Bacon's Rebellion

James A. Bacon





The Housing Bubble



If you thought the bust was bad, wait until the housing market crashes. According to John Rubino, the next downturn could bring the nasty recession we should have gotten in 2000. 


It sounds like such a noble undertaking. Who could possibly object?


Freddie Mac, the giant mortgage recycler, announced a partnership last month with BB&T bank and an affordable housing coalition in Alexandria to help poor people become first-time home owners. The faith-based initiative, “Catch the Vision, Develop the Dream” will provide homebuyer counseling and low down-payment mortgages to help low-income families purchase their own houses.


"The dream of homeownership is now one step closer to becoming a reality for more than 1,500 families," said U.S. Rep. Tom Davis, R-VA, at a roll-out of the initiative. "I applaud Freddie Mac and each of their partners for their continued efforts to expand homeownership in Northern Virginia."


Only a curmudgeon would fail to succumb to dewy-eyed sentimentality over the thought of helping Virginia's poorest citizens get a piece of the American dream.


Unless you happen to be John Rubino. The author of How to Profit from the Coming Real Estate Bust, Rubino is as compassionate as the next guy, but he  has no patience for the lofty platitudes and feel-good rhetoric that substitute for thought, especially among members of the political class.


“We’re creating a class of very fragile homeowners,” says Rubino. “People figure if they’re paying the same for their mortgage as they used to pay for rent, they’ll be OK.” But maintaining a house adds costs they may not have reckoned on – and poor people have little margin for error. “All it takes is one illness, one [auto] transmission going out, and they’re a step away from default. People are covering that stuff with credit cards. But they can’t keep it up forever.”


While Rubino worries about the ability of poor people to pay their mortgages and maintain their houses, what really concerns him is what initiatives like “Catch the Vision” portend for the broader housing market. Giving poor people a sliver of equity and hobbling them with debt is classic peak-of-the-

bubble behavior. Rubino regards a real estate crash as all but inevitable. And when it comes, nearly all Americans – not just over-leveraged homeowners – face a day of reckoning.


I’ve known Rubino for years: We worked together on the editorial team of Virginia Business magazine. He’s naturally cheerful, an optimist in his personal affairs, an up-beat guy with a ready smile -- not the dour-faced scold you’d expect from someone who's predicting imminent disaster. Now, I don’t know if his prophecies will pan out or not. But the risks he highlights are real, and intelligent people will take his warnings into account, whether planning their personal finances or plotting taxes, spending and other public priorities in Virginia.


Rubino lays out his case breezily, but with a convincing array of charts, tables and statistics in his book, easily obtainable through I’d recommend it to anyone interested in the future of real estate and the economy. In a nutshell, he argues that Americans have sustained their standard of living by borrowing excessively, especially for real estate. At

some point, the easy credit will dry up and the bubble will be impossible to sustain. Then confidence will collapse and investor psychology will kick into reverse. Judging by previous real estate recessions in Boston and California, prices could tumble nationally by 20 percent or more. The bear market will vary from region to region, depending on where the worst excesses occurred, but Americans everywhere will suffer from the sudden crisis of business confidence and loss of buying power.


I'll let Rubino riff a bit: "We’ve been borrowing insane amounts of money to buy wildly overpriced homes," he says. "As a society, we are like a family that over the last few years has maxed out our credit cards. We have an SUV in the driveway and a big-screen TV in the family room. To the neighbors we look like we’re in good shape, but we’re not.


"In reality, we're about to lose our shirts. Since our homes are the things we’ve been borrowing against most aggressively, that’s where the worst pain will be felt. More and more people will have trouble making their monthly mortgage payments, home prices will fall, home builders and mortgage lenders will start laying people off, and the stocks of everything related to housing and consumer finance will plunge."


Scary words. Now for the hard, cold facts.


Home prices are the highest in U.S. history: The price of the average U.S. home has increased 181 percent since 1980, far outstripping the CPI index; over the past five years, it's up by 38 percent. The total value of U.S. housing has inflated by $5 trillion in the past five years. (Rubino is citing 2002 figures).


Mortgage rates, which have reached a 37-year low, have almost nowhere to go but up. For the past two decades, declining mortgages have made housing more affordable. When rates reverse course, they will push monthly payments higher and crush the buying power that has sustained prices to this point.


