The Winners in the Housing Crash

Every day is bringing worse news in the US credit/housing disaster. I'm more and more convinced that the US is in big trouble. I'm also convinced that we won't be far behind.

Its tempting to think that when houses decline in price, people, in general, are "losing money". This isn't quite right however. What's being lost is wealth. No money has been created or destroyed!

Let's look at the flow of cash in housing.

Let's imagine a new build in California.

The land is orginally owned by a landowner, lets call him Albert.

A developer, lets call him Bob, pays Albert a sum of money for the land, "$A". The developer then builds a house on that land. This costs him labour and materials "$B" and "$C". In 2005 he then sells that house to a random punter, Charles. Since its at the peak of the boom, Charles pays a high price, "$D" for this house.

Now, again, since we're in a boom, D will be greater than A+B+C, i.e. the developer makes a profit, "P", where P=D-A-B-C .

Bear in mind also that, since it's boom times, there's a lot of building going on, so A, B and C will also be higher than you would expect in usual times. We'll come back to this later.

Charles, the purchaser, goes to a bank to borrow money. Lets imagine that he gets a 100% mortgage, with a standard variable interest rate (i.e. he's a prime customer).

The Bank basically gives Charles the whole purchase price, "D", which Charles then gives to the developer.

Fast forward 3 years and suddenly the house is worth a lot less. Let's assume that its dropped 30% in value, and is now worth 0.7D.

Theoretically this fall in value has been borne by Charles, the owner, who has "lost" 0.3D in equity. What actually happens of course is that Charles hands back his keys. The bank respossesses and then resells the property at 0.7D, losing 0.3D.

Obviously this is a very bad thing for the bank, and, on the face of it it looks as if that 0.3D has genuinely disappeared. This is not the case. In fact the 0.3D loss is perfectly counterbalanced by a 0.3D gain. Where is this? Well it's in A,B,C and P - i.e. its in the money that the landower, the building labourers, the providers of building materials and the developer made. All of these were higher than the would have been if the newbuild had originally been sold for 0.7D.

The question is where has this money gone? Here's where the real problem lies.

The money has, in most cases, been spent, either on locally produced or imported consumer goods. (O.k, they may have saved some of it.... but this is the US!)

The bank's loss of 0.3D has been transferred to these consumer goods manufacturers, resulting either in higher overall domestic GDP growth than would have been possible with a lower original selling price, or more profits for foreign manufacturers.

This is the real problem. The US has, overall, spent the wealth "generated" by the housing price boom, and therefore there isn't any offset to the huge inevitable asset based write offs. Oh dear.

BUT, lets not forget that the developers, labourers and landowners managed to consume a lot more in the past 3 years than they would have done under non-bubble circumstances. There were some winners...