Monday, May 24, 2010

Where did all the money go?

When housing prices went bust, where did all that equity go? Nowhere, it turns out.

James Surowiecki, in his recent column in the New Yorker, made a gaffe that surprised me. He said something to the effect that as a result of the housing bust, trillions of dollars "evaporated" overnight.

For the average Joe to think this is one thing. But for an economist? Shocking.

Here's the deal: That money didn't exist and never did. Like the price of stocks, what the last buyer is willing to pay does not represent the real value of the entire outstanding shares. If you sell off all the shares of a company at once, they will not likely yield the touted "Market Cap" calculated by multiplying the number of outstanding shares by the last share price.

No no, the actual value will be less than half that. And the same is true for housing.

One fellow, on a CNN report, whined about how he lost "all that equity" in his home, as if it were some sort of real money. He bought a house for $250,000. It shot up in value to $500,000, and then dropped back to $250,000. How exactly did he lose money? If anything he is dead even.

And in terms of real value, his house is worth the same as before. If he wanted to sell it for $250,000, chances are, he could buy a similar house for $250,000. In terms of comparing its value to other, similar houses, nothing has changed. His house is worth a house - what other houses are worth in his neighborhood. The "value" hasn't changed, only the dollar value.

Unless you create a realization event, and "cash out" all that equity, it ain't yours. If your home goes up in value, and you don't want to sell, then you have not "made" any money. You have only a potential to make money - an unrealized potential.

Potential is an interesting word. In Electrical Engineering, it refers to voltage. If you stand next to a high voltage line, but don't actually touch it (or have it arc to your body) you don't get electrocuted. If you turn off the electricity to that line, your condition stays the same. And unless you actually touch that high voltage wire, you will not know the difference between when it is "hot" or "dead", without some kind of instrumentation.

So to NOT SELL your house is like standing next to that wire and not touching it. You can't say "I nearly made a million bucks" just as you can't say "I nearly was electrocuted!" You either are, or you aren't. And complaining about money you "might have made" is akin to regretting not buying Microsoft in 1983. You might as well say "I could have been a millionaire, if only I bought those winning lottery tickets!"

In other words, like any other financial transaction, you can't whine about "lost equity" any more than you can't whine about making bad investment choices - or not selling your car the day before the transmission went kaput. Coulda been, shoulda been, but wasn't.

So there were no "Trillions" in evaporated money. Most folks, during the peak of the market, were not interested in selling. Many argued there was no point in selling, as if they sold, they would likely buy another house - and since all houses were priced alike, they would not "cash out". And of course, another reason many people didn't sell when prices were high was that they were convinced that prices would go even higher.  The same thing will prevent the gold-bugs from getting out in time, before that market too, collapses.

And bubbles always collapse. It's a law of nature.

The smart thing to do, in retrospect, was to sell out and then rent for a year or two. But few were willing to do that, as they feared being "priced out of the market". If they timed it wrong (suppose housing prices went even higher?) they could find themselves never able to afford a home again! Or, at least that was the theory. In retrospect, a pretty stupid theory. Why on earth would housing prices ever go to a point were no one could afford them? It made no sense.

A few smart people and a few lucky people (based on circumstance) did cash out and make real money. But many of the people who made tons of money doing the "buy and flip" ended up losing it all (or losing a lot of it) when the music stopped and they were still standing up. The problem with that crowd was that once they got hooked on the "buy and flip" drug, they couldn't quit - afraid to pay capital gains taxes on their rollover profits.

And yes, some average folks did get burned and lost tens of thousands of dollars in the process. The losses to the last people who bought in were very real, just as they are to the guy who bought the last share of Enron before it crashed. But their losses were not as great as the raw numbers might indicate.

Johnny-come-lately who bought a mini-mansion in 2005, putting little or nothing down, signing a "liar's loan" (no docs) lost very little - and got to live a nice house, until they threw his ass out. Those folks whine about how they "lost their homes" but the real loss was to the mortgage company, who took hundreds of thousands of dollars in losses - which were passed on to the rest of us, in the form of mortgage backed securities losses which were reflected in the balance of our IRAs and 401(k)s.

But the "phantom equity" of an overheated market was never "lost" for those who stayed put and could afford their homes. Most of those people, in their homes for 5-10 years, had enough real equity that when the housing prices went bust, they still had positive equity in their homes. They did not "lose" anything, they just did make as much as they could have.

So where did all that phantom equity money go? Nowhere, because prices and market values of homes don't represent real money, except for homes actually sold. A house just sitting there, which rises dramatically in price, does not create "wealth" unless the owner sells it.

For those homes, there was no money lost - merely a potential to make money was lost. And dollar bills don't represent potential wealth, they represent real wealth.

So no, the money didn't go anywhere. Some folks got burned badly, to be sure. We all took a hit in our investment portfolios. Many walked away from homes and declared bankruptcy. For the majority of us, however, we merely saw unrealized gains decrease. And many people still made a decent rate of return on their homes, even with the bubble bursting.

In a way, it is like the Stock market. I had one account with $100,000 in it. It went up to $120,000 and then sank to $80,000. Did I "lose money" in this account? Not really, considering that I invested $20,000 in it, ten years ago. a 400% gain in a decade is still one helluva ride, even with the "phantom losses" of last year.

The people who sold out before the crash realized those phantom gains. Those who sold after the crash locked them in.

But for the rest of us, there was no, and will never be, a "loss" from the market events of last year, as our portfolios are still worth more than we paid for them. You can't count your chickens before they hatch. And you can't realize gains or losses without a realization event.

The money didn't go anywhere. And James Surowiecki of all people should know that.