc. The leveraging of one new job within our economy has the effect of creating four or five total jobs.
Economists may determine economic cycles based on increases and decreases in macroeconomic statistics such as GDP (gross domestic product) or perhaps the more indicative GDI (gross domestic income). Nominal GDP is higher now than it has ever been. Even real GDP (nominal GDP adjusted for inflation) is near or at an all-time high. So what’s the problem?
People (voters) based their understanding on microeconomic values. Can they buy as much as they used to? NO. Are they being paid higher wages for the same amount of work? NO. The population continues to grow and per capita GDP is still below all-time record levels. And remember, we humans anchor at the best of times…
But wait a minute: if that’s all true, why is it that I noted in my last post that at the end of April 2011 my net worth had almost returned to its all-time high? (Note: May and the first few days of June have not been as kind and perhaps April will turn into a new temporary anchor for me!)
Loosely speaking, stock markets have done well because corporate profits have soared. Bond markets have done well because the Fed has kept interest rates very, very low. These corporate profits have not been uniformly distributed across the economy—only those with substantial assets have benefited. Real wages continue to decline for most working Americans; corporate executives, for whom real wages are once again increasing, are the exception.
In the next post, I’ll talk about why this imbalance, unless corrected, will put a hobble on the economy.