A farewell to ARMs - why the US housing market faces a credit crisis
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We are the hollow men
We are the stuffed men
Leaning together
Headpiece filled with straw...
~ T.S. Eliot, The Hollow Men (1925)
When we were still in our twenties, we volunteered - briefly - for the presidential campaign of California governor, Jerry Brown. Our job was to write the epistles that raised money for the campaign. Right away, at our first meeting, we realized that the candidate had no business in politics at all – let alone running for president of the United States of America. He thought too much...and he didn’t know how to lie.
"What do you want out of this?" he asked us directly. We were taken aback. Politics operates with winks and nods, not with eye-contact and a hand-shake. A real politician knows what people want – power and money – he doesn’t have to ask. And he knows how to buy them; he never has to come right out in the open and quote a price.
"How about ambassador to France?" we countered, only half joking. But Jerry Brown couldn’t take even half a joke. He looked us in the eye, hesitated, and then said, "Okay."
The deal done, the president-to-be announced that part of his mission would be to colonize space, whereupon the campaign blew up on the launch pad, and our plush pied- a-terre in Paris at taxpayers’ expense with it.
But Jerry Brown left us with something all the same. "Read Illich," he told us.
The problem with ARMs: the theory behind the phenomenon
Ivan Illich (1926-2002), a one-man melting pot, a Jewish-Catholic-Croatian-Mexican-American social philosopher and one-time priest, wrote a number of books, now all but defunct, that were classics of alternative thinking in the 1970s. Two of the most influential were 'Medical Nemesis' (1971) and 'De- schooling Society' (1975), which proposed that the experts who manned our schools and hospitals were actually getting in the way of education and health.
Illich was a radical thinker in some ways; in others, he was a reactionary who thought medieval society was more conducive to man’s well being than anything in the modern world. Reading Illich, one is never quite sure if one has on one’s hands a zealot of the Counter- Reformation, or of the Second International. But whatever Illich might have thought he was doing, what he really did was give us an idea about the way institutions everywhere work. What he showed us was that all institutions begin by looking out for their clients...and end up looking only after themselves.
'Medical Nemesis' describes how medical institutions turn people into consumers of health-care products, rather than healthier people. And 'De-schooling Society' shows us how educational institutions turn them into consumers of higher degrees, rather than smarter people.
Indeed, universities might actually make people stupider than they were before they entered, because they now know more of what isn’t so. In economics, for example, much of what is taught at university is wrong...and wrong-headed in the most profound way. The graduating economist is actually stupider than the man on the street. What he thinks he knows for sure ain't necessarily so. And the institution in which he learned what isn’t so, like the Soviet economy, has become a value-subtracting enterprise.
Illich might have been describing the financial industry. If ever there were men whose expertise subtracted from the sum of human knowledge, it is the savants of finance, those whose keenest ambition seems to be to sell investors products, rather than make them money. Who really makes money, after all, in hedge- funds or mutual funds? We know the answer; the people who run them. For everyone else, funds - whether hedged or mutual - are generally a value-subtracting business; investors who make their acquaintance, even passingly, end up with less money. What about stocks and bonds? There, too, the only people who make money are those who push the products or run the corporations.
The problem with ARMs: the hollowing out of prices
But today we point the finger not merely at Wall Street. All institutions are subject to corruption, not only those that grub for money. In time, all institutions get hollowed out. They all become peopled by men with head- pieces filled with straw, self-serving managers who do to them what the Israeli army is doing to Southern Lebanon. And thus we get revolutions, bankruptcies, civil wars, hostile takeovers and hedge-fund melt-downs.
The hollowness is everywhere – we soon run out of fingers - health care, education, defence, the dollar, democracy, employment, the 'things' you buy and the thing you buy the things with - money itself.
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Yes, the dollar too has been hollow since 1971. There is nothing in it, even as it is, but with every passing year it becomes still more consumptive. Its managers and promoters have long ago mined out its substance. All that is left is a shell, a scrap of paper, an echo, a ghost of real wealth.
But yet, prices for things are still quoted in dollars. People have nothing else to go on. They know the price of everything, as Wilde said, but the value of nothing. They believe nothing but prices. A college education works out to $20,000 to $50,000 per year and that drug treatment for arthritis might cost about $11,000 or $12,000 a year. A flat-screen TV, they reckon, is $1,500. A stock in such and such a company is quoted at such and such a price. The image is taken for reality. Consumers lack the imagination and time to figure out that the goods they buy are as hollow as the paper they use to pay for them.
Since 1971, wages too have been hollowed out. The working man has to have his wife at work too just to make ends meet. He sees the money coming in – he can measure it in dollars. What he can’t measure is the real effect on his family's life when both he and his wife have the worries of the workaday world on their shoulders. With no dollar price on the problem, it is ignored, yet, though income is higher, expenses soon rise to meet it. Housing and energy keep going up, and now the poor man finds he needs the help of the housing payment industry just to keep going.
The problem with ARMs: buying unaffordable property
In the dream world of the early 21st century, there has never been a better business than the credit business. The credit merchants borrow at institutional rates lower than at any time in their lives and re-lend to a public with an insatiable thirst for debt. The borrowers don’t seem to care about paying back; it’s enough that they can make payments. And the lenders don’t seem to care about not getting paid back; it’s enough that they can pass off more debt – first to the decent credit risks and then to the sub-prime borrowers, until they are doing little more than selling gaudy Cadillacs in the ghetto, with no money down. And there is scarcely a gaudier piece of junk than an adjustable-rate mortgage.
In the right hands, ARMs are legitimate bets on the direction of interest rates. But in the wrong ones - and who in America’s suburban ghettos understands yield curves? - they are homemade car bombs – liable to blow up in the wrong place at the wrong time.
And who would want such dangerous ARMs except the fools most likely to blow themselves up? That they are adjustable is their selling point. But like the rest of the fancy merchandise on the market – the I.O., or interest only housing payment, Neg Am, or negative amortization, and even the 50 year housing payment plan - ARMs are in fact diabolical devices intended to speed marginal buyers on the glittering road to hell. ARMs give the weakest buyer the luxury of pretending to buy what he really can’t afford. He pays a low rate while cash-flow is tight and hallucinates that rates will be even lower when he goes to refinance. Any wonder that now, finding themselves both ARMed and endangered, the poor consumers drag into credit counselling, long of face and short of finance? But at least they’re not alone.
ARMs are now some 11% of the value of housing payments originated during 2004-05 and are estimated at more than $430 billion. Nearly 18% of such homes also have zero or negative equity. Despite this and despite the 40 and 50 year housing payment plans that have joined the scene, combined new and existing home sales have declined for seven consecutive months. And that does not reckon the impact of the resetting of housing payments, once the initial 'teaser' rates offered by ARMs go up, as they inexorably will.
What can explain why legions of otherwise smart people do what will inevitably bring them to grief? Why would borrowers take on debt they cannot afford...and lenders take on creditors who cannot pay?
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If Illich was right, they do it because they must. Because like all institutions, even the housing business eventually comes to exist not for its clients, but for itself. The dream of home-ownership becomes hollowed out by the people who run the business of homes - builders, housing payment lenders, and finally even consumers themselves. For it is consumers, ultimately, who put down the ersatz money they don’t have to purchase the synthetic houses they can’t afford.
But then, dear reader, that is what revolutions, busts and bankruptcies were designed for.
By Bill Bonner for The Daily Reckoning. You can read more from Bill and many others at www.dailyreckoning.co.uk.
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