$5 Trillion in Housing Wealth Gone: The Impact of the Housing Bubble Bursting

A sane person surrounded by insanity will at some point, question his or her own mental health. Examining the past decade of housing especially from Southern California, the epicenter of the housing bubble, you begin to question economic fundamentals and simple rules of finance. At this point, we are reaching the overdue housing correction. Housing has created immense wealth in the economy and has propelled us out of a brief recession earlier in the decade. Yet this wealth was created on an illusion of easy credit. It is estimated that the housing bubble has created 5 trillion additional dollars of wealth as compared to a scenario where housing kept pace with inflation. This is important to note because historically, housing has only kept pace with inflation as an investment. When you have certain areas up 80 percent in real terms as the Center for Economic Policy Research has showed, we have speculation and not normal growth.

We will look at the past decade of housing and address the following issues: income, inflation, rental rates, bubble specific regions, and the public policy issue of bursting the bubble.

Income Has Gone Up

In real terms, per capita income has grown 2 percent annually since 1997. This is something positive for our economy. It does show that as a nation, we are growing and thriving. Yet certain industries are now facing the pull back associated with the housing downturn. Consumption and automobile sales are taking massive hits in the last few months. Construction is falling in large numbers. We have only started to see any of this impact in our economy. The $5 trillion in bubble wealth has created an extra $250 billion in consumption that would not be present if it were not for the housing bubble. This works out to be 2 percent of our GDP; in other words, without that wealth we would already be in a recession.

Even though income is up, it does not justify housing prices being up in real terms of 80+ percent. And with income being up, we also have higher cost associated with health care, energy, and household items so the 2 percent increase is really negligible.

Real Estate Has Normally Treaded with Inflation

Decades of data show that real estate normally grows at the rate of inflation. That said, why do we have real increases of 80 percent in certain areas? You may say, 80 percent is large and I doubt this is true. In California, countless homes that cost $175,000 in 1997 are now on the market for $500,000. Pick any of the 88 cities in Los Angeles County and you’ll see that this 80 percent number actually understates the growth. So is it possible for housing to fall 50 percent in a few years? If housing can go up 200 percent in certain areas over 10 years, then yes, a 50 percent drop is plausible. As a caveat, when you are arguing market fundamentals for a bubble, any number is possible but the eventuality is that the bubble will burst and market fundamentals do rear their head again. For example, the long tested rule of housing keeping pace with inflation.

Rents have not Increased Significantly

During the initial stages of the bubble, rental rates did go up in decent numbers. However, in the past few years, real estate has outpaced rental market rates by an unbelievable number. Most investors and economist associate a rental value on the property in terms of deriving the actual value of the home. For example, many investors will divide annual rents - expenses by the price of the home to arrive at a return on the investment. In most cases, it will always be slightly more expensive to purchase a place than renting even after factoring in tax benefits. The premium will always exist because you are purchasing an appreciating asset that is building up equity (normally at the pace of inflation) and will create a real store of value for you.

After a few years of bubble psychology and straightjacket number crunching, many people modified their equations to factor in 20 to 25 percent annual appreciation rates and thus justified the price of homes even though rental rates were significantly lower and in no way supported the market value of the home. The premium of the home was based on the false assumption of abnormal market returns. In simple terms, pure speculation. Now that more inventory is hitting the market and sales are dropping, we will see certain areas declining in rental rates. In certain prime areas, we will see an inverse reaction with rental rates going up while housing prices go down. It will all be specific to each certain market. In the end real home prices will decline.

Only Certain Areas Have Bubbles

Certain areas such as the South and Midwest actually saw no true real increase in prices over the past decade. Then we have areas such as the Southwest, DC, Northeast, and Florida seeing real price increases of 80 percent in certain regions. The bubble is national in the respect that overall statistics are heavily tilted by regional bubbles. Meaning, the numbers are skewed by certain metro regions being overvalued. Population trends do not justify the upward jump in prices because overall, we are seeing many baby boomers retire. If anything, they are getting ready to downsize their home as opposed to expanding for a growing family.

We also have massive construction that really had no bases in population growth. If anything, as a society families are choosing to have fewer children. The need for larger and bigger homes is spurned on by nothing more than bubble speculation. The demand is simply not there. That is why we are seeing a record number of vacancies hitting the market in many regions of the country. Many people bought homes in other states thinking that they would be able to rent them out as investments but forgot to check local market conditions. The population in many of these areas simply did not meet up with the growth in housing. In fact, some areas didn't even have a population to begin with - these are the future ghost neighborhoods of America.

Public Policy: Bursting the Bubble Now is Good

When you watch shows like American Idol or America’s Got Talent, you can see that some contestants honestly believe they are the greatest thing to walk this Earth when in fact, the sound of mating cats is more enticing. Just like these delusional would be superstars, we have many folks accustomed to the decade long bubble in housing. They feel entitled to this $5 trillion of pseudo-wealth created by a bubble fueled by horrible public policy. Public policy by who? The Federal Reserve and the hunger for mortgage backed securities on Wall Street. The quicker the bubble bursts the better it will be for the overall long-term sustainability of the economy. The bubble has already been left unchecked for too long and the repercussions will be felt to the very core of our nation. You cannot use debt to finance your entire economy. Unfortunately, we have too much credit floating around and we are going to face a radical public policy debacle and potentially a government (read public) bailout.

Many baby boomers are counting on the wealth in their homes. In fact, savings rates and retirement nest eggs for many of these folks are massively under funded. And why should they save? If they have the perception that their home is going up $50,000 per year unabated for the next decade, why fund a 401(K) or IRA when you can make much more simply living in your house. This is reflected in the response many people have regarding their retirement. They assume the money will be there. Like a mirage in the desert, the closer they get to retirement the more they will realize much of what they saw was simply an illusion.

Then we have 8 million people a year buying homes at inflated prices. Like Alan Greenspan has mentioned, bubbles are only identifiable after the fact, it is hard to say the exact start date of the bubble. Was it 1997 or 2000? It also varies on which region. Back to the millions of recent buyers, they are purchasing homes at current bubble market rates. When the market corrects, the negative wealth effect will hit these folks very hard and direct. Even those who bought 10 years ago and never planned to sell, will take a psychological blow because their once valued $500,000 home is now only “worth” $375,000. This will have a major impact in our nation’s consumption.

Even with this tremendous housing wealth, owner’s equity isn’t that high. A startling fact if you think about it. The ability to take money out of your home has been a national phenomenon in the last 10 years. Once thought as an untouchable resource, folks have been more than willingly to extract perceived equity and fuel consumption. This only increased the magnitude of the bubble. For one, the money tapped out of the home creates a 2^nd lien on the property that needs to be paid back. It isn’t free money. Yet people treat it as a grant that doesn’t need to be paid back. In many cases, these loans are paid over 10 years. Now what do you think the impact on a person taking out $50,000 in their home only to realize their home was never worth that additional $50,000? My guess is they will feel slighted and think that they got suckered into signing up for $50,000 of relatively cheap debt.

This irresponsible lending has created an environment where the only recourse is a hard and steep correction in the housing market. The Fed, housing industry, buyers, and sellers were only all too happy to be accomplices in this bubble. Yet this doesn’t mean that what has occurred is based in any economic reality aside from the fundamentals of asset bubbles. It was all an illusion. Now that we are seeing subprime lenders imploding and mortgages resetting, the true cost of this economic expansion is coming to fruition. The more and more I look into this issue, the more it seems that we will not see a soft-landing in housing.

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