Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.For example, the biggest decline home prices in Los Angeles County is seen in the lowest priced zip code: the fabulous 93591, the Lake Los Angeles part of eastern Palmdale in the high desert. In February, 21 homes sold there. The median price was $55,000, down 78% from February 2008. In contrast, in the worst zip code in Compton in the 'hood, 25 homes sold, with a median price of $140,000, down 52%.
How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?
In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners. In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin. In some of the cities hit hardest, borrowers who purchased in the low-price tier at the peak of the bubble have seen their home value decline 50% or more. Over the past 18 months as housing prices have fallen, millions of homes became worth less than the loans on them, huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury. ...
Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system.
By the way, I drove through both Palmdale and Compton last week, and I have to say ... they look marvelous. Practically every residential street in SoCal looks great in early Spring. (The commercial streets not so much). Slums in SoCal just don't look like slums on The Wire. I wonder if Countrywide and Fannie Mae arranged to take Chinese bankers interested in buying their cruddy mortgage-backed securities and stock through Palmdale and Compton in late March?