The Real Threat of the Housing Bubble

Includes: ICF, IYF, IYG, IYR
by: Colin Twiggs

The seriousness of the housing bubble is best illustrated by the ratio of the S&P Case-Shiller Composite Housing Index to Disposable Income per capita (before adjustment for inflation). The previous high of 0.45% in the late 1980s was dwarfed by the reading of close to 0.6% in 2005/2006. There has since been a strong retracement, but the index remains well above the 0.4% level needed to motivate home-buyers.

With real estate exposure exceeding $7 trillion and total capital and reserves of just under $1 trillion, a further 10% fall in house prices would have a devastating effect on the banking system. Much of their normal margin of safety has already been wiped out by the existing fall. While this may appear an extreme scenario, the economy faces falling consumer sentiment and declining incomes from an approaching recession.

I am sure that the problem has been keeping Ben Bernanke awake at nights. With interest rates already close to record lows, the only tool the Fed has left in its toolbox is inflation. By raising nominal incomes rather than lowering house prices they can achieve the same end — but at what long-term cost to the economy?