Where'd It All Go?

Last week on CNBC's morning program, co-anchors Joe Kernen and Becky Quick were asking, regarding the mortgage/housing market troubles,

"Where'd all the money go that went into these houses that are now empty?"

Kernen was musing about where all that money went which was borrowed to build now-useless housing.

Who ended up with the money? Or did it just 'disappear?'

Pardon me for saying so, but, isn't that a stupid question? And Kernen and Quick are both smart enough to already know the answer.

The money was part of the assessed, imputed present-value of those homes, lent by financial service providers.

Essentially, based upon local demographics, overall economic outlook and the borrowers' financial outlook and current condition, someone lent them the money to build a house of some assumed value in that market at that time. No matter how long the chain of borrowers and lenders, eventually, at the end of it, some person or entity bought a financial instrument promising repayment, over time, at some interest rate, in exchange for the cash that trickled back to the home's purchaser, with which to pay the various people engaged in building the home.

So the money in those homes- the value lent against them- went to the contractors, tradesmen, and, yes, a little went to the financial intermediaries, as well.

As with the excessive lending and capitalization of web-based companies during the 'dot.com' boom, capital flowed from people and entities to projects- homes or businesses- judged to have future value and an ability to repay the borrowed money.

Of course, to the extent that financial intermediaries used excessive leverage, the dollars lent by investors became, in some cases, 30 or more times that amount. Banks are allowed certain capital ratios by the Basel Accords, while the banks allow certain ratios for brokers to which they lend. With firms such as Merrill Lynch and Bear Stearns purchasing and operating mortgage banks, I'm sure the leverage for dollars flowing into the housing sector were greatly amplified versus prior housing bubbles.

As I reflected on this post earlier this morning, it occurred to me that one of the by-products of the excessive investment in the housing sector was an overall economic leverage which was much greater than if those investor dollars had flowed to a non-financial sector, such as energy, consumer goods, or almost any other sector.

The investments in housing and related sectors diverted funding from other sectors. But, since so much of the real estate boom was predicated on values which, especially in 'hotter' markets like Las Vegas, Florida and California, could not long be sustained, those investments were at risk nearly from the outset.

When the leveraged 'values' declined, the thinner-than-normal equity slices evaporated quickly, and investors took their hits next- almost immediately. For example, a low-down-payment mortgage requiring only 5% of the purchase price of the home from the buyer could only withstand a 5% drop in real estate values before investors began to lose their capital.

With so much borrowed money flowing into an overheating sector, the damage to our economy was magnified because so much forecasted future value was brought forward, monetized as housing prices, lent, and spent.

So the answer to Kernen's and Quick's question is that an abnormally large amount of economic 'value' was created on paper, in the financial markets, to lend to buyers of over-valued houses which quickly lost value and destroyed the imputed values which had been assessed, borrowed, lent, and spent on housing and related items.

The cash went to pay builders, furnishers, appliance makers, etc. The offsetting 'credits' for these 'assets' are, of course, assets on the lenders/investors balance sheets. But they have now had to be written down to current values.

The laborers, contractors, and publicly-held house-furnishing-related companies enjoyed a brief, accelerated boom in revenues. Perhaps some even expanded capacity and created downstream revenue growth themselves.

Now, however, as Paul Samuelson's accelerator-multiplier work informs us, the same breakneck growth in housing-related spending and lending which drove prices and 'values' up in the expansion, are at work in reverse, coursing through the sector and depressing values.

The values represented by the peak prices of homes bought and constructed were contextual, and have vanished. The real dollars exchanged for those prices did, for a moment in time, also exist.

But the reverse multiplier effect on all these vendors, assets, etc., have destroyed much of the capital created and borrowed to fund these houses.

Since valuation is a function of perceptions, those values are now gone. And so is much of the transitory wealth which existed at the time of peak values in the housing markets.