It certainly must be puzzling to the White House why survey after survey shows the American public is unhappy with the U.S. economy. Unemployment is near record lows, interest rates are at moderate levels, GNP growth is improving, the stock market recently set a new high, and even the federal deficit is shrinking.

Most observers point to the stagnant wage growth affecting the middle and lower classes, and the inflation pressures that are rippling through energy, food, and medical costs, as the cause of this unhappiness. There is reasonable evidence that in the past five or so years, the average American has taken equity out of their home just to maintain their standard of living and compensate for stagnant income and rampaging costs.

When asked about this, and the double-digit increases in consumer debt that have occurred this decade, former Federal Reserve Chairman Alan Greenspan always pointed to the similar increases in net worth that the consumer has enjoyed. The Fed publishes quarterly statistics on household wealth, and the most recent Flow of Funds Account for the first quarter of 2007 displayed exactly what Greenspan was talking about:

Household Assets $65.621 trillion
Household Liabilities 12.489 trillion
Net Worth $53.132 trillion

I’ve adjusted these numbers somewhat – I’ve taken out the non-profit enterprises that the Fed includes in their definition of households, and that reduces the net worth somewhat. Still, $53.1 trillion divided among consumer households is highly impressive; it comes to about $175,000 in net worth for each household. Of course, we know that calculating averages from these numbers doesn’t reveal too much, since wealth in the U.S. is so heavily skewed to a few hundred thousand people. Studies of the median net worth, rather than the mean, show that the typical American household only has about $38,000 in net worth, hardly an amount on which to retire.

Wall Street loves to talk about these numbers as well, and delve into the asset details so they can salivate over the $6.6 trillion sitting in checking and savings accounts, or the $3.2 trillion invested in bonds and other credit instruments. What if just a portion of this money shifted into the stock market? What a rally that would be!

So what are Americans seeing that the Fed and Wall Street cannot recognize? The same Flow of Funds report has shown a consistent decline in the savings rate in the U.S., confirming to some degree the economic theory that incomes are growing very slowly while costs are rising rapidly. But even so, can’t Americans look to the future and take psychological comfort from their massive amounts of net worth? Surely this tidy pool of money is available down the road for retirement, and it must be generating some income today for the consumer? When we look carefully at these two assumptions, we uncover the flaws in these arguments and some of the real reasons why Americans are, and of right ought to be, worried for their future.

Let’s start first with the consumer’s investments in equities. Wall Street is fond of telling investors that “in the long run” equities generate pre-tax returns of 8% each year. Surely this should be the most preferred asset class of all. But in the household accounts, equities rank third and are only 16% of total assets, half of the amount devoted to real estate. By March of 2007, consumers had invested $10.5 trillion in corporate equities and mutual funds (most of which is also in equities). This amount is actually less than the $10.9 trillion invested in this category at the end of 2000. At the bottom of the stock market crash in 2002, the consumer had only $6.8 trillion left, and this decimation of their equity and mutual fund portfolios has obviously had a discouraging effect (apparently the consumer isn't waiting for “the long run”). The consumer simply has not participated in the wondrous stock market rally from 2003 – 2007. This may not only be fear, but simply a lack of resources, bringing us back to the stagnant wage problem. The average American workers may not have the ability, given their other costs, to allocate as much to their 401k’s as they did in the past.

Real estate, the other major asset of the consumer, at first shows a different story. Home equity was valued at $11.4 trillion in the household accounts at the end of 2000, and has soared to $20.8 trillion by the first quarter of this year. This is 32% of the total wealth in consumer hands, by far the biggest category of wealth, and it has grown at a compound rate of 9% per annum.

To generate this wealth, the consumer increased their mortgage debt from $4.8 trillion in 2000 to $9.8 trillion this year, which is a compound growth rate of 10.7% p.a. If you are going to double your debt in seven years, shouldn’t you have an even greater percentage increase in wealth to show for it? If you don’t, you haven’t made a very good investment.

And therein lies the problem. Housing has not been a very good investment for the consumer. One reason mortgage debt has grown faster than housing wealth is that the consumer has been enticed to “cash out” their equity with home equity lines of credit (HELOCs). Who hasn’t heard or read the advertisements from bankers and mortgage brokers to “take some cash” out of your home, as if you the consumer earned this as income?

