The old saying: “The riches and wealth are in my house,” is true, but when it is time to buy a home, make sure you understand the process and have the extra financial resources to do it.
News that the Federal Reserve is considering a new $1 trillion round of quantitative easing is being accompanied by new data showing the ratio between home equity and disposal income is at a historic low.
This unprecedented ratio is all-important in a credit society since it demonstrates that expansion possibilities are limited to non-existent if American consumers cannot borrow.
Since there has not been significant personal wealth created over the past decade, this new ratio is especially unsettling for specific segments of the economy (housing, durable goods, leisure, entertainment, travel, luxury items) and indeed, the entire U.S. economic system.
In some parts of the U.S., homeowners owe 40% to 50% more than what their house is now worth. Most of these homeowners will never close this gap. In effect, this makes these unlucky homeowners prisoners in their home homes, at least as far as unlocking the potential appreciation potential which drives all real estate sales.
This is a nightmare for millions of homeowners, which spills into the overall economy. The reason: borrowing from home equity fuels purchases and new consumption. With the home equity wealth engine offline, and no other wealth creation vehicles filling the gap, long-term growth prospects are weak.
While foreclosure and defaults offer some remedy and are commonly used by commercial real estate developers who fall into similar circumstances, the social stigma has kept many individual homeowners from taking that step, even though it may make financial sense.
Even the Mortgage Bankers Association, which publicly discourages mortgage defaults for all borrowers, quietly negotiated a short sale of its Washington DC headquarters by selling it for $34 million, according to James Surowiecki, of the New Yorker magazine.
Falling Home Equity Ratios
In a new paper written by Andrew Wilkinson, chief economic strategist at Miller Tabak, the ratio between home equity to disposable income has fallen to 54%. Wilkinson called the drop in this ratio a visit to “unprecedented” territory.
Another view on the importance of housing was offered by Vincent Reinhart, the chief U.S. economist at Morgan Stanley. In one communication, Reinhart said, “Obama Administration officials have come to realize that the ongoing dysfunction in the mortgage market is a key impediment to sustained expansion.”
This “dysfunction” is deep, disruptive, and corrosive to the millions of homeowners, who owe more on their house than it is worth. To make matters worse, portfolio returns over the past decade have been increasingly volatile.
The S&P 500 index of large domestic stocks has been virtually flat since the technology bubble burst in 2000. The annualized return for the S&P 500 from Jan. 1, 2000, to Dec. 31, 2011, was 2.42%, according to SeekingAlpha. In 2011, the S&P 500 ended the year at 1,257.60 compared with 1,257.64 in 2010. This 0.0032 percentage change was” nearly the index’s smallest change — positively or negatively – ever, according to MSN Money.
All this hurts household net worth, a key measure of American family financial security. Over the past three to four years, the combined losses in the wealth-generating engines (home equity, portfolios, savings, salaries) have caused household net worth to drop by $2.45 trillion to $57.4 trillion, according to the most recent Federal Reserve’s flow-of-funds report.
To accommodate their decreasing wealth and acknowledge their pessimism, Americans reduced their debt in the third quarter of 2011 for the third straight year, according to Federal Reserve data.
This puts new meaning into the financial service industry’s use of the phrase “wealth management.” More accurately, it should be called “wealth re-creation” since that is what needs to be done today.
Adopting this new phrase may seem a minor point, but language is a powerful force, and professionals who hold themselves out as “wealth managers” in 2012 have erected a high hurdle to clear if they do not produce real results. Better to accept this new reality than create false expectations.
After all, it is the small things (transparency, fee disclosure, objectivity) that will help rebuild credibility in the financial services industry.