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I'm In a Net-Worth State of Mind

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The residential real estate market is unfolding in textbook fashion toward the end of the denial phase...

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As I attempted to assimilate the bullish vibes emanating from Michael Thompson's presentation at Minyans in the Mountains 3, he began to explain why even a housing slowdown would be unlikely to do too much harm to the economy. His take is that the overall Net Worth of the consumer is at all time highs, and affords it a nice cushion as the "housing ATM" dries up. Needless to say, my pavlovian bearish reaction was to ask myself how much of that Net Worth was in fact locked into real estate. As a proud member of the "you need to get out more club," that question has haunted me since, and led me to spend this past weekend digging for the answer through enough financial stats to confirm that I definitely do need to get out more (actually it was a good excuse to watch Tiger Woods dispense an athletic and psychological beating-for-the-ages on his competitors, some of whom have been spotted drooling and curled in the fetal position outside of Prof. Hanson's office).

Here is what my weekend of seclusion has uncovered:

Household assets, excluding real estate (broadly speaking "financial assets"), are basically back to the same level we saw at the peak of the 2000 equity bubble, but the ratio of Total Liabilities to Financial Assets has jumped from just under 20% in 2000 to more than 30% in 1Q '06. The culprit is a $5.3 trillion increase in liabilities, with household mortgage debt making up $4.5 trillion of that amount. So from a "liquidity" standpoint, the consumer is arguably in worse shape than it was in 2000.

The reason for the perceived strength of the consumer's balance sheet seems to be a $5.25 trillion dollar increase in the "real estate equity" line. Now, if the increase in equity were permanent I probably would not be penning this. But there lies the $5 trillion dollar question: Will this equity gain be permanent?

This requires revisiting my heretical piece suggesting that, outside of replacement costs, real estate has no real value except for the emotional and fleeting passions that compel someone to pay a premium for lake-views, wooded backyards, penthouse ego-trips, or commute-free living (please read the linked piece in full before throwing cyber-darts at me). We will call this premium the "Value of Land & Intangibles (L&I)". What we see is that in 1997 L&I made up just over 25% of real estate values. As of 1Q '06 that had jumped to more than 38.6%, eclipsing the 35.5% mark at the peak of the late '80's bubble, and the 30% level registered in 1963.



What followed after each of these spikes in the ephemeral value of L&I is not a pretty picture: From 1963 to 1966 L&I values (all figures adjusted for inflation) fell 10% and it took until 1969 for L&I to return to 1963 levels; between 1990 and 1995 L&I fell 25% and the 1990 level was not recouped until 2000; even in the aftermath of a modest bout of speculation at the end of 1973, the energy crisis squeezed the life out of the party resulting in a L&I drop of 37% by the end of 1974.



In a different format, here you can again see that whenever L&I appreciation sprinted away from the growth in replacement cost value, the former ultimately corrected and/or spent significant time treading water.

If you can get past the fact that I laid out the above statistics in the first place, I find that the data pretty much puts to rest any suggestion that the assets residing in real estate L&I are anything but permanent.

Within the broad outlines of secular bear markets – denial, migration, panic - the residential real estate market is unfolding in textbook fashion toward the end of the denial phase, which began with the denial that buyers had left the party, and is now ending with a period during which sellers can't accept that, despite the total absence of buyers, their properties just are not worth what they think.

In the next few months, as the carrying costs, mortgage resets, and mortgage problems set in, sellers will abandon the "real estate is a sure thing" ghost, and swear it off as the pariah of asset classes, thus introducing the spiral of lower prices. At risk of stepping into the very dangerous business of making predictions, my sense from having lived through the last bust up-close and personal, is that - if all goes well - we should see about 30%-40% of the L&I value evaporate, or $2.2 to $3 trillion dollars, or roughly what we are already seeing in Jeff Saut's "Continuity of Thought."

I'm afraid that is when a lot of people will wish they were Minyans, and they learnt how to draw that all-important line between net-worth and self worth.
No positions in stocks mentioned.
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