24 July 2009

The Financial Crisis Has Slaughtered Generation Y

The impact of the financial crisis has been quite different for people of different generations. While all generations have taken a hit, the nature of the typical individual's economic progress over his or her life have hit different generations differently. Generation Y and the generation that preceded the Baby Boomers have been hardest hit.



The attached chart, via Calculated Risk, is a national index of commercial (in red) and residential (in blue) real estate prices with the index set at 1.0 for January 2001 to the present.* The national urban consumer price index in the United States from January 2001 to the present has increased 23% in the same time period.

Uninflation adjusted real estate prices reached peaks of about 80% over January 2001 levels for residential real estate (in 2006) and about 90% over January 2001 levels for commercial real estate (in late 2007), before dropping to current levels very close to 23% over January 2001 for both types of property. Historically, trends in commercial real estate tend to lag trends in residential real estate.

Thus, an examination of the table shows that in inflation adjusted terms, both commercial real estate prices and residential real estate prices, nationally, are almost identical to what they were in January 2001 (with a housing bubble and its collapse in between).

Caveats:

1. A return of real estate prices to the point they were at in the tech bubble does from their peak doesn't established that prices have hit bottom, only that they are more reasonable than they have been for a long time.

2. Real estate is fundamentally a local market. Regional markets vary a great deal and bigger markets, like California, have a disproportionate impact on the national numbers. Some markets have experienced massive housing bubbles that have since collapsed. Other markets missed almost all of the housing bubble and have experienced relatively stable prices when the housing bubble collapsed.

What's left after the caveats?

1. Aggregate real estate price indexes are most relevant as a macroeconomic indicator. One of the leading theories that tries to explain the rise of consumer debt and collapse of the savings rate over the past decade (which has been quite well documented in the specifics) is that this was driven by "paper" wealth effects.

In other words, as real estate owners and financial market investors saw the value of their assets rise on paper, they felt wealthier and spent some of the increased paper wealth on consumer expenses. But, more often than not they chose to do so by borrowing money, rather than by cashing out their investments and spending the cash proceeds.

Now, at an aggregate level, all of the real estate appreciation (and as I've noted separately, financial asset appreciation) wealth brought into being since 2001 has vanished, but the consumer debts incurred because people believed that they had that wealth remain obligations of those consumers -- at least until something traumatic happens in those consumers' lives, like a California foreclosure, a short sale waiving a bank's right to a deficiency judgment, a loan modification agreement that changes the principal amount owed, a setoff of a 401(k) loan against the 401(k) assets, liquidation of real estate and financial assets at a massive loss compared to the peak price, or a bankruptcy.

In the meantime, the consumers who overextended themselves in realiance upon on unrealized paper wealth, are in considerable financial pain as they try to service debts that they can no longer afford because their wealth from asset appreciation is gone.

2. For those who got into the real estate market in January 2001 or earlier, real estate hasn't been a very lucrative investment -- no better than a savings account -- but it also hasn't been a bad investment. On average, they haven't lost money on what they put into it. It has been par for the course for what someone who is buying real estate in order to use it, as opposed to for investment purposes, expects from it.

Indeed, real estate bought for use that has been held for that long has been a better deal. All of the interest and property tax payments have been tax deductible, while none of the rent payments of household would have been tax deductible (the tax benefits of mortgage and property tax interest v. lease payments slightly favor leasing for commercial property user-owners, although it is a close call, however). The fact that mortgage payments don't go up, while rents do, has provided residential and commercial property owners with a considerable benefit in this time period (in theory, a long term fixed rent lease provides the same benefits, but long term, fixed rent leases for eight and a half years are rare). And, the implict return on down payment and principal payment on purchase money mortgages in the form of a reduced housing payment relative to a 0% down mortgage, has gone untaxed for the entire period. In contrast, the interest on cash in a savings account would have been taxed.

For most people, buying in January 2001 would have been a rational choice, even if they had known that the collapse was coming and knew that they would not be able to time the collapse of the housing bubble or leave the investment at all. Knowing that the housing bubble collapse and financial collapse was commoning would have caused many people to make smarter choices about incurring consumer debt during the past eight and a half years, but it wouldn't have prevented them from buying a house in the first place.

