Economic Distortions Caused by the Housing Bubble

For a decade the Housing Bubble dramatically distorted economic activity. These distortions and their impact on the economy as they unwind have important implications for the length and severity of the downturn.

A Dramatic Increase in Leverage Underwritten By Unsustainable Asset Values

During the Housing Bubble the amount of debt attributable to houses increased in real and relative terms by a degree never before seen in history. The value of the housing stock in the U.S. more than doubled as it expanded by in excess of $9 trillion. Under normal circumstances such an increase would have contributed to a substantial expansion of home equity for existing owners. Instead, during this period of real estate appreciation, the ratio of debt relative to the value of housing increased dramatically.

As property values rose potential buyers would normally have been prevented from or have found it increasingly difficult to purchase houses. Homes become less affordable relative to income, capital available for down payments and cash flow necessary to service mortgage debt. Buyers relied on increasing percentages of debt to purchase higher priced houses. This capital was available for a myriad of reasons including government intervention, the Federal Reserve’s decision to lower interest rates, yield hungry foreign capital seeking risk-adjusted returns, the influence of securitizations, and a full continuum of companies working to facilitate the creation of mortgages. In many cases people borrowed 100% or more of the perceived value of the property to finance purchases. Others took out Option ARMs which resulted in debt levels far in excess of the transaction value of the home.

Another “financial innovation”, the ability to monetize theoretical equity gains through home equity loans, further exacerbated the leverage problem. Owners with rising equity and expectations of further increases cashed out their paper gains in favor of current consumption. As such, theoretical equity gains from rising prices were diminished or erased. This is the equivalent of Internet investors in 1999 borrowing money secured by unsustainable stock values in order to finance the consumption of motorcycles, boats, vacations and flat screen TVs.
As prices have fallen the equity gains are evaporating but the debt which was incurred remains. As leveraged as the asset class was at the height of the Housing Bubble, every day it becomes more leveraged as prices fall and equity disappears even more rapidly. One in six mortgages in America has a balance in excess of the underlying home’s value. Homeowner equity is at the lowest level as a percentage of total home value in U.S. history.

This extraordinary level of debt has dramatic implications for the economy as home prices continue to fall. Consumption is effected and consumer confidence is eroded. Consumer focused businesses suffer and unemployment rises. The debt must be serviced and repaid. When it can not be serviced or if owners decide it is not in their best interests to do so, foreclosures result which further erode home prices and destroy the capital base of our lending institutions.

The Wealth Effect of Rising Home Prices

Consistent and rapidly rising home prices distorted the economic decisions of home owners. As home values rapidly appreciated, leveraged equity returns contributed to a dramatic wealth effect. When people gain wealth they choose to consume more goods and services. As 75 million U.S. households experienced rising house values the impact of the bubble affected the entire economy. These people spent more money.

Rising values also dramatically distorted the U.S. savings rate. Americans consistently lowered their rate of savings as the Housing Bubble persisted. The savings rate dropped to zero and then went into negative territory during the worst of the mania. Such decisions seemingly made sense to homeowners as their wealth rose regardless of individual savings rates. Why save a small percentage of your paycheck when the consistent appreciation of your home increases your net worth by many times that which you could have saved?

Home equity loans facilitated this distortion as individuals could monetize their increasing equity for current consumption. The government’s tax policies further incentivized this activity. For anyone with a credit card balance, the prospect of accessing a home equity loan was an obvious benefit. Instead of paying recurring fees and high interest rates, a home owner could borrow money via an equity loan and deduct the interest for tax purposes. With the expectation of future gains, most borrowers anticipated that rising home values would effectively pay off the loans.

Home equity loans constituted approximately 3% on consumer spending from 2002 through 2005. This source of consumer spending has been removed from the economy. Record low savings rates further fueled the Housing Bubble driven consumer boom. Not only is the incremental consumption gone, but Americans will have to increase the rate of savings to pay back debt, make up for years of missed savings and restore equity in their houses. Such activities will further damage consumer spending. Even conservative people who didn’t over borrow or access home equity loans may reduce spending due to negative wealth effects from falling home prices, stock market losses, rising unemployment or impaired consumer confidence.

The Direct and Indirect Economic Impact of the Housing Bubble

The impact of the housing boom on the industries that constructed new housing, facilitated mortgages and executed home transactions was profound. While these segments are small relative to the total economy, their impact was dramatic, extended far beyond those specific sectors and dominated economic gains at the margin.

Home construction, mortgage facilitation and sales functions created millions of jobs. The impact of these incremental jobs was material. Employees produced goods and services, shopped in malls, ate at restaurants, bought houses and paid taxes. Employers that serviced homebuilders including carpenters, painters, furniture manufactures, roofers, landscapers, electricians, plumbers, wallboard manufacturers, sales people and marketers directly benefited from these activities. Real estate brokers, appraisers, mortgage brokers, investment bankers, ratings agencies and title companies were enriched by increased transaction levels. Many other businesses were affected by the increased employment, higher expenditures and the non-direct, iterative impact of prosperity.

Unfortunately this homebuilding episode was an economic distortion. The demand for incremental housing supply was driven by ill-advised government agendas, dangerous, inappropriate and highly leveraged mortgages, speculative investors, optimistic buyers and a massive availability of cheap capital. Today we have the largest inventory of empty housing units in our country’s history.

There is no reason to believe that any of these economic benefits will persist. We have already seen massive layoffs and contracting economic activity in the most affected geographies and industries. The employment benefits from the Housing Bubble will vanish as economic activity returns to levels last seen in the 1990s.

Impact of These Distortions

A decade of unsustainable housing appreciation dramatically distorted economic activity. The Housing Bubble created a legacy of extreme home leverage, deflating housing prices, negative wealth effects, declining economic activity and rising unemployment. The implications as these distortions unwind make it unlikely that the U.S. economy will avoid a prolonged depression.