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The Foreclosure Crisis in 2008: Predatory Lending or Household Overreaching?

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Letter Writer:

Fulton Wilcox, senior partner in Colts Neck Solutions in Colts Neck, N.J.

Date Posted:

Sept. 14, 2011


Following is a response stimulated by the recent article entitled "The Foreclosure Crisis in 2008: Predatory Lending or Household Overreaching?" The authors (William R. Emmons, et al.) conclude that the spike in mortgage defaults is not explained by lenders behaving as the equivalent of drug dealers in the schoolyard, leaving "overreaching" as the default explanation. The authors observed that prevention "requires the ability to 1) recognize an asset bubble, 2) classify the bubble as a systemic risk to the economy and 3) curb the formation of the bubble."

My suggestion is to use the Federal Reserve's Z.1 balance sheet reports as an assets "overreach" detection and diagnostics data source. Although the Federal Reserve's Z.1 release notes barely acknowledge the existence, let alone the dynamism of assets and asset values, Z.1 reporting fortunately includes balance sheets, which I suggest be made more inclusive and available in normalized "real" dollar variants to help with time series analysis of asset trends.

To illustrate the "bubble detection" value to an analyst of existing Z.1 balance sheets reports, following is a retrospective analysis of Z.1 B100 balance sheet data since 1990. All data referenced below comes from these balance sheets.

America's Balance Sheets Existing Federal Reserve Z.1 balance sheets encapsulate views of two of what might be termed America's major economic "tectonic plates," household and "main street" business. The B100 balance sheet provides asset, liability and net worth data for households (plus non-profits), while the B102 and B103 reports, taken together, provide balance sheet data on "Main Street" –private sector business and industry, excluding financial and agricultural private sector business.

The Federal Reserve does not publish an overall "America's balance sheet," although one is needed. The asset values reported are immense. In the first quarter of 2011, the B100 household (and non-profit) balance sheet reported assets of $71.9 trillion, liabilities of $13.9 trillion and a net worth of $58 trillion. Given the notion that we are in a "debt crisis," the present modest size of liabilities is a surprise. Just as most of Japan was high and dry above the recent tsunami, the so-called sub-prime debt crisis has comparatively narrow, although intense, impact. Non-financial businesses (as reported in the B102 and B103 balance sheet reports) own assets of $39.9 trillion, liabilities of $18.8 trillion and have a net worth of $19.6 trillion. Their recovery has substantially lagged the household sector. Together, household and "main street" businesses in the fist quarter of 2011 owned assets of $110 trillion, had liabilities of $32.7 trillion and $77.6 trillion in net worth.

The Federal Reserve publishes other reports with balance sheet sorts of information, but it is not clear to what degree these can be aggregated without duplicating assets or liabilities.

One analyst who made the attempt estimated that, overall, "America's balance sheet" holds assets in the $180+ trillion range, or about 14 times current-year GDP.

Following is an analysis centered on B100 report data for the last 21 years (since 1990).

B100 reported household (and non-profit) assets, liabilities and net worth growth since 1990:  In 1990, reported household (and non-profit organizational) assets totaled $24 trillion, with liabilities of $2.4 trillion and a net worth (assets-liabilities) of $13.9 trillion. An analyst asked in 1990 to prescribe "Goldilocks" not too hot, not too cold "bubble alarm" boundaries to B100 balance sheet asset growth over the next few decades might have suggested a range of 5 percent-6 percent compounded annual growth (CAGR). B100 reporting is in current dollars incorporating both real growth as well as inflation; so 5 percent-6 percent would have been a reasonable range. Twenty-one years later, in the first quarter of 2011, B100 reported household assets were $71.9 trillion, and the 21-year asset growth CAGR was 5.3 percent. Over the same period, liabilities increased from $3.7 trillion in 1990 to $13.9 trillion, a somewhat "hot" 21-year CAGR of 6.5 percent. However assets were much larger; so, first quarter of 2011 net worth (assets minus liabilities) increased 5.1 percent CAGR, to $58 trillion. Although assets were within the Goldilocks band in 2011, the 21-year ride was bumpy. B100 reported assets poked above the 6 percent CAGR alarm level twice during the 21-year period, once signaling the .com bubble and the second time, the real estate bubble.

Drill-down to B100 reported real estate assets, debt and net worth:  If one drills down from total assets to "real estate" assets held by households, this narrower but still large economic "tectonic plate" exhibits a messy, energetic pattern that can and did spawn tsunami waves of excess demand or grossly inadequate demand. Real estate asset's 21-year "flow" since 1990 started with 10 years of placidity, with B100 reported asset growth running somewhat below the hypothesized Goldilocks "too cold" 5 percent CAGR lower alarm level. As described below, that "too cold" growth in housing asset values in fact was an early indicator of the .com bubble. As the .com bubble burst, in 2001 real estate assets rather suddenly increased 10 percent (from $10.2 trillion to $11.3 trillion), rising from "too cold" growth to intersecting the 5 percent CAGR boundary. By 2003, real estate assets had nearly crossed the "too hot" 6 percent CAGR boundary ($13.8 trillion versus $14.1). Trillion-dollar moves in two years are remarkable and, literally, "alarming." By 2005, household real asset values totaled $2 trillion above the 6 percent CAGR level, and by 2007 had bubbled $3 trillion above the 6 percent CAGR level ($20.8 versus $17.8 trillion). Of course, "too hot" had to end, and by 2009 real estate assets declined $2.9 trillion (to $17.9 trillion) from its 2007 peak value of $20.8 trillion. By the first quarter of 2011, real estate assets declined another $1.8 trillion to $16.1.trillion, $2.3 trillion below the 5 percent CAGR "too cold" boundary.

