Creative Destruction in the Housing Market

At a conference in Vancouver, Canada, last summer, a moderator asked apocalyptic analyst Doug Casey what the solution to our economic mess was. "Explosives," he replied. It echoed a theme put forth by former Treasury Secretary Andrew Mellon during the Great Depression. "Liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate. ... It will purge the rottenness out of the system," Mellon famously said in 1931.

Casey wasn't alone. In 2008, then-Treasury Secretary Hank Paulson phoned former Federal Reserve Chairman Alan Greenspan, seeking his input on ways to stabilize the economy. Greenspan "suggested that there was too much housing supply and that the only real way to really fix the problem would be for the government to buy up vacant homes and burn them," according to the book Too Big to Fail.

Warren Buffett offered a similar approach in his 2009 letter to shareholders. There are only three ways to fix the housing crisis, Buffett wrote. The first, and most effective: "Blow up a lot of houses." Last year, Detroit Mayor Dave Bing took him up on it, proposing plans to bulldoze 10,000 vacant homes and empty buildings over three years.

What are these people thinking? Nothing crazy, actually. They've grasped the heart of what's crushing the housing market: There are simply too many homes.

Some numbers to chew on: From 2001 to 2006, 11.0 million homes were built in the United States. During that period, a net 7.8 million new households were formed. That 3.2 million-home gap represents the overbuilding that pushed housing into bubble territory. During the boom years, those extra homes were easily absorbed into the market because so many speculative buyers were purchasing two homes, five homes, 10 homes, just to flip them for profit. Now that that casino mentality has been deflated, demand for housing has returned to its roots -- buying just to have a place to live. That means those 3.2 million homes built in excess of people's living needs are now sitting idle. The nationwide home vacancy rate is currently 2.5%, up from about 1.5% before the bubble.

Which raises the question: What do you do with these vacant homes? Some have been following the advice of Casey, Greenspan, Buffett, and Bing. They're blowing them up.

Bank of America (NYS: BAC) just announced plans to demolish 100 Cleveland homes, with similar plans already under way in Chicago and Detroit. Wells Fargo (NYS: WFC) and JPMorgan Chase (NYS: JPM) have donated thousands of homes to local governments and nonprofits, many of which will likely be razed.

The incentive for banks to destroy homes is straightforward: Banks owe property taxes on homes repossessed during foreclosure, and some homes are so derelict that repairing them to a sellable condition is often costlier and a bigger hassle than just blowing the damn things up.

The trend will never get big. Even if tens of thousands of homes are destroyed, the effect would be trivial. But the fact that banks are merely considering demolishing homes underlines that the single most important factor holding the housing market back is excess inventory.

The good news is that inventory is being cleared out naturally, and quickly. New home construction has slowed to a pace not seen in recorded history, now at just one-third of 1959 levels, when recordkeeping began. Far more households are being formed today than new homes are being built. That has the same effect as blowing up homes -- in either case, excess inventory is being cleared out. Extrapolating from current levels, it's not hard to make the argument that we could actually face a housing shortage in another few years.

How crazy does that sound? About as crazy as someone telling you four years ago that banks would be destroying homes today. And yet, that's where we are.

Fool contributorMorgan Houselowns B of A preferred. Follow him on Twitter @TMFHousel.The Motley Fool owns shares of Bank of America and JPMorgan Chase. The Fool owns shares of and has created a ratio put spread position on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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