Southern California’s Cultural Pathology

[IrvineRenter]

Come by and enter our discussion on the bubble.

Southern California's Cultural Pathology

http://tinyurl.com/2ofb2u

Southern California is a beautiful place. The weather is perfect, there is a lot to do, and the people are generally friendly and keep out of your business. For those reasons and many others, I have chosen to make Southern California my home. However, Southern California is not perfect. The culture is infected with pathological beliefs that have led us to the huge problem with house affordability and the impending disaster in our real estate market.

What do I mean by Cultural Pathology? There are certain beliefs if widely held and acted upon by a group of people leads inevitably to collective suffering and/or destruction. One example we all see is in the American auto industry. Before imports hit our shores the American auto industry used to believe the quality of their product did not matter, people would buy their product irrespective of quality. For many years, the industry was successful despite this pathology. This belief allowed offshore competitors to enter the market, build market share, and finally take over the industry. The American auto industry’s belief system has had a pathologic effect on their business which has caused much suffering in Detroit, and it may ultimately lead to the bankruptcy and destruction of our major automakers.

The best treatise on the pathology of cultural beliefs was George Orwell’s novel 1984. In Orwell’s vision, a totalitarian State had convinced the populace the following:

* WAR IS PEACE
* FREEDOM IS SLAVERY
* IGNORANCE IS STRENGTH

Although these statements are clearly contradictory, in the story the slogans do make sense to the State. For example, through constant “war”, the State can keep domestic peace; when the people obtain freedom, they become enslaved to it, and the ignorance of the populace is the strength of the State. Just as Orwell’s Big Brother convinced the populace the above contradictions were true, Southern Californians (with a little help from their own Big Brother, David Lereah, president of the National Association of Realtors) have convinced themselves the following:

* APPRECIATION IS INCOME
* CREDIT IS SAVINGS
* DEBT IS WEALTH

Just as these statements are contradictory and ridiculous, the proof that these statements are believed is that they are reflected in the actions of Southern Californians. For example, through borrowing against one’s increasing home values, appreciation is turned to income; when people obtain more credit, they spend it like available savings, and a large amount of debt used to finance a large, opulent home makes one wealthy. Ask any homedebtor in Southern California, and they will tell you that makes perfect sense.

The problem is rooted in a basic misunderstanding of what separates the rich from the poor: the habit of saving. You have heard the expression, “the rich get richer and the poor get poorer.” It is more accurate to say the rich save money and the poor spend it: in the end, the rich will have money, and the poor will have none. This is not one of life’s inequities, but rather of of life’s simple truths.

When you hear your average Joe tell you he wants to be rich, what he is really saying is he wants unlimited spending power. He wants the ability to spend like the rich people he sees wearing Rolexes and driving BMWs to their mansions in Shady Canyon. This is why, when given the chance, poor people will emulate the rich by spending beyond their means in order to be rich. Of course, in the process, they spend themselves poor.

Appreciation is Income

Look at the difference between the behavior of rich and poor when it comes to home price appreciation. The rich view home price appreciation as adding to their net worth. If lower interest rates allow them to refinance, they will restructure their debt to pay off the loan more quickly in order to increase their wealth. Poor people view home price appreciation as income; free money for them to spend. If lower interest rates allow them to refinance, they will restructure their loan to pull as much home equity as possible and reduce their payment as much as possible so they can spend more. If any net worth happens to accumulate, they obtain a home equity line of credit and spend the appreciation as quickly as possible — it makes them feel rich even though it really makes them poor.

Credit is Savings

So how do the rich and poor deal with credit? The rich don’t carry consumer debt. Why would they pay interest on a credit balance when it almost always costs more than the income they earn on their savings? The rich will use credit sparingly and most often pay off any credit balances each month as the bill comes due. In contrast, the poor carry as much consumer debt as they can afford to service. Whenever they receive an increase in a credit line, they believe they have more money to spend, just like it was savings. In a strange way, a credit account is like a savings account, only it has a negative balance. In a savings account, the saver earns money; in a credit account, the spender loses money. Again, the rich have savings, and the poor have credit.

