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Forbes Magazine
Home Sick
Friday September 27, 10:04 am ET

By A. Gary Shilling

The now-strong housing market will hurt in the coming second recession. Those who got easy mortgage loans won't be able to handle them. It all will ripple upward.

Sad that your stock portfolio is in a shambles? Glad your house is appreciating rapidly? Don't be too glad. The housing boom is soon to go bust. And the way it will come to an end will affect everyone, even affluent homeowners.

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Most people don't see housing as overblown, just benefiting from strong demand. They don't see the weakness because huge overbuilding is absent, at least thus far. In some places like California and New York, builders are hamstrung by geographic and zoning limits, and elsewhere they've shown restraint.

Nevertheless, this is a classic bubble. You know that when investors believe there's no place else to go. The same argument was used for owning ridiculously overpriced stocks in the late 1990s. Another indication: Loads of folks are aboard. Home ownership rates for people under 25 leaped from 18% in 1997 to 23% in 2001.

Like any speculation, the housing bubble feeds on itself. Rising prices encourage new buyers to rush in before they go even higher. And higher prices allow homeowners to use their accumulated equity to buy costlier homes. Price jumps also encourage more leverage. A decade ago, the home equity of Americans with mortgages was 21% of their abodes' market price; continual refinancing and home equity lending have reduced it to 16%.

You can't blame people for getting into home ownership. This venture is just so darn easy. Cheap money (6% for a fixed-rate, 30-year mortgage) is one factor. Another is that lenders have dramatically lowered their eligibility standards. Down payments for first-time home buyers now average 3%, down from 20% a decade ago. Fannie Mae, Freddie Mac and other government-sponsored lenders are striving for social justice by buying mortgages issued to low-income homeowners who put down 3% or less.

The implosion will start among first-time homebuyers with few other assets. They support the whole housing market through the move-up chain, whose links are tenuous. Ralph Kramden buys a small tract home from Al Bundy, who moves up to purchase Mike Brady's more spacious split-level, which Mike sells to resettle his bunch in the McMansion of Reginald van Gleason III.

What will burst the bubble? Don't look for the usual suspects--interest rate hikes or overbuilding. Look instead for a second recessionary dip brought on by wealth losses and pink slips, pressuring consumers to retrench. When the Ralphs of the nation are laid off, they won't be able to make the mortgage payments on the homes they've bought or to buy a house to begin with. Then the bad news ripples through the move-up market. People like me living in tony Short Hills, N.J. really do need to think about home sales in gritty Newark.

As housing demand dries up, prices will fall and the whole mechanism will work in reverse. Those with big leverage will see their equity wiped out, forcing them to sell, pushing prices still lower. Up to now, house appreciation has been offsetting stock losses for many people. That helpful phenomenon will then be history.

As already-rising delinquency rates go higher, lenders will withdraw. Bankers are reluctant to begin widespread foreclosures, a p.r. no-no, yet they surely will no longer be as loose with lending as they are today. Also, delinquent mortgages don't provide them the resources for additional lending. A big question is whether Fannie's and Freddie's losses will force a bailout, a great fear in Washington where memories of the S&L debacle a decade ago are still vivid.

House-price drops typically lag the economy. In the early 1990s Los Angeles residential real estate didn't peak until two years after overall business topped out, and then single-family house prices fell for six straight years. In Houston, during the oil-bust 1980s, house prices dropped for five years.

Residential prices take a while to react largely because the market prices of people's houses are not available daily to force them to admit that their property has declined in value. Even if they are thinking about selling, they can ignore reality and believe that their neighborhood is temporarily out of favor. Or they have a lousy real estate broker. Or it's winter and they need to wait for spring.

Don't be lulled by the fact that housing has not yet been hit by the deflation that has creamed stocks. There's still time, though, to join us in shorting conventional home builders. Sure, builders' P/Es are relatively low and the big ones are gaining market share. But as home building dries up, big builders will inevitably wither, too. My firm also is short Fannie.

A. Gary Shilling is president of A. Gary Shilling & Co., economic consultants and investment advisers. Visit his home page at

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