This Week: Real Estate: The Precursor to the Crisis
Next Week: Employment, Wages, and Government Workers
Week 3: Social Attitudes and the Stock Market
History is an important part of human culture. It is studied to learn about our ancestors or to discover the mysteries of the past. History is also analyzed so that we can try to avoid mistakes now and in the future. The question is then: What will the Greater Depression look like? We can examine history to get clues. As with all comparisons, every detail cannot be a cut-and-dry parallel because things are changing every day.
Since this article is titled the Greater Depression, “scenarios” were created that are worse than the economic downturn that occurred during the 1930s. This article is based on speculation if a downturn worse than the Great Depression occurs. Hopefully, nothing like this would ever happen. In fact, GTM is not as bearish as some forecasts because we believe that society has made too much progress to fall to levels of the markets during the 1930s. However, it is interesting to draw some comparisons.
One comparison to the original Great Depression is how the crisis began. A perfect place to start is to examine housing.
Galbraith said that the first sign of problems in the system was the Florida real estate crash in 1926. This was a full three years ahead of the stock market crash of 1929. The crash in real estate in Florida was blamed on a great hurricane that ripped through the streets of Miami (p. 5–6). But the reality of the situation was that speculation in land was running rampant.
How did the speculation in land crash? The land speculation crash is not that much different than today’s conditions. Primarily the crash began because of leverage and small down payments on property. “In the Florida boom the trading was in ‘binders.’ Not the land itself but the right to buy the land as a stated price was traded. This right to buy—which was obtained by a down payment of 10 percent of the purchase price—could be sold…The use of the binder cut the burden [down payment] by 90 percent—or it multiplied tenfold the amount of acreage from which the speculator could harvest an increase in value.” (Galbraith, p. 18–19).
If the value of the land did not appreciate, the speculator lost money. However, many people stretched themselves too thin in hopes for a tremendous profit by using the leverage of putting down only 10%.
At least in the great land boom in Florida in the 1920s, people had to speculate with 10% down, creating a 10 fold leverage position. Let’s compare that 10% down payment to what happened during the recent real estate boom and crash.
During most of the recent real estate boom, banks allowed extreme lending conditions, (ELC—sorry I couldn’t resist because everyone else has their own acronym, for example, TARP, TALP, CDO, CDS) compared to the Florida real estate crash of the late 1920s.
In many cases, a 0–5% down payment for real estate was acceptable. In some other cases, loans were underwritten for 125% of the value of the home or land. Theoretically, a 100% loan (or more) carried an "infinite" leverage to both the individual and bank. The obvious problem occurs when real estate blips down just a little or, in recent times, substantially. The slightest decrease in prices automatically puts the mortgage negative. Yikes.
For instance, an investor bought a property for $100,000 and received a 125% loan from the bank. The investor takes the extra 25% and uses it to put 5% down on 5 other properties valued at $100,000 each.
If things go wrong, the investor’s losses become tremendous. However, the losses that that banks have to take are exponential because the banks are on the hook for all 6 mortgages. If the person can’t pay the mortgages, the banks foreclose.
Instead of the bank selling the property below market value for a small loss, the bank has to take a substantial loss because the real estate market has fallen so much. In many areas of the country, property prices have fallen 20–30%, and in some highly speculative areas, the prices have declined even more. At least back then, there was still an average of 10% down for a little “cushion.”
Let’s see what happened in speculative housing areas in the 1920s. Galbraith stated, “In 1925 bank clearings in Miami were $1,066,528,000; by 1928 they were down to $143,364,000.” That is virtually an 85% reduction of value of bank clearings. Henry Blodget in Newsmakers wrote, “Home price declines are already approaching those in the Great Depression, when they plunged 30% during the 1930s. With prices already down almost 20%, it's not a stretch to think we might exceed that drop this time around.”
In Paul Krugmann’s book, The Return of Depression Economics and the Crisis of 2008, he commented, “Remember the key rationale for this lending was the belief that it didn’t really matter, from the lender’s point of view, whether the borrower could actually make the mortgage payments: as long as home prices kept rising, troubled borrowers could always either refinance or pay off their mortgage by selling the house.” (p. 167).
As it stands currently, many people can do neither. First, since values of homes have decreased so much, and little money was put down, it eliminates the possibility of refinancing to get a lower payment. Secondly, if someone is lucky enough to sell a house in this environment, because of the small or no down payment, that person would be underwater with the mortgage. This becomes a lose-lose situation for everyone involved with the mortgage because of the negative equity: the person, the banks, the mortgage insurers. And even after the sale, one would owe more than the sale price.
According to wsj.com, “Prices in places like Miami, Las Vegas and Phoenix have roughly halved from the highs in early 2006, according to Case-Shiller.” If speculative properties fall more than prices in the 1920s, prices would still require another 80% off of these levels for a total of 90% reduction. To make other areas worse than the Great Depression, properties could fall 50% or more to “stable” areas. To reach these levels, prices still need to fall another 33% from current levels.
Real estate prices won’t stop falling until all the infinite amount of leverage has been absorbed by the system. So much unwinding still has to take place that this proposal isn’t a completely ridiculous idea.
