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Baby Boomer Risk: The 7:1 Solution
January 5, 2004

If you want to understand why the widely reported U.S. �economic recovery� feels less than convincing, go buy yourself a copy of the new book, The Two-Income Trap: Why Middle- Class Mothers and Fathers Are Going Broke by Elizabeth Warren and Amelia Warren Tyagi.

Warren, a law professor at Harvard and author of The Fragile Middle Class and her daughter Tyagi, a former McKinsey consultant, have collaborated on this book to argue that twoparent, middle-class working families are on the brink of financial disaster. The reason? Because the demographic wave known as the Baby Boom has bid-up the cost of housing and related services to unmanageable levels. Families have boosted income to keep pace with the speculative boom, but many families considered by the banking industry to be solidly middle class � and of high credit quality � are in fact insolvent.

The number of families declaring bankruptcy or receiving a foreclosure against their house has shot up dramatically, Warren & Tyagi report. But for every American family declaring insolvency, another seven families have financial problems that would warrant a bankruptcy filing.

Contrary to popular myth, American families aren't in financial trouble because they're squandering second incomes on luxuries. On the contrary, both incomes are almost entirely committed to necessities such as home and car payments, health insurance and education. When an unforeseen event such as serious illness, job loss or divorce occurs, families have no discretionary income to fall back on and little savings.

The Internet bubble of the late 1990s and the related swings in the value of the equity markets may have seemed gigantic at the time, but this important book suggests that the biggest bubble of all � namely the market for U.S. homes � may be in imminent danger of a correction.

For a while now, we have been bothered by the fact that the rate of increase in mortgage originations and re-financings has far exceeded the underlying rate of economic growth over the past few years. The rates of increase in the assets of the largest mortgage provides like Fannie Mae and Freddie Mac are likewise out of step with the underlying �real� economy.

We wonder at the sanguine attitude of our neighbors and friends regarding residential real estate valuations, especially when many of the properties they inhabit could not earn sufficient rent to cover the mortgage � much less the local taxes and school fees. If the authors are right about the 7:1 ratio between financial zombies and bankruptcies among American families, then it is time to join the renting class and short the stock of the bank that held your mortgage.

The powerful point made by Warren & Tyagi is that not only home prices, but the cost of all manner of local services, have been driven to extreme levels compared with household income during the middle age of the baby boomers. The chilling statistics in this book confirms our longheld view that the children of the boomers are spending and borrowing to keep pace with their more affluent parents.

Like stocks during the Internet bubble, all markets eventually revert to the mean, usually with an prolonged excursion below that level. When the credit cycle linked to the Baby Boom is done, politicians and central bankers will be praying for the return of some 1970s style demand-pull inflation.


New York, January 12, 2004 - We heard a number of comments about our last comment regarding the financial fragility of the American family and, indirectly, the sacrosanct real estate market. One veteran bankruptcy practitioner said: �Agreed. I expect the bust will occur in this order: Rising interest rates, increasing defaults on credit cards, increasing individual bankruptcy filings, which will increase the number of people hoping to sell homes to take out a profit and stabilize their balance sheets, and it goes downhill from there. In other words, I expect credit cards will bust, causing a housing bust.� The same onlooker adds optimistically: �We'll have to wait and see.� Keep those cards and letters coming.

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