Deliberately confusing the consumer on this matter should have been a prosecutable crime. The consumer enjoyed a market gain as the housing bubble picked up steam, but the only way for the consumer to “earn” this gain and convert it into actual cash was to sell the home and move to something that carried a smaller mortgage. This is not what happened. The consumer added to their debt, since these HELOCs are second and third liens on their property, and the portion of equity the average consumer now has in their home has fallen to nearly 50% of their mortgage(s). This compares to a 68% equity/loan ratio twenty years ago.

And what about that old real estate maxim “housing values never go down.” That’s been true not only since WWII, but even earlier, with the exception of a few years during the Great Depression. But the real estate industry left out an important qualifier: the rate of increase was always just enough to cover the increase in consumer prices, at least until 1996. Real estate was a good nest egg for the consumer, and it was certainly better than having no nest egg, but with taxes and maintenance costs, it was not the best asset class in which to invest.

Everything changed around 1996, just when HELOCs became popular and banks stopped limiting your use of these loans to home improvement or college costs. HELOCs took a fixed asset with no liquidity until it was sold, and created an asset that needed to be marked-to-market routinely so that the home could be saddled with additional debt on any increase in market value. Mortgage borrowing for first mortgages or HELOCs really took off in 2002 when the Fed pushed interest rates down to 1% for a whole year. The real estate market at first became turbo-charged, and then evolved into a classic financial bubble, where increases in home values beget further borrowing for vacation homes or speculative investments.

As is often the case in a financial bubble, everyone extrapolated the past into the future and this affected their investment decisions. Phenomenal growth rates in home values led to all sorts of abuses and poor credit standards, but more importantly brought enormous market risk into the consumer’s portfolio. If home prices could soar, they could now also collapse, leaving the homeowner with a mortgage that doesn’t go down (for negative amortization loans the balance actually goes up), while the home value is deflated. This is precisely what is now happening across the U.S., especially in the overheated markets on the coasts.

So it is death to the old maxim that real estate values never go down. Once again, as with the equity market, the American consumer is going to wind up painfully disenchanted with an asset class as an investment and retirement safeguard.

But that’s only one side of the net worth picture. We haven’t even looked at the cash flow aspects of all this wealth that has been created. Isn’t this $53.1 trillion in net worth throwing off some cash flow here and now to the consumer? Unfortunately, no it is not, and to obtain an answer to this question I looked at all the basic assets and liabilities as defined in the Fed data, and applied various yields or costs, as the case may be, using Fed data or other data from reputable sources.

This table shows the result, and the footnotes at the end of this article explain the assumptions:

The first thing that pops out of this table is that the consumer’s biggest asset, their home, earns them nothing at all. The home has enormous utility as a shelter, of course, but this isn’t in the form of cash flow to the consumer. On the contrary, property taxes and maintenance eat up a significant part of the consumer’s annual budget. In this table, I’ve applied the tax rate assessed the median U.S. home at the end of 2005 (the latest data available), and I’ve left out maintenance costs entirely (there is little reliable data on home maintenance costs). It is appropriate to take into account property taxes, because they are an asset tax, unlike income or sales taxes which are applied to the consumer’s cash flow and which are not appropriate to include in this table.

Property taxes alone cost the consumer nearly 1% of their home value every year, and since this is the biggest asset the consumer has, this net cost seriously reduces whatever earnings the consumer may generate from their other investments. These other investments – bank accounts, municipal and corporate bonds, equities, and pension or insurance proceeds – are overwhelmed by the property tax component, and the net result is that $65.6 trillion of assets generates less than 1% p.a. in revenue for the consumer.

Consumer liabilities are much smaller, but notice the enormous disparity between yields and costs. The average home mortgage rate is 6.25%, and nearly ¾ of all home mortgages are financed with a fixed rate. With property taxes added, the consumer will pay out $814 billion for the privilege of owning their home and meeting their mortgage payments. The deck is stacked even more severely against the consumer for short term loans for automobile purchases (currently 6.85% for a three year loan), bank loans (2% + the prime rate, or 10.25%), and credit card debt (average 18% annual rate). While these liability balances are much smaller than the asset balances, the dramatically higher interest rate costs when compared to available yields significantly detract from the consumer’s financial health.

There are other ways to slice the Fed data, and changing the assumptions can improve the situation somewhat or maybe even swing the consumer to a slight positive cash flow position. Economists and academics who have done this work tend to take comfort from the large balances in the asset column, when compared to the smaller balances on the liability side, but this ignores the detrimental and substantial spread between available yields and interest rates being charged the consumer. Even so, many of these studies do come to one conclusion: the consumer may not be so wise putting so much of their net worth into real estate. In this table, we come to the conclusion that the consumer is spending $281 billion this year to support total net worth of $53.1 trillion.

