Five reasons why real estate bubble is so lethal

23 October, 2010, 16:16. Posted by Zarathustra
Tags: Banking, Bubbles, Real Estate

It might feel very good for people who have home in a real estate bubble. But the bursting of it is very lethal, as they almost invariably caused recession and worse still, banking crisis. And when a banking crisis does occur, it is hard for the economy to regain full strength. Why? Why the self-correcting mechanism of market economy fails spectacularly in real estate market?

house Photo by Ed Schipul

1. Your home is almost your entire wealth

Perhaps you are very wealthy with multiple real estate investments and a large portfolio of stocks and bonds, but most people are not as wealthy or lucky as that. Your home is likely to be a very large proportion, if not the entire, of your wealth. This make the bursting of real estate bubble so lethal to the economy because declining home prices means a drop in your wealth. Decrease in value of your wealth will probably deter you from consuming (wealth effect).

2. Leverage in home purchases

Most people buy homes with mortgages because a home is a big ticket item which is usually not possible (for most people) to pay for that in full with cash. The presence of leverage is very danger because a declining home prices can potentially render your net worth negative (negative equity). If you borrowed 70% of the home price to buy a home worth $2mn, for example, a drop in home price for 30% would wipe out your wealth, if that is effectively your entire wealth. Worse, any drop more than 30% would render your net worth negative. Destruction of your wealth will be very damaging, and you might not want to spend as much as before.

3. Banks like to lend to people to buy home, with bad reasons

Banks traditionally charge relatively little capital (or lower risk-weights) for mortgage lending for bad reasons. The idea that banks can seize your home if you default makes it seems safe to lend money to you to buy home. This works in normal time when the number of people defaulting on mortgage payments are low, as the value of the collateral (i.e. your home) is stable or rising, banks have good probability to get back the money by selling the seized homes. But not in a systemic breakdown of housing market. When there are many foreclosures, banks may be forced to sell the property at fire-sale prices, so that banks will have to make write-down of their assets. As a result, a decline in housing market invariably makes bank’s assets qualities deteriorate. As the assets qualities of banks deteriorate across the board, banks have to conserve capital in order to maintain compliance to the capital adequacy requirement, and even have to raise new capital by selling new shares. Banks will be less willing to lend in such situation, decreasing the availability of credit flowing through the economy.

4. Time lag between construction and completion

The self-correcting mechanism in market economy failed spectacularly in real estate market. For other manufacturing products like toys or electronics, manufacturer can change their rate of production relatively easily. When the demand is high, manufacturers can increase production under certain limiting factors, like supply of raw material, labour, etc, but the increase is relatively easy to achieve. When the economy slows down, manufacturer can also scale down the productions and clear the inventories by simply cutting prices. These kind of adjustment may be carried out in the order of months. However, in case of real estate, property developers have no luxury to increase or decrease their production (i.e. building) quickly. When demand for housing is high, developers can buy more raw material, i.e. land, to build. However, depending on the scale of the development, planning and construction process may add up to years. As a result, property developers may scramble to buy lands at the peak of the market, but as the construction completed, the supply will hit the market at the bottom, creating even more excess supply at the bottom of the market.

5. The Vicious cycle

All the above factors add up and form a very lethal vicious cycle. As home prices drop, your wealth drop, limiting your ability to consume. Banks’ assets qualities deteriorate, making banks unwilling to lend, so companies cannot obtain credit to fund their investments, affecting the real economy. As the real economy deteriorate still, the economy as a whole lose jobs, corporate earnings decline, making home prices to drop even more, and banks assets qualities deteriorate even more. As the housing market struggle to recover by clearing housing inventories, newly constructed start to hit the market even though the market does not need that much, making the recovery hard.

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