Debt is Wealth

There are a great many Southern California residents who live in big houses, and they believe that makes them rich. To them, the possession and use of an expensive house makes them wealthy even if they have no equity in the property. The rich buy less home than they can afford and work to pay off the debt in order to maximize their net worth. The poor stretch their finances to possess more home than they can afford with loan terms which never retire the debt, or in the case of negative amortization loans, actually increases their debt held against the property. This ensures they either never gain any equity or only gain it by appreciation, and as mentioned previously, if prices appreciate they quickly withdraw the gain to fuel more consumer spending.

It’s a California Thing

So what happens when you give poor people money? They spend it. I’m sure you have all heard the stories of people who won the lottery and managed to spend themselves into bankruptcy a few years later. These stories are classic examples of the pathology of the beliefs of spenders. A great many Southern Californians are spenders. This is why I contend that Southern California has a strong cultural pathology. The reason our house prices have been bid up to such dizzying heights is because there is a high percentage of our population in Southern California that subscribes to the spending habits I have described. They went out and borrowed as much money as they could with suicide loans, bought up all the real estate they could get their hands on, and in the process drove real estate prices into the stratosphere. In other areas of the country, reckless spending is not so trendy, and home prices have not been bid up so high.

I grew up in the Upper Midwest in a rural farm community. Pretentious displays of conspicuous consumption are less common in the Midwest, and consumerism is often viewed with contempt rather than envy. In short, there is a smaller percentage of the general population in the Midwest with the aforementioned pathologic beliefs. To prove this, I would like to profile Minnetonka, Minnesota, a suburb of Minneapolis with very similar income and demographics to Irvine. According to Sperling’s Best Places, the median income in Minnetonka, Minnesota is $84,024, and the median income in Irvine, California is $84,253. I think that is close enough to be a good comparable. The median home price in Minnetonka is $305,600 and the median home price in Irvine is $689,000 (92620 Zip Code). If my thesis is correct, one would expect to find a much higher percentage of home loans utilizing exotic loan terms in Irvine as compared to Minnetonka. Remember the Map of Misery?

Map of Misery

In fact, according to the map, in 2006 the Minneapolis area had 8.7% of its loan originations were negative amortization, while Orange County had 32%. In all of California more than 80% of loan originations in 2006 were either option ARM or interest-only. Here we have two groups of people with the same median income, and with the same access to credit making very different choices. Potential homebuyers in Minnetonka and Irvine faced the same decision on taking out a suicide loan and buying more house than they can afford or chosing to live within their means. Very few in Minnetonka chose to overextend themselves, so they did not bid up the values of their houses. Orange County (and the rest of Southern California) chose to utilize exotic financing and thereby real estate prices were bid much, much higher. The high utilization of exotic financing was the cause of the price increase not the result of it. Nobody was forced to buy.

So if we accept the premise that Southern California has a high percentage of its population with the spending habits I have described, so what? Everyone here in Southern California is spending freely, feeling rich, and enjoying life. What is the problem? Where is the pathology? Isn’t it true Californians are just more financially sophisticated than the rubes back on the farm in the Midwest?

It is pathologic because it is not sustainable: It is a house of cards. There is an inevitable Day of Reckoning when all debts must be paid. Charles Ponzi was the most extreme example of the pathologies illustrated in this post. So extreme was his activities, that the term Ponzi Scheme has become synonymous with the use of ever increasing amounts of investment or debt. This scheme is also encapsulated in the expression “robbing Peter to pay Paul.” At some point, the debt becomes so large that no lender is willing to loan more money and no greater fool can be found to bail them out, and the whole system comes crashing down. However, while the debt was building, the debtor became accustomed to a certain lifestyle and level of spending. When the credit is cut off, the debtor can no longer spend, and a great deal of suffering ensues.

