Are we endangered by a new Savings Paradigm ?

In the pantheon of new paradigms, Savings deserves a special mention. Low savings rates, are often spoken about as the likely source of a future calamity. However, relatively few individuals seem worried about the level of their own savings; they are more focussed upon wealth issues, like increasing the equity in their homes. For many, I believe there a new paradigm at work. And those economists, critical of the savings rate are not being heard, because they are relying upon outdated formulations. Old notions of savings have muddled the subject to a point that clear thinking became nigh impossible. This short essay is an attempt to unmuddle it.

Before you run off screaming, or nod off with boredom, let me have a chance to mention why our notion of savings is important. Understanding how we save, can help you increase your wealth, and may help you protect your wealth in the changing times ahead. Isn't that enough reason to read on?



Economists and government officials alike talk about the need to increase savings. What do they really mean? Is it important? Are they targetting meaningless financial targets, while individuals who are less encumbered by old fashion thinking, are behaving in a totally rational way. Perhaps those formulating governmental policies, are guilty of "fighting the last war", while the important surmishes of the current war, are being lost, for lack of understanding.

First of all, let's aim for a definition. On the edges, are two extremes. There are cash "savings" which pile up in bank accounts. And then, at the other extreme of a savings definition, there's personal wealth: the value of an individual's total assets: cash, securities, and real estate, net of all debt. Finally, there's the technical definition used by economists when discussing the savings within the economy as a whole, that runs something like this: "National savings is computed by combining the savings of households and corporations, while subtracting the budget deficit of the government." (that's from Business Week, May 2004.) Those who use the technical definition, are say that savings in the US look inadequate -and perhaps in the UK as well. Yet the economy goes on growing, with individuals pursuing their own goals, and the US Government Treasury sales supported by monies flowing in from surplus countries like Japan and China. With this process going on for so many months and even years without a serious breakdown, is it right to remain concerned?

'One Account' Blurs Savings and Mortgage debt
The new savings paradigm is most apparent in the design of a relatively new financial product, called a "One Account", released about two or three years ago by banks and financial service companies in the UK. The idea of the "one" account is that an individual does not need two separate transactions, one a mortgage loan, the other a savings account. Normally, if a homeowner keeps them separate, the savings account proves inefficient. The individual is in effect, giving the bank his savings, and then borrowing it back at a higher rate of interest. Why pay a "spread" on your own money? What the "one" account does, is to give the individual a mortgage, but with flexible repayments (within certain broad limits.) This way, if there is extra cash at the end of the month, the individual simply pays down his mortgage, thereby increasing the net equity in his home. If in the next month, he needs money, he increases his mortgage debt somewhat. So long as at the high point of each year, the debt stays below certain pre-agreed limits- which are related to a normal amortisation schedule - the lender is happy. From the individual's standpoint, the beauty of this scheme is that he is paying off the more expensive mortgage debt. The reduction in interest expense provides a better return, than the saver would get from interest on a savings account. And the 'one' account may also reduce taxes, since there is no savings income subject to taxation. (This type of account works best when the mortgage debt, or the least a portion of it which can be prepaid and reborrowed, is at a floating rate.)

This type of loan flexibility has helped individuals to think about savings in a more powerful way: The real challenge is to increase their net wealth, not just the balance of their personal savings accounts. And this notion has helped them to see their homes as a vehicle for savings. It is obvious that increasing net equity increases their wealth. And home equity is increasingly liquid wealth too, because there are myriad financial methods (remortgaging, equity release loans, selling-to-rent) for releasing that equity. With this liquidity achieved quickly and cheaply, equity-in-the-home becomes almost indistinguishable from equity in a savings account or in a securities account.

Government officials, and their economists, may be out-of-date if they think that the balance of a savings account matters to the new breed of Home-Equity-Savers who have grown up in our age of quick-and-easy financial services. Logically, most people will put their efforts into increasing their aggregate wealth, more than trying to hit some mythical cash savings target. Ironically, in a time of soaring property prices, this objective has encouraged many to borrow even more money, in order to buy a bigger house than they need, or a second property, in the hope that the value of the larger property investment will increase, pushing the investor's net equity to a higher level. And what's wrong with becoming a landlord? Particularly, if the amounts to be received in rentals, exceed the amounts paid out as interest. It is not only big hedge funds who can enjoy the benefits of a "carry trade." So we see that, the new wealth paradigm has the impact of increasing debt, and reducing traditional savings.

Risky Business
Of course, there are risks in this aggressive borrowing program. Rates have been low for years, and many fail to believe that they can shoot back up to the old high and dangerous levels. But with oil prices now surging, inflation may be making a surprise comeback. And a sharp rate increase is particularly dangerous for those who have over-borrowed or exposed to floating rates. A second risk is that property prices can fall. If and when they do, it they may decline even faster than they speed at which they rose. A fall would reduce net equity, while also making it more difficult, or even impossible to generate liquidity from refinancing. There are less obvious risks too. Credit could become less available. The forward march in financial innovation has been encouraged by the steady rise in property prices. If prices fall, and loans turn sour, banks will tighten their credit policies, and the ability to easily liquify equity in a property may evaporate, even as that equity is melting away.

