Sunday, February 13, 2011

Econ 101

Here is a fun math problem. It will take some research on your part and I don't know the answer because it will be different for everybody. If you're not a homeowner or haven't bought a house since 1997, then don't bother working the problem. It doesn't apply to you.

First, the research part: You need to know what your house was worth in 1997. This information is available from the county and even in my backwater county is available online. I only had sales data from 1993 and 2001 so I interpolated to get my 1997 value as $117,500.

Second, adjust for inflation. Since 1997 there has been about 30% of inflation, so take that number and multiply it by 1.3.

$117,500 X 1.3 = $152,750

What does this number mean?
According to John Talbott this number is where the value of my house (or your house as the case may be) will bottom out at when the housing bust bottoms out and the coming recession is in full swing. I have been reading Mr. Talbott's book Contagion - The Financial Epidemic that is Sweeping the Global Economy...And How to Protect Yourself From it, and I can't help but believe it. It's actually the second book I've read recently on the same topic. The other one was Aftershock - Protect Yourself and Profit in the Next Global Financial Meltdown. These guys have similar things to say about the days to come but they say they are happening for different reasons.

This is not a book report so I'm not going to compare and contrast these two books but I will say that their message is of vital interest to all of us. How many people do you think bought houses since 1997? And of those, how many had 20% or less of the purchase price as a down payment? It's a lot, and those mortgages are in significant peril of defaulting as home prices fall. So what happens to the economy when lots and lots of people start defaulting on mortgages? I think we'll all get to find out pretty soon (we've only seen the beginnings).

So to put the math problem into perspective, I bought my house about 16 months ago for $226,800 and if I put any faith in Mr. Talbott's estimate I should expect that its value will fall to $152,750.

It's a good thing I like my house. I will most likely be here for a long time.
I think everybody should read Contagion and Aftershock and determine for yourself how you will meet the coming challenges. The sooner preparations begin, the further along they will be.

Math Problem Details:
For the details on the math problem and why 1997 was chosen as the key year, please see Talbott's book, chapter 5.