We are quickly approaching the Day of Reckoning in our housing market. In my view this will be Armageddon for California debtors: the spending will stop, they will lose their homes and with it their illusion of wealth, and they most definitely will not be enjoying life. The cause of all the weeping and gnashing of teeth will not be some exogenous event, but rather a direct result of the circumstances they themselves created.

[greekfire]

IR,

You give a nice synopsis of the Piggington Blog (er, Powayseller’s posts) over the past 2+ years. Nearly everything you said makes sense, however, it will take some time for the general public (and fundamentals) to catch up.

I want to say that I feel you, but that there is some inconsistency with at least one of your statements. The Minnetonka vs. Irvine example is the one I would like to highlight. Although both cities have extremely similar median incomes, they both have extremely dissimilar housing demand.. The reason that Minnetonka median home prices are so much lower than Irvine’s is simply due to supply and demand. How many people do you hear of driving cross country from the East Coast to end up in…Minnesota?

In hindsight, it is plain to see that a plethora of Irvine’s demand was driven by speculation in the OC, LA County, as well as Riverside County. With that said, even speculation has to succumb to the laws of supply and demand. The point I am trying to drive across here is that there appears to be a measurable difference between the number of people that want to purchase a property in Irvine (nice weather year round), versus those that want to purchase a property in Minnetonka (nice weather May-September, crappy weather the rest of the year).

Of course, local economies, diversity, public schools, and the like all play a role, but you catch my drift. Having grown up in Maine myself, I see exactly where you are coming from. Ten years ago I would probably have told you that you are completely full of it. However, Arizona, Texas, and Nevada have caught on and present much more competition to potential California transplants. Add to this the age of the Internet and you have a workforce that can potentially be connected from anywhere there an internet connection.

[IrvineRenter]

greekfire,

Good to know I am capable of parroting Powayseller…

“the reason that Minnetonka median home prices are so much lower than Irvine’s is simply due to supply and demand.”

“The point I am trying to drive across here is that there appears to be a measurable difference between the number of people that want to purchase a property in Irvine (nice weather year round), versus those that want to purchase a property in Minnetonka (nice weather May-September, crappy weather the rest of the year).”

One of the points I was trying to make is that those statements are fallacies not backed up by income statistics or availability of housing inventory. Although I will agree with you that Irvine is a more desirable place to live (otherwise I would move to Minnetonka), demand is measured in dollars, and Minnetonka has the same amount of dollars available to purchase housing as Irvine does. There is not so many fewer homes available in Irvine than Minnetonka to justify a median home price that is more than double.

[NeetaT]

IrvineRenter,

Thanks for the edifying write-up. I found it very informative, well written, and interesting. I think most people lack the patience to handle finances in the most efficient and practical manner. They want everything yesterday. My wife and I have careers of what I consider mid to low income. I’m in the military and she is a hotel front desk manager. Because I follow the rich persons guidelines that you set forth in your write-up, my wife and I are able to put away $6,000.00 a month after all our monthly expenses are paid. Most people will not agree with what I have done in the past to get me to this point. First of all, with the exception of my first automobile, I buy everything with cash or credit card to be paid in full. In other words, I don’t buy anything that I cannot pay off immediately with cash, not even a house. Oh yes, I was castigated for buying a house with cash in full on the day of closing. It is unreal how much money I saved when I bought with cash. I have since sold the house and now rent in Virginia Beach, VA. I am again being castigated for renting, but for now it makes since for my wife and I. Anyway, to make a long story short; by virtue of my financial habits, I am able to do what all the spendthrifts are doing with the peace of mind that I have a substantial amount of money saved up, have no debt and can buy a house with cash even in San Diego. As a consequence of most peoples credit spending habits, prices go up as inflation gets out of control due to everyone being able to afford everything via credit. If I had it my way, no one would be able to borrow money and prices would remain in check.

