Once upon a time owning a home was a relatively safe investment.  In fact, national housing prices rose annually for more than 60 consecutive years.  Three generations of Americans enjoyed stability from homeownership and benefited from leveraged equity gains as prices steadily appreciated.

Homeownership continues to be ingrained in American culture, but housing is no longer a safe asset class.

A Historical Explanation

Back in the day mortgages were used to finance conservatively structured home purchases.  Transactions required material sums of invested equity and were unlikely to default. 

In 1945 housing as an asset class was capitalized by 15.9% debt and 84.1% equity.  Prices are unlikely to be volatile or fall nationally with such a high equity mix.  The requirement of a material down payment regulated valuations, and short-term or regional price declines could not trigger self-sustaining, foreclosure-driven, asset depreciation.  It was good to be a homeowner.    

By 2005 the amount of debt underlying the U.S. housing stock had increased to 40.1% of the capital structure.  But this figure was masked by the Housing Bubble.  Highly leveraged Affordable Mortgages (including many with zero or negative equity) were dramatically reducing the amount of capital invested in houses by buyers.  Many owners were additionally withdrawing paper equity gains through the use of home equity loans.  The reported percentage of debt capitalizing housing did not rise during the bubble, as would be expected, because Affordable Mortgages were also driving unsustainable increases in home prices which obscured the rising use of leverage.

When the debt driven Ponzi Scheme collapsed, the transformational impact of Affordable Mortgages was revealed.  At year-end 2009 debt comprised 61.9% of the value of the U.S. housing stock.    





In four years Owners’ Equity has declined from 59.9% to 38.1%.  Debt now constitutes 61.9% of the value of the U.S. housing stock.  This figure has temporarily improved from 66.5% in the first quarter of 2009 but is again being eroded by falling prices.

Why Houses Are No Longer Safe

The increased use of leverage to finance assets inevitably erodes the safety of those investments. 

Highly leveraged assets exhibit increased price volatility.  Price fluctuations occur more rapidly and are of a higher order of magnitude.  This volatility may benefit owners when prices rise, but also heightens the likelihood that valuations will fall.  Either way incremental volatility, resulting from greater leverage, reduces the actual and perceived safety of an investment. 

Over time the higher the percentage of debt employed to purchase an asset, the more its price will appreciate.  This is exactly what occurred during the Housing Bubble.  As the restraints of a down payment are removed homebuyers are able to pay an increasing amount for houses.  Competition for these assets inevitably forces prices to rise until equilibrium is reached with the altered financing environment.  

As the percentage of debt used to finance houses increased from 15.9% prices appreciated.  A more compact and extreme example occurred during the Housing Bubble as debt on the U.S. housing stock increased by 167% in 10 years and prices appreciated by 189% (Case-Shiller 10-City Price Index).  Nothing changed other than financing options became more lenient. 

Today’s housing market continues to be defined by high prices sustained by decades of increasing leverage.  Debt-driven valuations are dependent upon the continued availability of financing, are more likely fall and have a greater distance by which they may decline. 
 
A home buyer today is not participating in the same market that their grandparents did.  Home prices are more volatile, more likely to decline in value and more dependent upon Government subsidized mortgage financing than ever before.  Owning a home has never been more risky and house prices should be discounted accordingly by an appropriate risk premium.