There is an old saying of “Things are going to get worse before they get better”.  Today, I think many movers and shakers on Wall Street are forgetting this fact and viewing much of the current crisis with rose-colored glasses.

The problem I see is that too many Wall Street investment guru’s are forgetting some simple economic facts, and the issues concealed behind this lapse are going to turn the economy even more upside down.

Let me explain.

We all know that houses have become much more expensive in many markets.  A home that sold for $80,000 can now cost $200,000, and in some markets the “starter” homes run $500,000 or more.  And this upward rise in prices was fueled by a combination of low interest rates and easy credit to even marginal buyers.  Throughout 2003-2005, a home put on the market often sold within days and received multiple bids as happy homebuyers chased their dream homes.  Of course this had the effect of driving up the price homes sold at.

But, this also created a huge bubble in the economy.  For years conventional wisdom was that a person should not purchase a home if it cost more than 3-4 times his annual salary.  So a person making around $50,000 per year would be cautioned to only pay at most $190,000-$200,000 when purchasing a home.  But during the real estate frenzy of the last few years, people were encouraged to purchase homes that they could not afford based on their salary.  The encouragement was based on a suggested method of financing the purchase.  First, it was assumed that the home would most likely increase in value allowing the overextended buyer to either sell for a profit, and purchase another home at about the same price, (using the profit to reduce the effective purchase price), or to refinance every few years, using the equity to reduce the overall monthly payments.  These solutions can work, but only when buyers can be found to guarantee that prices continue to rise.  Should prices fail to rise, many who purchased homes will either find themselves facing foreclosure, or will find themselves trapped in a home they expected to resell after two years, and forced to continue working and making payments for little gain until the market starts growing.

And the market will struggle to grow in the near future.  Banks are going to head back towards the 4X salary rule, which means that even in 2 earner families the effective maximum house price will usually be less than $400,000.  (based on 2 people earning just about the national median salary of approx $45,000).  People who purchased more expensive homes, or who have a home at the high end of this range may find it difficult to receive their asking price.  This has already started to occur in many markets which are reporting that houses are staying on the market much longer and that when they do sell, its often at a considerable discount against the original listing price.  What had been a strong sellers market has been routed and buyers have almost complete control of the current market.

But Wall Street ignores this.  They will talk as if once the current bank credit crisis is dealt with people will again see the economy roar along without any aftereffects from the collapsing of the housing bubble.  If they do acknowledge some damage they talk about the construction industry. 

The economy isn’t quite as isolated though.  Right now we are seeing some families hurt by foreclosures and others struggling to meet mortgage payments they cannot escape, but we have to consider the economist view of the broken window parable.  In it we consider the shopkeeper who has a window to his store broken.  The optimists will say that “at least the glazier was given employment by the window breaking, so there is no harm to the economy”.  But the economists note that the shopkeeper had many other uses for the money he had to spend on repairing the window.  That lost opportunity could prove to be far more significant than the one day’s work given to the man who repaired the window.  Today we face the same situation.  Wall Street is talking about “well, only a few people are losing homes and the others are able to make the payments.”, but a good economist is asking, “how much economic opportunity is being lost because people have too much of each paycheck going to maintain their mortgages?”.

Its part of an old economic equation.  In economics payment of a loan has no economic value, just as in accounting the payment will actually reduce both the credit and debit sides of the ledger.  The interest is a recognized cost, but the payment on the principle is merely a transfer of money against a sale which occurred in an earlier time period.  As variable rate mortgages reset their rates and many people find themselves having to put more money into paying their mortgage, it will have the effect of reducing consumer “spending” and the economy will find itself fighting the drag this creates.