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As the Real Estate Bubble Pops, so Does the Economy   (March 14, 2006)

First, let's demolish the cliches people spout to justify the notion that today's skyhigh real estate prices are permanent:

  • If prices drop, people won't sell, they'll hang on until prices recover. There is some truth to the psychology of that premise--no one wants to lose money--but the reality is, tens of thousands of houses will go on the market and will be sold regardless of the price. Why? People die, and their heirs just want the money, now, not in five years.

  • The fact that 20% of recent home purchases have been made by investors has no bearing on the market. Say what?!? If you're a savvy investor, and the market is clearly softening, what are you going to do? Sell. Sell as fast as you can, before the herd turns and tries to sell out before the crash. But irony of ironies, the rush of the investors to sell will trigger the very crash they rightly fear.

    As described in yesterday's entry, this hopeful cliche also ignores what happens when adjustable-rate (alas, always a low "teaser rate" to start) mortgages rise (the harmless sounding "resets"), triggering foreclosures. The lenders can't wait five years for values to recover; they need to get the distressed properties off their books ASAP, regardless of their losses.

  • Interest rates will drop as the economy flattens out, supporting higher real estate prices. You can wish for whatever you want, but experts see rates rising. Consider these excerpts from yesterday's article in the Wall Street Journal: A Central Bank Triple Play Produces Worries:
    "The market feels a lot like it did in March of 2000, right near the top," says Mr. McClintock of Babson. He doesn't expect a pullback nearly as severe as that one, but he has the same sense of excess market optimism at a time when the economy is slowing and bond yields are rising.

    Even the pessimists figure that bond prices will suffer more than stock prices. The prospect of higher interest rates makes existing bonds, with their lower yields, look relatively unattractive.

    Fears are spreading again that the Fed will keep pushing rates up until some blowup occurs in the financial markets or the economy -- at a big investment fund, for example, or in the housing market.

    Record U.S. trade deficits pumped dollars abroad, which foreigners obligingly recycled into U.S. Treasury bonds and notes. The heavy demand for U.S. bonds kept U.S. bond yields from rising much, which in turn kept U.S. mortgage rates low. Consumers borrowed and spent, and money was cheap despite the Fed rate increases. Warnings of coming trouble increasingly were ignored.

    Despite a bout of nerves last week as bond yields rose again, that kind of hopeful thinking has survived.
    In a nutshell: foreign buyers of U.S. debt (bonds) have artificially suppressed interest rates. Now, with rates around the world rising, the U.S. must raise interest rates in order to keep our bonds attractive to foreign investors--Asian central banks and Mideast nations flush with record oil profits.

    The inevitable conclusion: as bond rates rise, so do interest rates. As Interest rates rise, housing prices drop and foreclosures rise, putting more downward pressure on housing values. As housing values drop, American can no longer borrow their equity to spend, spend, spend. According to many sources (for example, Parade Magazine this past Sunday), American pulled out $880 billion from their home equity in 2005 alone. That accounts for about 7.5% of the entire U.S. economy, and about 10% of all consumer spending.

    And what happens to the economy when Americans can no longer count on more debt to support their lavish spendng? Recession.

    If you need some numbers, please read this piece from the Wall Street Journal: The Debt Bubble Threatens to Derail Many Baby Boomers' Retirement Plans

    Let's start with a shocking revelation: If you borrow money, it eventually has to be repaid. We all know this, of course. Yet the data suggest many Americans are trying their hardest to ignore this inconvenient fact.

    But they can't ignore it forever. Forget the 1990s technology-stock bubble. Forget the recent real-estate mania. To my mind, today's debt bubble will prove far more damaging. It's going to derail many baby boomers' retirement plans -- and it's already hurting the generation that follows.

    Facing facts. Make no mistake: The statistics are ugly. As a nation, our borrowing is growing as fast as our wealth, we are loading up our kids with college debt, and we are continuing our spendthrift ways into retirement.
    While this might be easily dismissed if it was from some wildly unfactual blog, this is from the august Wall Street Journal. How long can we as a nation dismiss the facts? For better or for worse, the markets will not dismiss the facts for much longer. The stock market is heading lower, predicting the coming "the real estate bubble has finally popped" recession.

    As housing weakens both in sales and prices, it feeds what is known as a negative feedback loop: the lower prices drop, the less people can borrow, and the debt machine grinds to a halt. As the cost of borrowing rises, people's spendable cash plummets, leaving them less to blow on consumer goods, further weakening the economy.

    In sum: the evidence is in, and it's compelling. Look out below.


    copyright © 2006 Charles Hugh Smith. All rights reserved in all media.

    I would be honored if you linked this wEssay to your site, or printed a copy for your own use.


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