TIME: The Real Estate Bust: How Bad?

[question everything]

Thursday, Sep. 13, 2007
The Real Estate Bust: How Bad?
By Justin Fox

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THAT A REAL ESTATE BUST MIGHT LAND US IN a recession is in a way fitting because it was a real estate boom that kept the last recession, in 2001, so brief and shallow. Trying to stave off deflation in the wake of the stock-market crash, Alan Greenspan's Federal Reserve cut the short-term interest rates that determine what homeowners pay on adjustable-rate mortgages. Meanwhile, investors desperate for someplace other than the stock market to put their money piled into mortgage securities, driving down the cost of fixed-rate loans. Housing markets, already doing well amid the strong economic growth of the late 1990s, exploded.

To a remarkable extent, housing drove the entire economy. Real estate, residential construction and three other housing-related Labor Department job categories together add up to 6.6% of U.S. employment. But they accounted for 46% of the new jobs created in the U.S. between January 2001 and May 2006, when the sector peaked. The main reason for the boom's doom was that in the nation's San Diegos, double-digit annual price increases put most homes out of the reach of middle-income buyers. The mortgage industry and its funders on Wall Street responded with laxer lending standards and creative loans (no downpayment, teaser rate, interest only, etc.) that really made sense for borrowers only if prices kept going up and they could sell at a profit or refinance. When prices stopped rising last year, the edifice began to crumble.

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THESE ARE THE KINDS OF THOUGHTS THAT occupy Yale economist Robert Shiller, who with Karl Case of Wellesley has done more than anyone else to document the postmillennium real estate boom and warn about the inevitable bust. Shiller first made his name in the early 1980s attacking the notion, then widely accepted, that the stock market rationally reflects the true value of the companies whose shares are traded on it. He and real estate specialist Case then teamed up to show that home prices are even more subject to booms and busts than stocks. They did it by measuring repeat sales, which give a better picture of price movements than the figures published by the real estate industry. In 1991 they turned this into the business that supplied the price data used in this article.

After publishing a best-selling critique of the stock bubble, Irrational Exuberance, just as the market peaked in March 2000, Shiller set to work adding a chapter on real estate for the second edition. As part of that effort, he cobbled together an inflation-adjusted index of home prices going back to 1890, which showed that a) the price runup from 1997 to 2006 was by far the biggest on record and b) home prices can fall for decades. Put those two together, Shiller argues, and it's at least possible that we're due for an epic decline in prices. "People think that home prices go up a lot," he says. "But home prices in 1990 were at about the same level as in 1890." Shiller allows that the scarcity of property near the coasts might mean prices there will remain high, but then notes, "We can't make any more of the land, but we can build huge high-rises on the beach."

Huge high-rises on the beach, in fact, played a major role in Florida's boom and bust. There are 40,000 condominium units being built right now in greater Miami, and consultant Lewis Goodkin estimates it will take five to seven years just to work through all that inventory. That's five to seven years of downward pressure on local housing prices, construction employment and the like. The great test of the coming months and years is whether the U.S. economy is strong enough to withstand that kind of pressure without buckling. Right now things aren't looking good, but this is an equation with too many variables--Fed rate cuts, congressional bailouts, the ebb and flow of the global economy--to solve in advance.

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