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A genuine hard landing for U.S. housing will send up dust all over the world. Most people can't bear thinking about it...which is exactly why we like to write about it. Bill Bonner explores...

We end this week in a state of low dudgeon. Everyone we ever heard of who was in a state of dudgeon was in a high one. As contrarians, we felt the need to do something different. 

A state of dudgeon is nowhere near Indiana. Instead it is merely the condition of being good and mad. So maybe it is closer to the West Coast. Why the typical resident of dudgeon should be high is a mystery to us. But we leave that for another day. The subject of today's reflection is, instead, why the typical resident of the 50 states should be festering with resentment in the first place. 

A genuine hard landing for U.S. housing will send up dust all over the world. Like the impact of a giant meteor it threatens to block out the sun...and lead to the extermination of whole species of investments. Most people can't bear thinking about it. We at The Daily Reckoning, of course, make it our business precisely to think what most people can't bear thinking. 

And in keeping with contrarian principles, we will begin out thinking at the extremities of the bubble and work backward. We perambulate east to understand what is happening here in the west. There, we find that even the lowliest of Chinese factory workers depend on companies that export to America. These exporters depend on mass importers, such as Wal-Mart, who in turn depend on millions of average Americans to continue buying their goods. 

Poor Mr. Typical has not had a wage increase since 1972, according to the U.S. Department of Labor's website. He earned the equivalent of $334.60 a week back 24 years ago. Now, the figure is just $277.96. But he didn't cut back spending just because his income fell. To the contrary, he put his wife to work...and now he has got himself a wallet bursting with credit cards, along with a neg-am, payment optional mortgage, a credit innovation as popular with Americans today as Crispy Kreme donuts at a police benefit. 

Approximately 40% to 50% of all new mortgages written in the last two years were ARMed...and dangerous. To fully understand how these mortgages work, you probably have to have been hanged...or at least been to a public hanging. Then you would have noticed that when a man dropped from the scaffold, there would be a considerable give in the rope...until it snapped taut and broke his neck.

Mr. Ramiro A. Ortiz, president and CEO of one of Florida's most aggressive lenders, described the slack in the noose last month when he was asked what would happen if a homeowner couldn't make his payments.

"In our situation, the customer has some flexibility and can choose some other options to weather the storm till the times are better."

Yes, he can skip a payment if he wishes, and let the principal of the loan rise - to a maximum of 115% of the original amount. So, if he merely has a month to wait for his bonus check...or suffers some other one-off calamity....he can make it up the next month and all will be well. But when he hits 115%, the rope tightens on his neck, no matter how many checks are in the mail.

When just a few yahoos get themselves into trouble nobody cares. But should a general cyclical turndown put many people into his situation, the results could make the whole world shudder. The U.S. economy is still 25% of the entire world's economy. Foreigners depend on the United States to continue buying...the U.S. depends on its lumpen-consumers to continue spending...and these same consumers depend on debt for their spending, debt backed by house price gains.

Reading the papers and talking to homelanders we conclude that the housing bubble is over...and unlike other observers, we believe it will come to a rude end, for three reasons:

The first is demographic. The typical baby boomer has a total of $60,000 in net worth. For the last 10 years or so, he has not had a reason to save. Why get 3% in the bank when you could get 12% from housing? Counting leverage, most people probably got at least twice that. The typical retirement financing plan was simple: buy a house in Florida...then sell the house in New Jersey. Naturally, the Sunshine State boomed. But where did the boom come from? Housing, of course. In the period, 2001-2005, employment growth averaged 2.2% per year - third highest in the nation. But job growth in the property sector grew more than twice as fast, at 5.6%.

Naturally too, house prices seemed hitched to a rocket launch at Cape Canaveral. In the three years, 2002-2005, property prices rose 77% compared to income growth of only 1.4%. 

In the run-up to their retirements, the baby boomers were net buyers of houses. It was a way for them to finance their golden years. Now that the boom is over, they will most likely be net sellers - because they will need the money.

What is seldom appreciated, especially by America's homeowners, is that housing prices do not go up reliably. In fact, for most of the last century, they reliably went nowhere. According to Robert Shiller, during the entire period from 1890 to 2004, property rose at an average annual rate of just 0.4%. And in many parts of the country, over long periods of time, prices went down. The price of farmland in Western Kansas, for example, hit a high in the commodity boom of the late 1880s and has still not recovered. 

The International Monetary Fund analyzed home prices in a number of countries from 1970 to 2001, and found 20 "busts" - when real prices fell by almost 30 percent. All but one of those busts led to a recession.

Japanese property prices have fallen for 14 years in a row, by 40 percent from their peak in 1991, and consumer spending has been weak, leading The Economist to conclude, "Americans who believe that house prices can only go up and pose no risk to their economy would be well advised to look overseas."

And The Economist of May 29, 2003 adds:

"House prices have fallen in nominal as well as in real terms in Germany and Japan over the past seven years. A house in Tokyo now costs less than half what it did in 1991, after a now legendary property-price bubble in the late 1980s. Yet the 36% real increase in average house prices in Japan in the seven years to 1991 was less than the increase over the past seven years in half of the countries we track in our index.

"German houses used to be the most expensive in Europe: in 1975, they cost three times as much as French ones. Today the two have more or less evened up, largely because German house prices have been steadily declining in real terms. Germany is still suffering a hangover from a massive construction boom after unification, encouraged by government subsidies and tax breaks. Prices in eastern Germany are still falling in response to excess supply, though in western Germany they have risen slightly over the past few years. 

