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The Financial Destruction of America's Middle Class
By Bill Bonner | Published  01/8/2007 | Stocks | Unrated
The Financial Destruction of America's Middle Class

"The Financial Destruction of America's Middle Class."

You will not find that headline anywhere today. Why? Because it isn't there. It is a headline from the future.

Instead, if you look through today's papers, the headlines you get are
reassuring:

"Job growth is strong, surprising economists," says the New York Times.

"Fears of U.S. Slowdown Recede," adds the Financial Times.

David Lereah, Chief Economist for the National Association of Realtors, says the worst of the housing slump is over:

"As the housing market recovers from its correction, existing home sales should be rising gradually during 2007 - it looks like we may have reached the low point for the current cycle in September. We've entered a more sustainable period of home sales now, and we expect greater support for prices over time as inventory levels are eventually drawn down."

A man who likes his women fat and his investment margins thin must find America, 2007, an agreeable place. According to official statistics, the average voter is bigger than ever. But they are balancing on the tightest of tight wires. According to the financial news, never before have citizens had so little margin for error.

They read the headlines and are happy to believe them. "The bad news is behind us," they say. "We don't need any margin...because there will be no errors."

Yet, this is not the first cycle in the housing industry. It is just the biggest and wickedest. Typically, says Max Fraad Wolff in the Asia Times, housing prices fall 30% in a downturn, over a period of about four years. If that is so, this one has a long, long way to go down.

Edward Learner, director of the UCLA Anderson Forecast, makes a more modest guess; he expects new house prices to go down 5%-10% in the year ahead. The average house in Los Angeles is now valued at $510,000. That's about 50% too high, says Learner. It could take five to ten years to get prices back to normal.

Meanwhile, UBS says default rates on sub-prime loans have doubled...to 8% of the total. Since 2002, more than $1 trillion in such loans have been written. And now, many of them are going sour. In October, for example, foreclosure rates in the sub-prime market were running 42% greater than the year before. And in November came news that some of the packaged securities backed by sub-prime mortgage loans were being downgraded by Moody's - barely six months after origination. Downgrades are common - mortgages go bad as people die, get divorced or go broke. But it usually takes longer than six months.

Behind this news is a story that won't go away:

The Financial Destruction of the American Middle Class - this is the story we've been talking about for the last three years. The plot is very simple. Most people do not work for the finance industry. Most people do not get huge bonuses. Most do not own Picassos, nor do they have houses in Aspen. Most people earn ordinary wages. And they have not had a real raise in the last 30 years.

"If we use 2005 dollars and the CPI-U (consumer price index for urban consumers), average weekly earnings decreased by about $1 per week over the 30-year interval 1975-2005," writes Wolff. "The folks have thus stopped saving and have taken on massive amounts of housing and consumer debt."

Wolff continues:

"In 1999, total outstanding household debt was $6.4 trillion. As of the end of the second quarter of 2006 total outstanding household debt was $12.3 trillion.

"Household debt has increased by almost as much since 1999 as the sum total of all debt accumulated by all households across the preceding 220-year history of the [United States]. In 1999, household mortgage debt stood at $4.4 trillion. At the close of the second quarter of 2006 it had more than doubled to $9.33 trillion. In 1999, consumer credit outstanding was measured at $1.6 trillion.

"Today, this stands at approximately $2.4 trillion dollars, signaling a 50% increase in less than seven years. This is usually soft peddled and talked down by comparison to skyrocketing housing values. Household assets held as real estate increased by $9 trillion from 2000-2006. This might be called the mother of all modern bubbles. Yet household net worth struggled up by a mere $1.2 trillion. Net worth badly lags housing values because of waves of cashing out. When these waves crash ashore it will be with massive destructive force."

The middle class still thinks it is the middle class. It owns one or two or three automobiles. It has children in college...a house with air-conditioning...maybe some mutual funds. But it is living on borrowed time and borrowed money...in a borrowed house.

Even though house prices were rising, owners' equity as a percentage of household real estate actually fell from 58% to 54%. In other words, people 'took out' so much wealth from their houses that they ended up with a lower percentage of ownership than they had had before - even at today's high prices. As prices go down, their 'equity' will fall even further. For many homeowners, it will disappear altogether.

"Americans keep refinancing and re-mortgaging. Why?" asks Wolff. "There really is only one answer: desperation. Freddie Mac informs all those who dare to look that 90% of its refinanced loans resulted in new balances at least 5% higher than the previous loan."

Someday, perhaps soon, many middle class Americans are going to begin to realize that something has gone wrong. Their houses will be falling in price...while their debts are greater than ever. They will realize that they have been bamboozled.

And someday, a politician will begin to speak for these people. He will not tell them that they have been fools. Instead, he'll explain that they have been betrayed by their leaders...swindled by Wall Street...conned by corporate CEO's and flim-flammed by Republicans and Democrats.

He will be partly right.

And more thoughts and opinions...

*** A few readers wrote in last week, wondering about our argument:

"Imagine that the dollar is suddenly worth only 50 cents," we wrote.

"People who thought they had nearly $9 trillion in assets suddenly realize they have lost $4.5 trillion. Where did the money go? Who was on the other side? The lenders are out trillions...while the borrower - the U.S. government - has achieved debt relief of the same amount. But it never actually had that amount of money; that is, it never had the money to pay back the loans...and never would have. In effect, the trillions would just be 'written off' like a bad debt. This doesn't mean people are necessarily worse off...but they definitely would have less cash and credit - less liquidity - than they had before. And other asset prices would collapse."

