Lets assume that the following dire scenario happens:
House sales and prices continue to drop over the next two years. The subprime buyers cannot be kept in their houses despite much government interference. It simply isn't in their interest to stay. They foreclose and/or declare bankruptcy. However they aren't the only ones. Other "prime" homeowners with negative equity, negative net worth but otherwise good credit realize that they also have no incentive to stay in their homes. Many of them also join the subprime crowd. The negative feedback is obvious. More foreclosures lead to more inventory which puts more pressure on prices. The deflationary psychology sets in. People put off buying because prices are dropping so quickly. The Fed will do its best but can't force people to buy houses. Washington will do its best to pass legislation with incentives to slow the crash but with only mild effects. Prices drop by 10% per year for four years, a total of 35% and then start to decline another 2% for the next six years. The total 10 year decline is 42%. With 2% inflation, real prices have dropped by a factor of 2.
What would the consequences be?
I don't really know. But I think this would lead to many different crises, certainly a long recession if not a depression. Some of the milestones would probably include
Home builder bankruptcies
Financial company impairments
Failure of leveraged speculators
- Major bank balance sheet impairments
- Recession in countries with housing crashes
- Recession spreads to most other countries
- Failure of mortgage insurance companies requiring Government bailout
- Near or complete insolvency of Fannie Mae, Freddy mac requiring Government bailout
- Investment bank failures
- Major bank failures
- Currency devaluation arms race
- Rise of protectionism
- Major inventory/capacity overhang in manufacturing/export countries like China
- Deflation in all major asset classes
- Flight to safety, US dollar?, blue-chips, health care, high cash-flow, recession resistant companies, Treasuries
- International goverment intervention in mortgage market and banking
- Panic, crises, unforseeable events and eventually resolution and recovery
In the end (whenever that is), houses are no longer sexy "investments". They become more affordable and necessary "expenses". They are just the place where you live.
As I mention above. I don't know how it will end or what will go right or wrong along the way but many of these things could happen. Many will only happen if house price declines cross certain thresholds. A 10% decline will be manageable. A 20% decline will be major pain. Beyond that, my above scenario is (I think) quite likely and I don't see what could cause prices to stop decling at only 20%. They will still be very expensive for most people and still a negative carry for renting out in most markets. I don't think most companies have a plan for 30% price declines.