If this were a balance sheet presented for the wealthiest 100,000 Americans, it would look dramatically different. Real estate would not be as significant a component of assets, which would be concentrated in credit market instruments, equities and mutual funds. The wealthiest Americans are rentiers – they derive their income from dividends and interest payments, and their mortgage and tax payments are a much smaller component of their income.

It would be better if the average American rented their home and placed their savings in market instruments or equities, where they could obtain better returns. True, renters are still paying property tax indirectly, but apartment renters at least share this burden with others in their building. Unfortunately, government policy is weighted in favor of home ownership and against renters. The tax code gives substantial offsets for mortgage interest costs (these tax benefits are not taken into account in the table, but then again neither are maintenance and depreciation costs). The real estate lobby is very powerful, and a Democratic Congress is much friendlier to the housing industry and to the unofficial central banks that support the industry - Fannie Mae and Freddie Mac. No change should be expected anytime soon in U.S. real estate policy.

This means that incentives will still push the U.S. consumer into real estate as a prime investment and retirement class, even if falling home values disillusion everyone about real estate as a safe investment. As long as government policy pushes the average American into housing as their main asset, and as long as the financial industry is able to charge extraordinary rates for borrowing money, the consumer is facing a losing battle. The average consumer will never have enough investment income to offset their real estate costs and the high rates imposed on consumer borrowing.

Who wouldn’t worry about such a dilemma?

Footnotes (corresponding to the Table numbers, far left column)
---------

1. The tax rate uses a U.S. median home value in 2005 of $167,500 and a median property tax of $1,614, to generate a melded tax rate of 0.96%. The source of this data is an article entitled Special Studies, written by Natalia Siniavskaia, at Housing Economics.com. No costs for depreciation and maintenance are included in this table, even though these costs may be substantial. Offsetting this is the fact that for item 10. below (mortgage liabilities), no benefit is given for tax offsets on interest payments.
2. Consumer durables generate no cash flow. They do incur maintenance and depreciation, but these numbers vary considerably from an auto, dishwasher, or bedroom set, and the Fed data do not break out the durables numbers into such categories.
3. Checking deposits tend to receive less than 1% p.a. in interest payments, though time deposits can exceed 3% p.a. The melded average is assumed to be 2% p.a.
4. The 5.07% yield is a simple average of the current yields on major asset categories: municipal securities (4.15%), corporate bonds rated Baa (6.27%), 2 year Treasury notes (4.57%), and 6 month CDs (5.28%).
5. Equities held outright or in mutual funds receive the current dividend yield for the S&P 500 index of 1.8% p.a. If this category were carefully broken down into the mutual fund component for equities and for bonds (which earn a higher yield), the overall yield on this category would be somewhat higher than 1.8% p.a.
6. Equity in non-corporate businesses, such as retail stores, is accorded a 3% p.a. net operating margin for cash flow purposes before taxation. The 3% figure comes from a Wells Fargo Corporation study on small businesses.
7. According to the Census Bureau, 12% of Americans are now receiving retirement benefits. Therefore 12% of the life insurance and pension reserves are considered to be paying out at a yield of 6% p.a., which is close to the corporate bond yield.
8. Miscellaneous assets are granted the same yield as checking and time deposits.
9. Total Assets of $65.6 trillion generate a net cash flow of $612 billion, for a weighted average return of 0.93% p.a.
10. Current mortgage rates range from 5.85% for an ARM to 6.39% for a 30 year fixed rate mortgage. Since nearly 75% of all outstanding mortgages are fixed rate, this blends to a 6.25% implicit rate for all mortgages.
11. According to the Fed data, 2/3 of consumer credit consists of auto loans (costing 6.85% for a current three year loan), and the remaining debt is credit card receivables, which I have assigned a rate of 18% p.a., the minimum assessed a consumer with a high credit score.
12. Bank loans are assigned a cost of 2% over the current prime rate of 8.25% p.a.
13. Unpaid life insurance premiums are assumed to incur a cost somewhat higher than long term bond yields.
14. Total Liabilities of $12.5 trillion carry a weighted average cost of 7.14% p.a., or $892 billion per year in cash flow from the consumer.
15. On a net basis, the consumer pays $281 billion each year in support of $53.1 trillion of Net Worth. This is equivalent to an annual 50 basis point tax (1/2 of 1%) on Net Worth.