By Jack Sparrow
From the NYT, "Debts Rise, and Go Unpaid, as Bust Erodes Home Equity":
PHOENIX — During the great housing boom, homeowners nationwide borrowed a trillion dollars from banks, using the soaring value of their houses as security. Now the money has been spent and struggling borrowers are unable or unwilling to pay it back.
The delinquency rate on home equity loans is higher than all other types of consumer loans, including auto loans, boat loans, personal loans and even bank cards like Visa and MasterCard, according to the American Bankers Association.
We are now seeing something new, and shocking — traditional debt service priorities have been turned upside down. The average American is more likely to ditch the mortgage than the credit cards.
Not to get all Mad Max on you here, but to see hard evidence of this phenomenon is genuinely alarming. The system as we know it — and by “system” I refer here to the vast, subtle and highly complex network of borrowing and lending relationships that collectively finance the US economy — is breaking down.
From Repair Mode to Survival Mode
Why say this? For a couple reasons. First off, think about more traditional, or “normal,” debt service priorities. In a functioning system, no one in their right mind would think about letting go of the house before the boat or the credit cards or the car.
This is because the mortgage is generally the largest obligation, and thus one of the most devastating hits to the credit profile when let go. It’s also because there are varying orders of magnitude in terms of credit delinquency and cultural shame… and ditching the house trumps them all.
In a functioning system, strapped borrowers would retain normal debt service priorities — letting go of the smaller obligations first — because in the back of their minds they would be focused on a path to rebuilding and repair.
When a borrower lets go of the house first, however, that says a few things:
- The overall situation is seen as hopeless and beyond saving.
- Given the above, immediate survival measures become the highest priority.
- Ditching the house becomes a logistical and strategic decision…
- While keeping up the cards / personal loans etc. provides access to cash.
In other words: When it’s all going down in flames, what do you do? You hunker down and hold on to what you can, for as long as you can. And you abandon traditional considerations, like repairing credit and getting back in good standing, as naive and too far gone.
The Evaporation of Trust
We can see evidence of this systemic breakdown more clearly by examining the actions of three different groups — investors, homeowners and banks.
- Investors are piling into US Treasuries and super-safe corporate debt (i.e. debt issued by iron-sided blue chips seen as close to risk free), with a willingness to accept insanely low yields that suggests faith in economic recovery has been lost.
- Homeowners, as noted in the NYT piece, are increasingly giving up on the hope of returning to a functional credit system and instead going into a sort of “cash survival” mode, throwing the ballast of large obligations over the side and retaining whatever access to immediate liquidity they can.
- Banks, like their bluechip corporate brethren, continue to more or less sit out the economic recovery and hoard cash, quite possibly as a rational response to 1) the bleak economic outlook in respect to mid-tier lending opportunities and 2) the leverage and bad loan booby traps still buried deep in banks’ books.
Combine the above three elements — investors taking an opt-out by funding those who don’t need the money, homeowners going “Mad Max,” and banks ceasing to functionally participate in the revival of the broad economy — and what you get is not only a classic liquidity trap profile, but an evaporation of trust within the system.
Trust is very, very important. As an invisible and hard to articulate concept, the importance of trust can hardly be underestimated.
Hernando de Soto wrote an excellent book on this subject called The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else.
The title of de Soto’s book should probably be revised, as capitalism has now gained strong footholds outside the West. But capitalism within the West is struggling, as a result of evaporating trust and vanishing faith in the ability of the credit system to function.
To sum up de Soto’s point very roughly, dynamic economies are built on a foundation of trust and property rights. The willingness of economic participants to trust each other, and to engage in mutually beneficial transactions without fear of being fleeced — and without excessive red tape — is precisely what enables a dynamic economy to function smoothly.
And so, when we see glaring evidence of a loss of trust and faith — on the part of investors, homeowners, and banks alike — that is a huge warning sign.
How Did We Get Here?
And just how did we get to this juncture? How did so many homeowners get up the creek without a paddle?
Through the old and predictable path, as laid out by Ludwig Von Mises (the father of Austrian economics) long ago: Boom expansion brought about by credit expansion.
From the same article:
"I am not going to be a slave to the bank,” said Shawn Schlegel, a real estate agent who is in default on a $94,873 home equity loan. His lender obtained a court order garnishing his wages, but that was 18 months ago. Mr. Schlegel, 38, has not heard from the lender since. “The case is sitting stagnant,” he said. “Maybe it will just go away.”
Mr. Schlegel’s tale is similar to many others who got caught up in the boom: He came to Arizona in 2003 and quickly accumulated three houses and some land. Each deal financed the next. “I was taught in real estate that you use your leverage to grow. I never dreamed the properties would go from $265,000 to $65,000.”
The system is breaking down, as the Austrian school long ago predicted it would, because of a massive and ongoing debt buildup that, at least for a time, was encouraged at every single level — Washington and Wall Street, public and private.
And thus, after a long unbridled romp with Keynesian psychology, the mother of all “Austrian tails” could be coming up around the bend. As Ludwig Von Mises said:
There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
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