Plankton and Ponzi Finance

Ever since subprime lenders started going belly-up at an alarming rate, everyone's quickly coming to the same conclusion - people with bad credit buying houses with no money down may not have been the best way to increase the level of homeownership.

Paul McCulley over at Pimco is the latest to jump on the bandwagon with his March communication in which first time homebuyers are compared to microscopic organisms in the sea - plankton - the bottom of the food chain that serves as the ultimate source of nourishment for most aquatic life.

[Whales don't actually eat in the normal sense - they just swim around in the ocean with their mouths open and somehow the tiny organisms get filtered into their stomachs. No chewing required. ]

Mr. McCulley's archive revealed no recent writing on lending standards, though he has written two pieces over the last year or so that come quickly to mind. One story addressed the impact of mortgage equity withdrawal where the wonderful acronym MEW was first heard. In the other, Austrian Economics got a little respect from the establishment. Aside from the fact that he thinks a bit too much like a an economist at the Federal Reserve, he seems like a pretty nice guy.

His most recent missive goes into great detail on the relationship between plankton (first time homebuyers) and Ponzi Finance (what passed for mortgage lending, up until a few weeks ago).

Watching the on-going meltdown in the sub-prime mortgage market, which is triggering a sharp tightening of underwriting standards to these dicey credits, I was reminded of prescient writings by two serious thinkers: Bill Gross and Hyman Minsky. Both narratives go back a long ways, with something that Bill wrote in August 1980 – 27 years ago! – particularly poignant:

“The Plankton Theory, like life itself, begins and ends in the ocean. Plankton, of course, are almost microscopic organisms that serve as food for higher life forms.
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In the case of real estate, the plankton would be the first-time buyer (perhaps a young married couple) with a desire to own their own home but with very little capital to carry it off. When the time comes that they can’t pull it off – either through an inability to come up with a down payment, or to service the monthly mortgage – then the ‘plankton’ would disappear and the rapid escalation in housing prices would ease as well. For, unless the current homeowner has someone to sell his house to, he’ll be unable to afford the house with the view or that extra bedroom, and the process would continue into the echelons of Beverly Hills and Shaker Heights. In the end, the entire market would wither on the investment vine and home prices would stop increasing at the same rapid rate. So to gauge the health of the housing market, look first at the plankton. Without their presence and financial vitality, the market’s not going to repeat the experience of the past 10 years.”

Bill’s call was a good one, as displayed in Chart 1: home price appreciation tumbled in the first half of the 1980s, as the homeownership rate fell: the Plankton Theory at work! Draconian Fed tightening at the beginning of the 1980s had something to do with it, too, of course, as the Plankton were priced out of the market by high interest rates, independent of the availability – or underwriting standards – for home mortgage loans.

But the theory held: it’s the first-time buyer, stretching to buy, that is the life’s blood of vibrant property markets. And intrinsically, there is nothing wrong with a young family stretching to buy that first house; most all of us did, as did our parents (many with the aid of the GI Bill). Optimism about rising incomes and making lives better for our children is the cornerstone of the American Dream.

Conclusion so far? Maybe a home ownership rate above 65 percent really isn't that great an idea. That extra one percent back in the late 1980s had a tough time holding it together and in many parts of the country, foreclosures and short-sales were common.

In early 1990s California, home prices retreated up to 40 percent in some areas.

Fast-forward to the present and the chart above shows that we are now four percent over the magical 65 percent homeownership rate. Don't extrapolate the 1990s California price decline to today. Not only would that be unfair, it would be impossible.

The second integral part of Mr. McCulley's story involves theories of financial crises espoused by Hyman Minsky, a fellow who has been heard of a time or two before around here, most notable for coining the term "Ponzi Finance".

Minsky, who passed away in 1996, was the father of the Financial Instability Hypothesis, providing a framework for distinguishing between stabilizing and destabilizing capitalist debt structures. He first articulated the Hypothesis in 1974, and summarized it beautifully in his own hand in 1992:
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"In particular, over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make positions by selling out positions. This is likely to lead to a collapse of asset values.”

Clearly, the explosion of exotic mortgages – sub-prime; interest only; pay-option, with negative amortization, et al – in recent years, have been textbook examples of Minsky’s speculative and Ponzi units.

And as Bill Gross explained long ago, such mortgages have been the food of the Plankton, the first-time homeowner, driving the homeownership rate to record highs, as displayed back in Chart 1, while also fueling accelerating home price appreciation. But as Minsky had forewarned, eventually this game must come to an end, as Ponzi borrowers are forced to “make positions by selling out of positions,” frequently by stopping (or not even beginning!) monthly mortgage payments, the prelude to eventually default or dropping off the keys on the lenders’ doorstep.

As noted here a year and a half ago in The Biggest Ponzi Scheme Ever?, like asset bubbles in the eyes of Federal Reserve economists, the "Ponzi" label can only be properly applied to today's housing market "after the fact".

That is, only if the value of the underlying asset collapses will it be confirmed that today's housing market is a true "Ponzi scheme". Though "Ponzi financing" has played a key role, housing in the U.S. will surely fare better than the company for which Charles Ponzi collected money and paid huge returns to early investors during six months in 1920.