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Life in the Bubble: House Prices and Net Worth

Asset price inflation made us "rich", on paper, and pushed pundits to pronounce economic health, banks to lend and folks to spend, spend, spend. Here is where complication enters the picture.
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Thank you for all the great comments on the last post. I hope you find this second installment in the series valuable. It starts slowly but, it is my hope you will find it worth the slog. I start by laying out the household balance sheet and look at how that is in play- at risk. The roles of housing prices, debt and market conditions are explored below.

As of April 2007 total household debt stood at $13.432 trillion dollars. This statistic and many to follow, come from the Federal Reserve Board's Z1-Flow of Funds [pdf] Publication. 1 Total debt includes mortgage borrowing, car loans, credit card debt and all other reported forms of bank, credit union and financial borrowing. Over the last 10 years the average growth in household debt was 9.3% per year. Total household assets stand at $69.608 trillions. This includes real estate -- $22.874 trillions -- stocks, bonds, bank accounts, mutual funds, pensions, consumer durable goods. This gives American households a net worth of $56.175 trillions. Net worth is calculated by summing all assets and subtracting the summation of all liabilities. That works out to $187, 250 in net worth for each of the 300 million Americans. At first glance this appears a picture of flabbergasting affluence. When reporters handle this information, wealthy America tends to be their message. The wealth of America is both vast and impressive.

What gets lost in the story? How did we arrive at a point of falling stock markets, declining house prices, rising debt and general turmoil? Part of the answer lies in the problem of valuing assets that move rapidly in price. Way back in 2002 our net worth was a relatively paltry $38.8 trillion dollars. That is just 69% of today's grand total. We have increased the value of our houses by $7.1 trillions in those short 5 years. Across the same period we added $13 trillion in value to our financial assets and $4 trillion in the value of the assets in our pensions. On paper that is! Most of these changes in value are really just changes in price. Thus, asset price inflation made us "rich", on paper, and pushed pundits to pronounce economic health, banks to lend and folks to spend, spend, spend. Here is where complication enters the picture.

These years of rapidly and magically expanding wealth were furnished, in large part, be easy access to huge volumes of credit on great terms. People borrowed and spent. More money chased the houses and assets available and bid up the prices. This showed up as rising value of assets. As prices increased confidence in future price gains grew. More was borrowed and further bid up prices. Fear and risk were banished as more and more debt chased up asset prices. That is how bubbles form. All that borrowed money showed up as rising debt too. We borrowed an additional $3.85 trillion in home mortgages from 2002-2007. A 64% increase in mortgage debt bought us a 52% increase in the value of real estate. This suggests trouble. We should have gotten more growth in assets to compensate for all that extra debt. Some of the bloom is off the rose. It gets more complex, bare with me. All that money we borrowed, the extra $3.85 trillion, has to be paid back. It has to be paid back on time and with interest or you get what is happening now, mortgage defaults.

This is how bubbles burst. The prices of assets, houses included, can rise and they can fall. The money borrowed to purchase the house is relatively fixed. The re-sale price of the home is far from fixed. This mismatch between fixed value liability -- mortgage -- and variable value asset- house price-can cause trouble. It can also furnish gains. That is why so many chased the dream. They believed, they put their borrowed money behind the dream. For a while it worked, not anymore. Confidence in the bubble is sliding. Faith wanes in the prudence of borrowing more and more to buy increasingly expensive assets. The real risks come crawling back up, out of the dark corners where they were banished during the euphoria. You start reading writers like me. I have been telling this story for 13 months.

Trouble quickly begs the question, how will we pay it back? We could look to our savings, but we don't save anymore. Not since back in 2004 did we have a positive personal savings rate. We can look to sell assets, borrow more or pay out of income. Let's start with the idea of selling assets. There is evidence that this one is gaining in popularity. Many folks are clearly trying to sell their homes (the inventory of unsold homes on the US market has been high lately. The National Association of Realtors reported [pdf] a 7.8 month backlog as of June 2007). Global stock markets have been tanking as people sell equities to raise money. The problem with this idea is that the more people try to do this, the lower asset prices fall. We then run the asset inflation in reverse. Asset prices deflate or decline. Prices are fleeting and adjustable. The debt, like all those tattoos people like these days, is forever. When many decide to sell something, they flood the market with vastly larger supplies of the item in question. All else being equal, this will exert a potent downward pressure on the things everyone is trying to sell. Some folks will do well, others much less so. Recent declines in home prices, and bonds made up of home loans, are a very relevant example here.

Across the globe financial firms, investors and speculators are trying to get out from under anything with mortgage backed security taint on it. They too had trouble -- despite all those models, professionals and research reports -- valuing these mortgages. Thus, it is no surprise that millions of American families had trouble figuring the worth of the deals they took on. Like American families, these firms neither correctly valued, nor correctly understood the risks they were taking. Everyone is looking to sell assets and borrow more. Asset supply is spiking up and credit is harder to find. This is creating falling prices and rising fear. This shrinks asset prices. Like that great self reinforcing bubble that inflated the credit and house bubble, the new trend self extends.

What about borrowing more? People are clearly doing this. On August 07, 2007 the Federal Reserve released the Consumer Credit Outstanding Report (G19).3 This report revealed a 5.5% increase in consumer credit outstanding from April through June of 2007. June, the last month of available data, saw a 6.5% in consumer credit. Global central banks are also trying to help firms do this. The European Central Bank (ECB), the Federal Reserve Bank of the US (Fed), The Bank of Japan (BOJ) and others have made hundreds of billions available in the last few days. They are trying to make cheap and vast pools of credit available to the firms caught in the shuffle. Like millions of families and homeowners, asset markets and bankers are running scared. This fear and all the folks running for the exit, smash prices and confidence.

We are in the fear and asset deflation process now. It clearly has further to go. There will be better days, and more really rough sailing ahead. The next installment of this series will look at where we are headed. We will look at re-payment from income issues and the likely future direction for house prices and credit conditions.