Watch the Housing Market, And Fear for Your Country!

The news that Manhattan real-estate prices took a plunge last quarter may not be the loud crack in the sky presaging doom, but it is less than happy tidings. The New York Times reports that prices dropped a startling 13 percent in a three-month period.

It also reports a similar weakening of the real-estate markets in formerly hot towns like Boston, Washington and San Francisco. These are not the only places where real estate seems to be running into trouble, but another 13 percent drop in a three-month period hardly seems likely. That would be a free fall, behavior you see from time to time in the stock market, but not in real estate. Let’s call this last three-month performance one of those unaccountable blips.

Still, something is afoot.

It may only be that the housing market has reached a price plateau. Maybe we’re hitting a period of stability, of neither up nor down in real-estate prices. Nothing to rejoice about in that; such a situation may not be the crack o’ doom, but doom itself. It is possible that a level real-estate market could trigger a major recession, which will, in its turn, bring real-estate prices farther down later on.

Doom or no doom depends on whether or not American prosperity turns on a continuously rising real-estate market. Retiring Federal Reserve chairman Alan Greenspan has recently published some numbers suggesting it does. He says that the practice of “cashing out”—that is, refinancing the house every couple of years as its value increases—has given consumers a huge unearned income stream.

His figures tell him that refinancing and home-equity mortgages constitute no less than 7 percent of American disposable income. In money, that’s an infusion of $600 billion a year, or twice the size of George Bush’s tax cuts. For that gigantic sum to vanish, real-estate prices don’t have to collapse; all they have to do is stay the same. If they stay the same, consumer spending shrivels. Add on to that the rise in the cost of fuel and the continuing flat or slight decline in the line on the graph indicating personal income and voilà! Recession.

For years, economists have taught us that the driving force in American prosperity is consumer spending. The fuel for that driving force has been the Greenspan policy of such cheap and available money that anyone in the United States not behind bars or in a straitjacket could get a loan to buy a home.

It was quite a system that we worked out, or stumbled on, this past generation. You bought a house on a next-to-no-money-down basis, the house increased in appraised value by 10 percent even before the first load of dishes got put in the washer. You refinanced the house to extract the 10 percent appreciation and spent it on a vacation and, by the time you’d returned from the camping trip to Colorado or the Kalahari desert, the value of the house had gone up another 10 percent. Time to refinance again and use the money to wipe out the family’s credit-card debt. And the best part of it has been that this income was manna from above, free money you didn’t have to work for. The only labor involved was signing the paper and putting out the effort to get down to the mall and spend it before it was time to refinance again.

The system has been an A.T.M. available for an infinity of withdrawals, and you never had a need to make a deposit. People gave up saving, as the figures show, and why not? Who needs to save if somebody is going to fill up your bank account every year or so with near-automatic punctuality? In such an atmosphere, the millions went on a shopping spree with their free money.

There is no precedent for this.

During the stock-market boom years of the 1990’s, close students of these matters spoke of the “wealth effect,” by which they meant that when people saw how their investment accounts were swelling up, they felt that they were wealthy and spent like crazy. More often than not, they didn’t cash in their stocks, hoping, as they were, that their securities would continue to increase in value. Nor did they, à la housing, borrow on their stocks. They just felt rich and spent as if they were. Then, as many of us know to our sorrow, they got whacked when the stock market tanked, but at least they were not up to their hairlines in debt.

The housing boom/bubble hasn’t created a wealth effect. This time around, people got the cash smacked right into the palms of their hands. It’s as though, instead of a wealth effect in the 1990’s boom, shareholders had borrowed on their stocks as they increased in value. Had they done so, not only would their securities be worth much less after the market caved, but they would still have owed the money they had borrowed as well.

In fact, nothing that horrible could have happened. The Securities and Exchange Commission doesn’t allow that kind of borrowing, least of all by inexperienced financial naïfs. The financial disasters of the past have taught both sensible business people and regulators that that kind of upside-down debt pyramid puts not only individuals at awful risk, but the entire society.

What small shareholders cannot do with their stocks, they can do with their houses.

The rules make it impossible to borrow what amounts to $15 on a security that ends up being worth $10. You can do it with your house, however. Millions have put themselves in just that situation if housing prices continue to fall.

The Federal Reserve, which is a rough counterpart in housing to the Securities and Exchange Commission in stocks and bonds, has done nothing to impede this particular form of craziness, probably because it has been the fuel of economic growth, and evidently there is no one in authority who will take it upon himself to look at the quality and dangerousness of the growth.

Nor was there anywhere a council of wise persons to say the wise old things like “Put something away for a rainy day; don’t spend it all.” Just to the contrary: The wise persons have been raking it in at the top as this magic system of borrow and buy, borrow and buy drives growth. It matters not what kind of growth, nor whether this is a sustainable financial model for America or the world. If the numbers are up, it’s good, and if the numbers are up a lot, it’s better.

For the last few years, the wise persons have been telling us that as long as mortgage rates stayed low, house prices would remain high and higher. According to this way of thinking, all it takes to sustain a boom/bubble is cheap money. Well, the money is still cheap. Mortgage interest rates haven’t taken any big appreciable jump upward. So how is it possible for the boom to stall?

Mr. Greenspan may have supplied the clue. He says that 14 percent of home mortgages are for second homes. Many of those second homes are places in the country, but many are not: They are houses and apartments bought as a speculation. They are bought to be held until construction is complete and then sold. They are to be flipped as fast as possible, if for no other reason than that the flippers don’t have the bankroll to hang onto a property for any extended period of time. These places are bought for fast resale and, we can suspect, such sellers will cut their prices much quicker than a person selling a house he is living in.

If this is so, we have an example of an overbuilt market, a condition that reappears as regularly in construction and real-estate development as the ocean’s tides. The last time it happened was 25 years ago in commercial real estate, and the ripple effects almost put the whole damn country in the poor house.

So let’s hope this article is needlessly alarmist and completely mistaken.