Everything's Going To Zero

No, not really. But now you know the worst-case scenario. And here's the good news: The odds that that will happen are likely similar to the odds that a comet will hit the earth (in which case we'll have other things to worry about).

But what will go to zero?

* A lot of leveraged portfolios.
* A lot of equity in houses.
* A lot of consumer net worth.

As Warren Buffett succinctly observed, anything multiplied by zero is zero.

Put differently, when the value of the asset drops below the value of the debt used to buy it, poof -- the owner's equity just went to zero. So it's not just Wall Street that is rapidly developing a distaste for leverage.

For example, let's take a back-of-the-envelope look at the housing market. A couple of years back, the value of US residential real estate was about $20 trillion. Mortgage debt constituted about 45% of that ($9 trillion) and owner equity 55% ($11 trillion). (Very rough numbers)

Now, the value of the US housing market is down 21% and headed to, arguably, down 40%. In other words, if the peak value was $20 billion, the current value is about $16 trillion, and the trough value will be about $12 trillion. So what will happen to homeowner equity?

PEAK
Value: $20T
Mortgage Debt: $11T
Homeowner Equity: $9T

TROUGH
Value: $12T
Mortgage Debt: $11T
Homeowner Equity: $1T

The good news: It won't go to zero! The bad news: with 45% debt-to-value, a 40% drop in value will reduce equity by almost 90%. Ouch. And by the way, that percentage holds regardless of what the actual peak value of the housing market was, as long as you start with 45% debt-to-value.

And what happens if you have a more typical debt-to-value ratio -- say, 80% debt? Then, unfortunately, your equity IS going to zero. In fact, it will only take a 20% fall in the house price for that to happen:

PEAK
House Value: $500,000
Mortgage (80%): $400,000
Equity: $100,000

TROUGH
House Value (down 40%): $300,000
Mortgage (80%): $400,000
Equity: -$100,000

So a lot of consumer households will get wiped out.

What about stock portfolios?

The worst peak-to-trough stock market drop was 1929-1932, when the S&P 500 dropped 86%. Horrific, but not zero. (Unless you were carrying margin debt). But here's keeping our fingers crossed that the S&P 500 won't drop 86%, which would be a long way down from here. (Given the government's aggressive response to the crisis, we think this is very unlikely).

And, to close on a happier note, here are some things that almost definitely aren't going to zero:

* Consumers that have enough cash flow that they won't get forced out of their houses when their equity is zero (the house prices will eventually recover, and then the same leverage will work on the upside).

* Investors who don't panic and sell stocks at the bottom. As long as the portfolio is diversified and the companies don't go bankrupt -- see below -- the prices will eventually come back.

* Companies with no debt and strong cash flow that would still generate cash if you cut their revenue significantly.

A few prominent examples of such companies in tech-land?

Apple (AAPL)
Microsoft (MSFT)
Google (GOOG)
Cisco (CSCO)

See Also: US Consumers Are Broke

Comments

[mamacat]

My Dad always taught me that buying a new car was a horrible investment. As soon as one drives it out the driveway of the car lot, it is worth $5,000 less than the sticker price. Still, people don't abandon their cars, because they need them, and I see many people staying in their houses, because they need a place to raise their families.

Someone who buys a house only as an investment might decide to walk away from the investment, but someone who bought a home probably is looking for a way to stay in the home. There may be many people, trying to stay in their homes, who need and deserve our help to make it through these tough times.

[KillTheMessenger]

The Prius we bought last year seems to sell $6000 above what we paid for it... every rule has an exception. But in general you are right. If I ever felt like buying a luxury BMW, I would go with a used model. Three years and 15,000 miles will shave almost 50% off the sticker price.

I am also in the market for a used Hummer. Dealers, send me your best offers! I will pay up to $15 for a yellow one. But only if it comes with a full tank of gas.

:-)

[LeftRight]

Nah, that full tank of gas more than triples the price......

