The Upride Ends: Now It Gets Interesting

San Diego — From bubble bailout to debt deflation? That would be the most dangerous fallout from the bursting real estate bubble. The doomsday scenario isn't likely, but San Diegans must face grim facts: the steady rise in home values, one of the steepest in the nation, is over. People went deeply and dangerously into debt to buy homes they couldn't afford. Rising home values bailed them out for years. No more. Sales are down sharply; prices are finally edging down. Now the risk is debt deflation: people cutting their spending to continue paying their mortgage, thus crimping the local economy.

That will happen to some degree, but how much is hard to predict: "We are already seeing a housing slowdown," says James Hamilton, economist at the University of California, San Diego. "We see an increase in defaults; we certainly see price declines. Is this going to be a temporary adjustment or a full-out crash with bankruptcies and panic selling? I just don't know."

July's home sales in the county were down 30 percent from a year ago, according to La Jolla's DataQuick Information Systems. The median price of homes of all kinds in July was $487,000, down 1.8 percent from a year earlier. Detached single-family homes (condos not included) had a median of $560,000, the same as a year ago. Some sellers of downtown condos are already taking a haircut of 10 percent or more. These quoted prices are deceivingly high because sellers often won't go below a certain price, and carrying costs can eat them alive as the home sits on the market.

It's a stark contrast to the boom days. Between July of 2001 and July of this year, median detached single-family home prices doubled.

The giggle juice flowed, and people took unwise risks to get in on the party -- more so than in other U.S. cities. Last year and this year, two-thirds of mortgages were of the exotic variety -- particularly interest-only or negative amortization. In such mortgages, borrowers' monthly payments can be lower than the amount required to pay off the debt. Thus, the loan balance keeps rising, and home values must rise, too, to keep the borrower afloat. These mortgages can be one-way tickets to perdition.

The zooming real estate values didn't only rescue crapshooters; they helped bail out average San Diego families writhing in a cost-income squeeze. High and rising home prices induce euphoria and therefore stimulate excessive consumer spending. According to the most recent report by the Council for Community and Economic Research, San Diego's cost of living is 43 percent higher than the nation's. But incomes are less than 15 percent higher. For decades, San Diegans have had their heads in a vise.

The national savings rate is a horrifying minus 1.7 percent. In 1980, it was plus 12 percent. The savings rate isn't calculated for individual metro areas, but it's a good bet that San Diego's is below the national percentage.

For merchants, the big rise in home values in this century was a mixed blessing. Yes, people bought more furniture and appliances when they moved into new homes, and the wealth effect boosted all kinds of spending. But as prices soared, affordability plummeted; households with median incomes of almost $65,000 a year can afford a mere 4.6 percent of homes on the market. This is one of the reasons that the county's population began declining last year. Home buyers in hock above their heads are spending an inordinately high percentage of their incomes servicing their mortgages; that, too, hurts local businesses.

As home prices rose, more and more people borrowed against the inflated value of their houses. The big question is how much of that phantom financing went for everyday expenses. If people were borrowing against bloated home values to buy their groceries, household goods, cars, and the like, then the economy will suffer when the tap dries up, as it is already starting to do. Unfortunately, there aren't reliable statistics showing where that borrowed money went.

Alan Gin, economist at the University of San Diego, doubts that much borrowed money went to finance local consumption. He thinks the bulk of it "was plowed into move-up housing. Somebody bought a $200,000 home; then they went to a $500,000 one, then to a $750,000 home. They just reinvested in higher-priced homes. They fueled a lot of the housing boom."

Now what happens? New housing will be whacked, says Gin. "As prices reverse, construction will reverse," agrees Ross Starr, economist at the University of California, San Diego. That will hurt. Right now, 7.27 percent of San Diego's jobs are in construction, according to the San Diego Association of Governments. That's up from 6.21 percent in 2002. Another 1.81 percent of local jobs represents people working in real estate offices, up from 1.67 percent in 2002.

So that means 9.08 percent of total jobs are in real estate, but that's only part of the story. That percentage does not capture mortgage bankers and brokers -- and the county is full of them now -- or real estate entrepreneurs working on their own. It's possible that close to 12 percent of San Diegans work in real estate one way or another. By contrast, a mere 1.7 percent work in biotech and 1.2 percent in computers and electronics. "The entire country is vulnerable," but San Diego more so because its economy has been so dependent on real estate inflation, says Gin.

Edward Leamer, director of the Anderson Forecast at the University of California, Los Angeles, says the U.S. economy "will muddle along for several years" because of the real estate falloff, and San Diego's muddle may be stickier. Prices on both coasts soared much more than inland. Among coastal cities, San Diego was a highflier. Now we're seeing the reverse. In July, San Diego's prices actually declined; in other Southern California cities, they were still rising, albeit barely, notes Leamer. Also, the percentage of San Diegans working in real estate is higher than in other metro areas, he says. Still, he does not expect a recession in the United States or in San Diego.

Financial institutions will feel the squeeze, says Starr. The people who got the interest-only and negative amortization loans may not have put much money down. Sinking values will hurt. "This will result in distress sales," he says. "We will see some pockets of debt deflation. In downtown condos, we have seen price declines that are enough for highly leveraged borrowers to see their equity wiped out. The lender may be left holding the bag. Borrowers will hand over the keys and say they are sorry it didn't work out."

There's another scenario that could be even scarier. Gin notes that historically, people have done "whatever they could do to hold on to their homes." They will cut down on consumption, perhaps take second jobs. Or, worse, "they could take out 50-year interest-only loans -- go to even riskier mortgages."

That's like dope addiction -- the kind of approach the city's government has been taking.

Some demographic and economic factors are hard to predict. In 2008, baby boomers begin to retire. Some economists predict they will sell their homes to finance their golden years; that would put downward pressure on home values. On the other hand, if housing slumps severely in once-overheated markets like San Diego, the Federal Reserve could lower interest rates to fill the bubble again.

Another factor suggests the sting could be mild. Starr points out that San Diegans for decades have lived with high housing prices, excessive and risky debt, a cost-income squeeze, low savings, and real estate boom-bust cycles. We've lived on the edge before and maybe can do it again.