[carlislematthew]

One of the points I was trying to make is that those statements are fallacies not backed up by income statistics or availability of housing inventory. Although I will agree with you that Irvine is a more desirable place to live (otherwise I would move to Minnetonka), demand is measured in dollars, and Minnetonka has the same amount of dollars available to purchase housing as Irvine does. There is not so many fewer homes available in Irvine than Minnetonka to justify a median home price that is more than double.

IMO, it’s perceived demand that is sometimes more important that actual demand. It’s artificial. It’s easier to say “Orange County will always be in high demand” compared with “Minnetonka will always be in high demand”. The perceived level of always-high demand creates an impression (illusion!) that “prices will never go down”. When you have THAT in your mind, you decrease the perception of risk, and you inflate the prices.

Perversely, the widespread assumption that prices never go down, is one the reasons that prices went up so far, and then went down!!

[RottedOak]

A better way to compare Irvine and Minnetonka might be to look at their price increases over the past decade. Sure, many might consider Irvine to be more desirable, and thus it commands higher prices overall, but I don’t know of anything that has happened in the recent years to make Irvine increasingly more desirable than Minnetonka.

[IrvineRenter]

“IMO, it’s perceived demand that is sometimes more important that actual demand…The perceived level of always-high demand creates an impression (illusion!) that “prices will never go down”. When you have THAT in your mind, you decrease the perception of risk, and you inflate the prices.”

That is an excellent point. The “real estate never always goes up” delusion also had its part to play.

[Nancy_s soothsayer]

IrvineRenter,

Bygollygosh, you write so well!!! I could feel the wisdom oozing from that masterpiece you wrote. Thank you. Amen to all of that.

[AK]

I read somewhere that “broke” is the condition of having no money, but “poor” is the set of attitudes and behaviors that keep you broke. I wish I could remember who said that …

[Anonymous]

Well put.

Irvine Renter wrote:

In all of California more than 80% of loan originations in 2006 were either option ARM or interest-only.

Can you point me to the source of this quote?

I think it sums up the Cali housing market issues in one short, sweet statistic.

CG

[bub]

Broke is a temporary condition, poor is a state of mind.” –

— Sir Richard Francis Burton

http://www.quoteworld.org/quotes/2176

[Anonymous]

Why is So. Cal the bad seed in this? Though I agree with the premise of the article, I think focusing on Southern California as the poster boy is off the mark. SoCal real estate lagged the nation during the run-up in the late 1990’s.

And which city leads the nation in foreclosures? The great Midwestern city of Denver. Is Denver’s pathology any different than here?

[Anonymous]

Denver may lead now, but So Cal will catch up and take the lead over the next year or so, no problem.

[CardiffBaseball]

I don’t consider Denver to be the Midwest. Far more Western, than say Chicago, Cleveland, Minneapolis or St. Louis. However I am sure the foreclosure rates are high there as well. Bear in mind that these areas never saw the ridiculous runup in prices, and thus there is less equity to fall back on. Here foreclosures were a non-issue for several years because of run-up.

[Anonymous]

Wow. An excellent synopsis of the scourge of SoCal. I moved here from the East Coast 3 years ago, and agree completely. Although most urban areas suffer from the same pathology, although to a lesser degree. I think the root of the problem in SoCal is that gratification MUST be instant. Folks just don’t want to work hard and get rich slowly. Yes, some are fortunate enough to work slightly and get rich quick, but the only reliable bet is to live below your means and enjoy life not for the car that you drive, but for the choices that you make being a true expression of your personality. Oy, that said, folks should just grow up and realize that the size of their house has absolutely nothing to do with who they are. I rent an 800 sq. ft. half of a duplex, and make more than $330K a year. I also contribute more than $10K per year to a few select 501(c)(3)s, and love every minute of it. I also like the security of knowing that I could quit my job tomorrow, walk away from the rental, and wander the earth for 10 years on amassed savings. That’s not what Madison Avenue touts as cool, but that’s my idea of true freedom.

[Author]

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