Weekend Reality (Realty?) Check

We know how we got here, right?

First, let's define an "affordable house."

That is a house that has a price of no more than three times your pretax (gross) income.

Second, let's define an "affordable mortgage."

That is a mortgage that is initiated with 20% down, a "front end" (or housing costs - principal, interest, taxes and insurance - "PITI") ratio of no more than 28%, and a "back end" (or DTI - that is, all debt service requirements including your house) ratio of no more than 36%.

These are the underwriting guidelines that have proven safe over more than one hundred years of experience.

Now here's the problem, as is nicely illustrated by this chart:


(click the chart for the "full size" copy in a new window)

Remember, this is inflation-adjusted money.

You can also look at this right side scale a bit differently. Divide by roughly 50 and you get "price to income".

Notice how price to income has typically hovered around the 2-3x annual income level? It has gone lower - during the years of the roaring 20s and the Depression, it was in fact quite a bit lower - but after WWII when the boomers showed up, until the "irrational exuberance" era, it has never been materially over 2.5x income.

Now its 4x.

Now let's run some "money scenarios":

Today's 30 year fixed mortgage is running around 6-3/4%. Let's say we have a $200,000 house, 20% down, so we are financing $160,000. How much is the payment?

Principal and Interest on that loan is $1031,95.
If interest rates rise to 8%, the payment goes to $1,166.25
If interest rates rise to 10%, the payment goes to $1629.49
If interest rates fall to 5% (the historical low even when Greenspan cut FedFunds to 1%) your payment is $855.35.

Note that this does not include insurance and property taxes. Assume $1,000 a year for insurance (unless you live in a high risk area like Florida, then it could be double that or more) and property taxes are all over the map - from $1500 or so all the way up to $5,000 or more, depending on where the house is. We'll assume a "lower" tax and "normal" insurance environment - so add $250 a month for both insurance and tax escrows.

Ok, this puts your monthly "nut" between $1100 and $1900, depending on interest rates. With today's rates, its around $1,300.

On a conservative lending basis this means you need ($1,300 / 28%) or $4,642.85 in pretax monthly income to buy the house, or an annual pay of approximately $56,000.

You must also not have more than $371.43 worth of additional debt service in order to stay within the 36% "back end" ratio.

The latter is a killer. $371.43 is pretty much one car payment for many people, especially those who "consume larger than their means." But don't we need two cars these days? How many car payments can you find for $175, and then what about credit cards?

Remember, you need enough left after your debt service to be able to pay the heating and electric bill, the water bill, the trash collector bill. You need gas for your car and food to eat. You need to buy clothing. If you have children, they need food, clothing and school supplies. You need to be able to pay for routine medical expenses not covered by "insurance" (which is another fraud all on its own, but out-of-scope for this posting.) All of these things consume money, and all of them are "needs", not "wants". Finally, you need to be able to put aside some amount of money for an "oh shit!" fund (e.g. your refrigerator breaks, your car drops its transmission, or you get laid off and need enough money to be able to find a new job) and you need to put aside something for your retirement (if you think the government will take care of it... well, that's yet another fraud!)

In reality a person living "today's lifestyle" can't buy a $200,000 house on $56,000 in income. They could if they were conservative with the rest of their life, but they're not.

That's reality.

These ratios are not subject to wild revision because some politician wants it that way. They are what they are!

Now the "Big Lie" that the Media and especially the financial engineers and the Realty Boards have told repeatedly - and gotten away with - is that "we can fix this with some fancy financing."

The truth is that more than one hundred years of financial experience in this country says that's bullshit.

What has happened over the last seven years is that after the 2000 stock market implosion (which was itself caused by fraud and our government's willful refusal to prosecute the wrong-doers until their firms blew up, taking your money with them) Alan Greenspan, prodded along by lawmakers (so he claims anyway) attempted to prevent a recession by lowering FedFunds to 1%.

We still got a recession, but not nearly as bad as it could have been.

What we got instead was far worse.

