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Friday, December 14, 2007

Krugman: After the Money's Gone

by Calculated Risk on 12/14/2007 11:49:00 AM

Update: Also see Krugman's blog: Why negative equity matters

[T]he problem with the markets isn’t just a lack of liquidity — there’s also a fundamental problem of solvency.
Paul Krugman, NY Times, Dec 14, 2007
Paul Krugman writes in the NY Times: After the Money's Gone
First, we had an enormous housing bubble in the middle of this decade. To restore a historically normal ratio of housing prices to rents or incomes, average home prices would have to fall about 30 percent from their current levels.
The WSJ recently had a series of graphs titled: Genesis of a Crisis. Here is the chart of the Price to Rent ratio.

Price to Rent Ratio Click on graph for larger image.

This graph is based on a ratio of the OFHEO house price index to personal consumptions on rent. Note: Later today I'll post a graph based on the Case-Shiller index.

As Krugman notes, house prices would have to fall about 30% to bring the Price to Rent ratio back to a more normal ratio.

Second, there was a tremendous amount of borrowing into the bubble, as new home buyers purchased houses with little or no money down, and as people who already owned houses refinanced their mortgages as a way of converting rising home prices into cash.
The Fed recently released the Q3 Flow of Funds report. The report showed that household percent equity was at an all time low of 50.4%.

Household Percent Equity This graph shows homeowner percent equity since 1954. Even though prices have risen dramatically in recent years, the percent homeowner equity has fallen significantly (because of mortgage equity withdrawal 'MEW'). With prices now falling - and expected to continue to fall - the percent homeowner equity will probably decline rapidly in the coming quarters.

Also note that this percent equity includes all homeowners. Based on the methodology in this post, aggregate percent equity for households with a mortgage has fallen to 33% from 36% at the end of 2006.

As home prices come back down to earth, many of these borrowers will find themselves with negative equity — owing more than their houses are worth. Negative equity, in turn, often leads to foreclosures and big losses for lenders.

And the numbers are huge. The financial blog Calculated Risk, using data from First American CoreLogic, estimates that if home prices fall 20 percent there will be 13.7 million homeowners with negative equity. If prices fall 30 percent, that number would rise to more than 20 million.

That translates into a lot of losses, and explains why liquidity has dried up. What’s going on in the markets isn’t an irrational panic. It’s a wholly rational panic ...
From the post Professor Krugman mentions: Homeowners With Negative Equity

The following graph shows the number of homeowners with no or negative equity, using the most recent First American data, with several different price declines.

Homeowners with no or negative equity At the end of 2006, there were approximately 3.5 million U.S. homeowners with no or negative equity. (approximately 7% of the 51 million household with mortgages).

By the end of 2007, the number will have risen to about 5.6 million.

If prices decline an additional 10% in 2008, the number of homeowners with no equity will rise to 10.7 million.

The last two categories are based on a 20%, and 30%, peak to trough declines. The 20% decline was suggested by MarketWatch chief economist Irwin Kellner (See How low must housing prices go?) and 30% was suggested by Paul Krugman (see What it takes).

As Krugman notes: The current crisis is not a liquidity problem, it is a solvency problem.