Is America's Cash Cow Headed for the Slaughterhouse?
Posted on 07/08/2007, 06:23
By Dana Nicholas
Sparked by low interest rates, the housing boom has played a key role in fueling the economy for the past several years. As the housing market collapses, consumer spending tightens.
Not long ago, homeowners across the U.S. used the lure of historically low interest rates to reduce monthly mortgage payments and take equity out in their homes. As the housing market gained steam and the value of homes continued to rise dramatically, many owners dipped into the equity pool time and again.
But homeowners failed to ask themselves some vital questions: What would happen if they could no longer obtain extra cash by accessing the equity in their home? How were they going to afford house payments when interest rates on their adjustable rate mortgage began increasing? And even worse, what if the value of their homes declined?
Instead, they were blissfully using equity in their homes to pay off other debts, put the kids in summer camp, buy new cars, and fix up the house. Each increase in the value of their home meant more money to spend ... a never ending stream of riches.
But it was a money supply that never would have existed without inflated housing prices and low interest rates. It was an illusion of wealth with nothing to back it up.
Ultimately, for the past several years American spending habits have been sustained through the use of credit.
Home Equity – America's Cash Cow
There is no question that the massive credit wealth created by the accessibility to home equity spurred consumer spending and fueled the economy.
Earlier this year, a study by former Fed Chairman Alan Greenspan and Fed economist James Kennedy showed that close to $5 trillion in "free cash" was obtained from home equity extractions from 2001 through 2005.
The term "free cash" identifies cash available to the homeowner net of closing costs and mortgage debt. This is money that was used for consumer spending, home improvements, to purchase other homes, and acquire other assets.
By comparison, during the prior five-year period – 1996 through 2000 – the amount of "free cash" generated by home equity was less than half of that … just under $2 trillion.
Bottom line: By the end of 2005, approximately $3 trillion in additional home equity had been added to the pool of economic wealth since the beginning of 2001.
Free Cash has its Price
Higher interest rates, slack lending standards and predatory practices in the subprime arena have all led to the demise of the booming housing market.
Because of the recent downturn in real estate, the biggest problem confronting homeowners today is that many of them now have negative equity in their homes.
If their homes are not worth what is owed on them, these individuals will be unable to refinance as ARMS resets occur … and may not be able to afford the steep rate adjustments. This is true both in the prime and subprime mortgage markets.
Even if there is enough equity to remortgage at lower rates, lending standards are in the process of being scrutinized and tightened. This is occurring just as many homeowners are finding they need to refinance now more than ever, because they can no longer afford their existing mortgage.
This is a tough enough situation for prime borrowers. Throw subprime into the pot, and those who are most in need of a new mortgage are going to be squeezed out of the housing market entirely.
According to RealtyTrac, an online foreclosure data provider, more than 1.2 million foreclosure filings were reported in 2006, up 42% from 2005.
Even worse, first quarter 2007 data showed more than 430,000 foreclosure filings during the first three months of the year … up 27% from the previous quarter. In fact, RealtyTrac stated "The nation's quarterly foreclosure rate of one foreclosure filing for every 264 households was the highest quarterly foreclosure rate since RealtyTrac began issuing its report 27 months ago."
The worst part of it is that many individuals who are now losing their homes to foreclosure owned their homes outright prior to taking out loans against them!
Free cash? I don't think so.
The Equity Frenzy is Over
It is estimated that approximately $2 trillion in adjustable rate mortgages (ARMS) will be resetting in 2007 and 2008. And the Center for Responsible Lending (CRL) estimates that: "2.2 million households in the subprime market either have lost their homes to foreclosure or hold subprime mortgages that will fail over the next several years. These foreclosures will cost homeowners as much a $164 billion, primarily in home equity."
With personal savings at the lowest they have been since the Great Depression, a dwindling ability to access home equity, and a rapid rise in defaults, we are starting to experience a halt to the spending free-for-all that has sustained the economy for the past several years.
Worse yet, despite optimistic speculation earlier in the year, the U.S. housing debacle has recently caused a ripple on Wall Street, and is now showing definitive signs of global impact.
That's a double whammy for the economy, because at the same time that America is losing it's cash cow, investors -- both foreign and domestic -- are becoming skittish and starting to pull money out of U.S. markets.
Although there aren't a lot of options for cash-strapped homeowners at this point, smart investors can start looking at promising global investments to keep their portfolios intact and continue to make profits during the fallout.
Stay tuned for articles on alternative investments to help you build your own cash cow.