Note: I wrote this over a year ago and posted it at City-Data. Few believed me:
The Current Situation
What has happened is that many home owners saw the value of their homes double, then treble, then quadruple (in some areas), and then took out second mortgages or home equity loans. Some owners used that money to upgrade to a more expensive home, others spent the money on improving their homes, but quite a few just used the money to buy bling.
In two years the baby boomers will begin retiring and likely downsize their homes. Property taxes have soared in the very areas that saw the biggest growth rates through the latest housing boom and most retirees can't afford or do not want to pay the ever-increasing property tax rates on their homes. These retirees will look for condos or small homes in retiree-friendly states but who will buy the homes they need to sell?
There are far fewer GenX/GenY buyers than there will be boomer sellers. Further, over half the household wealth in the country still belongs in boomer hands. Yes they may be able to help out their kids to buy a house, but they also have the government whacking their wealth with capital gains, estate, and gift transfer taxes. They won't be able to give their kids much of a help. There won't be much, if any, tax relief either. As the boomers retire they're going to come calling for all those IOUs in the (laughably named) Social Security trust fund and all those Medicare benefits.
The middle class in the United States is shrinking as the wealth divide increases. The past 30 years have seen high-paying manufacturing jobs go abroad and now many professional service jobs, particularly in IT, going abroad as well. Employment may be high, but job earnings aren't keeping pace with true inflation and certainly not with the soaring housing values. In short, the relatively young middle class now cannot afford a house comparable to one they grew-up in. Even with two incomes they're reaching for any kind of mortgage they can get for the house they think they should be able to afford. This doesn't bother most buyers though because not only will the government give them tax breaks for buying a home and the Federal Reserve has dropped interest rates to nearly zero, but the buyers have grown-up in an environment where housing prices have only gone up. To them, a house is a safe investment. There will always be someone who wants to buy their house for at least what they paid.
To stimulate investment following 9/11, the Federal Reserve dropped interest rates to nearly nothing and began flooding the US economy with cash to keep it afloat. They did this by making interest rates drop to next to nothing, making money as cheap as possible to get. Nobody was making money in those assets whose value is measured against interest rates (think of bonds and savings accounts). An investor getting 2% in their savings account wouldn't be making enough in interest to pay for the gas to get to the bank! So money had to go somewhere. 9/11 saw a stock dip but soon money began pouring into the stock market because it literally had nowhere else to go short of under the mattress. That flood of liquidity did very well for the stock market; the proverbial rising tide that lifted all boats. As the stock market recovered, something else happened. Many people, post 9/11, wanted to get out of cities and those who decided to stay in cities decided to buy. After a major disaster, and in subsequent unstable times, people tend to hunker down; gathering their family, increasing the size of the family, and securing assets. This mentality, combined with the low interest rates, the willing Mae sister lenders, and the increased cash people had, made them look for a, "safe," asset. That asset was real estate.
People who had houses saw the value of their house increase. If they had an older mortgage, they refinanced to a lower rate. Buyers just entering the market felt they had to act now to get in on the real estate boom. Many saw the increase in the value of their homes and decided to make their homes more valuable still by adding-on or remodeling. Others bought second homes. Now when that happened, plenty of people saw their, "net worth," soar. Suddenly people were worth far more money than they ever were because the cheap Fed money helped them buy an asset whose value kept going up and up and, at least on paper, people were worth more since they owned more. So what did people do?
They spent it! They bought bling, they bought second houses, they even sold their previous house and bought even more expensive McMansions! So long as interest rates were low, they could afford payments on a nicer house. It was a good investment, in their eyes, because the newer, more expensive house kept going up in value too. And they started using their home equity credit for vacations and luxury items like expensive cars, boats, and designer clothes. Prices of things seemed to be rising a bit but given the feeling of newfound prosperity, it didn't matter much.
Things, you may notice, which don't appreciate in value.
What did it matter? The stock market was doing great, housing values were going up, and people were feeling positive about the economy. The matter is that the wonderful flood of Fed money which people loved when it was a bunch of tasty waves on their favorite surfing beach, eventually turns into a tsunami of money. Once the stock and housing markets were saturated, there was only one place left for the money to go. Where it has always gone after stocks and real estate markets become saturated in a mass inflationary cycle: commodities. Oil, cotton, nickel, copper, aluminum, and yes, the quintessential orange juice and pork bellies. Saavy investors saw that stocks were overpriced, housing was overpriced, what was left? The long, long, neglected commodity markets. Money poured into commodities and, as a result, the prices of commodities soared too. Most people saw curious stories about the penny and the nickel now being worth more than their face value but they didn't worry about it. Why does it matter? Well, to make OR consume things, you need commodities. Even if the US is now primarily a financial service economy, we still need cars and orange juice and bacon and cotton. When the costs of those materials rise, the manufacturers pass those costs on to you, the consumer. This is what most people consider to be inflation and of course it isn't.
The inflation started waay back when the Fed started dumping money onto the US people to keep the economy going. They started printing as much money as possible, getting other countries to lend us the money to do it (hence the soaring budget deficit).
First we get all that new, cheap money. Yaay! We can afford nice stuff!
Second we buy stuff with it. Real estate and stocks! Since nearly everyone is feeding at the cheap money trough, the rising tide kicks in and everything seems to go up! Yaay! We can afford even nicer stuff!
Third, all that money we're spending ends-up in the pockets of manufacturers and financeers who like to buy that which is undervalued. They want to buy assets when they're cheap, not when they're hot. As they have always before, that money went into commodities. Manufacturing costs increase, prices rise, wage earners want raises, pensioners want increases in benefits, and the government has to raise money (via taxes) since it too has pay for what it buys and things aren't getting any cheaper. But now interest rates are higher. Prices are going up, adjustable rate mortgages are going up, only this time there is no source of nearly free money. Like drug addicts seeking a fix, our dealer has raised prices after we got hooked and we have to scrape to afford our McMansions and BMWs. Worse, those assets we borrowed against, the houses, are either in static value or declining. Many people are paying mortgages on a house that now costs less than they paid. Certainly the housing boom didn't hit everywhere and some places may be seeing an upswing, but those markets are relatively small compared to the general trend and so won't have much effect on the market as a whole.
This time we have a demographic and economic crisis helping the housing crash along. Some banks got risky but others were more sober. Those are the banks that will make money on the way up AND the way down. Remember, Trading Places? Remember Mortimer and Randolph Duke explaining commodities to Billy Ray? "The good part is that no matter whether our clients make money or lose money, Duke & Duke get the commissions."
