Friday, 14 June 2013

DINS. Dual Income, No Savings

On this link, Elizabeth Warren on bankruptcy speaks about the huge rise in bankruptcy among American middle class families. 

But that was the sub-prime crises wasn't it? Feckless people with mortgages on worthless property? No, just plain, middle class folk, with both partners working, who got behind on their house payments.

Elizabeth Warren does a comparison with families in the 1970s, when couples usually depended on a single income. Why were bankruptcies less common then?

It is tempting to assume that the 70s generation were more frugal. Don't people eat out more now? Dress more expensively?  And so on.  Not so, the kind of spending that seems to be typical 2013 conspicuous consumption - home electronics, clothes, eating out - are, in inflation adjusted spending terms, actually lower than in 1970. In any case, these expenses are optional, if you run into difficulties you can postpone them. But what has risen, as the analysis in the lecture shows, are the much higher fixed costs of mortgages.

In prices adjusted for inflation, present day, middle class Americans are paying way more for their houses than in 1970. The fact that nowadays mom, as well as dad, is often bringing home a significant salary is not helping. The extra cash coming is going straight out again to service the debt, mainly on a much higher mortgage.

Back in the 70s most families managed with one car. But these dual income families have higher fixed costs, they need two newish cars so both partners can get to work. Taken on their own car running costs are lower, cars are relatively cheaper, more reliable and service costs are lower. 

Other things being equal, even houses should cost less, mortgage rates are lower. But those mortgages are much higher, house prices have risen much more than the rate of inflation. 

And it's not because houses are better. Unlike cars and electronic goods houses cost more only because people can pay more. They are not significantly better in any qualitative sense. (Not in Britain and the USA, although modern German houses are superior to their 1970s equivalents in terms of insulation/energy costs)

So is this is where all that house price equity growth came from? According to Warren, when mom stopped being a home maker, and became an essential part of the income stream to pay the mortgage, what happened was this. House prices rose because the couples buying new homes could afford to pay more. See also, my earlier blog, Blowing-bubbles

And the problem with that, and the reason why Elizabeth Warren writes about a new, modern day debt problem, is that when both partners must work to make the house payments, the probability of payment problems is much increased.

The higher fixed costs of the modern household put the financial situation in a higher risk position. Families are falling into bankruptcy, generally after a family member has fallen sick. Back in the days of stay-at-home-mom, if a child got sick mom was there. Now she has to stay off work, and the family immediately start to feel the pressure of those high fixed costs.

Moreover, many people can't afford to save anything to give themselves a buffer. They tell themselves the equity in the house constitutes their savings although they cannot get at those savings without selling up. Instead, they get into difficulties and finally declare bankruptcy. Then whatever equity they have accumulated goes to their creditors, and they lose the house.

So, let's see if we can test the premise, as implied by the Warren video, that house prices have risen to soak up the available income. And, it's worth noting, prices have gone through similar massive increases, and for much the same reasons, in Britain as well as the USA.
Back in 1979 I bought a small house in Crawley, England. I had a salary £4800 per year. Then, with a maximum mortgage available of 3.5 x annual salary I was able to borrow £16800 (90% of the value of the property). With a £1700 deposit I was able to buy a house costing £18500.

So, all things being equal, and only adjusting for inflation, how much should I be paying today? Let's just imagine that I'm aged 29 again :), just leaving the RAF and starting my new career in the private sector. 

If we use the Bank of England inflation calculator it turns out that my 1978 salary of £4,800 would today be around £20,565 per year. In fact, engineering salaries have done a bit better than that, BAE quote between £26,000 and £28,000 per year starting for graduates so, allowing for the fact that I was a bit older than most graduates in 1979, and I know I got a bit more, perhaps my 2013 equivalent salary would be £30,000pa.

So, in salary terms, and disregarding partners income, I already ought to be quite a bit better off.

Today's salary of £30,000 would permit, using the same formula 3.5 x annual salary, would with a 90% mortgage of £105,000 only get me a house priced at £116,000. And that with a 10% deposit needed of £11,000.

But today that same house will cost £172,500. This would require a salary of almost half as much again,  (£44,357 per year x 3.5) to give me the same 90% mortgage. (£155,250.) And I'd need to raise £17,250 as the deposit, not far short off the original total cost back in 1979. In fact, today's mortgages generally assume a smaller percentage deposit. So, if we take the more achievable deposit of 5% I'd need to borrow £163,875 or around 5.5 times my equivalent salary.

Had house prices only risen at the rate of inflation the property should cost a mere £80,000, easily achievable on the equivalent single household income of £30000pa.

Had the house price kept in line with salary inflation it would be cost £116,000. But in fact it has risen to £172,000.

So, I can only agree with Elizabeth Warren - the reason prices have risen so much is because income has risen, or at least banks now will lend more against both partner's income. So, the advantages of the dual income household, with all the implications of vulnerability to being unable to make the payments, has led to nothing beyond increased house prices. 

You can decide for yourselves if this is caused by the banks being prepared to lend more against less security. With, generally, plenty of equity in the property, if the household can't make the payments, the bank is still covered. And this is an incentive for encouraging house price inflation, although initially the lender is more at risk, after a few years of equity growth, the risk to the lender is diluted.

In summary: Dual income households are able to afford increased house prices. Increased house prices need bigger mortgages. But those increased incomes have been totally absorbed servicing the extra debt that increased house prices created. 

The result of sending mom out to work has been to make houses cost more.

Suddenly, the conservative, catholic, Bavarian principle of encouraging mom to stay home and look after the kids makes real sense.

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