The Deflation Bubble: We Are Still In It!

The 2008 Crisis didn’t really start in 2008—it started much earlier. As we emerged from the Tech Bubble at the end of the 1990s, we lost, and have continued losing, jobs to automation and off-shoring. We gained significant productivity particularly in the manufacturing sector. Many who lost jobs never completely recovered, but took part time jobs and in some cases used their free time to create new businesses after cultivating skills they may not have known they had.

Through the early part of the new decade (2000-2010), many shifted into new forms of work. Perhaps they were initially the second or third job holder in a household, but even then it may have been difficult to make ends meet. Many looked for ways to continue a lifestyle to which they had become accustomed. Many chose debt, which they could see might help them in a temporary way, not to just keep their life style but to also pay for educational training they might use to improve job prospects. They would not need to borrow money forever. Further, this temporary debt might disappear.

Borrowing against home equity appeared reasonable. They could use temporarily the equity they had built, and if as the housing market continued to grow, housing prices continued to escalate then the increases in home value would, in effect, pay for the second mortgage loan. Many used the equity they had built in their homes like an ATM machine, a characterization that is not completely fair, as it was certainly not viewed that way by many at the time. The Federal Reserve Bank and its chairman had helped create the makings of a housing bubble in the early part of the decade to help replace the Tech Bubble which had burst in the late 1990s.

The Housing Bubble created an opportunity for new home owners to get into a home for relatively little money down and see it’s value appreciate substantially over time—and even make money by buying and then selling, and then buying again with money made on the sale of the original home or just putting the profit in the bank and then getting out of the market completely with a nice little profit. This process came to be known as “flipping,” and was so widely adopted that many made significant sums of money by flipping. It only worked if the price of housing kept increasing, which is exactly what was done for several years until 2008.

The owner of an existing home who lost his or her job earlier in the decade, but had significant equity in the home, could borrow against that equity to finance lifestyle, education in the hopes of becoming equipped for a better paying job, or simply to get ready to make money by “flipping” new houses. An example, illustrative of how things may have gone while the Housing Bubble was still working may have gone as follows: Let’s say the resale value of a home may have increased by $40,000 while a homeowner borrowed $30,000 to help finance re-education in preparation for a better paying job. The homeowner had paid down previously the original mortgage by $50,000. If the homeowner sold at the house at the inflated value, then there’s a net profit of about $60,000 minus closing costs. The $60,000 could then be used as a down payment on the next house or a retirement abode, whatever comes next. Of course, later during the Housing Bubble one might have used all or only a fraction of the $60,000 to get into a new home or multiple new homes with the intention of selling all or some of them at a profit in the following 1-2 year period.

However, let’s assume the original equity loan and resale was done by a family not considering entering into the life of real-estate moguls. Let’s assume also they took the equity loan of $30,000 in late 2006 and that they were intending to sell the home in late 2008 or later, because they thought that $30,000 educational loan  might allow the homeowner to gain employment by then. The sale of the house would set up a move with the acquisition of a new home near the place of new employment. By late 2008, home sales bottomed and prices for new and existing homes bottomed as well. In an unforeseen  complication, banks were making few loans. In this example, let’s say the $40,000 in anticipated increased value of the home plus another $70,000 disappeared from the original price of the home. Since the $50,000 equity the home owner has is only in relation to the original price of the house, this means that the anticipated market price is now $70,000 below the original, the home owner can expect to sell for $20,000 less than he still owes on the original mortgage. He can’t sell unless he can find that $20,000 to pay off the bank at closing. He’s underwater by $20,000. But, it’s worse than that because he still owes $30,000 on the second mortgage that he must also take care of at the closing as well if he tries to sell the house. He can’t sell as he is $50,000 underwater overall. The homeowner is hopelessly underwater and can’t afford to do anything about the house now.

In the case above, let’s just say the homeowner has made good use of his 2nd mortgage loan by expanding his education. He finds an excellent job, but in another area. Luckily he is able to rent/lease his $50,000 underwater home to a friend, who has his own set of problems, but can be trusted to care for it and indeed make certain changes that can potentially improve the value of the home. With the rent/lease arrangement the payments on the existing mortgage can be covered and within five years the amount still owed can be brought down by the $20,000 needed to bring it within line with apparent market value. The homeowner feels that he/she and the family will be able to make it on the new job, but there will be little additional money for extras if they are to pay down the $30,000 2nd mortgage loan over the next several years. The plan will allow this hypothetical family to pay off the 2nd mortgage debt and sell the original house by late 2013 or early 2014 without incurring additional debt, and subsequently start fresh. The family won’t have much extra money to spend until then.

There are likely many families with this kind of financial outlook or worse. Many are now starting to work their way past these kinds of significant financial obligations. Our hypothetical family will require another year at least, while others may be longer—perhaps until near the end of the decade or beyond. Most are spending very little for extra purchases.

Many in similar position may have rebuilt retirement savings and some may have been able to pay down their mortgages such that they are not significantly underwater. However, some of those who hold second mortgages may not have paid much if anything on them. Likely very few have switched into a positive equity position on their houses. If they are edging toward retirement, they may be thinking realistically about selling while home prices are still quite depressed. If they have sufficient funds for a down payment they may still be able to buy a comparable or smaller retirement home. At the same time, after 3-5 years or more of building back retirement savings and relieving their underwater position on their house, they also will have gone though a considerable period deferring major purchases.

Clearly 2008-2009 turned into a massive deflationary bubble owing to significant losses in retirement savings and net reductions in home equity. Even if not all homeowners were underwater many have seen significant losses in net worth given the diminished values of their homes. Most Americans switched directly to savings mode in 2008 and stayed there through 2009. GNP declined in both years. Spending picked up slightly in 2010, but stayed low and perhaps fell a bit as unemployment fell slightly in 2011. GNP increased in both 2010 and 2011, but at low levels indicating growth to be weak. In 2008-2009 Americans spent little beyond necessities. Prices dropped as businesses tried to sell off inventories. Americans kept their cars longer or sold their 2nd or 3rd cars, car pooled or shared rides, rode bicycles more or walked when they could. They got more wear out of clothing, did many home repairs on their own, sold items they didn’t need, and closed down rooms they neither wanted to heat in the winter nor cool mid-summer. In many cases, they found there was a lot encumbering their lives that wasn’t really needed. They learned they could do without many items and services they had previously considered essential. Many deferred purchases that others sold to make a living. Merchants whose products or services suddenly felt the impact of less demand often cut their prices. Significant price reductions occurred throughout the economy and strengthened the deflationary trend.

Only now in early 2012 is there evidence of some release in the pent up demand that unleashed the 2008-2009 downturn in prices. While it does not seem as though we will see an upward trend in prices anytime soon, Americans are beginning to buy cars and trucks in greater numbers. New and existing home sales are still low but show evidence of increasing. Unemployment is also reduced. New jobs have picked up substantially in the past several months. These are positive signs, however, with significant numbers of unemployed and working poor as well as many households still feeling pinched by lower wages, or having to help or take in relatives, the current deflationary trend may not end anytime soon.

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