Housing Burst Will Cause National Recession

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Submitted by powayseller on April 14, 2006 - 5:33pm

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
felt countrywide.

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
wiped out.

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
their pay.

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
country growth.

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
assets.

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
point.

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.

Submitted by Jim Brubaker on April 23, 2006 - 11:47pm.

Thanks PrivateBanker for the SIPC correction. I'm just getting old.

What I was trying to convey with mutual fund managers, is that they have never experienced a bear market. The market has only gone up since 1972. The idea of holding cash to wait for a good buying opportunity doesn't exist with them. They must invest the money as fast as they receive it. There is no performance factor for holding cash.

If the market ever decides to tank, everyone of these money managers has made the same bet, the market is going up.

Normally if the market did tank, investors could wait to sell hoping that the market would make a come back.
The case is different with Mutual Funds. If their holders say sell and give me cash, they have to sell into a downward spiraling market. These manager's might be very intelligent and skillful, but their hands will be tied if and when this happens.

Submitted by privatebanker on April 24, 2006 - 8:33am.

OK, here's my take on this just for sake of debate. I totally respect your views first and foremost.

Mutual Fund managers do carry a cash position which can vary depending on market conditions and the fund's objectives. They can also employ derivative strategies to protect asset value. This takes us into another category. Active fund managers can manage a cash position depending on how the market is behaving. They may not keep it for a long time but there is no rule against them doing so. If you invest in an index fund, you probably won't have any cash position and no break from a crashing market. These funds offer daily liquidity so people that start panicking on a market dip can get out. The successful investors are the ones who stay in for the duration.

The last bear market to my recollection was fairly recent. I believe it really got started in March of 2000. Before that, back in the 80's, the market was pretty ugly for a while. My point here is everything is cyclical. Certain assets will outperform other assets depending on macro and micro economic situations. Always make sure that you invest in a fund where the manager has been around for atleast 5-7 years.

I just think investors need to keep a grander view of their investments and not focus on short term trends. If you do your homework and pick the right managers you should be fine. Have exposure to as many noncorrelating asset classes and stick to an asset allocation policy of rebalancing.

But like I said, this is just my view and I've been in the business a long time and have experienced a lot of crazy markets (up & down).

Submitted by Jim Brubaker on April 24, 2006 - 10:27pm.

I remember a Monopoly game we played a long time ago, The bank ran out of money, so we printed some money using a pencil and paper--these were $1000 notes. Then we ran out of houses and hotels, we improvised. We used chess pieces.

Now take two steps backward into today. Derivatives are a parachute that will save the world when everything hits the fan. If you believe that, then contrary to my beliefs, the tooth fairy must still be alive.

Submitted by privatebanker on April 25, 2006 - 7:45am.

Are you serious?! No wonder that tooth has been sitting under my pillow for all those years! I've been waiting for my big windfall! I'd better let JP Morgan know that their derivatives are no good anymore, thanks for clearing that up.

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