"Hot money" started chasing houses. This drove prices up beyond those conservative guidelines above. Those who owned houses during this period saw their values double, triple or go even higher. This felt real good.

Unfortunately real wages for the bottom 80% of the earning public did not keep up with actual price inflation. Not the phony-baloney CPI printed by the government, actual price inflation. See, food and energy prices have been going up consistently for more than ten years. But - we ignore that in our "official computations." In fact, in my home, a grocery basket that cost me $100.00 seven years ago now costs more than $200. Yet we're told "inflation expectations are well-anchored." Uh huh.

But we "felt" wealthy. During the boom I literally had Realtors banging on my door uninvited telling me that they had "clients" who wanted to buy my home - at 4x what I paid for it four years prior! While some areas of the nation were somewhat insulated from this phenomena none were totally immune.

Many Americans, under pressure with their REAL income, started taking this "wealth" out of their house and spending it. They refinanced into risky mortgage products or took HELOCs to "consolidate your credit card debt." Of course they didn't cut up the plastic at the same time, but rather kept repeating this cycle. We were told that house prices never go down.

The problem with this, of course, is that even if its the truth you have turned home OWNERSHIP into yet another fraud! This one is particular pernicious and nobody is talking about it - not lawmakers, not regulators, not the media.

That fraud is simple - You don't own something if you can never pay off the debt. If your consumption is financed by continued withdrawal of appreciation, you will never have a clean deed to your property!

Perpetuating this FRAUD and taking it to a whole new level we now have REVERSE MORTGAGES where instead of dying with no debt at all your house becomes your piggy bank in your retirement years and you die with absolutely nothing but a big fat smoking hole in your personal balance sheet!

Now there's nothing particularly wrong with renting your living quarters. In fact, its a perfectly valid option.

What is fraudulent and criminal is telling people that "home ownership is the American Dream" when in fact you are actively putting forward programs that insure that those Americans never really own their home; they are simply renting their house from the bank!

There is in fact only one way to solve the problem with Home Affordability.

House prices must fall, on average, 50% in constant dollars from the 2005 peak. In certain "bubble" areas they will fall more.

There is simply no other fix that will actually work.

Now home prices are falling. This cannot be stopped.

The Consumer, now scrambling to find some way to continue to pay the bills, has shifted his spending TO CREDIT CARDS. The latest credit report says it all - revolving debt increased eight percent last month - a rate that was sixteen times the rate of wage growth. This continues a trend that has been on an absolute tear since the housing market started to turn downward and it is extremely dangerous for the American economy.

What's worse is that we've allowed pervasive fraud to permeate Financial Firms who are now using the very same vehicles that ultimately sunk ENRON!

I am speaking specifically about "SIVs" and "Conduits" - that is, off-balance-sheet investment vehicles that are absolutely opaque to regulators and investors.

This needs to be criminalized as it is a clear and blatant end-run around the regulatory capital requirements that banks and other regulated entities live under.

These "balance sheet games" are why the 23A exemption letters were granted by The Fed - an incredibly STUPID act that knows no parallel since the Great Depression. The correct course of action for regulators to take was instead to refuse to issue the 23As and demand that all off-balance-sheet vehicles instead be accurately reported and reflected in regulatory capital requirements.

There is no way for investors, regulators or anyone else to be able to accurately know what a firm's financial picture looks like if that firm can hide potential or actual liabilities off its balance sheet!

This has made an absolute mockery out of Sarbanes-Oxley, not to mention just good common sense. If a firm wants to either lend more money than regulatory capital permits or simply lie about the liabilities they carry and/or insure all they have to do is create a "SIV" or "Conduit" and PRESTO - it totally disappears off their balance sheet! The problem, of course, is that the liability is not really gone, and if it "comes back" really bad things happen.

LIKE ENRON.

What has happened to this point today is that Ben Bernanke and his "buddies" have cut "FedFunds" by 50 basis points, which the Market "cheered." Fact is, the bond market has actually priced money higher than it was prior to Bernanke's "intervention" and what's even worse the dollar has been debased by more than four percent in the last month!

Now let's talk about what paths are available both to government and private industry as we work this problem.

