Bondad,

I've been thinking about the risk dynamics of the housing bubble as an unappreciated aspect of what has happened.

There are two critical inflection periods to consider:

1988: At this point the U.S. banking industry (which had absorbed what was left of the S&L industry), had a total of $600 billion in real estate loans and the same amount in commercial/industrial loans. By last year, C&L loans had crept up to about $1 trillion, but real estate loans have leaped frog to nearly $3 trillion, well over 50% of all bank assets.

The banking industry has created several areas of risk in this period. Concentration risk in real estate is now significant and is a component of the massive amount of credit risk that exists in real estate. Banks think they have mitigated this credit risk with the collateral from the real estate and the put they have to the federal government through Fannie Mae, but this put is going to be severely constrained once Congress sees how much they have to underwrite in a real estate recession.

As to the collateral, banks will discover they have unexpected price or market risk in their portfolio. Theoretically, this market risk is minimal because it is "granular" (many small uncorrelated pieces) and housing prices have never gone down nationally. But that will no longer be true. Housing prices are starting on the road down nationwide, and the portfolios will be seen to be much less granular because most homeowner's behavior will be the same.

This brings in the next inflection point.

1996: this was the first time housing values started to appreciate at a rate well beyond annual inflation. Nothing like this had been seen since WWII, and the double digit growth in values led to all sorts of behaviors, such as treating your house like an ATM, or lending to poor credit risks because the market will take care of all future problems.

This dramatic growth in market risk since 1996 - in other words the risk element of the housing bubble - was intimately connected to the government put, and reinforced by the Fed's easy money policy of 2001 (much blame for the housing bubble is focused on Greenspan's Fed, but they were only half of the problem; Fannie Mae and Freddie Mac and the moral hazard risk of the put were the other half).

The economy has been riding the up-curve of market appreciation, but with this curve cresting and all of us starting to slide down the other side of it, the market risk element is going to be better understood. By most statistical analyses, the market risk ballooned when home values moved two to three standard deviations above housing price trends since WWII. We have quite a mean reversion experience ahead of us.

Who shares in this market risk? The federal government because of the implicit guarantees they offered through the housing GSEs. The banks because of their foolhardy reliance on collateral (a mistake the Japanese banks made in the 1980s), and most surprisingly, the consumer or homeowner.

Prior to the housing bubble, a homeowner's basic risk in a mortgage was the possible loss of their income and inability to repay the fixed rate P&I. The bubble has dragged homeowners into the far less comfortable world of market risk as well as employment risk. If they have an ARM they must worry about interest rates, and for the first time the nation will have to experience actual declines in housing values. This will be a more severe shock to consumer confidence than the tech bubble collapse, because many more millions of consumers are affected.

This problem has the potential, in fact the likelihood, of lasting five or more years as we enter housing stasis - few people will be able to move because mortgages will be scarce, and without price appreciation "moving up" ceases to be economical. In fact, "moving down" will be the only thing that makes sense - if you can still sell your house at a profit - and we are already seeing downsizing to smaller houses occurring in many markets.

The post mortem of this whole housing bubble mess will ultimately have to look at this risk phenomenon, particularly how it happened that large amounts of market risk were allowed into the housing market.