From the June 2006 issue of Wealth Manager Web • Subscribe!

Burst Bubble

In most respects, a slowdown in housing is clearly not a good thing. Edward Leaman, an economist at UCLA's Anderson Business School, says that eight out of 10 recessions since World War II began in the housing sector. But although a housing-led recession now wouldn't make anybody but a Democratic congressional candidate happy, some economists suggest that a market correction in housing would not be entirely bad news.

Although a deflation of the housing bubble would pose some major risks, some economists see a bright side to the end of go-go price increases. They say the most useful result (and one that's probably occurred to more than a few people without a Ph.D) is that houses will be cheaper to buy.

Not only is that obviously a good thing for first-time homebuyers, Leaman argues that it may also be a good thing for pre-retirement owners as well. One way to think of the property boom, he says, is that the growth in homeowners' assets should be offset by a liability of lower affordability for younger people who want to buy a home. But falling prices might not be all bad news for today's homeowners: In fact, if Leaman is right, Baby Boomers who lose their nest egg may be gaining an annuity. Lower mortgage payments, in Leaman's view, will leave young workers with more money to pay for the taxes needed to help support Boomers' health care and Social Security needs.

Right now, real estate is soaking up a tremendous amount of the economy. In the first quarter, 6.2 percent of all GDP was generated in residential real estate, according to Robert Shiller, an economics professor at the Yale School of Management, a level he says has been unsurpassed any time since 1960. Another indication: Craig Thomas, an economist for Torto Wheaton Research, a real estate research firm based in Boston, estimates that in the current property boom, contractors have "built somewhere around 4.5 million more houses than we have actual residents."

Less investment in housing could also be a gain for sectors of the economy outside real estate. "We'll use our resources better once prices come down, and it stops this over-activity in the housing construction sector," predicts Shiller, author of the bestseller Irrational Exuberance, which predicted the end of the great tech stock bubble.

Shiller points out that when your house gets more expensive, it "doesn't get any better if the price goes up. You still have the same house. So what does it mean when the price goes up? It means that we're all worried that there won't be more. If we finally realize that [housing is] not so scarce, aren't we all kind of better off in some sense?"

The end of exciting real estate returns could also lead people to consider investment opportunities beyond real estate. "They're not thinking about all the different investments that they might make," Shiller says. "They're thinking about housing because everyone's talking about it... people are not thinking, 'I could invest in China, I could invest in India, I could invest in a million different things.'"

Or bonds. Marc Faber, a Hong Kong-based investment advisor, argues that a price correction of 10 percent or more would cause consumption to slow and spark a bond market rally. However, Faber is not sure this will happen, referencing Federal Reserve Chairman Ben Bernanke's comments a few years ago that in the event of price deflation, the Fed would simply print more money. "It is far from certain that we shall get deflation in any asset class given Mr. Bernanke's printing press and his eagerness to prevent asset deflation from occurring," Faber wrote in an email.

Even within the real estate industrial complex, investors are likely to find some new opportunities if values sink. Christopher Whalen, a bank analyst based in Croton-on-Hudson, N.Y and a managing director of Institutional Risk Analytics, argues that although mortgage defaults are likely to rise in the coming months, hurting most banks, investors are likely to find some investment opportunities within community banks that have 30 percent to 40 percent of mortgage risk on their balance sheet, rather than the much higher percentage of mortgages on the books at such large banks as Washington Mutual or Bank of America.

Perhaps most important, if home price growth reverts to its normal, long-term average of 1 percent to 1.5 percent annual price appreciation, Leaman believes Americans will begin to save again. "It'll eventually lead to a realization on the part of Americans that the only way to grow our nest eggs is to actually save, that the house is not going to be some magical tree that's going to take care of us with more and more fruit every year," he says.

Bennett Voyles is a New York-based freelancer writer who wrote about unusual tax deductions in the April issue.

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