If intervention continues to prevent home price declines we will get all of the following:

• Massive real inflation. We're already suffering from it, but it will get worse. Much worse. The dollar is under severe pressure already and there are many economists and market technicians who expect it to fall all the way to FORTY over the next few years. This is a raw cutting in half of the dollar! What does that mean? It means that everything we buy that is imported will double in price. DOUBLE! The start of this is already evident as we have debased our currency by four percent in less than one month!
• Wages will not keep up. The middle class in this country will be destroyed. Their real purchasing power will decline by fifty percent or more as debt service overwhelms them.
• Approximately half of all our Treasury Debt is held by foreigners. As they take haircuts on the principal value of those investments of up to 50% from today's levels - remember, they've already lost 20% in the last three years - they will demand much higher interest rates to buy any MORE debt or roll over what they have now. Since our government continues to insist on raising the debt ceiling and spending more and more money, the real cost of money in the form of interest rates will rise precipitously, no matter what the Fed does. This is already happening in the bond market and it will get much worse. Since the Fed cut rates the 10 year interest rate has actually RISEN. Foreign holdings of our debt have decreased. That is the real cost of money and its going the wrong way. All of this is due to the intentional act of Ben Bernanke in bailing out the Investment Banks who had made bad bets - acts which he "protected" when he cut Fed Funds and issued the 23A "exemption" letters to SIX large banks.
• Foreign governments will "depeg" from the dollar, the dollar will be replaced by a more stable currency for oil sales, and we will be effectively "cut loose" economically. While the United States remains a "powerhouse" of consumption we run the risk of seeing that become less and less relevant over time as our ability to actually spend will be unable to keep pace with inflation and currency depreciation.

In short, home prices in "constant dollars" will decline anyway, but along with the decline we will destroy the middle class of this nation and ultimately its competitiveness.

If, on the other hand, we defend our currency by raising interest rates and immediately revoking the 23A exemption letters outstanding we will get the following results:

• House prices will correct to roughly 2000/2001 levels in absolute dollars. Those homeowners who purchased during the last two or three years will be underwater and many of them will default on purpose; some will be unable to pay, but others will simply mail the keys to the mortgage company.
• Those firms that too inappropriate levels of risk by buying these CDOs and other instruments will be screwed. They will be forced to eat the losses that should accrue when risky bets go bad. Some of them will fail outright; this is a desirable outcome, not a bad one. Those who make risky bets in the market must be allowed to fail or there is no way for investors to properly price RISK.
• The homeowners who are foreclosed upon will become renters for a while. However, in a couple of years, once they have had time to live "clean" of the default, their credit will begin to recover and they will be able to buy either their original house back or another similar house at half the price it formerly was! We will replace UNSTABLE housing markets with STABLE ones.
• The Middle Class will be protected. With a strong dollar our debt will be desirable as capital appreciation will be the rule for foreign holders. They will thus want to hold our government notes, demand will increase, real interest rates will fall and our Middle Class will continue to enjoy a reasonable cost of living.
• Inflation will be forced downward, protecting real purchasing power, which is particularly important for our middle class.
• Mortgage lenders will be FORCED to write only solid, defensible loans. Why? Because they will have in front of them the consequences for not doing so.
• The equity markets will correct. The S&P 500 currently has a huge percentage of its earnings represented in "financials" which made most of their money not through conservative banking but rather through equity stripping from America's Middle Class! This will "go away" as those banks are forced to eat these losses and they will cease engaging in these practices. This will result in a significant market correction - but once it has occurred, true growth will return to America's equity markets.
• Productive actions inside the US will become rewarded instead of punished. Today, the most profitable thing for a company to do is to sell outside the US because of currency translation. We have also, through these same policies, promoted offshoring everything! A strong currency reverses this incentive - now the incentive is to produce HERE and improve productive capacity INSIDE THE UNITED STATES. This is how real value is created for America.

In short, we stand at a crossroads. Our government and our citizens - you and I - have allowed "The Pigmen" on Wall Street to literally strip trillions of dollars of wealth from Middle Class America and transfer it to themselves.

