"Your House is an ATM" -- Savings has Been Replaced by Reliance on House Price Inflation
Are we endangered by a new Savings Paradigm?
In the pantheon of new paradigms, Savings deserves a special mention. Low savings rates are often spoken about as the likely source of a future calamity. However, relatively few individuals seem worried about the level of their own savings; they are more focused upon wealth issues, like increasing the equity in their homes. For many I believe there is a new paradigm at work. And those economists, critical of the low savings rate, are not being heard by the general population, because the Average Homeowner beliefs are simply behind the times. Old notions of savings have muddled the subject to a point that clear thinking became nigh impossible. This short essay is an attempt to unmuddle it.
Before you run off screaming, or nod off with boredom, let me have a chance to mention why our society's notion of savings is important. Understanding how we save can help you increase your wealth and may help you protect your wealth in the changing times ahead. Isn't that enough reason to read on?
Economists and government officials alike talk about the need to increase savings. What do they really mean? Is it important? Are they targeting meaningless financial targets, while individuals who are less encumbered by old fashion thinking are behaving in a totally rational way? Perhaps those formulating governmental policies are guilty of "fighting the last war," while the important skirmishes of the current war are being lost for lack of understanding.
Let's start with a definition. On the edges are two extremes. There are cash "savings" which pile up in bank accounts. And then, at the other extreme of a savings definition, there's personal wealth: the value of an individual's total assets: cash, securities, and real estate, net of all debt. Finally, there's the technical definition used by economists when discussing the savings within the economy as a whole that runs something like this: "National savings is computed by combining the savings of households and corporations, while subtracting the budget deficit of the government." (that's from Business Week, May 2004.) Those who use the technical definition are saying that savings in the US look inadequate - and perhaps in the UK as well. Yet the economy goes on growing, with individuals pursuing their own goals, and the US Government Treasury sales supported by monies flowing in from surplus countries like Japan and China. With this process going on for so many months and even years without a serious breakdown is it right to remain concerned?
'One Account' Blurs Savings and Mortgage debt The new savings paradigm is most apparent in the design of a relatively new financial product called a "One Account" released about two or three years ago by banks and financial service companies in the UK. The idea of the "one" account is that an individual does not need two separate transactions, one a mortgage loan, the other a savings account. Normally, if a homeowner keeps them separate, the savings account proves inefficient. The individual is in effect giving the bank his savings and then borrowing it back at a higher rate of interest.
Why pay a "spread" on your own money? What the "one" account does is to give the individual a mortgage, but with flexible repayments (within certain broad limits.) This way, if there is extra cash at the end of the month, the individual simply pays down his mortgage, thereby increasing the net equity in his home. If in the next month he needs money, he increases his mortgage debt somewhat. So long as at the high point of each year, the debt stays below certain pre-agreed limit - which are related to a normal amortization schedule - the lender is happy. From the individual's standpoint, the beauty of this scheme is that he is paying off the more expensive mortgage debt. The reduction in interest expense provides a better return, than the saver would get from interest on a savings account. And the 'one' account may also reduce taxes, since there is no savings income subject to taxation. (This type of account works best when the mortgage debt, or the least a portion of it which can be prepaid and reborrowed, is at a floating rate.)
This type of loan flexibility has helped individuals to think about savings in a more powerful way: The real challenge is to increase one's net wealth, not just the balance of their personal savings accounts. And this notion has helped them to see their homes as a vehicle for savings. It is obvious that increasing net equity increases their wealth. And home equity is increasingly liquid wealth too, because there are myriad financial methods (remortgaging, equity release loans, selling-to-rent) for releasing that equity. With this liquidity achieved quickly and cheaply, equity-in-the-home becomes almost indistinguishable from equity in a savings account or in a securities account.
Government officials and their economists may be out-of-date, if they think that the balance of a savings account matters to the new breed of Home-Equity-Savers who have grown up in our age of quick-and-easy financial services. Logically, most people will put their efforts into increasing their aggregate wealth, more than trying to hit some mythical cash savings target. Ironically, in a time of soaring property prices, this objective has encouraged many to borrow even more money in order to buy a bigger house than they need, or a second property, in the hope that the value of the larger property investment will increase, pushing the investor's net equity to a higher level. And what's wrong with becoming a landlord? Particularly, if the amounts to be received in rentals, exceed the amounts paid out as interest. It is not only big hedge funds who can enjoy the benefits of a "carry trade." So we see that, the new wealth paradigm has the impact of increasing debt and reducing traditional savings.
Of course there are risks in this aggressive borrowing program. Rates have been low for years and many fail to believe that they can shoot back up to the old high and dangerous levels. But with oil prices now surging, inflation may be making a surprise comeback. And a sharp rate increase is particularly dangerous for those who have over-borrowed or exposed to floating rates. A second risk is that property prices can fall. If and when they do, it they may decline even faster than they speed at which they rose. A fall would reduce net equity, while also making it more difficult, or even impossible to generate liquidity from refinancing. There are less obvious risks too. Credit could become less available. The forward march in financial innovation has been encouraged by the steady rise in property prices. If prices fall, and loans turn sour, banks will tighten their credit policies, and the ability to easily liquefy equity in a property may evaporate, even as that equity is melting away.
The risks are there to be seen, but when the central banks like the Fed and the Bank of England seem relentless in keeping stimulus in the economy in order to avoid a recession, few worry or think too hard about the risks they are taking. The risk looks remote to those who are accustomed to seeing a regular increase in property values. And they remain focused on the upside challenge, seeking ways to increase their net equity. With wealth in property seemly indistinguishable from wealth in traditional "more liquid" investments.
My fear is that, like many "new paradigms", this one will fade into a tragic memory when the inevitable crisis hits.