THE BLOG
11/16/2008 05:12 am ET Updated May 25, 2011

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