Housing 2007 = Stocks 1929

By Dan Jones
August 10, 2007

I was having a regular lunch with Michael Nystrom the other day and started mouthing off on my favorite economic analysis du jour. To wit: the collapse of the housing bubble in 2007 will be seen by history as the equivalent of the collapse of the stock bubble in 1929. He liked the analysis and asked me if he could write it up for BNB. I said, wait, this is my schtick – let me write it up. So here it is:

It all started, once upon a time, in the mid 1980’s, when a bunch of warning blips started popping up on my analytic radar screen. They were all about housing. These blips countered everything I thought I had learned about financial responsibility. In those days, I was still operating on those old stodgy assumptions that housing was part of one’s prudent economic planning – not where future income was to be made. During my early 70s passage into adulthood, the common wisdom was that housing paced normal inflation. No more, no less. Mortgage debt was a curse to be warded off. I remember when my parents went to mortgage burning parties. The banks did due diligence to make sure that your house mortgage was not more than two and a half times your income. But that was then. Anyone who took a second mortgage was probably in trouble. Quaint, wasn't it?

Suddenly, in the mid 80's that prudent financial wisdom no longer held. Housing prices were going up faster than the rate of inflation. In those days, everybody was hyper aware of inflation, after its ravages outstripped rational expectation after the mid 70's oil shock. But I gotta tell you, those 18% mortgage rates of the early 80s seemed to take the wind out of its sails for a while. Only for a while though. As those rates started coming down below 10%, housing prices started growing like they were on steroids. For a few years there were returns of more than 10% a year on housing investments.

Suddenly, everybody was talking about the price of his house. Competitive condo valuation was the cocktail party sport of choice. For a lot of my peers, their housing investment provided competitive returns to traditional investments like savings and securities. By the late 1980s, I was watching housing prices skyrocket while people on average weren’t actually earning any more than a decade earlier. My candy store mentality could no longer make sense of the market.
It was wacky. But hey, those were heady times. It was morning in America, the beloved Gipper was claiming that deficits (i.e. debt) don’t matter and back then, we were only a few trillion dollars in debt. Little did I know that one of history’s great speculative bubbles was just starting.

Soon, most of my generation saw that meteoric appreciation, and collectively decided that putting their money into real estate was smarter and more secure than stocks and bonds. This was especially true after the ‘87 Crash. Underlying values no longer seemed to matter in our economic lives. Real Estate was safe because “they weren’t making any more, and nobody ever looses money in real estate.” The sky was the limit. And for the past 20 years, except for an occasional blip, the common wisdom was right. Real estate has been a phenomenal investment in terms of its returns. The problem was that most people seemed to forget a few, basic truths about that market.

Residential real estate can't be a productive investment like commercial or industrial real estate. Except for market appreciation, it doesn’t earn income for the investor unless cash can be removed due to constant inflation in value. Your house only provides three tangible benefits: shelter, status and a tax dodge. And if you think about it, the last two of those are not always a sure thing. The status value might disappear if you are paying more than your can afford for it, and that tax deduction could be taken away if the rest of the world suddenly wants to collect on the US debt obligation. (But that is another tale altogether)

At various times during the 90s and especially after the Dot Bomb, it seemed like there had to be a moment when rationality would intrude on this manic market. But it didn’t happen. I had to admit that the financial system knew how to put band aids on cancer. Greenspan flooded the system with cash (we all learned the word liquidity), markets recovered and asset prices were off on their wonderful trajectory. The sky was literally the limit.

For the past 25 years, we just haven’t had the major correction in real estate prices. Instead we got flippers, and ATMs on the side of the house and hedge funds dividing up CDO tranches. Today, people assume that debt is merely another condition of modern life like traffic jams and global warming. It is definitely not seen as a bond of subservience to the lender which could limit total life options if not paid off. You just flip the property to the next fool and cash out.

So we drank our own Kool Aid, believed that everything was possible, and ignored all of the grey beards who said we might have to make changes. Greenspan and Bernanke could print all the money we needed. The Dollar was king, everybody was buying our debt because we were the last remaining superpower. The sky was the limit. We Baby Boomers didn’t worry that we had the lowest savings rate in history. We were going to cash out of our houses, and use the proceeds to fund our retirement. Or so we thought.

1929 Revisited
Which brings me back to the Market Crash of ‘29. If you read Studs Terkel’s book, Hard Times you can see the stories of the folks who were so convinced that their stocks were going to rise that they put all their savings into the market. Mailmen remembered the volume of brokerage statements that they delivered in ‘28 and ‘29 to all sorts of ordinary folk. Everybody was going to get rich on the market. Until they didn’t.

Today, the stock market is a sucker’s game. The mathematicians, and hedge funds have played the market to their benefit, not to ours. Housing seemed to be the perfect democratic investment where everyone in the “ownership society” could find security. But it seems now that it was all an illusion. It was the crack in last year's illusion of the infinitely expanding housing market which started the inevitable road to the current crisis with the hedge funds and the sub prime mortgages. Even the greater fools and the flippers couldn’t unload their property because finally, even the fools could no longer believe that a family making 65 thousand a year could afford a half a million dollar house. It became too silly. Just like the asset valuations in 29', the whole scheme no longer made sense. And so it started to crumble.

Now we are facing the downside of this debacle. My guess is that we will see all the asset market crumble on the back of this house bubble collapse. And future economists will use the great Housing Crash of 07 as the moral lesson for future speculators.