Rather than let their equity build as home values rise, Americans are refinancing their debt and draining their equity to sustain lavish lifestyles. Equity as a percentage of home value hit a post World War II low around 2000, declining to 55 percent, down from 70 percent as recently as the mid-1980s. When prices do decline, as they inevitably will, homeowners will have less equity than at any point in history to cushion them.


In a related phenomenon, Rubino notes, consumers are gorged on debt. Homeowners have been piling on new mortgage debt at an unprecedented rate -- $820 billion in 2002 alone. That wouldn't be so bad if they'd used that debt to restructure their household balance sheets, but they haven't. Credit card liabilities are soaring too. Total consumer debt as a percentage of disposal income reached 14 percent in 2002, higher than at any time but a brief spike around 1988.


Consumer debt happens to coincide with record U.S. debt of all kinds, including business and government. The federal government is running up half-trillion dollar annual deficits again. Add it all up, says Rubino, and debt amounts to an astronomical $34 trillion -- that's trillion with a t, folks -- or about $450,000 for a family of four.


Much of this debt has been financed from overseas, but we can't count on the world's generosity forever, Rubino warns. Currently, the U.S. is running a balance of payments deficit of roughly $500 billion a year. The world is sloshing with dollars. And it looks like the tide is turning: The dollar has been falling against major currencies for the past year, and he expects it to fall a lot more.


Says Rubino: "For the last couple of years, foreign investors have begun to lose interest in buying our bonds and stocks. What they’re doing instead is converting into yen and the Euro. They’re selling dollars, pushing down the value of the dollar. It’s been an orderly decline so far. But orderly declines don’t stay orderly. Peoples’ perceptions change. People see they're losing money, and they all bail out at once."


Complicating the picture is the existence of something that no central bank really understands or controls: derivatives. There are some $170 trillion -- again, that's t like trillion -- of these financial instruments, interest rate and currency swaps mostly, laced through world financial markets. The people engaging in this financial hedging and speculation think they know what they're doing. Indeed they may, as long as financial markets follow familiar patterns. But if the dollar undergoes a prolonged plunge, asks Rubino, who knows how these complex, interlocking obligations may be affected? Conceivably, one big failure could trigger a series of cascading defaults.


Rubino thinks a currency cataclysm is inevitable -- indeed, he's researching that very subject in his current book project -- and he believes that such a crisis will trigger the real estate collapse.


When the crisis occurs, hundreds of billions, maybe trillions of dollars of foreign capital will pull out of the U.S. Supply and demand of credit will shift drastically. Interest rates -- and that includes mortgage rates -- will soar. Higher mortgage rates, combined with a change in investor psychology caused by the collapse of the dollar, will kick the props out from housing prices. Households with adjustable-rate mortgages will face escalating payments even while the value of their properties decline. Millions of Americans will find their mortgage obligations exceeding the value of their houses.


The immediate impact of the real estate bust will be felt most intensely in regions, like Boston and California, where prices have seen the greatest run-ups. The Washington metro area should be hit as well, says Rubino, though not as badly. Prices haven't outpaced incomes by as wide a margin as they have in the super-heated markets. Other metro areas in Virginia may get off relatively mildly.


But the concussion, like shock waves from an asteroid strike, will spread beyond the point of impact. A huge chunk of the economy revolves around real estate: land developers, home builders, construction workers, real estate agents, mortgage financiers, real estate insurers, and the like. Issuers of other forms of consumer debt will be close behind as homeowners, faced with the devil's dilemma of falling behind in their mortgage or credit card payments, start defaulting on their credit card debt.


In the Washington region, Freddie Mac and Fannie Mae, private companies who repackage mortgages for sale to secondary markets, could be major casualties. Capital One, a major employer in Northern Virginia and Richmond, could run into big trouble, depending on how well it's managed its credit card risk. Rubino regards it as all but certain that big home building companies will tank and the construction industry will shrivel.


As the blast radius expands, the damage spreads. The value of all homes in the U.S. runs around $13 trillion to $14 trillion, Rubino notes. A 20 percent decline in property values across the board could vaporize some $3 trillion in equity. The impact will be far more pervasive than the Internet crash not only because the destruction of wealth will be greater but because far greater percentage of the typical household's net worth is tied to housing equity than was ever invested in stocks. Homeowners will curtail spending, perhaps on a scale not seen since the Great Depression. Thus, in a tertiary impact, businesses from furniture manufacturers to restaurants, from appliance manufacturers to vacation resorts, will suffer drastic fall-offs in business. As these enterprises lay off workers, unemployment rises and purchasing power declines even more, spreading even more misery.