[drkazmd65]

I have only ever bought 1 new car (for my wife to drive, in 2003), and that one we bought with the intention of owning it for at least a few years after the payments were done. I currently own a 2000 Mazda Protege that I bought used in 2003. Best investment I ever made as far as a vehicle goes. Somebody else had already eaten the depreciation, I bought it for a relative song, and plan to drive it sans payments for a couple more years.

Those of 'us' with a steady cash flow (as pointed out by Mr. Blodget), that don't panic, that aren't too overextended, and play for the long haul (>3-5 more years) will come out the other side stretched, strained, but OK.

A house is a place to live, and anybody that viewed their house as a piggy bank and refinanced it to pay for vacations, crapola, or such deserves to stress about losing that house.

[PT6]

Obama should make an address to the Markets!

Obama Televised speeches PUSH MARKET UP

A pattern is developing:

From -5 to +155 in Roanoke, Virginia Today
From -250 to +108 in Indianapolis, Indiana Oct 8

The Market seems to have Great CONFIDENCE in OBAMA!

Every time Paulson of Bush speak the Market goes down showing NO CONFIDENCE!

[sonoffestus]

Our home was always seen as our "home", not our investment. For 20 years we lived there, we maintained it and improved it. We enjoyed it, we had fun and we relaxed at home. Twenty years later, we sold it and made a nice profit. We were lucky, we got out when the going was good. We never thought of our home as an investment or an ATM. It was place we LIVED.

We now live in our second home much smaller,less costly to buy and maintain, and it's gone up in value since we purchased it in 05, BUT it is still our HOME. Frankly, if one wants to invest, there are much better ways to invest than real estate. Do the math, add all the years taxes, maintenance costs, expansion costs, new fridge,stove, etc., etc.. In most cases, one finds that that haven't lost money, but their return on investment is not what they thought, or say. All in all home ownership is good, and in most cases it's better than paying someone else rent, but I believe the "home as an investment" mentality created big problems for many American families. The needlework never said," Home Sweet Investment". Did it?

[LeftRight]

Don't know what happened, apparently I was too controversial. Here's my post again.

Henry,

The chance that a comet will hit the Earth is not that low. In fact, it's 100%. Where the chances drop is whether a SPECIFIC comet will hit the Earth on a SPECIFIC date! In other words, it's pretty unlikely that Halley's comet will hit the Earth on April 14 2071, but that *A* comet will hit the Earth on *SOME* day is a guarantee!

[KillTheMessenger]

It's also pretty much granted that neither of us will be around. Our kids won't be around. And not even our species will be around because the big ones happen on the million year time scale.

So that's what scientists call a "no-brainer".

:-)

[LeftRight]

I never said that it would be a big one =)

[JBS]

That's one way of looking at it.

Whether it happens in 1 year, a thousand years or a million years ... when it happens, we won't be around.

[olephart]

Here's a different take:

PEAK
House Value: $300,000
Price Paid: $500,000
Mortgage (80%): $400,000
Cash out of pocket: $100,000
Equity: $-100,000
TROUGH
House Value (down 0%): $300,000
Mortgage (133%): $400,000
Cash loss: $100,000
Equity: -$100,000

The value of the house remains constant; it provides one each unit of shelter at a given level of comfort. The price paid reflects the loss, stability or increase in the value of the money required to obtain a constant level of shelter/comfort. The fallacy was looking at a unit of shelter as an investment rather than something that is consumed/used on a daily basis. Increasing the price only increases the cost of what is being consumed/used. If your landlord raises the rent are you getting more or just paying more?

[KillTheMessenger]

Even if your landlord raises the rent you are getting, on average you are getting more for your rent than you are getting for the cost of owning a house. The total cost of keeping a house is always much higher than that of renting if we only count the function of shelter and do not assign a value to luxury (not counting some tiny cottages in the middle of nowhere).

And don't forget, if your house rises in value, so do your property taxes. And those are quite severe for nice homes in good neighborhood.

[olephart]

Compare apples to apples, rented homes to rented homes. Take two identical houses, one rents for $1,000 the other for $2,000. If they are identical, which one gives you more house? Just because the rent is more doesn't mean you get more. Same with purchasing a house. Just because you paid more doesn't mean you got more given identical houses.

