I haven't really commented on the financial meltdown except to point out the failure of the Free Market Fairy believers, but now it appears that even they themselves are pointing out the obvious, including Alan Greenspan:

"Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief," he told the House Committee on Oversight and Government Reform.

Yes, the free market is powerful, but it's nothing when faced with the strongest force in the universe - stupidity.

Lynne and I also keep getting questions about our own financial health since a good portion of our retirement investment has been in real-estate in the form of rental properties. The answer is that we're doing just fine because the real-estate bubble was not uniformly spread across the whole country and the Raleigh area hasn't been affected. Part of the reason is that the area around Raleigh is flat, wooded, and buildable for 75 miles in every direction, which tends to keep prices reasonable. We also had less speculation in the area, and the dot com bust hit here particularly hard which kept house prices flat for a long time. That's not true in other areas of the country as the follwing chart shows.

Here is the Four-Quarter Percent Change in OFHEO MSA-Level House Price Indexes (2008 Q2 Data) for Raleigh, San Jose and New York City:

A better way to look at the data is as a cumulative change in house price over the same time period, which gives us a Cumulative Four-Quarter Percent Change in OFHEO MSA-Level House Price Indexes (2008 Q2 Data). This starts with all housing prices indexed at 100 in 1995 and cumulatively applies the percent change for the 13 year span.

As you can see from the above charts that housing prices in NY and San Jose have to decline about 40% from their current highs, and that doesn't take into account the fact that prices may overshoot on the downside, nor does it include any inflation in prices that may have occured before 1995. Also note that high-end houses have risen faster and thus have further to fall. ( I expect Sarah Susanka, author of The Not So Big House, to become even more widely known over the next few years. ) The reason this is significant is that it means a lot more homes are going to be worth less than their mortages and that will continue to drive foreclosures and jingle mail, which has further knock on effects in the credit markets, which drives up interest rates and makes it harder to get loans, and round and round it goes, following the same path that the bubble took, but this time in reverse, and going much much faster. Given the uncertainty around how much equity that really is, and if house prices really will fall that far, and the turmoil in the credit markets I wouldn't be surprised if the Dow didn't bottom out at around 7,000, but that's just a guess.

Back to the rental market, we're pretty secure in that our local our house prices didn't participate in the bubble and shouldn't fall far, if they decline at all, and that the rental market should only expand; with all the foreclosures there is going to be higher demand for rental property as those people have to live somewhere, and with tightening credit new entries to the housing market such as new entries to the workforce will have a harder time securing a loan and will also rent in higher numbers, which should keep vacancy rates low.

Notes: All of this data comes from Office of Federal Housing Enterprise Oversight and I've loaded the data for the three MSAs into this spreadsheet, which is also the source of the graphs in this blog post.

The core essence of the theory of the winner of the nobel prize for economics for 2002 ,Daniel Kahneman, is that people not alway make rational decisions, even though that the decision comes after deep thinking. My guess is that this is the root of the current economical state - this is not stupidity (but I'm sure that stupidity also took part here somehow), but a basic human behavior that we need somehow to overcome.

Posted by yoav on 2008-10-25