We have enabled this by chasing speculative bubbles, eschewing regulation and encouraging cheating. We are all responsible and we can either buck up and stop this or we will watch our nation come under increasing pressure and our Middle Class disappear.

Fact is, this is up to us, not to those on Wall Street or in Congress.

If Congress will not act, then we must. We must act politically to literally "throw the bums out." Sentiment shows time and time again that America "hates Congress but loves their Congressman."

This is wrong folks.

Your continued silence is why we have a housing mess on our hands. Your desire to get something for nothing - an impossibility - is why we are here.

Either we get off our collective asses today and demand that Congress enact all of the below - right now - or we will see the "bad" scenario play out. "Tax the Rich" won't fix it, nor will more tax CUTS. The problem is not tax policy - it is willful refusal to deal with outright fraud in our financial system.

To fix this Congress must do all of the following:

• Stop lying to the American People. "Home Ownership" is indeed part of The American Dream, but you do not own your home until it has no mortgage on it! Therefore, serial refinancing, HELOC-taking and speculation are not part of Home Ownership. Neither are "subprime mortgages." Only conservative mortgage underwriting is part of The American Dream.
• Prosecute those who were involved in equity stripping and false advertising. No mortgage advertisement should be legal if it implies or references "The American Dream" unless it is a CONSERVATIVE mortgage that actually leads to a clean-deed ownership of the property. If current law does not make this an indictable offense, we need new laws. These deceptive practices simply must stop.
• DO NOT - under any circumstances - bail out the mortgage companies and the investors who purchased their paper. Failure must be allowed and irrespective of the damage done to these firms, it has to be work its way through on its own.
• ALL off-balance-sheet "conduits", SIVs and other such vehicles must be banned. Any contingent liability that is associated with a bank or other firm must be accurately and completely reported. Did we learn ABSOLUTELY NOTHING from Enron's implosion?
• Force qualification of mortgages on the highest rate to which it can reset over the life of the loan under Federal Law. There ARE legitimate reasons for people of high net worth to use "interest only" and "Option ARM" loans, but for 90% of Americans they are a debt trap and do not lead to actual home ownership, as there is no way for the borrower to ever pay off the mortgage!
• Reinstate Glass-Steagal. Repealing this act was absolutely asinine and it needs to come back on the books as US Law - right now.
• Aggressively prosecute any and all who "leak" inside information and those who trade on it. If the US Attorney's office will not immediately start subpoenaing trading and phone records associated with the "surprise" discount rate cut, along with the front-running of the Fed Funds rate cut, we need a special prosecutor. Ditto for the outrageous "Bear Stearns/Buffett" rumor. The data is easily accessible both for the phone records and for trading records. TIME TO START THE PERP WALKS if you expect Americans to TRUST the financial markets.
• Demand that the recent interest rate cuts are reversed and the 23A Exemption letters be revoked. If Bernanke refuses to do so immediately then Congress needs to exercise its authority under The Constitution to regulate our currency and, if necessary, remove him. It is absolutely imperative that our currency be defended to prevent rampant inflation and the destruction of our middle class.
• If you want to try to protect homeowners amend Bankruptcy law so that all mortgage debt can be discharged in a personal bankruptcy, and that all "short-sale" differentials are exempt from taxation. That will provide very effective protection for homeowners who effort to "unscrew" themselves.

The choice is ours folks. We can either act TODAY or we can forget about our Middle Class and economy.

This is not something we have the time to do "when we get around to it."

We either act now, as Americans, or we write off The Middle Class.

What can you do?

You can start by going over to http://www.senate.gov/ and http://www.house.gov/. Look up your Representatives and Senators and fax them a copy of this letter.

Then call them and make sure they got it. Make sure they understand - you absolutely will vote next year according to their actions (or lack thereof.) Congress understands only one thing - the loss of their jobs!

Then, and this is the most important part - get 10 of your friends to do so as well.

Simply put - America must come to understand that if we do not act now tomorrow will be too late.