The Wealth Effect on Steroids

Driving north from Los Angeles over the Memorial Day weekend, it was hard not to notice the wealth effect created by the California housing boom. Home equity "extraction", made ever easier by competing lenders via lines of credit and cash-out refinancing, has enabled an entire generation of homeowners to spend money like their parents never dreamed - all thanks to the rising value of their homes.

The phrase "wealth effect" was heard frequently in the late 1990s when companies like Cisco where flying high. Then, long time Cisco shareholders could sell some stock, pay a little tax, then go out and buy something nice. Or, maybe they would just take some money out of that boring savings account and spend it instead - better to stay "invested".

The wealth effect has been a great driver of personal consumption in the U.S. over the last ten years, and personal consumption has been a great driver of U.S. growth. In fact, consumption makes up an ever increasing share of U.S. GDP - a GDP that is closely watched by the rest of the world.

At this point, policy makers must have concluded that growth by any means is good growth - that somehow increased consumption, based on increased home equity "extraction" is a good thing.

[The term "extraction" when used with home equity has always been bothersome.
Its common usage related to a dental procedure gives it a connotation of removing something that shouldn't be there - this is precisely the opposite of the historical role of home equity, as something that should be there. ]

The Wealth Effect on Display

On the drive north, the beneficiaries of the wealth effect are very conspicuous. One after another - young men with their families in large new trucks - towing boats, all-terrain-vehicles, and jet-skis. All seemingly brand new. Some of the trailers piled so high with shiny toys that they look dangerous - better not to follow too closely.

Monstrous quad cabs with full length beds, camper shells, and huge tires - no chance of this fitting into a standard size garage - the bigger the better ... some adorned with bumper stickers saying things like "God Bless America".

How do these thirty-somethings afford all of these expensive toys?

It was hard not to notice all the new malls popping up too. Outlet stores and large outdoor malls with huge signs - a vast array of choices from which the consumer can choose. All clean and fresh. Pleasant pastel colors, in stark contrast to much of the surroundings - crumbling buildings far off in the distance and roads that seem to be in greater disrepair by the day.

In the most recently constructed malls, there seems to be a new trend - one-stop shopping for homebuyers. Lined up in consecutive suites one finds a Realtor, then a home loan company, then an escrow company - from left to right, easy to follow. This allows consumers to more easily purchase homes, which allows the existing housing stock to more easily rise in value, which facilitates more consumption due to rising home equity, which enables the building of more malls.

A virtuous circle!

And the billboards. After passing the giant IKEA distribution center, a regular pattern of billboards emerged. Billboards provide a pretty good insight into what drives the local economy. In this case it was clear - billboards for homebuilders, Realtors, home loans, and Indian casinos. Then another homebuilder, another Realtor, another home loan company, and another casino.

When you think about it, today, these go together quite well.

So what about the steroids?

The world doesn't normally work this way - people, by the millions, do not just find hundreds of thousands of dollars on the sidewalk, pick it up, and spend it.

Just like baseball players don't normally hit as many home runs as they have in recent years, homeowners don't normally spend as much money as they have in recent years - they don't improve their lifestyles in such an extreme manner without some outside assistance. Sure, federal agencies have recently issued new guidelines for home equity lending, but the horse has long since left the barn - home equity withdrawal, like steroids in baseball, has become ingrained in the culture.

People now believe that this is the way the world works - that somehow they are special - that they are deserving.

Like steroids, home equity withdrawal is part of a much bigger system that has evolved over a period of years. Most everyone involved has been increasingly delighted with the results to date, but there is a growing awareness that something is not right.

Just like the sluggers who broke all the home run records needed some help, the young men towing shiny new toys behind big new trucks have needed help too.

Let's hope that fixing the looming problems caused by home equity "extraction" goes as smoothly as fixing the problem of steroids in baseball.