Sunday, June 5, 2011

On Investing: Part 14 (contd.)

Housing as biggest asset

The last posting discussed mistakes encouraged by the “most people’s largest investment” myth. To some extent those mistakes originate from confusing the verb form, invest, with the noun form, investment. Compound that confusion with mistaken beliefs about sunk cost, and the result is plenty of room for mistakes. With the second myth that “houses are most people’s largest asset,” there is no verb form. Yet, the mistakes the second myth create dwarf the first.

In fact, this “largest asset” myth was a major contributor to the recent financial collapse and the current slow recovery from the recession. Keep in mind that almost everyone’s largest asset isn’t their house; it’s their future income stream. But, everyone seemed to have forgotten that little fact. Banks wrote mortgages based on home prices, ignoring the largest asset of the borrower: their income. Borrowers leveraged up their largest asset, future income, to acquire an asset with a largely fixed return, a place to live, essentially guaranteeing that their capital would not contribute to income growth.

The mischief the “largest asset” myth encourages doesn’t end there. For example, it is now very trendy to discuss rational defaults for underwater mortgages without any reference to the default’s impact on a person’s largest asset. There is no doubt that a default is a quick way to shrink a balance sheet. It eliminates a big asset and a big liability, and, for an underwater mortgage, reduces the negative that “underwater” implies.

It reduces leverage, but unless there isn’t any other debt, it’s no guarantee of a solution to overleverage. It influences other assets’ values, most importantly future income. It has an impact on future income in a number of ways. First, it can affect employment prospects. Second, it can create the need for income to cover new expenses. For example, it increases the interest rate on other loans, not to mention their very availability. Further, the return from the asset, a place to live, has been eliminated. The cash flow effects can, over time, eliminate the initial impact of eliminating the asset and liability.

What makes sense is to put the size of the asset in proper context. The asset may be big and the liability may be big. However, it is almost never bigger that the value of future earnings.

Whether acquiring the housing asset made sense in the first place is more important than asset size. Generally, if the house made sense to purchase in the first place given income and the rest of the balance sheet, it is unlikely a default suddenly makes sense (unless something besides house prices also changed). If the home purchase never made sense in the first place, default is probably inevitable.

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