The Real Real Estate Risk

Everyone is acutely aware that there is a recession going on in the real estate market.  You don't need to be a stock guru to recognize that 50 - 80% price drops in building, mortgage, and banking stocks signals that trouble abounds.  Many market observers are saying that the credit crisis is subsiding because the LIBOR spread has narrowed somewhat to the Fed Funds Rate, credit is available and ‘substantive interest rates cuts' are assured.

So once the market can understand and discount the risk, future market action is only affected by the new unknown risks.  So by all accounts the Real Estate bubble should be bottoming soon and the entire financial sector will be better for it.  Right?

Not so fast.  The real unknown risk is how much the rest of the economy will slow from the damage caused from credit and real estate recession.  Earnings estimates for the overall market as measured by the S&P 500 for the fourth quarter 2007 are expected to be flat.  Drilling down into the numbers, you will find that a 67% decline in earnings is expected for financial sector alone, which accounts for one-fourth of S&P 500 profits.  Excluding financials, however, expectations are for profit growth of 12%-- a pretty outstanding quarter should that come true.

Here is the real risk: if the non financial companies miss their numbers and corporate earnings slow appreciably.  If unemployment also rises, then the conditions would be ripe for the economy to spiral down into a more significant, widespread recession than seen in recent history.  Real estate historically never has had price depreciation unless unemployment was rising.  That's why there were so many doubters when real estate peaked in 2006. 

So far real estate has only been adversely affected by the credit bubble (outside of the rust belt anyways).  If the normal bad real estate market conditions arise, another leg down would soon follow.  Unemployment is rising.  If demand for goods and services wanes due to tapped out consumers, inventories will rise, and even more layoffs will follow.  A snowball effect from rising unemployment to a further decline in housing prices is what has Fed Chair Ben Bernanke and others completely spooked.  The real risk is a down cycle caused by an economic downturn, not just a credit bubble bursting.

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