Subprime Debt: Falling House Prices Hurt Rich, Poor and Everyone Else

We took a brief vacation from our exile this weekend. But it is as cold south of the Loire as it is north of the Channel.

And there was no warmth in the markets last week, either. They were tepid. Nothing much happened. Up a little, down a little...back and forth...it was hardly worth watching.

The only excitement came from Bear Stearns' (NYSE:BSC) efforts to rescue its hedge funds. The funds had bought a few too many mortgage-backed securities and got into trouble.

Of course, we all know that the subprime problem is "contained". Hank Paulson and Ben Bernanke have both said so.

But we are not convinced. Fires are "contained". Uprisings are "contained". Containers, we know, can hold liquids...and solids too. But we're still not sure if you can contain such a vast mortgage problem so easily.

To put it another way, you can contain something while it is still small, localised and manageable. You can't contain it when it's spread everywhere. It's already too late. In a speech at the Mansion House last month, Mervyn King, governor of the Bank of England, was considerably less sanguine than his American counterparts: "Excessive leverage is the common theme of many financial crises in the past. Are we really so much cleverer than the financiers of the past?" he asked.

The short answer to that question is, of course, no. Subprime mortgages represent a substantial portion of the entire mortgage market. But it is not just the subprime part that poses a threat. The real problem is that American homeowners have too little money. Why do they have too little money? Because they've spent too much. And where did they get too much money to spend? From the equity in their houses.

In the last six years, America's middle class has run down its balance sheet in a remarkable way. Never before have homeowners owned so little of their own homes. In the '60s, homeowners barely mortgaged 30% of the value of their homes. Today, that figure is close to 50%. And it's happened while house prices rose at the fastest pace in at least 80 years. Thanks to rising prices, owners' equity increased US$4.37 trillion since the beginning of this century. But, in a prodigious feat of borrowing, mortgage debt increased even more - US$5 trillion.

But now, house prices are falling. A few days ago, Business Week reported that on June 25, according to the National Association of REALTORS, the rate of existing-home sales slipped 0.3% in May, to an annual pace of 5.99 million units, while supply climbed to 8.7 months, the highest reading since June, 1992. The median price of a new home dropped 11% in April from the previous month, to US$229,100, the biggest decline since 1970.

Homeowners are taking a hit, and these are not just people who live in trailers and watch daytime television. No, dear reader, they are us! Well, not necessarily us, exactly...but they are most people.

"Nearly 70% of Americans either own or are in the process of paying off their homes. Everyone wants to believe the worst has come and gone, because that's what's best for them. But we don't always get the market outcomes we want or expect," The Survival Report’s Mish Shedlock quipped.

The rich can lose money in the stock market and no one will particularly care - there are too few of them. The poor and their problems will always be with us, but they affect only a miniscule part of the financial system. The problems of the rich and poor can both be "contained." But middle class troubles are troubles for the whole financial system...and the whole economy.

The rich save money in bonds, art and investment property. The poor save no money at all. But the middle class saves money in its own houses and uses the "savings" (equity) when they are needed - for education, health emergencies, unemployment, and retirement. After a long spree of borrowing and spending, many middle class families have little savings left. And if house prices continue falling, even that sliver of owner's equity will disappear. In the next downturn, the middle class will be wrung out like a wet mop.

"The housing crisis is different than other crises of the past. In the 1989 crisis, fewer people owned real estate," Mish continued. "In the 2000 tech bust, not everybody owned tech stocks. But in both cases, the impact was far reaching. What does that mean now, when most Americans own property AND a mortgage, alongside their stock portfolios? What does it mean when so many of the new jobs in America - as many as 43% - come from the housing industry?

"Tighter spending. Lost jobs. Troubles for retail, restaurants, car dealers, advertising companies, jewellers, remodelling contractors, furniture manufacturers, banks, electronic retailers, and more. It's like a virus - it can't help but spread."

Then Middle America will be on the same footing as the subprime market today. And the subprime problem will be everybody's problem.

Bill Bonner
The Daily Reckoning Australia

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