Monday, December 24, 2012

Macro-economic 'bubbles popping'

By now, every person on the planet already knows about the housing bubble that effectively eliminated middle-class 'wealth' in the United States and most other developed nations.  I added quotation marks around the word wealth above, because most of these middle-class citizens didn't own the wealth in their residential property in the first place, but only the imaginary gains that would be achieved if the property were sold, less the mortgage owing, or outstanding. 

In reality, as sellers (assisted by over-zealous realtors) push home prices ever higher, combined with a decreased cost of borrowing (mortgage rates are at an all-time low), people kept buying larger and more expensive homes - certainly paying more than the replacement cost of the house by far - and living beyond their means. Today, if the outstanding mortgage is greater than the possible sales price of the house - as is the case for many homeowners across America - we refer to them being underwater.

However, there are two bubbles that will cause future corrections in the near- to medium term.  

These are:

1. Student debt

American and Canadian parents (and parents from other countries also, but I can only comment on what I know), have been indoctrinated to believe that their children are entitled to a college education.  This is regardless of the often dire personal financial situation of the parents. 

Many parents - well intended, no doubt - had used HELOCs to help fund the cost of education, helping exacerbate the situation described above.  Using their residential property as an ABM, they kept borrowing against the fictitious future resale value, feeling confident in their poor financial/lifestyle choice for two hopelessly incorrect reasons:

(a) the value of their home will keep going up, and
(b) their kids won't be able to get good jobs without a college degree

Now, as U.S. unpaid student loans approach $1 trillion, these young graduates can't afford to repay their debt, mainly because they cannot get work commensurate with their expectations (or entitlements) as a college graduate, inclusive of a salary high enough to allow them to repay the debt. Many work in retail for minimum wage, because that's the only job they were able to get hired for.

Worst, the parents are often saddled with the first mortgage, a second one, a HELOC... and an adult child back at home who cannot find good employment.  The government - mismanaging federal student loan programs just as badly as they mismanage other social programs - offer debt forgiveness, refinancing, etc. to students who would perhaps have been better off without the debt, or $200,000 college degree!

How will this situation end?  Regrettably, not well... and the summary above only scratches the surface of a growing financial burden and future bubble, ready to pop!

2. Property tax

You may have seen a few media reports about a housing recovery. If you believe those, or the bluster from politicians during recent election campaigns, you're in for a rude awakening.

One of the primary reasons resale properties (and new, but perhaps to a lesser degree) cannot sell is because of ever increasing, burgeoning, property tax. Property tax on a residential home is no longer related - in any way - to the value, property size, acreage, number of rooms, frontage, etc.  

Property tax may be mathematically based on some combination of these factors - i.e. if your neighbor's house is larger, she may pay more tax, pro-rated - but the actual gross amount of the tax, or the total due each year, is required as a contribution to your local government's unaffordable compensation schemes, pensions to support retired workers, and some of the cost required to fund services (like schools, roads, etc.).

In fact, if you were to take the time and trouble to review, even at a high level, your local town's budget, you will be amazed to see most of your property taxes are being allocated towards compensation (salaries, pensions).

This next bubble is already in existence, a problem exacerbated by falling property prices. With the low cost of borrowing, every $100,000 of mortgage debt costs the average person with reasonably good credit, less than $500/month.  That means that a $200,000 mortgage would cost the borrower less than $1,000/month.  This sum may be considered affordable to most  middle-class Americans.

However, the property tax in States like NJ and CT (that I'm most familiar with) often exceed the cost of the borrowing.  For example, if the property tax on a house in these 'bankrupt states' runs at $12,000 annually (a common scenario), the potential buyer is faced with a dilemma: while the $1,000/month mortgage payment may have been affordable, the additional $1,000/month makes the total cost of ownership unaffordable (especially considering utilities, insurance, ongoing maintenance, etc.).

The result is twofold: (1) people who may have aspired to home ownership - regardless of the reason - keep renting and (2) local governments under ever increasing pressure to fund and support the union demands of their existing and retired employees, have ongoing downward pressure on their incoming revenue (as owners default, file for tax value re-adjustments, leave the town, etc.), with ever increasing costs (higher pensions and medical insurance for retired employees; higher wages and benefits for current employees).

So... what happens now? Some towns and some homeowners file for bankruptcy; few refinance and change their ways.  Next bubble? You betcha... the cost of funding government in its current state is simply unsustainable.

The fix is fortunately quite simple.  Read "Should your kid go to college," Part 1 and Part 2. These postings should at the very least help you address the college funding crisis with a logical and common sense approach to the question of borrowing.  As for the property tax bubble - I can't offer to fix that, and it will burst under the pressure of non-sustainable government spending (unfortunate for us all).  However, the basic fix is really simple... buy what you can afford, based on your family requirements, and NOT to impress your family, colleagues and/or friends.

It's the most basic of all financial literacy: Live within your means!