A few thoughts on debt and economic crashes
People discover that you can make a lot more money with borrowed money. You can buy $1000 worth of stock on 10% margin by putting up $100 and borrowing the rest from the broker. Then if it goes up 10%, $100, you sell and double your money. The problem is if the price falls and your collateral loses value. The broker sends you a margin call, telling you to put up more collateral, and if you don't, he sells out of your account to pay himself off. Margin calls make people sell in a falling market, which forces prices down farther, and it's very easy to lose everything. The October 1929 crash was much worsened by forced selling due to margin calls, even apart from the panic selling that followed.
Margin-buying in stocks is considered very risky, and the regulators restrict it. But in housing it's been routine since the 1940s - put up 20% and borrow the rest - and it has always seemed fine. It is, if home values are fairly stable and houses are a place to live in rather than a speculative asset. The mortgage payments amount to rent, except that you gradually become a full owner.
Houses became instruments of speculation when people began buying more house than they could afford, expecting that way to make more money on its appreciation. Just as a rising stock market ultimately rests on the underlying economy, so do housing prices, although in both cases that seems not to be the case as prices rise and make people rich without actually producing anything. Some of this seems real, because people spend these paper profits for things, actually enriching the producers, but it's illusory because what they're spending is bubble wealth.
On the way up, we prove that there is definitely a free lunch. Without producing anything, people just keep making money, and they spend it without seeming to be living too high because the assets they borrow against are greater. Just as the summer of 1929 had brought a "New Era" in which the business cycle was over and everyone would just get richer and richer, we had the "New Economy" in our own day.
Eventually, things get so that "values" must keep rising to keep the music playing. To keep servicing debt there has to be more to borrow against. When we reach that point, there will be trouble. Somehow the bubble will pop, and the effects depend on how fundamental it is to the real economy. Tulips, or even the tech bubble - not so bad.
There are several differences between stocks and housing. They crash differently, and with different results. A stock market crash is in itself not a very big deal. The October 1987 crash was 22% in one day, and it made no real difference. A housing crash, especially on borrowed money, is a very big deal.
Unlike a bull market in stocks, the recent housing boom fed everything else. People could buy because they could use their appreciating houses as ATMs, and they could keep up with their credit cards. People remodeled and more houses were built, giving work to many people. Being able to sell easily, houses turned into a fairly liquid asset - they were easily flipped, like stocks.
As Paul Krugman pointed out in 2005, the housing crash started out with sales resistance. Prices kept slowly rising in late 2005, but houses were getting hard to sell, and inventory piled up. That meant that the free money from housing appreciation began drying up fast and hurting the real economy, although denial kept people from realizing it for a while. When the subprime crisis made the news, prices were falling, but a great deal of damage had already been done. The drying up of home equity wasn't margin calls, but the effect was similar, although less abrupt.
With people unable to keep borrowing on houses, the brakes were slammed on the real economy. People maxed out their credit cards, but with no more home equity to eat, the picnic was over. People have had to stop buying, and it's harder to make payments. Foreclosures have begun on a big scale, and apart from the damage to the speculative financial system, this means more downward pressure on housing prices. Everything that rested on the housing bubble, which unlike the case with stocks is pretty much everything, is unraveling.
Leveraging worked like magic on the way up, but the same magic in reverse is working on the way down. Falling prices make value disappear everywhere else. Foreclosures reduce the values of all other properties in the neighborhood, but they also destroy the value of mortgages and everything based on them in the books of banks and everyone else that owns them, multiplied by the leveraging which was creating funny money on the way up. It really does fall down like a house of cards, the cards above knocking down those below, the weight and downward pressure quickly increasing.
Trillions of dollars in credit card debt are beginning to go bad and threaten those that hold a lot of it, like Bank of America. The housing market is by no means done crashing, so even more loans and paper based on them will go bad that haven't yet. There are something like $55 trillion in credit default swaps (CDS) going bad out there.
Let me describe briefly how those work. You loan Judy $10,000,000 at 6%, so she's supposed to pay you $600,000 a year plus some principal. You buy a credit default swap from me for say 1%, $100,000. This lets you sell the loan for more money to somebody else who will need to collect the money from Judy, because being insured against default the loan is much safer, so you certainly get your $100,000 back. Giving me the money causes you no pain - everybody wins, right? Now this is a completely unregulated business, so although this is an insurance contract, I don't need any money to pay off with in the event that the borrower doesn't pay. That's all right if I make a lot of these contracts, and if I don't spend too much of the money paying myself for being a Really Smart Guy, and if less than 1% of the borrowers go south.
That's a lot of ifs, and lately they haven't been coming off, which is how Lehman Brothers wound up in the dumper. The CDS isn't paid off when Judy quits paying, and whoever owns the loan gets stiffed. He didn't just get stiffed on bad paper. This was a good loan: the credit raters said so, because, look, it's insured against default! We're going to all be seeing a LOT more little surprises like this in months to come, maybe trillions of dollars worth.
So maybe the lunch isn't free after all, in the financial system, although there is free lunch with God. As Jesus taught us to pray, "Give us this day our daily bread." Only that lunch, while free, is not served with lying, theft, and four-flushing, which the world has taught us to look to for our free lunches. It turns out that God's free lunch costs us all we have in certain ways - but then so does the world's free lunch, doesn't it?