[Bobotheclown]

After eight years do you still believe everything this administration says about this crisis? The very real credit problem is only a problem for investment banks that found themselves in a technical liquidity crunch when the very predictable retirement of the baby boom generation coincided with the collapse of the subprime CDO ponsi scheme. The average person who has one house that they live in may or may not realize paper profits on it but they have no connection to this crisis. They are simply being used as an excuse to loot the Treasury in the waning days of the criminal conspiracy called neo-conservatism.
The problem comes from the loss of confidence of the international central banks and major investment houses in the American financial system precipitated by the "fire in a crowded theater" response of Paulson and the Bush administration. Other countries see that a theft of this size imperils their assets and they are acting accordingly. The coming cutoff of funds will cause a chain reaction of job loss, mortgage defaults, bank defaults, further job cuts and foreclosures. The Fed is powerlesss to do anything about this spiral once it has begun. So the market has further to fall as this unwinds and a new monetary system will need to be created (probably through devaluation as Nixon did) to redefine assets.

[DuganS1]

What does the "retirement of the baby boom generation" have to do with the financial crisis? The average person will have a connection to the crisis as evidenced by the terrible economic numbers that have come out recently and that will be worse for October. Many predict the unemployment rate will go over 7% and maybe 8%, which will be terrible for the country. Just curious what has been done that you consider theft? I think it would be criminal if the government didn't do what it has done to stem the crisis. If the govt left the economy to its own devices we'd have some very very serious problems and would be looking at unemployment that could rise well into the double digits.

[JBS]

A lot of us were right on the cusp. I **WAS** in eleven months, September 2009.

Now with my 401k & IRA accounts in the tank, my retirement plans are out the window.

[Sagantech]

"Just curious what has been done that you consider theft?"

This is outrageous! This is our money that Paulson's crony bank executives are now taking.

http://www.guardian.co.uk/business/2008/oct/17/executivesalaries-banking

[Catatoniclaconic]

Perhaps then the answer lies on the other side of the equation? Write off the bad debt as quickly and as ruthlessly as possible. Share that haircut with the homeowner - the actual consumer - by devaluing the principal on their mortgages by 90 per cent if necessary and adjusting their interest accordingly. Should work with minimal funding needed.

That is where it will end up anyway and the sooner we get it done the sooner we can get back to work and avoid the whole drama of more people getting kicked out of their homes and joblessness etc. etc.

[ivangoldstein]

That is exactly how you restore the health of the economy...write off the bad debt.

Unfortunately the Republicrats plan to move the bad debt from the banks to the taxpayers by TAKING OUT MORE DEBT. In fact, our entire financial system is about creating debt. Money itself is not money but new debt. It's the only game in town and why the best strategy for everyone is to DECLARE BANKRUPTCY if they are too far behind!

What does this accomplish?! If everyone paid back their bills or declared bankruptcy if they couldn't the money would disappear. Kinda like the end of Fight Club without the explosions.

[Catatoniclaconic]

There is a playbook - funnily enough in 1997 it was the IMF and other multilaterals forcing restructuring on the banking sector in Asia, and nobody was even talking about recapitalization until AFTER the debt had been written off and the particularly bad banks were forced to merge.

While shareholders of banks in particular will have to take hits, these are balance sheet transactions. Insisting on keeping the value of property at full face value is absurd. Write these assets down and then inject the 700 billion into a recapitalization.

[marthlois]

Ah SH&T Henry. If the government gave us all a piece of the bailout for AIG, we'd each pay taxes on it and have enough left to not only pay our mortgages but pump it into the economy.....now that's a recovery plan. We're so sick of this crap. Can you even imagine the boon to the economy that would be. Let's see - about $460,000 per person less taxes?

[January]

Most of the commentary I read on the current US financial situation assumes that most Americans want to follow the pattern of just getting in line with the majority and waiting for your turn. That has worked for a long time. And I cannot begin to estimate what a difference it now makes that standing in line (keeping up with the Joneses) has led us like lemmings off the cliff.

