The Problem With Debt

15.4 million homeowners now owe more on their houses than their houses are worth, up from 13.6 million four months ago.  The number will probably top 20 million when all is said and done.  To mark this sad stat, we’ve updated our post from last fall on the power of leverage.

As Warren Buffett succinctly observed, anything multiplied by zero is zero.

Put differently, when the value of the asset drops below the value of the debt used to buy it, poof.

Nowhere is this concept more important than in the housing market.  A couple of years back, the value of US residential real estate was about $25 trillion. Mortgage debt constituted about 45% of that ($11 trillion*) and owner equity 55% ($13 trillion). (Rough numbers)

Now, the value of the US housing market is down almost 30% and headed to, arguably, down 40%.  In other words, if the peak value was $25 trillion, the current value is about $18 trillion, and the trough value will be about $15 trillion.  So what will happen to homeowner equity?  It will drop by 70%.

Value: $25T
Mortgage Debt: $11T
Homeowner Equity: $14T

Value: $15T
Mortgage Debt: $11T
Homeowner Equity: $4T

Ouch.  And by the way, that percentage holds regardless of what the actual peak value of the housing market was, as long as you start with 45% debt-to-value.  Also, most of that equity is owned by folks who own their houses outright.

And what happens if you have a more typical debt-to-value ratio–say, 80% debt?  Then, unfortunately, your equity IS going to zero.  In fact, it will only take a 20% fall in the house price for that to happen.  That’s why so many households are now underwater.

House Value:  $500,000
Mortgage (80%): $400,000
Equity: $100,000

House Value (down 40%):  $300,000
Mortgage (80%): $400,000
Equity: -$100,000

That’s also why lot of consumer households will get wiped out. 

(By the way, this is what killed all those Wall Street banks.  Unlike consumers, they didn’t have 45% debt-to-value ratios or even 80% debt-to-value ratios. They had 97%-debt-to-equity ratios.  So it didn’t take much of a decline in equity to blow them to smithereens.)

See Also: US Consumers Are Broke

* US single-family mortgage debt outstanding at the end of Q4 2008 was just over $11 trillion.

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