How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership
costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to
20.2, so the change had little effect on measured inflation: The CPI
underestimated inflation by about 0.1 percentage point per year during this
period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to
With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since "owners' equivalent
rent" is about 23% of the CPI). If home-ownership costs were included in the
CPI, inflation would have been 6.2% instead of 3.3%.
Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a
measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007.
The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.
How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?
In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners. In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin.
In some of the cities hit hardest, borrowers who purchased in the low-price tier at the peak of the bubble have seen their home value decline 50% or more. Over the past 18 months as housing prices have fallen, millions of homes became worth less than the loans on them, huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury....................