B100 real estate versus business equity tectonic plate "subduction":  One surprise was what, to stretch the "tectonic plate" metaphor somewhat, is the observed "subduction" relationship between households' holdings of real estate assets and investments in business equities. The tsunami of mortgage foreclosures is an effect of the energy released by the 2003-2007 subduction of real estate over business assets. Directly through actual buy/sell transactions or indirectly through "mark to market" price shifts, the .com bubble and the real estate bubble were fostered by shifts in "equity" between business equity and real estate equity. [On the B100 report, what I term "business equity" household holdings equals B100 report lines 24+25+30]. Indeed within the 21- year study period, there were three "subductions" with one or the other asset category over-riding the other, in terms of balance sheet "share" and absolute dollars.

In 1990, real estate constituted about 27.3 percent of all household (B100) assets, while business equity constituted 22.9 percent, with a variety of mostly fixed income or cash assets constituting the other 46 percent. [Non-profits also owned real estate assets, which the following analysis throws into "other" because B100 mortgage debt reporting covers only household mortgages]. Remarkably, by 1995, the relative shares of assets had crossed over (subducted), with the business equities share increasing to about 27 percent and real estate's declining to only 23.4 percent of total household assets. In 1995, a single percentage point shift in household asset share equaled $.4 trillion; so, the 4 percent decline in real estate's share constituted a $1.6 trillion move of asset value from household real estate into household-held business equity assets.

Early warning of the .com asset bubble was given and to a degree quantified by this estate/equity "subduction" as early as 1995. The energy driving such subductions is, of course, human; so, B100 dollar figures make visible shifting opinions and decisions of millions of asset owners and would-be owners. The .com business assets "overreach" peaked in 2000 when the asset balance reached 34.9 business equity and only 20.1 percent residential real estate, a total swing of about $3 trillion. Additionally, in 2000 the increase in combined "shares" of residential real estate plus business equity had increased from 50.1 to 55.4 percent of all household-held assets, shifting about $2 trillion from "other" assets. Many of the "other assets" (Treasuries, other debt instruments) are more conservative with respect to safeguarding principal or are less subject to "mark to market" price swings; so, the risk balance of the overall household asset portfolio shifted. The collapse of the .com bubble in 2000 reversed asset category share; so, by the first quarter of 2003, real estate had rebounded to a 28.5 percent share and business equity declined to 25.4 percent of all household asset holdings.

That two-year flip in market share signaled and, indeed, mechanically implemented the onset of the real estate bubble. As the bubble progressed, real estate asset value in 2005 reached 29.9 percent household asset share, business-oriented equity stayed at about 26 percent, and the two taken crowded out "other" by a few percentage points.

The real estate "crash" in 2006-2007 resulted in yet a third flip, with business assets resuming a dominant share. In the first quarter of 2011, real estate had declined to 22 percent share and business oriented equities had rebounded to 28.4 percent share of all household assets. Also, their combined share declined from the 2005 level of 56.3 percent to 50.8 percent, giving back more than $3 trillion to "other" mostly fixed income and debt assets.

Looking ahead for "alarms," the Federal Reserve B100 balance sheet data proved to be more informative and, indeed, from an intelligence perspective, perhaps more "actionable" than expected. Compared to examining the entrails of real estate or business investments (mortgage coverage ratios, the price of particle board, earning per share, etc.), balance sheet analysis is far better at highlighting macro trends and, indeed, quantifies them. If one looks at the recurring patterns summarized above, it appears that another "flip" between household holdings of business equity investments and real estate may be due. Also, a separate indicator is the likelihood of a 2013 or 2014 household real estate assets return to trend – specifically the 21-year Goldilocks CAGR range of 5 percent-6 percent. Although past performance is no assured predictor, both indicators suggest that first quarter 2011 household- held real estate asset value of $16 trillion will climb to the $22-$25 trillion level by the 2013-2014.

Such a "subduction" of real estate over business assets, if it occurred, would itself constitute a shock. For many, such a prospect is good news, but on the other hand, rapid oscillations in asset values risk "bubbles." Given that there is wide agreement that we are buffeted by "asset bubbles," one conclusion that would seem clear is the Federal Reserve and, perhaps, others, such as the Bureau of Economic Analysis (BEA) or others, should invest in tracking and diagnosing asset moves, within an America's "balance sheet" context.