"Over time, housing booms and busts in Europe, and especially in Britain, have been more pronounced than in the United States (see chart 5). House prices have also been more volatile in cities, where the supply of building land is more limited. For example, London house prices soared by 120% in the five years to 1989, then fell by 30% over the following four years. 

"In real terms, price declines of one-third or more are nothing unusual, examples being Australia, Italy and Spain in the early 1980s. Falls in nominal prices are much more common in big cities. Not only London but Boston, New York and San Francisco, too, saw prices drop steeply in the early 1990s."

The second reason we give, for why this property decline is not likely to be soft and easy, is technological. The invention of the modern automobile in the early 20th century seemed to doom America's cities. The cities were noisy, dirty, bustling places of commerce. Americans who could afford to do so dreamed of living outside the city centers. The automobile helped to make it possible.

The best neighborhoods of Baltimore peaked out in the 1920s. Even now, at the height of the greatest bubble in history they still have not recovered. Another example comes to us from Grant's Interest Rate Observer:

In Boston, Mr. John C. Kiley, writing in 1941, observed that prices had been going down for 11 years. He noted "in some of the older business and residential sections of the city of Boston have returned to levels below those of the pre-Civil Wars years." One hundred years of price appreciation - wiped out.

What had happened to Boston? Many of the richest people had moved out...driving out to the suburbs in their new Oldsmobiles.

"When I was I young man in the early 1980s, I used to play in a rock and roll band in Minneapolis," writes George Paulos at freebuck.com. "Like many bands of the era, we rented a "band house" to live and rehearse. Most of the band houses were located in Southeast Minneapolis. There were many large homes in that area for rent and the price was cheap. Our band house was a large two-story home that was built sometime in the 1920s. It was a two-unit rental with an upstairs kitchen and bathroom. We packed four guys into the house and still had plenty of room for rehearsing and all-night beer bashes. 

"We often wondered about the original owners of these mansions. It was obviously a wealthy neighborhood at one time. Many of the homes in the area were huge and intricately designed. What happened to these people and why was the area now so downtrodden? Many years later I learned about the Depression and how it affected land prices and neighborhoods. It turns out that Southeast Minneapolis was at the frontiers of development in the 1920s. 

"Although within the city limits, they were essentially the suburbs at that time. Homes like our band house were the McMansions of the day. They were built for a burgeoning upper middle class who had increasing incomes and easy access to credit.

"When the Depression arrived, these neighborhoods were hit pretty hard. 

"The real estate bust of the 1930s had a permanent impact on many neighborhoods. The once wealthy neighborhood that surrounded our band house was still suffering 50 years later. ... Even in the middle of a huge real estate boom, these neighborhoods are so blighted that they are still shunned."

What technological innovation threatens America's suburbs? The Internet. The automobile meant you know longer had to live near your work. You could just live within commuting range. Now, the Internet means that many people and many businesses can put themselves anywhere. We think they will turn their backs on the suburbs. 

Our third reason is the most important and the easiest to understand. Why will the bust in American housing be extraordinary? Because the boom that came before was extraordinary. 

In the last two years, homeowners in America took out $1.3 trillion from their house price gains, an amount greater than the GDP growth figures for those years. 

While prices rose only 0.4% per year from 1890 to 2004, they soared by 6.2% from 1997 to 2005. According to Shiller, it would take a 22% drop in residential real estate prices to bring house prices back to their long-term trendlines. Other experts have predicted a 40% retreat. 

Falling prices in the housing sector mean that homeowners no longer have any "equity" to take out. Instead, the flow of liquidity reverses...mortgage resetting, taxes, maintenance, debt restructuring, foreclosures - all of a sudden money must be put back in! A 5% fall in house price takes $1 trillion out of the net worth of American homeowners. A 40% drop would probably set the economy back about as much as the Great Depression. 

"The real estate bust of the 1930s holds important lessons for today," continues Mr. Paulos. "It showed that homeowners are bound together with their neighbors by chains of finance. Even responsible homeowners who maintain low debt can be undermined by their financially irresponsible neighbors. It may be that your best neighbors, the ones who have been aggressively upgrading their homes, are the ones who have been racking up the most debt. A closure of a large local employer or even a large tax increase could be the tipping point for homeowners on the edge.

"I recently visited my old band house. It was just as I remembered it. The hedges were massively overgrown, the siding was still rotting, and the porch was still sagging. It was a bittersweet vision. The rest of the neighborhood was a mixed bag. Some homes have been nicely renovated and others were still crumbling. Judging by the condition of the local businesses, the neighborhood is even more distressed that it was in the 1980s. Seventy years after mass foreclosures and the place still hadn't recovered. How will it fare during the next real estate bust?"

Mr. Paulos should plan to drive by in a year or two to find out.

By then, the chains of finance that chaff against the skin of the middle and lower-middle class might be tightening upon us all. And the dudgeon festering on the wrong side of town might have oozed over to the good neighborhoods. 

© 2006 Bill Bonner
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Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons). In Bonner and Wiggin's follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is - an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt at a discount - just click on the link below: "Now Perhaps Someone Will Listen!" http://www.isecureonline.com/Reports/RCKN/E_O_D/ You can sign up for a free subscription to the Daily Reckoning here: http://www.dailyreckoning.com. This essay was originally published in The Daily Reckoning.