When a massive asteroid hits the earth, it blankets the atmosphere with debris and dust, cutting off the sun and spreading its destruction to all corners of the earth. Similarly, in the modern, globalized economy, havoc in one nation's economy is rapidly transmitted to others, as we witnessed during the so-called Asian Contagion of the 1980s and, later, the Russian debt default. Havoc in the United  States could spread globally. Rubino doesn't discuss these quaternary effects in his book, but he was willing to explore some ideas during a recent chat.


A precipitous decline in U.S. purchasing power would have devastating effects on the economies, especially in Japan, China and other East Asian countries whose economies depend upon exports to the U.S. The financial systems of both China and Japan are incredibly fragile, with banks tottering under hundreds of billions of dollars of bad debt. A collapse in export markets could trigger financial crises in those countries. In China, economic hardship could easily translate into social unrest, political instability, riots, lawlessness and general mayhem. (See my column, "The Five Instabilities," April 28, 2003.) Disorder in China could disrupt global supply chains with incalculable consequences.


Rubino foresees the possibility of the United States, wracked by economic hardship, losing the political will to pursue the war against terror in the Middle East. If we pull out of Iraq and the bad guys consolidate power over the Gulf oilfields, convert oil wealth into nukes and long-range missiles, then the entire global balance of power turns topsy turvy. "The political side of this is too terrifying to think about," says Rubino. "If you take the U.S. out of the mix, you have global chaos."


Scared yet?


The tag-line for Rubino's book is "Money-Making Strategies for the End of the Housing Bubble." His first piece of advice is eminently sensible: Cut your spending now, reduce your debt load and, if possible, start saving. He offers a variety of more aggressive options such as selling short the stocks of home builders and credit card companies, investing in cash-rich companies like Microsoft and buying gold. Rubino himself has paid off the mortgage of his house just outside Moscow, Idaho, and is heavily invested in gold. (Major nations will deal with the spreading chaos by injecting massive liquidity into the financial system, which will be highly inflationary and spur people to buy gold, a traditional store of value, he argues.)


Individuals can buy Rubino's book for advice on how to protect their personal wealth. Unfortunately, there's no handbook for elected officials entrusted with Virginia's government spending and tax structure. At the very least, they should avoid the temptation to avoid optimistic budgetary assumptions which, if they prove unjustified, create painful budget crises like the one just past.


If economic chaos spreads across the globe, all regions will suffer. But will suffer more than others. Let's just say that I wouldn't want to be Arnold Schwarzenegger right now: California could slip from  "really bad" to "total meltdown." By contrast, a handful of polities -- hopefully, Virginia will be one of them -- will display fiscal caution and spending discipline. They'll be able to survive the turmoil with minimal tax increases and modest disruption to essential services. Owners of capital will seek the security of these geographic havens. All other things being equal, the economic performance of these islands of fiscal rectitude will be less dismal that that of their spendthrift counterparts.


Right now, as Gov. Mark Warner and the leaders of the General Assembly gird for combat over tax reform and spending issues, Virginia appears to be entering the virtuous up-side of a business cycle. Secretary of Finance John Bennett has just announced numbers suggesting that tax revenues this year are unexpectedly robust. Past experience suggests that Virginia can expect to enjoy several years of strong revenue growth. Given the backlog of perceived needs in transportation and education, our lawmakers would have to be super-human to resist the temptation to ratchet up state spending commitments.


Given the odds of another economic downturn, however, our leaders need to prepare for the worst. "Think of this as a sucker rally," Rubino cautions. "Don't be fooled into thinking that the 1990s are back. Build rainy day funds. ... Government gets into trouble when it thinks that surpluses will last as far as the eye can see. Virginia needs to manage itself with the expectation that revenues could drop."


If Rubino is right, we could save ourselves a lot of grief by following his advice. If he's wrong, it won't matter -- we'll be too relieved to care.


-- November 17, 2003










































Fire back!


You can berate Bacon at [email protected]


Or read his profile here.