Friday, November 25, 2011

Watching the housing meltdown

Recently I discovered a Finnish blog devoted to the dynamics of their housing prices boom.  If you took the details of their story and moved them to USA, it would be 2007 all over again with some not-so-minor adjustments.  For example, Finland has managed its affairs so carefully that they are currently the only Euro-zone country that still conforms to the original Maastricht guidelines.  As a result, she is being asked to co-sign a ton of bad debt for the rest of the EU—something that annoys a lot of Finns.  So there is that big difference.

Because they are so cautious and sensible in most economic areas, the Finns might be forgiven for thinking that their housing bubble is somehow different than the rest of the housing bubbles that have collapsed in the past five years.  They may be right—but I doubt it.  I heard a major-league Finnish Ph.D. make all the same bubble noises last summer and they sounded pretty much like the crazy talk I heard in USA back around 2007.  Here's how it works. (simplified)

Someone buys a house for $40,000 in 1977.  In 2007, some eager real estate booster tells this homeowner his house is worth $400,000. The fool thinks he's rich and can easily borrow against his increased equity. The real house is 30 years older and now needs some expensive maintenance. No problem, just borrow against the equity and while you are at the bank, get enough for two months in the Caribbean and some more for that new Audi.

So he now gets to buy his house again—only now repairs are much more expensive than new construction (did I mention the house needed a new $100,000 kitchen because the owners believe they have become gourmet cooks?)

So now we have a guy with a $40,000 house who spent $40,000 in maintenance to get it back to original condition. So the real house has been returned to its original value. And assuming it was done well, the new kitchen may have added $100,000 of value to the real house.

So even though he might have paid off the original mortgage, our owner is now $250,000 in debt (remember the super vacation and Audi). He finds the new debt service onerous but, hey, someone told him his house was worth $400,000 so he still feels rich even though he is in hock up to his eyeballs.

Of course, if the median family income in USA is $50,000, the most a reasonable young couple should be able to pay for a house is $150,000 ($100,000 would be a lot better). This means that unless incomes rise, nobody can afford that house at $400,000 and the prices must eventually crash back to affordable levels.

What friggen mess this is. It doesn't take much to turn a mortgage upside down. Get a bunch of foreclosed properties in the same neighborhood, and those inflated property values crash down pretty fast. My nephew recently bought a house near Orlando Florida for $110,000. It had been sold previously for $385,000. And the values would come down even faster if folks didn't cling to the crazy idea that high prices will return.

So now the construction industry has 50% unemployment and the real estate business is worse.  Thousands of folks with serious skills have been essentially unemployed for four years.  Meanwhile, beautiful houses sit vacant and deteriorate from weather to vandalism.

And all this pain came about because otherwise intelligent people came to believe that their homes were an investment. They are not—homes (the real ones we live in) are like cars. They start depreciating the minute we buy them. They wear out. And they need regular maintenance.

I should tell you, I repeated the above paragraph at a party in 2007 in front of some academics who were delighted by their new-found wealth courtesy of their rising home prices. (When these folks started feeling rich, they began reading the Economist which only confirmed their greedy fantasies.) They looked at me in surprise and anger for telling this obvious truth. I could not have made a bigger social error if I had shit in the punch bowl. Trust me on this—when folks get caught up in a property boom, the madness is nearly universal.

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