One reader's question:

"I own one dollar of cash and one dollar of Google stock. In case Google goes down by 50%, my liquidity is still one dollar. If I buy additional Google, my cash is simply transferred to someone else.

"Therefore the liquidity glut is going to be here for a long time. Is it not?

"Back in 2001, I wrote an article for 'La Tribune' called: la fatalité des liquidités (not bad, hey...!)

"Now, I am wondering how the liquidities will disappear.

"There are only two ways:

"1. Inflation
"2. People reimburse their debts.

"Would you tell me if I am correct?"

Another dear reader takes up the issue from a different point of view:

"I don't get your reasoning on what happens to assets if the dollar is devalued by 50%, as you write today.

"What really happens is dollar-denominated assets are re-rated upward in price to reflect the declining currency, and everybody feels happy because of rising markets - but it's all an illusion. It's really a secret confiscation of wealth, as incomes don't rise at the same rate, and savings and purchasing power are destroyed.

"It's just not realistic to expect the 'credit bubble to burst' and for assets to decline 50%. More likely they'll go UP by 50%, but in real terms they'll be down significantly.

"Personally I think this is what we're seeing now, and it could go to unbelievable extremes..."

And yet another with the same point:

"I take exception to the concept below that you wrote about.

"Asset prices would double to compensate for the 50% drop in the dollar. It would take twice as many dollars to buy Intel's stock. Stock prices would go up in nominal terms but not in real terms. If you left your money in the bank then you would really lose 50% of your money under your scenario above."

The problem with talking about the dollar is the problem with the dollar itself - you never know exactly what you are talking about. You reach for it and find yourself grabbing at air. If it were fixed to the wall, you could keep it in sight...and notice how other things move around in relation to it. We speak of 'inflation' and a 'falling dollar' but we might just as well try to use a sextant to locate a five-year-old at a birthday party. Nothing sits still long enough to give us a good sighting.

In what is typically referred to as 'inflation,' prices rise as the dollar sinks. But not all prices rise at the same rate. In a period of consumer price inflation, prices of butter and gasoline go up; but prices of financial assets usually go down, at least in 'real' terms, adjusted for inflation. Why? Because inflation undermined the income streams one expects from financial assets, especially if they are fixed. Bonds tend to go down a lot, because the interest investors expected to receive will buy less; so it is worth less. Stocks tend to adjust to inflation better than bonds; owners can imagine that the business can raise prices to protect profit margins. In fact, not many can. Inflation tends to make all projections of future income less certain, thereby reducing their present value (and asset prices). Of course, this is often hard to see...because prices can go up in an inflationary period. If we recall correctly, stocks in Zimbabwe soared in 2005 - even as inflation ran to nearly 1,000%.

But the dollar isn't at risk only because of consumer price inflation. It also changes hands on global markets...and it is priced in terms of other currencies and in terms of gold. This is what we were talking about in our little hypothetical above. If the dollar were marked down in the international currency markets, there might be little immediate effect - or even notice - in the United States. But overseas dollar holders would feel the pinch quickly and sharply. The Bank of China has one trillion in dollars. China cannot spend its dollars on hamburgers and shoe shines in New York. It has to trade them for other assets. If, suddenly, the dollar were to take a dive on the international markets, China would have less purchasing power. Much of its liquidity would vanish. Likewise, a crack-up in the derivatives, bond, or stock markets could wipe out liquidity. The dollars people thought they had would merely disappear. Remember, they were never in physical form. They were just accounting transactions...electronic representations of hypothetical 'wealth.' When dollar based assets go down in price, or the dollar itself goes down, there is less liquidity available. People do not have as much 'money' as they had before. They cannot buy as much.

We continue to think that this is the most imminent...and more important...threat faced by the world financial system: a deflation of its financial assets...and a general evaporation of liquidity.

*** 2007! We can hardly believe it. When we were ten years old, we wondered what life would be like in the 21st century. It seemed so distant, so remote...so impossibly far in the future.

But here we are...so deep into the 21st century, we already take the third millennium for granted. But each year, our fingers lag the calendar. We go to type 2007...and they hit 2006 out of loyalty to the old year...or even 2005...or 1999!

How quickly each year is discarded, thrown away like last year's calendar, yesterday's headlines and last week's girlfriend! People just don't stick with anything for very long. They are here...and then they are off...gone.

We were in a gloomy state of mind over the weekend. Another acquaintance of ours said he had prostate cancer. It seems to be going around like a bad cold. We even began thinking of our own funeral.

We had in mind a humble affair, naturally...just throw us in a ditch out on the prairie...with guitars playing lonely Hank Williams' tunes. But when we spoke to Elizabeth, we found that she had another idea altogether.

"Look, if we're going to have a funeral, let's at least have a nice one. With a proper church ceremony...a requiem mass, yes, that would be nice...speeches...organ music... It should be grand, beautiful."

"Wait...this is my funeral; I'll do what I want to," we protested.

"No, a funeral is done for the sake of the family; it would selfish of you to insist on doing it your way."

Unable to agree, we decided to postpone it. If we can't have the sort of going away bash we want, we'd just as soon not die. At least, not yet.

Bill Bonner is the President of Agora Publishing.  For more on Bill Bonner, visit The Daily Reckoning.