Alice in Debtorland: Why the Red Queen's Race Is Worth Recalling
Feb 20th 2010 10:00AM
Updated Feb 25th 2010 7:41AM
That's a situation with striking parallels to two financial issues at the heart of the global economy's troubles: declining asset values and excessive borrowing."Well, in our country," said Alice, still panting a little, "you'd generally get to somewhere else -- if you run very fast for a long time, as we've been doing."
"A slow sort of country!" said the Queen. "Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!"
You Can't Outrun the Bursting Bubble
With the exception of China, where massive government stimulus and lending has fueled another real estate bubble, asset values worldwide have fallen across the board from their pre-crisis 2007 highs.
Debt holders (both the owners of assets such as homes, and the lenders who hold loans against those assets) have responded to this decline in equity by paying down or writing down debt. But these reductions in debt have not created more equity, because asset values have continued to fall. Lenders and owners are "running fast" -- reducing debt -- but finding themselves in the same place in terms of equity.
I've created a chart to illustrate this financial version of the Red Queen's Race.
Here's an example of how reducing debt (running fast) can leave a lender and homeowner in the same place.
Let's say a hypothetical homeowner bought a house near the top of the housing bubble in late 2006 for $500,000 with 10% down ($50,000). The lender ponied up a $450,000 mortgage.
As housing values slipped 10% ($50,000 on that house), the owner found his equity had shrunk to zero, and the lender nervously noted that minus commissions and closing costs, the sale of the house would not even pay the mortgage in full.
If this were the end of the price decline, the owner could pay down $50,000 of the mortgage and restore his previous level of equity in the property. But as housing prices slipped another 10% from the top of the market (another $50,000 reduction in the value of our hypothetical house), the owner would find that his previous effort to reduce his debt level simply had matched the decline in the asset's value: The owner was running hard just to stay in the same place.
The same can be said of lenders who absorbed losses by writing down the value of mortgages. Writing off $50,000 of the $450,000 mortgage would not restore any marketable value to the loan, as the house was now only worth $400,000. A lender who wrote off a portion of the mortgage would also simply be running to stay in the same place.
With housing prices off about a third from their peak, the number of mortgages that are under water -- zero equity for the owners and a large loss for lenders -- has continued climbing. As DailyFinance's Doug McIntyre recently reported, by mid-June, more than 5 million homes will be worth less than 75% of their mortgage.
These homeowners have lost the Red Queen's Race, and so have the lenders who underwrote the mortgages on their homes.
The Danger of Focusing Only on the 'Monthly Nut'
As the chart above illustrates, much of this "running fast just to stay in place" resulted from aggressive lending and borrowing during the bubble years. As assets rose virtually across the board -- gold, real estate and stocks all rose from 2002 to 2007 -- then owners of those assets borrowed heavily against their rising equity by either refinancing or taking out a home equity lines of credit.
Let's return to our hypothetical house, once valued at $500,000. Back when it was purchased, at the peak, a mortgage of 80% loan-to-value or $400,000 seemed conservative. Now that the house may only fetch $350,000, the lender has lost at least $50,000 and the homeowner's equity has been wiped out.
This is the pernicious result of focusing narrowly on "the monthly nut" -- the carrying costs of a debt. As Greece has learned to its sorrow, the carrying costs (i.e.: the interest rate paid) on new debt, or on old debt that is expiring and must be rolled over, are not necessarily the same as they were in 2007.
That interest paid is a reduction in net worth -- of a household, company or nation.
As the Red Queen's Race illustrates, paying down debt doesn't move you forward if assets continue declining.
The Faster You Borrow, The More You Stay in Debt
Here's is another troubling example of the Red Queen's Race problem in action: the expanding federal deficit. Apologists and naïve Keynesians keep repeating the mantra that the government has to step in and borrow trillions of dollars, which it can then use to compensate for the decline in private spending that resulted when households and enterprises lost income. They assume that household and corporate spending will soon return to its robust 2007 peaks.
But the Red Queen's Race illustrates the folly of their assumption. Over-indebtedness can only be resolved by writing down or paying down debt -- borrowing more is not a cure. With equity/net worth essentially zero for many households and lenders, paying down debt or writing off uncollectible debt as assets fall in value does not create new equity: It is simply running in place.
Borrowing $1.5 trillion every year -- fully 40% of all federal expenditures -- in the vain hope that households and lenders can magically win the Red Queen's Race is folly. The federal government itself is now in the midst of its own version of the Red Queen's Race, borrowing fast just to stay in the same place. Unfortunately for those touting this as a long-term policy, that's a race not even a government can win.