Downthread is a poster who says the gap is between the smart ones and the dumb ones. My personal situation remains comfortable, too. But I am under no illusion that social disorder will not affect my comfort.

The American way assumes that we are all dumb. And that works, on and off. It assumes we can let those folks who walk away with golden parachutes make the right decisions. Yes, we need education so that full participation in the American system can be managed knowledgeably by all. But, ye gods, so long as the system can be "gamed," and there is no system that cannot be "gamed," we need an aristocracy of talent to keep us whole. Isn't there some less violent way of teaching people to be responsible than by clubbing us into the muck?

[urnumbersix]

Well Said!

[KillTheMessenger]

"Isn't there some less violent way of teaching people to be responsible than by clubbing us into the muck?"

In other countries that happens in public school. But public school is not an important government service in the US. Production of delivery systems for laser guided bombs is way more important.

[tomas0808]

The problem has been going on since the 60's, when house prices spun out of control. Imagine if the basic human needs, food,clothing,shelter, had been tied together during the post WWII boom so that their prices and rate of inflation weren't so easily manipulated. I did the numbers. If the price of a house had gone up at the same rate as a tomato, that house that costs 4 to 500,000$ now would be 120,000$. Affordable for the average worker who could have a dignified life without having to resort to consumerism. I'm not a conspiracy theorist,but who benefits from housing prices being so high?. The banks. And yet that still wasn't enough for them. They had to hand out credit cards to anyone and everyone. I just can't figure out if Reagan was naive or evil. An unregulated free market will always collapse.

[KillTheMessenger]

"I'm not a conspiracy theorist,but who benefits from housing prices being so high?. The banks."

I think a lot of baby boomers did profit, too. Many people have all of their savings tied up in their homes with the basic hope that if the market is up they can cash out and retire.

It does not work that way... but that didn't keep people from buying and selling themselves into a frenzy. You can't just blame the banks and not look at millions and millions of willful little helpers.

[JBS]

KillTheMessenger sez: "I'm not a conspiracy theorist,but who benefits from housing prices being so high?. The banks."

Real Estate Brokers, mortgage brokers ... they all get their cut. I get multiple solicitations every week from someone who wants me to let them sell my house and/or refinance my mortgage.

This is my HOME; I don't want to sell it and I don't have a mortgage. But, they expect me to give up what I have just so they can line their pockets.

One thing that's making me really angry right now is we just had property revaluations in the county were I live.

The greed-heads churned the market around here, and my property "value" increased to 300% of what it was on the last valuation, and with it, my property taxes went up to 300% of what they were last year.

In the meantime, the bottom fell out of the local housing market, and my house is actually worth LESS than it was 7 years ago.

But I'm stuck with those higher property taxes anyway. I'll be paying those rates for another 7 years.

[DuganS1]

Inflation is good for debtors as it erodes the value of the debt. For example, if someone bought a house that seemed expensive in 1965 at $50k, by 1980 they found themselves having a small mortgage payment relative to their income because of rampant wage inflation. This is also true with the national debt. Many may notice that the amount of our country's debt has doubled in the past 10 years, but because of the increase in nominal gdp, which takes into account inflation, our debt is about the same percentage of GDP as it was 10 years ago. Back in the 1870s and 1880s there was deflation, where people found the value of their debt increase year after year relative to their income. This resulted in a ton of people losing their houses and/or land to banks (significantly more folks than now). It also resulted in some massive recession as people were afraid to borrow any money because they figured that debt would increase over time.

[KillTheMessenger]

Inflation is only good if your income goes up with it. If not it will always take the same amount of time to pay back your debt.

