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Real estate has been driving the US economy.

After the Fed cut interest rates to 1% after the September 11 attacks, it became much cheaper to get a mortgage to buy a house. As the interest rates stayed relatively low throughout the past years, a surge in house buying resulted causing house prices to skyrocket.

Real estate speculators, investors, flippers, crib dealers, whatever you want to call them, were making money hand over fist as house prices wouldn’t stop rising. More people found out about this easy money and so they decided to get into the real estate market, creating more demand for houses, resulting in even higher house prices.

All of a sudden, Jessica’s house that used to be worth $200,000 last year is now worth $350,000. Jessica now has an additional $150,000 in home equity. Jessica doesn’t want to sell her home so she takes out a home equity loan. What is Jessica going to buy with all this “free” money? Well, Jessica needs a new car. How about a new plasma screen television? Or a vacation to the Tahiti? Or a facelift?

This is actually what has been happening in America. People are using their houses as ATM machines. U.S.consumers have discovered new purchasing power by extracting equity from their houses. They’ve been spending more than they actually earn from their paychecks. Making home equity cash “withdrawals” has allowed them to do this.

Check out my oversimplified explanation using illustrations:

The housing sector has been a key driver for growth in the economy by allowing consumers to tap into their rising home equity so they can continue to spend and buy more stuff.

This will only work though as long as house prices keep going up. Without a continuing fresh supply of funds from the housing sector, consumer spending growth could slow abruptly. In other words, once house values stop rising, Jessica will run out of equity to borrow from and will have to stop spending.

Below is a graph from a blog at Calculated Risk. Mortgage Equity Withdrawal (MEW) has been a significant factor in the GDP numbers. MEW represents borrowing (get money) by homeowners against the value of their house to finance their consumption (aka stuff).

Homeowners look at MEW like free lunch. Home prices magically go up, generating unrealized capital gains, which can be magically turned into cash, by borrowing against them. It’s not really free though since homeowners must pay interest on the debt. More on this later.

Taking a look at the graph, even if it is off a point or two, since there are very different estimates on how much MEW flows through to consumer spending, the point is that home equity withdrawals are a large part of GDP growth.

Here’s some more shocking news.

  • A study by former Fed Chair Alan Greenspan estimated that over $600 billion in cash out refinancings occurred in 2004.
  • Goldman Sachs estimated that in 2005, homeowners withdrew $834 billion.

The estimates are that consumers used between 50% (Greenspan) up to 68% (Goldman Sachs) of that money as discretionary spending (shopping).

If we calculate these figures from the past two years, that amounts to over a TRILLION dollars in consumer spending.

Imagine what will happen to consumer spending once consumers run out of home equity to borrow from?

Another problem Jessica has to start thinking about aside from running out of money to spend outside of her paycheck is the interest she has to pay on her home equity loan. This is called debt service obligations. Since the Fed has been raising rates and could continue to raise rates in the future, her interest payments will increase.

This means more of her paycheck will go to paying the interest on her home equity loan rather than “consuming” or spending money on other stuff. And remember its when people buy “stuff” is what drives the economy.