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Downside of a Bubble

Everyone knows that if there is a "bubble" in home prices, and if that bubble bursts, it will likely cause a few headaches for mortgage servicers. Default rates will likely rise, loss mitigation options will diminish and selling REO will become more difficult.

But the prospect of a bubble raises some challenges for the larger economy as well. To understand what a widespread drop in home values would do to the economy, it's important to remember just how important the housing sector has been to the economy in recent years.

As economic columnist Anna Bernasek of The New York Times pointed out recently, a bursting of the purported real estate bubble would likely have more profound consequences than the bursting of the stock market bubble did a few years ago.

Ms. Bernasek said an economic rule of thumb is that every $1 change in household wealth translates into about a five-cent change in consumer spending. As home prices have risen - and continue to rise - consumers feel wealthier and spend more of their disposable income. Or they even borrow more, often against the equity in their home, to fuel more spending. But the opposite is just as true. If consumers see the value of their homes start to drop, they'll start tightening their belts. And they'll have less room to tap into their equity through a home-equity loan product or a cash-out refinancing transaction.

In short, whereas the stock market bubble created few ripples outside of the financial services industry, the bursting of a real estate bubble, were it dramatic enough, might look like an economic tsunami. Consumer spending would contract, slowing down the economy. Home-equity lending, which totaled $200 billion last year, would likely dry up. Delinquency and default rates would rise. Default managers would find it more difficult to sell real estate-owned because of the downturn in the market, increasing loss severity rates.

As Ms. Bernasek points out, a decline in real estate values would point toward tightened underwriting standards at banks and perhaps higher interest rates to offset higher credit risk. We don't like to think of ourselves as nervous Nellies, but the prospect of a dip in real estate prices keeps growing.

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