Why The Housing Number Matters

Yesterday’s housing numbers may have the same impact as Time-Warner’s purchase of AOL did in January 2000.

The Time-Warner deal put a ceiling on Internet stock values, and from there all those stocks plunged to the floor. News that new home sales dropped 4.3% while housing inventory rose to record levels last month could do the exact same thing. Only while the Internet bubble bursting only hurt investors with enough money to afford stocks, this will hit everyone. 

And it gets worse. Houses are not liquid, that is, you can’t sell them quickly (as you can stocks). What happens is that houses go on the market and sellers hold-and-hold, waiting for a break. (The house here has been on the market over a year.) It’s only after a "motivated seller" finally cracks that we learn what all homes in an area are really worth.

Once that price is established, everyone in the area becomes poorer. This has a major knock-on effect. People stop going out to eat. People stop spending on fancy coffee, chiropractors, aroma therapists and pet washings. Those merchants, in turn, start laying people off and going under.  This means commercial real estate becomes less valuable, and some corners become worthless. (We already have a glut of mall space.)

(Google says this house was built by a Virginia developer on a road he decided to call Poor House Lane.)

What you get is a vicious cycle, instead of a virtuous circle.
People see other folks in trouble and hold their wallets closer. Crime
goes up. Tax receipts go down, especially local receipts. Foreclosure
rates go up.

Right now, the American economy is more leveraged to the housing market than at any time in history. Here in Atlanta, 32% of all recent mortgages were interest-only.
A crack in values means people are paying interest on money they no
longer have.  This was not true in England or Australia, where housing
had a "soft landing."

Housing also takes a long time to correct.  By the time it does
correct, housing is actually affordable. That is, the average buyer can
put 10% down and handle principal-and-interest payments representing
just a quarter of total income. This hasn’t been the case in America
for many years. But where else is the new money going to come from if
speculation is gone, if you’re just as concerned the price of the asset
will fall as rise?

A housing collapse doesn’t respond to any quick cure. A drop in
interest rates doesn’t make for a rise in sales, because the underlying
asset’s value has begun to fall and bankers don’t know what its real
value is. Thus they have to take a closer look at whether you can pay
the loan back, something they haven’t looked at until now.

Rising foreclosures means there is more housing inventory in the
"motivated seller" category — banks and county governments are always
motivated to sell. Thus, the real floor price of housing has to
overshoot its true value, in order to clear out that inventory. Once
the plunge begins, in other words, it continues.

Falling gas prices won’t help, either.

Dean Baker, co-director of the Center for Economic and Policy Research,
estimates there is $5 trillion in "bubble wealth" from housing that has
to drain out before prices stabilize. Consumers have borrowed $600
million on the value of their homes in the last year alone. Just getting housing starts back to historical trend levels will cost 2 million jobs, he says.

This is going to hit banks hard. It’s going to hit the government
harder, because so many of these loans are bundled by quasi-government
agencies like Fannie Mae. It’s going to hit foreign investors because they
bought packages of these loans, in the form of bonds, and suddenly they
may not get paid back. That sound you hear is supposedly U.S.
government-backed bonds blowing up in a Chinese investor’s hands. Think he wants more Bush debt?

We can’t just drop interest rates to the floor because inflation is now
real. If interest rates fell to, say, 2%, which is what they were at
just a few years ago, the government would be literally giving money
away, because inflation is now 2.5%. Worse, as people are pushed out of their homes rents go up, meaning inflation is actually rising while the crisis rolls along.

Given how leveraged the government’s balance sheet is, with Iraq costing billions of dollars per week and no new taxes being raised to pay for it, you can expect a rush away from dollars when those housing bonds start blowing up. This makes the spiral even-harder to stop.

Worst of all, this pain is going to start to be felt in September and October, when America is in the midst of its election season.

The recession has begun.