Greenspan’s Interesting Clarity
Chuck Ponzi September 2nd, 2005
I must admit that in recent comments, it appears that Mr. Greenspan has truly removed the gloves with respect to the housing bubble. While I remember the days of the mid 90’s where Alan’s comments were both cryptic and couched in complex thoughts that rarely a journalist could decipher his comments. Recently, I found that I have no troubles understanding one of his most recent and clear comments about housing asset price inflation. I will take an excerpt here:
“This vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent… But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low-risk premiums.”
Without being too pedestrian, it’s pretty clear that his “conundrum” has turned into both a bit of fear and a bit of “I told you so”. While so many blame the current asset price inflation on Alan’s own reaction to potential deflation, some of the more egregious problems were caused by ourselves. We have started a debt culture.
This debt culture has created a potential to fail in the future that our country has not seen since the 1920’s. While the stock market crashed in 1929 due to overleveraged stock market participants who were forced to liquidate under decreasing prices to cover losses, much of the same could happen over a much longer period in the US. Japan provides us a sobering look at deflating home prices for the past 14 years. Purchasing 15 years ago there would mean financial ruin for you and your family. The US has an even more transitory population: we move for jobs regardless of where we were born, our employers will lay us off without societal repercussions, and widespread personal transportation allow us more mobility than the Japanese. We also have a higher ownership rate (70% compared to 60%) This increases the churn of homes in the US because Japan does not encourage first-time homebuying like the US (only 13% of 25 to 34 year olds own in Japan compared with 40% in the US). Statistics courtesy of our good friend David Lereah. Therefore, a more liquid market would more likely experience faster and more dramatic asst price appreciation as well as depreciation. All of this points to the fact that US homeowners are more likely to simply walk away from depreciating assets if job losses, sickness, or other economic hardships occur.
Where does this lead us? Well… we’re acting a bit like the japanese in our debt lending by accepting low risk premiums, and the longer this goes on, the greater the risk to all participants, lenders and borrowers. If liquidity were to be suddenly shored up by investors demanding a greater return for thier risk, or if percieved risk were to suddenly jump, borrowing would become much more difficult for buyers. Interest rates will increase accordingly. Even established buyers might not be able to purchase homes due to restricted risk premiums; all of which will only serve to slow the real estate market and put the power of purchasing into well qualified buyers.
It has been my assertion that the housing bubble was caused not by low interest rates, but by excess liquidity that banks could only farm out by lowering lending standards. It was this easy credit that was extended to a whole set of the population that had never before been entrusted with credit; this caused “neverending” demand. Much like college students that max out their first credit card, only to find that the payments exceed their income, many of today’s buyers will be unable to make payments in the future.
Our little “deflationary concern” may soon turn into a financial meltdown since problems tend to spiral: Increases of forced sales trigger lower prices, which triggers lower spending and more foreclosures; lower spending triggers more layoffs; foreclosures trigger financial losses for banks and MBS holders; financial losses triggers less liquidity; less liquidity triggers higher interest rates; which triggers more defaults on ARMs and HELOCs… the list of effects could go on forever. Our economy is increasingly dependent on house price appreciation, but 2 things keep these trees from growing to the sky.
1. Credit has limits, since some risk premium must be attached to borrowing money, and interest must be charged. Investor sentiment is everything here.
2. Even a leveling off will decrease construction jobs that will kick-off the above process, so increasing growth is necessary to keep the merry-go-round going.
I am asking you for your thoughts about the potential of a financial crisis due to excessive borrowing during the housing boom. What do you think the risks are to our economy?
