Who else is in trouble?

By now, you probably realize that I think the homebuilders are in worse trouble than the mortgage lenders. Their collateral is not as ephemeral, since it is a real asset, but it is also much less liquid. Don't get me wrong, I think the mortgage lenders are in very big trouble as well, but the big lenders cannot be allowed to go out of business due to the damage to the economy. Nobody is going to miss a homebuilder going belly up.

The only way out of the mess is the way we got into it, the hard way.

I live in NY, where, due to gentrification, low interest rates, super lenient credit terms, a weak dollar, and up until '03 or so a weak equity market that couldn't compete with real property returns, the residential real estate market was literally on fire. I mean quite a few areas of Brooklyn saw (up to) a 300% to 450% increase in transaction price (notice how I did not say value). This was, in part, due to gentrification, and as a socio-economic phenomenon I don't believe will be easily reversible and will have some staying power. The balance was due to a housing bubble, which is very different from most bubbles due to the fact that the assets are very illiquid and require significant investment and more importantly often involve significant leverage which tends to exacerbate gains and losses considerably.

So... The end result is that you have houses that went for $180k in 2000, selling for $700k now. Your average middle class public school teacher makes about $35 - 50,000 per year, and can count on about a 2-4% increase annually (I'm just guessing at this). During the boom period, housing prices went up a max of 450% and a minimum of at least 100% while wages went up around 15% (again, just taking a guess, but you get the point). They were able to buy this house in 2003 for $300k, not because they could afford it (10 years ago they need 120% of their gross, b4 tax income for down payment and closing costs, while the debt service would be more the 50% of their disposable after tax income as a off the cuff calculation), but because you had engineered mortgages that allowed flexibility in debt service, and very low rates which made it more affordable. 

Now, the esoteric loan is out, and rate are shooting up, independently of LIBOR, treasuries, and other traditionally correlated rates. The obvious result of defaults, and reduction of both transaction volume and pricing is starting to soak in, but developers are still churning out product at a ridiculous rate because they to have binged on easy credit and must sell all of the land that they have bought (this is cheaper than holding depreciating land while paying debt service on it), and take a loss on underwater option contracts. The additional supply added to a market that is swimming in inventory is serving to further depress pricing which causes lower MBS true value due to diminished collateral value. Further depressed pricing puts more mortgages under water, causing more people to walk away from their homes, causing more foreclosures and REOs (bank owned real estate for sale), which causes lower MBS values due to higher defaults and which causes more supply on the market at fire sale prices, which causes more people to walk away from their underwater mortgages which causes more foreclosures which causes lower MBS values due to defaults and lower collateral, which.... Hopefully you get the picture. 

This scenario has to play itself out until that teacher on a $50k salary in Brooklyn can again afford to buy a house under conventional terms currently offered by a bank (my bet would be 20% down, full doc, at rates about 150 basis points from where we are now). Until then, home prices will continue to drop, for they are out of reach of the main fundamental driver of lasting home value, the everyday buyer. 

Now, factor in a 25% drop in home value nationwide, and I think it spells recession, but I am not an economist, just an arm chair investor. Also, keep in mind that real estate is very localized. Nobody lives in a median home, so you cannot use aggregate arithmetical measures to quantify home value across the US, not even across a single city. The example above applies to one small section of Brooklyn (bed stuy). Less than a mile over, the fundamentals are different (downtown Brooklyn), and 2 miles over in Manhattan, the average cost of a home is over 1 million dollars (hence the dearth of public school teachers)...