The risks are there to be seen, but when the central banks like the Fed and the Bank of England seem relentless in keeping stimulus in the economy in order to avoid a recession, few worry or think too hard about the risks they are taking. The risk looks remote to those who are accustomed to seeing a regular increase in property values. And they remain focussed on the upside challenge, seeking ways to increase their net equity. With wealth in property seemly indistinguishable from wealth in traditional "more liquid" investments.

My fear is that, like many "new paradigms", this one will fade into a tragic memory when the inevitable crisis hits.

"The Smoking Gun", Prelude to a Property Crash

I feel like a detective who has found the Smoking Gun.
The interesting thing, is that the gun is not truly smoking, not yet. Because the bullet hasn't been fired. But if I am right, I have found the gun that holds the bullet which may burst the Debt Bubble. And if that happens, a related phenomenon, the Property Bubble will burst with it. Then, the world will be a different place.

Globally, Debt is $100 Trillion, US Govt. is $7 Trillion+, and Growing. Where will it end? The Debt Bubble has grown to the highest % GNP since 1929, now over 300%.

My worry is that too much debt has been built on too fragile a foundation, and there is only one way that this debt will be reduced. That is through a crisis that will change the borrowing and spending habits of generations.

We are back in the bind of our grandparents.
There is simply too much debt. In 1929, just before the Wall Street crash and the onset of the Great depression, global debt reached a then-unprecedented 270% of global GNP. How much is it today? Just over 300% of a much-larger GNP. And unfortunately, we may be facing the same consequences that our grandparents did as debt was liquidated in a depression.

DEBT is a four letter word rarely spoken by central bankers and mainstream economists. They would rather talk about supply and demand, public confidence and consumer spending. But the fact is that American consumers (and indeed, most consumers in the developed nations) have become too complacent about borrowing money to fund spending. Savings rates in America have fallen for decades. Yet our economists have told us not to worry. First, we were told it was fine, because stock prices were rising. America's free-spending habits were fine because of the increase in the value of their stock portfolios. But then the TMT boom turned to bust, and something like $7 Trillion was wiped off the value of American stock portfolios. And the knock-on effect is that many Americans and West Europeans now worry whether or not their pensions are going to be sufficient to allow them to retire in the style they expected.

Again, we are being told not to worry. Why? Because housing prices are rising. Americans were given the gift of lower interest rates by the accommodative Federal Reserve. After 11 interest rate cuts in less than two years, mortgage payments are much cheaper. The same size paycheck could finance more housing. So what did Americans do? They bought new homes, and swapped smaller for larger. And of course, increased demand and easy finance pushed up the price of housing.

Total residential homes in America are now worth more than $13 Trillion. Americans have reacted to this increase in their wealth. Not just buying new and larger homes, but also refinancing their existing mortgage loans. It seems so obvious: The value of their homes have increased. And mortgage rates are lower. So why not take a larger mortgage, at a time when it is so much cheaper to service. In addition, it seems "safe" because the collateral for the loan (the home) has increased in value, meaning that new debt can be incurred without much increase in gearing. So why not spend it? A holiday, a new car, or just a shopping spree. Thus, the rate-cut bonus from an accommodative Fed, is keeping the consumer-driven economy going. Or so it seems.

Home-buying and refinancing activity have greatly stimulated demand for mortgage debt. Some $2 Trillion in mortgages were taken out last year. About two-thirds of that debt was refinancing existing mortgages. But overall debt is rising and is now something like $7 Trillion, on a housing stock with an estimated value approaching perhaps $13 Trillion. That does not sound too worrying, a 7 to 13, or about 54% Loan advance rate. But the problem is that the debt is not equally distributed. Some families (older, with memories of the great depression perhaps) are borrowing little or nothing, and others (younger people, just starting out perhaps) have leveraged to the maximum point - 75, 80%, or even 90% or more. Whatever the banks will allow in some cases. And if the required equity isn't available, some have borrowed on their credit cards, or incurred other forms of expensive debt, to come up with that vital equity. And they are being encouraged to do this by roving bands of entrepreneurs, eager to teach that borrowing, buying, and renting out is an easy road to riches. Well maybe not, if conditions change.

What if house prices stop rising? Or what if they start falling?
Parabolic price rises, such as we have seen in the housing market in America (and in the UK as well), have a way of reversing themselves, if they are not strongly supported by fundamentals. The only fundamental reason for this rise is cheaper borrowing costs. The other factors which might support it: such as rapidly rising incomes, or rising rental values are just not there. This is easily- borrowed money chasing asset appreciation, not income. Indeed, in many parts of the US and the UK, rentals are now falling. Clearly, this debt-fuel housing speculation is not a sustainable situation.

Some feel it will go on until interest rates rise. They say, if rates stay low, there's nothing to worry about. But this thinking is wrong. Long term rates have begun to rise, but a rapid rise in rates is notb the only way to stop the upward spiral. There's another danger, that of a tightening of credit availability. And it grows more likely every day.