:-)

[Choicelady]

Having a home in which to live, not to use for extraction, does NOT require a bailout. It is a problem for those seeking reverse mortgages if the house is not free and clear or for those needing to move. But for those of us with jobs, some savings, very little debt other than mortgages, it is NOT a problem. If there is to be support, let it go to people who got screwed by the mortgage brokers who pushed them into subprime terms when they qualified for conventional mortgages (65% of those facing foreclosure appear to be qualified for conventional rates.) Let them go to the original lender and refinance at those much lower rates, but for Heaven's sake do NOT pay off the first mortgage in full with tax money! That just rewards the creepy lenders and hedge fund and banks! Force them to refinance, and then let THEM eat cake. They preyed on would-be homeowners. They should be forced to make adjustments NOW.

[othel]

Mr Blodget's example of the debt/equity issue in the forecloser market is easily understood. However the vast majority of these extremes exist in only 2 states: California & Florida. The government's efforts should be concentrated in these areas. Single-home owners, living in their houses, should be singled out for help first. There should also be review of appraisal practices in these states to see if a pattern might exist indicating fraud.

[LeftRight]

Really? Only in CA and FL? Cause here in IL the average cost of a house dating back to 1890 has been around 110% of what it would cost in 1890 (accounting for inflation). During the last 7 years, it shot up to more than 200% of what it cost in 1890!

[KillTheMessenger]

One might point out that the financial totals are meaningless. Households like mine which have their homes paid off and are sitting on cash and are basically not invested in the markets at all are not going to take any loss. I won't lose a dime except for the perceived value of our home, but that's not important until I need to cash out.

OTOH people who have bought late and too expensive HAVE ALREADY taken the loss when they bought their home and their overpriced stocks. But that loss happened in the past (or is happening now for those who are still gambling at this table).

So all this really does is to separate the "haves" and "have nots" into the smarter ones and the not so smart ones. And while I agree that that's a human catastrophe for the not so smart players, it does not translate into meaningful macro-economic numbers that can be expressed as totals of markets. Bifurcated distributions can not be described well by averages and standard deviations. Only Gaussians can. And this one is far, far away from being a Gaussian distribution.

[SisterAnn]

Those who bought at the peak were as smart as anyone. They did just like the rest of us and bought at the price homes were at the time.

They probably saw homes going up and decided they had better buy before they went higher.

Our home is paid for and we bought in the nineties. We lost a little in the market, but only 4% over all of the IRA.

Also, in some areas housing didn't go to extremes. In our area it was overbuilt, then when prices started going down, they went bankrupt, leaving the banks with the houses.

Too many unsold houses and banks not loaning unless you have perfect credit and a big down payment, keeps builders from building.

Some builders are building small affordable homes and are selling them.

The reason banks don't want to lend is they are afraid that the good mortgage holders, who pay their payment on time and have good jobs, will lose those jobs. You can't make payments when you don't have an income.

[Parducci]

These are some great ideas on tech stocks. With ideas like these, you should go into the securities business. Oh, wait. You can't because YOU HAVE BEEN BANNED from the securities business FOR LIFE by the SEC.

[OtayPanky]

Let's put some lipstick on this pig!

Oink! Oink!

[DuganS1]

The statistics in the article ignore the fact that the vast majority of folks have been making timely payments on their mortgages so mortgage debt should be continually going down for most people. It also doesn't take into account those who have been able to refinance into lower rates. The home value numbers also don't take into account the inventories, which should trend down within the next year because of a massive slowdown in home construction and a large number of people (of which many have called the second baby boomer generation) reaching the age of household formation. These two dynamics (low construction and high population growth) should balance out the supply-demand element and result in the stabilization or even increase in prices. It's also important to note that home values have mostly went down in only a half dozen or so areas around the US (Miami, Vegas, Phoenix, N Cali, S Cali) and those are the same areas with the highest population growth.

[KillTheMessenger]

We should also note the the parents of the second generation of boomers had a savings rate of eight to ten percent. The people you call the second boomer generation which would now be eligible for household formation have a negative savings rate.

Bummer!

Or is it

Boomer!

[DuganS1]

The savings rate numbers are highly misleading because they don't take into account 401k contributions (which are significant) or values, IRA contributions, and other retirement and insurance related savings vehicles. Twenty to thirty years ago people had to save their own money for retirement because things like 401Ks didn't exist.