Foreclosures do not destroy wealth

Much media hay has been made over the astonishing foreclosure rate in August, as lenders took back the greatest number of homes in a month since records have been kept. Some of the language used in these articles evoked imagery of hurricanes sweeping across the nation and destroying vast stores of wealth in the form of houses. Breathless references were made to the large number of underwater mortgages (currently estimated at 25% of all outstanding mortgages), and how that ensures that housing prices will fall for months to come, and how the country will be dragged into ruin as a result. Clearly, the economic education of many journalists leaves much to be desired.

Let’s get this straight. Foreclosures and declining housing prices DO NOT destroy wealth. The amount of goods available for consumption has not declined because housing prices have declined. Declining housing prices merely redistributes existing wealth in the country, from current homeowners, to future homeowners. While current homeowners feel (and are) poorer, future homeowners pick up a bargain home and have more disposable cash. This transfer of wealth should work out to an economic wash.

Despite the above reasoning, most economists agree that large declines in housing prices are bad because of two externalities. Firstly, if the number of current homeowners exceed the number of future homeowners (which it does in the US, with an estimated home ownership rate of 60-70%), the psychological impact of declining wealth among economic winners is likely to be swamp that of increasing wealth among economic winners, both because the winners are in majority, and because the pain of economic loss is felt more keenly than the pain of economic gain. In other words, poorer current homeowners become gloomy and stop spending, and this gloomy mood infects the richer future homeowners, who also reduce their spending. This is the “wealth effect” that many journalists refer to, except that most do not point out that this is a psychological effect rather than an actual economic reduction in wealth. And psychology, as most veteran value investors know, can and often do turn on a dime.

Secondly, large declines in housing prices lead to huge losses for banks, causing them to run short of cash required for extending new loans, thereby depriving the economy of credit. This is probably an appropriate end for banks, since it was their reckless assumption that housing prices will keep rising that got us into this mess. And there is an easy solution for this side-effect of house price declines; the government could and should backstop the banks, perhaps easing the required regulatory capital ratios (i.e. regulatory forbearance), or just bailing the banks out, as it has done before. However, there is a political problem in bailing out unpopular banks; it is much more politically appealing to bail out the homeowners, thereby achieving an indirect bailout of the banks anyway.

Still, nearly all the scenarios that can play out due to housing declines do not result in an actual destruction of economic wealth. The rate of economic expansion in the US may be reduced for a few years due to psychological effects and a reduction in investment opportunities and credit, but overall, when all the dust has settled, existing wealth in the country will have been somewhat redistributed, but life will go on.