Of course, the story is much worse for people who bought real estate during the housing bubble with little money down (the classic starter home buyer), or put new money into the financial market during the post-tech crash financial market boom. These people, if they didn't pull out of these markets before the housing bubble collapse and bear stock market, have been slaughtered economically, no matter how prudent their spending habits may have been. The more recently they go in, and the more slowly they got out, the worse it has been for them.

Put another way, the Boomers and most Generation Xers have been battered by the financial crisis, but not ruined by it. In contrast, Roughly speaking, the generation of people born in the late 1970s or 1980s (late Generation Xers who hit "respectibility" late, and Generation Y) has been been financially turned uptside dow by the housing bubble collapse and financial crisis.

The collapse has also been particularly hard on those who accumulated much of their funds for retirement during peak earning years in the 2000s, who planned to retire near the peak (around 2006-2008) or in the decade or so afterwards.

Many people in this age group still had substantial exposure to more volatile parts of the financial markets, encouraged by financial planners who have encouraged retirement investors to think in terms of time horizon about the dates at the end of their life, rather than the beginning of their retirement. Now, they have seen the nest egg they planned to live on in retirement evaporate, and they have little time to win their losses back at work and still retire anywhere close to on schedule. For many, this will mean that they most continue to work well into the 70s, at least, to recover sufficiently to support theselves. This group of people were born roughly in the Great Depression or World War II, the pre-baby boomers.

Even those in this generation who didn't rely on real estate appreciation or volitile financial investments to cushion their golden years may be in trouble. Middle class employees of big businesses with fat defined benefit pension plans (like autoworkers), whose companies collapse in the financial crisis, will soon learn that the Pension Benefit Guarantee Corporation does not preserve 100% of their promised benefits. Small business owners in this generation are at high risk of seeing their long stable businesses, whose transfer to a new generation of owners had been their plan to finance their retirement or leave their children with something of value, fail. Time is bad for businesses all over in a down economy, and small businesses that have had a stable business model for half a century and are now under new and inexperienced ownership are in a poor position to innovate in the ways needed to weather the worst economy in eighty years.

* The use of the world "Real" in the name of the index is a reference to the name of its proprietor, the index itself is not inflation adjusted.

7 comments:

Michael Malak said...

Gen Y may not have suffered from the housing collapse because they have been averse to homeownership in the first place. There are at least three reasons for this:

1) They couldn't afford the bubble prices

2) They preferred urban to suburban living, and renting is more common in urban environments

3) Related to above, they don't want to be tied down to a mortgage and the need for a steady income (typically what they eschew as a "corporate job") to support it.

I tried quickly to locate stats on homeowners' ages and foreclosure rates, but couldn't find any right away.

Andrew Oh-Willeke said...

Foreclosure rates are very closely linked to low down payments and negative equity. The current wave of foreclosures has also followed very shortly after the purchase of the home -- most of the loans go bad in three years or less.

The stereotypical foreclosures have been on low down payment loans in starter home neighborhoods in the suburbs.

Experienced home buyers are frequently able to bring more sizeable down payments to closing with equity built in their prior home (particularly where houses were sold in bubble markets).

Average loan amounts in foreclosed loans have also been lower than the average loan, again supporting the notion that starter home buyers are hardest hit.

Certainly, there is no doubt that owners of foreclosed homes are much younger, on average, than owners of homes generally (about 30% of whom have no mortgage at all, something very rare for a Gen X or Gen Y homeowner).

My supposition that starter home buyers were disproportionately Gen Y was just that, an educated guess based upon a somewhat dated stereotype of a person's typical economic life cycle.

Michael Malak said...

A large portion of starter home buyers might have been Gen Y, but that doesn't imply that a large portion of Gen Y bought homes. I was contesting the headline claim of "slaughtered Generation Y" by pointing out that a large portion of Gen Y avoided home ownership in the first place.

But even your assumption about a large portion of starter homes going to Gen Y is suspect. Foreclosures in Northern Virginia, from whence I escaped the bubble in 2006, were in large part from immigrants who were "pursuing the American dream". There were also others on shaky financial ground, such as divorcees. The handing out of easy money attracted a diverse population.

christopher Smith said...

That is a sad reality, we dont know what will happen, some dreams may can not become truth.

Andrew Oh-Willeke said...

The point is not that people failed, but that failure has generational components that are only loosely tied to moral responsibility.

The fact is an argument for a more compassionate approach.

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