This is how I believe the bubble will burst:
Banks and securities buyers will stop providing debt on the same easy terms as before. A tightening of credit availability, will slow the housing market, and turn it down. Once it becomes apparent that credit is tighter and house prices are falling, the current virtuous cycle, pushing house prices higher and higher, will reverse and go into a vicious cycle. Houses prices will fall, and put loans in jeopardy. The lenders will react by lending less, and on less attractive terms. This will dry up demand for housing. The timing of this turn in housing may be soon. Indeed, it may be happening now, right in front of our eyes.

How debt saturation and Market Perceptions can turn the market.
We need to look at the peculiarities of the US mortgage market and see how it is led mainly by securities buyers, rather less than the old-fashioned banks that still maintain one-on-one relationships with their borrowers. This change is important, because it means that this business has grown in a way that has left it with fewer credit controls. Originators lend money because they can resell it. Packagers buy loans because they can repackage them and resell them as securities. And the end buyers buy the securities because they are well rated and have low historical default rates. There is less discipline built into the system, than in the old days when the banking system had lending officers who knew their clients. The current system is built for speed and volume growth, not for safety. If the information upon which those ratings are based is less accurate than previously, or conditions of the borrowers change due to a declining economic conditions, it will take time for the ratings to reflect it. The beast is built to run, not to think. But once it slows down, it may realize it has run onto quicksand.

At this point, I need to introduce the loan packagers, and those that assist in the securitisation process. There are two giant twins, Fannie Mae (FNM) and Freddie Mac (FRE). These two (along with a smaller sister, Sallie Mae, who helps assist in Student Loans) are Government Supported Entities, whose special role was created by an act of the US Congress. They support the mortgage market, by buying loans in bulk from mortgage "originators" (companies like Countrywide Credit, Doral, and New Century.) It is these originators, not FNM and FRE, who interface directly with the home owners. They process the papers and create the loan documentation. They may also provide the original loan advance, but they often get their money back by reselling the loans to FNM, FRE, or others that bundle them, and re-create the loans as securities. Effectively, an FNM or FRE security is an obligation of these companies, and is further supported by the cash flow and repayments of the underlying loans in the bundle. This is a massive business. During last year, the total amount of mortgage financings was about $2 Trillion, and FNM and FRE were involved in packaging almost half of that total. As mortgage originations have zoomed in the last year or two, FNM and FRE have increased their own participation. And they have had to borrow to support that increase.

How much debt do they have? Wait for it: over $1.3 Trillion.
Yes, that is over a Trillion Dollars, 1,300 Billion dollars of debt outstanding. It has risen by about 20% in 2003. That figure is about 10% of the value of all the US residential housing, and perhaps 20% of all the total mortgage debt outstanding.

Though government supported - they have a mandated function - their debt is not guaranteed by the US government. Instead, these are private companies, and their shares trade on the NYSE. They are massive entities with a combined market capitalisation of about $100 Billion. This is the value the stock market puts on the companies.

The scary thing is the relationship between their debt and equity. The actual book value of their equity, the "real" amount of owner's capital they have to meet contingencies, rather than how the stock market values them, is considerably less: about $16 Billion for FNM and $18 Billion for FRE. And this means these two have very high gearing: 45:1 for FNM, and 34:1 for FRE. This is much higher than the 15:1 or 20:1 gearing of major banks. In other words, they only have about 2-3% of their assets which belongs to them, the rest is borrowed. So if something goes wrong with the loans they hold, then there is only a very tiny cushion of protection.

It was not always like this.
In past years, these two had lower gearing. Just 10 years ago, they had about 3.7% and 6%, equity to assets, for FNM and FRE respectively. And now their regulator, the Office of Federal Housing Enterprise Oversight (OFHEO) has become concerned that risks are too high. Perhaps the Enron scandal has strengthened their resolve. The regulator is beginning to become more vocal, and is proposing adjustments to accounting rules. I hope it is not too late. Has the horse bolted already?

We have been assured that both FNM and FRE are "within their regulatory limits", but only just.FNM, for example, we were told had regulatory capital of $26.4 billion, which was $1.2 billion (4.6%) above the core capital requirement:

Calculations: (from last year)

.Measure..... Fannie Mae : FreddieMac
Core Capital. $26.382 bn : $21.450 bn
Minimum...... $25.227 bn : $19.520 bn
Excess Amount $ 1.155 bn : $ 1.930 bn
.... % Excess .. + 4.6% .: .. + 9.9%

The problem is that they continue to grow rapidly, with debt up 20%+ over the past year, that's over 5% per quarter. And so the approximate 5% surplus can easily be fully used, or even exceeded. What then? These figures are calculated every quarter. So FNM will be reporting at the end of each quarter. If their core capital is insufficient, then they will either have to: raise new capital, depressing their share price, sell off (without recourse) loans or other assets they are holding, or slowdown their acceptance of new business.

Cracks are beginning to appear through out the financial sector. Vulnerabilities abound.

The gun is getting hotter, and may be smoking soon.

"Dr.Bubb" writing for DebtBubble.com