This topic is in response to a question by North County Jim, in the topic
"Obvious Guy" sez a Soft Landing is Possible. He challenged my assertion that a housing bubble bust will cause a nationwide recession. He believes that RE bubbles and their fallout are
local in nature. He noted that the dotcom fallout and the S&L debacle did
not cause a recession. He made a good argument, and when someone is sharp
enough to make a good argument, I take the time to respond in kind.
I will quote/paraphrase from From John Talbott's book, Sell Now.
Industry expert predictions about the post-bubble economy are as rosy as
they were during the boom. Prices have gone up too much in too many areas
for there not to be a major correction that will be national or even global.
Our most overpriced cities are also our largest cities. The 22 most
overpriced cities are more than 40% of the total value of all residential
real estate in the country. Even if a housing correction could be magically
contrained within their city limits, the negative wealth effects would be
The weakened economy will shake through the Midwest and interior states, as
well. Once accelerated job losses associated with the end of the housing
boom hit, their home prices will drop violently downward. A $125K house in
the Midwest that has appreciated $20K in the last nine years has as big a
percentage risk of a decline in price as a $3 million home in Malibu. Houses
do not have to go up in price in order to come down. The prices of many
homes in the Midest will end up lower than they were before the boom.
People have mistakenly tried to compare a national housing collapse to a
bear market in stocks. There is no comparison. The U.S. stock market is
worth some $15 trillion, while RE is worth more than $20 trillion. More
than 75% of all U.S. stocks held by individuals are held by the richest 10%
of Americans, while nearly 70% of Americans own their own homes. A decline
in housing values will be felt more broadly.
Another difference: housing is purchased with more debt leverage. So if
you have 80% debt on your home and the market price drops 10%, you absorbed
a 50% drop in the value of your equity. The net effect on investor wealth
is 5-10x higher for a similar housing price percentage decline as compared
to a stock decline. Even homeowners with equity should watch out: if you
had 40% equity and the market drops 30%, you will see 75% of your equity
Imagine a stock decline so substantial that 50 - 100% of many investors' net
worth evaporated. That has never happened, not even during the crash of
1929. If housing declines in price by 30%, a return to where prices were
just 2 years ago, many people would lose most or all of their net worth.
Nobody has been talking about the magnitude of this possible disaster. The
media has discussed the ramifications of a housing decline that is so
optimistic, involving slight price downturns and soft landings or pauses in
a continually increasing market.
The major impact of an adjustment in housing prices on the economy is not
going to be due to the wealth effect, but from the simple fact that our
economy for the last 5 yeasr has been built on only two foundations: the
housing market and government (mainly military) spending.
The first economic impact is 1 million RE brokers who have been chasing 6%
commissions will become unemployed. Next, 1 million more people working as
mortgage bankers, appraisers, title lawyers, commercial bankers, mortgage
packagers. Remaining employees in this industry will see 35% salary cuts,
as their pay is commission based, and if sales prices fall 35%, so will
The next business to dry up is the renovation business. New home
construction will also almost cease.
The construction, home renovation, banking, and real estate industries are
four of the largest industries in America. Layoffs in these industries will
be significant enough to cause a major recession. But unfortunately, the
story is not over.
When Suzie Realtor is laid off, she buys less groceries, attends fewer
movies, buys fewer dresses, vacations, cars, and goes out less to eat. The
pullback in consumption from those who face reduced salaries and layoffs in
the housing industry will pull other healthy industries down with them.
Layoffs will spread, and the economy will begin a serious contraction.
Because the US is such a driving force of the world's total overall
consumption, a recession here is sure to spread globally. No world power can replace the purchasing
power that might evaporate from the US. Our
rercession will be the force that ends up deflating the housing bubbles
worldwide. Global recessions will result. The first rule of developing
countries is: No US growth means no US consumer demand, means no developing
But I have not yet told you the worst part. If you are squeamish, stop
reading right now.
Remember that significant amount of debt leverage that homeowners have on
their homes that magnifies any housing price decline and increases the
impact on homeowner equity? There is a counterparty to that debt that
suffers as well. We cannot forget the banks, Fannie Mae, Freddie Mac, and
the other institutional holders of all the mortgage paper we have created.
Since banks have become so aggressive in their lending, much of this
mortgage paper will be fairly worthless when home prices decline.
Fannie Mae and Freddie Mac are leveraged over 100 to 1 in aggregate. That
means their real assets only cover 1% of their loans. Thus, if only 2% of
their portfolio experienced 50% credit losses, they would be technically out
of business. The taxpayer tab could easily run 20% of their assets, or
about $500 billion.
Commercial banks' total assets are 40% in RE, so a decline of only 12% in
the price of their entire portfolios of mortgages and RE assets would wipe
out their toal bank equity, which is typically about 5% of their total
Worse, banks don't actually have to lose money before the real threat is
realized. The real threat is loss of confidence of depositors in the
banking system. Banks have only about 5% in cash on hand to repay
depositors. The rest is in illiquid assets, like loans. The government
does not have liquidity to save all the banks, in case it would come to that
Because this would be the first national housing crash, and because almost
all banks hold a significant amount of their assets in mortgages, the
government would have great difficulty guaranteeing all the depositors'
funds. We are talking trillions of dollars in deposits that might want to
walk out the door in any one day.
This is the end of Talbott's excerpt. May I add this: small cities all
over the US, which had no runup in prices, are already seeing waves of
foreclosure, because ARMs are a nationwide phenomenon. Also affected are
cities hit by poor American competitiveness such as the auto industry: in
Detroit suburbs, where the rich have cut back on gardening, manicures, etc.,
the fallout is felt on those secondary industries. The nursery owner is
having financial difficulty, because the rich clients had to cut back on
their regular big spring gardening expenses.
Another item Talbott overlooked: as interest rates have risen, the MEW
(mortgage equity withdrawal) effect is going to subside. Consumer spending
is 2/3 of the economy, according to economist reports. Imagine what will
happen if that even is cut in half! The MEW wave is dying, and so will
consumer spending along with it.
One last point: The USA, once the greatest productive nation, has become the greatest debtor nation on Earth. Our trade deficit is possible because we have the world's reserve currency. Other nations won't keep sending us money forever. The party will soon be over on that front as well.
Sorry to be so gloomy, but knowing the facts makes us better investors, and we can prepare our finances much better, armed with this full story.
Let's all of us put our brains together, add to this topic, and then pass it along to everyone we care about.