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Jay Currie

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6/05/2005

Who, Me, Worried??

The state's booming housing market has generated $1 trillion in increased home equity since 2000, triggering billions of dollars in consumer spending, the California Building Industry Association reported yesterday.

In addition to strengthening the economy, the gain in home values makes it highly unlikely that widespread mortgage defaults will occur in the event of a sharp economic downturn, said Alan Nevin, the association's chief economist.

"People have the ability to borrow against their homes," Nevin said. "If times get tougher, they could borrow a sufficient amount to pay their mortgages."

Refinancing has enabled homeowners to buy goods and services "they wouldn't have been able to afford otherwise," he said.
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While currency pricing may be an abstraction, the ability to borrow really large chunks of money agianst the paper profits locked up in your house is very real and very worrying. Pace builder economist Nevin, where people have leveraged their borrowing against the appreciation of their home during the good times, they can, in the event of an economic downturn, become mega-paupers in an instant. What Nevin seems intent on ignoring is that in a downturn people will a) have already borrowed against the equity in their homes, b) be watching that equity evaporate as housing prices fall...

The problem with the current state of real estate prices is twofold. First, they have lost touch with what people actually earn and now reflect such never, never financing schemes as interesst only mortgages. Second, it will be difficult, if not impossible, to engineer a "soft landing". The second problem is a function of the first.

If you buy a house for $400,000.00 with a downpayment of $40,000.00 and you have an income after tax of $60,000.00 you are buying an asset for six times the total of your yearly net earnings. This is a bit crazy; but imagine you have done this and the value of that asset goes to $600,000.00. Now you look like a genius. So, feeling your oats you go and borrow $100,000.00 to pay off your credit cards and put in that new home entertainment center. Now you owe eight times you net annual income.

So what if you lose your job? Or you keep your job but there is a downturn and the houses on your block are being sold at discounts of 20% (a relatively mild housing crunch) from the top price of $600,000. Well, you're ok because that means your house is worth $480,000.00 - and you only have $460,000 in debt secured against it.

Of course you are not going to be able to borrow any more money agianst your equity and that is going to mean you will not be able to buy more stuff on your credit cards with the assurance that the rise in the value of your equity will pay those cards off. Which will, if it happens in the suburbs of North America, lead to significantly reduced economic activity....the malls will empty.

Now, add a little oil shock. Nothing catastrophic, say $75.00 a barrel oil and $4.00 a US Gallon gas. Are we having fun yet?

A minor bump - a terror attack, a wiggle in the upward curve of gas prices, a mild sell off of US currency and Treasuries by Japan and China - might be enough to shift a downturn in housing prices into a bit of a rout.

The fate of a given suburbanite as he drowns in home equity financed consumer debt, while personally tragic, is largely irrelevant. However, the joker in the pack has been the way in which banks have bundled their second and even third mortgages into securities, discounted the paper and sold it to pension funds or as bonds.

The accurate measure of the value of a currency, as I argued below, is a matter of the bets which speculators and central bankers put on the future prospects of a nation. If the real estate bubble, with its doubtful lending practices and willingness to pass the paper to the last sucker, shows signs of collapse, all bets are off with the USD.

Which, I fear, will overwhelm the relative prudence which Canadian lenders have shown in their dealings with our own often inflated real estate market. While a rising tide lifts all ships, tsunamis ignore borders.