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The Problem With Debt

Henry Blodget CEO/Editor in Chief, Business Insider Recent Posts

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July 20, 2009

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“Hi Henry, I would point out that if you ...”

Anita Campbell

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As Warren Buffett succinctly observed, anything multiplied by zero is zero.

Put differently, when the value of the asset drops below the value of the debt used to buy it, poof.

Nowhere is this concept more important than in the housing market. A couple of years back, the value of US residential real estate was about $25 trillion. Mortgage debt constituted about 45% of that ($11 trillion*) and owner equity 55% ($13 trillion). (Rough numbers)

Now, the value of the US housing market is down almost 30% and headed to, arguably, down 40%. In other words, if the peak value was $25 trillion, the current value is about $18 trillion, and the trough value will be about $15 trillion. So what will happen to homeowner equity? It will drop by 70%.

PEAK

Value: $25T

Mortgage Debt: $11T

Homeowner Equity: $14T

TROUGH

Value: $15T

Mortgage Debt: $11T

Homeowner Equity: $4T

Ouch. And by the way, that percentage holds regardless of what the actual peak value of the housing market was, as long as you start with 45% debt-to-value. Also, most of that equity is owned by folks who own their houses outright.

And what happens if you have a more typical debt-to-value ratio--say, 80% debt? Then, unfortunately, your equity IS going to zero. In fact, it will only take a 20% fall in the house price for that to happen. That's why so many households are now underwater.

PEAK

House Value: $500,000

Mortgage (80%): $400,000

Equity: $100,000

TROUGH

House Value (down 40%): $300,000

Mortgage (80%): $400,000

Equity: -$100,000

That's also why lot of consumer households will get wiped out.

(By the way, this is what killed all those Wall Street banks. Unlike consumers, they didn't have 45% debt-to-value ratios or even 80% debt-to-value ratios. They had 97%-debt-to-equity ratios. So it didn't take much of a decline in equity to blow them to smithereens.)

* US single-family mortgage debt outstanding at the end of Q4 2008 was just over $11 trillion.

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Henry Blodget, Article, Debt, financial planning

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Anita Campbell 2 years 6 months and 19 days ago

Hi Henry, I would point out that if you don't need to sell your house or get a home equity loan on your home for a couple of years, you may not be affected at all. Dips in the real estate market affect those who need to sell or cash in their equity. For everyone else, it may even be good news in that now you have the ammunition to go seek a lowered reappraisal of your home for real estate tax purposes.