Monday, June 13, 2005

Housing Crash

This article reveals the irrationality in people's thinking about housing:
The key difference is that stocks are purely financial investments. You can sell a stock on a whim, and you don't have to run out and buy another. By contrast, people live in houses, and if they sell they have to move -- which is both costly and time-consuming.

"How could you have a housing crash?" asks Ted Aronson, managing partner at Aronson Johnson Ortiz, a Philadelphia money manager. "We all just sell our houses and move into a trailer park?"
No, the way you have a housing crash is that the guy next door to you gets divorced and has to sell his house and the market clears at a rate much lower to yours. You are now upside down on your mortgage, so if rates rise or you are forced to sell, you will give your house back to the bank rather than eat the $200K loss. Incidentally, banks expect this.

Banks will have to write down their losses and sell their new assets at firesale rates. This will push mortgage rates higher and depress prices further. People with ARMs will also end up upside down on their mortgage and be pushed to make payments they just cannot. They will cut spending if possible, if not, they will hand the keys back to the bank.

This will continue until the only people holding houses are those with fixed rates they can meet BUT their property price will be set by the guy next door who had to sell.

An interesting point on the consequence of the pop:
The IMF found after studying housing cycles world-wide that "private consumption fell sharply and immediately in the case of housing price busts while the decline was smaller and more gradual after equity price busts." That's even though housing price declines were usually smaller at 30%, adjusted for inflation, compared with 45% for stocks. The U.S. had never experienced a decline of such a size in the period the IMF studied, so it's unclear how much the global experience would apply to the U.S.
Remember -- cheap equity frequently went back to consumers in the form of crazy promos. Those of us who did not get in on the Internet bubble could still order furniture online at deep discounts with free shipping! So an equity pop would just reduce "excess" spending generated by shareholder wealth being channeled to consumer surplus via freebies.

In housing, ARMs mean that higher rates/lower prices will result in less household discretionary spending as more money goes into making those mortgage payments. If people aren't upside down on their loans, they will eat dogfood to make payments until they 1) divorce or 2) get fired. Then they hand the keys back to the bank.


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