We are in the middle of what appears to be the most severe economic downturn since the great depression. This recession came on quickly and took most people by surprise - things had been going so well. There is a great deal of discussion of what caused this economic plight. It is the topic of a least 20 new books, a top-flight panel has been formed by congress to study the question and see how to avoid this type of melt-down again, and almost all of us have been impacted in some way - many severely.

It turns out that the culprit is easy to identify. As Pogo said in a south Georgia swamp nearly 40 years ago, "We have met the enemy and he is us." 

We killed the economy. You, me, the real estate agent next door, the home builder, the mortgage banker, and everyone else who bought, sold, built, appraised, financed, or refinanced a home between 2000 and 2006. That is most of us. The list actually goes on, as discussed below.

The fundamental problem is that the value of houses being sold in the U.S. by 2006 greatly exceeded our ability as a nation to pay for them - and not just for low-income families. For at least 50 years, prior to 2000, the value of housing was pretty closely related to income. (This relationship is probably as old as our nation, but we only have authoritative data since 1950.) 

In 1950, the median price of housing sold (new and resale) was $51,753 in 2006 dollars ($7,400 in 1950 dollars). That same year, median family income was $23,983 (again, in 2006 dollars, as are all dollar values that follow). That is a ratio of "housing price to income" of 2.2, a ratio that continued for the next 50 years. The ratio went a little below 2.0 in the 1960's and 70's, but has been about 2.3 since 1980.

In 2000, the median price of housing was $138,088 and the median family income was $58,869, a ratio of 2.3, about what it had been since 1980. Then from 2000 to 2006, the median price of housing increased by 70%, to $234,400, while median family income actually dropped by 1.7 percent to $57,868. This is a "housing price to income" ratio of 4.1, nearly twice the historical average. The "mortgage debt to median family income" ratio went from 93 percent in 2000 to 154% in 2006, a 63 percent increase. (In 1950, it was mortgage debt was 35 percent of median family income.) This happened in a very short time - from 2000 to 2006.

At the same time, the total mortgage debt followed the price of housing and went up by $5 trillion at the same time real incomes were falling. This meant that the economy was being fueled not by increasing income, but from the injection of "phantom equity" created by this unsustainable inflation of the price of housing. At the end of 2006, there was $11.2 trillion of mortgage debt on U.S. residences, at least 45 percent of it was based on phantom and unsustainable values.

Who created this housing inflation?  We did. We wanted larger houses, which builders built, agents sold us, and lenders financed. Investment bankers then securitized the mortgages, rating agencies gave them top "investment grade" ratings, and regulators watched. They all justified the financing on "comparables" showing that the price of other housed sold in the neighborhood justified an appraisal. I have never seen "median family income in the neighborhood" as a justification of an appraisal of the price residential real estate. ("Rent rolls" are the core to appraisals in much of commercial real estate, but that discipline did not carry over to residential.)

The entire nation celebrated the increasing value in the price of housing as a good thing. Very few were asking the question "can we afford houses twice as expensive?" (A few did ask. Robert J. Shiller of Yale was an early voice of caution, as were a few others, but too few.) We were making too much money to ask if it was sustainable. All the way through the supply chain - building material suppliers, developers, contractors, real estate agents, appraisers, mortgage lenders, investment banks, rating agencies, etc. Local community banks were especially hard hit. They loaned the developers the money for "acquisition and development" of the land and loaned to the builders the construction financing. They may have originated mortgages, but few keep them on their books, electing to sell the mortgages into the securitization pools.

When the hick-up came in late 2006, it started in adjustable rate mortgages. These wicked devices started a borrower with a low monthly payment, that stepped up to an unaffordable level - unless the borrowers income somehow could increase by 30 percent or the value of the house increased enough to refinance.

It did not take much of hick-up to kill the cow. Default rates started to climb and everyone started looking at what was the real value. Investors found themselves holding notes secured by mortgages on real estate that was nearly 50% overvalued - across the country. This is not just in low-income communities, as some have suggested. The data does not support the allegation that this collapse is entirely the fault in "sub-prime" mortgages. It certainly contributed, but the borrower in Alpharetta who was making $250,000 a year and bought a $1 million house is just as much to blame as the borrower who made $30,000 and bought a $120,000 house.

The problem of course is not just in housing. The artificial infusion of extra cash into the economy from the housing bubble has stopped. Real incomes are continuing to fall and everyone is spending less. As the economy moves at a slow rate, the value of commercial real estate will continue to drop, and there will be continuing business and bank failures.

So, what happens to get us out of this? First, the $5 trillion of phantom equity in residential real estate has to come out of the economy. Much already has, a significant percentage of which has been absorbed by all of us in some fashion, including the government's rescue of the economy to cover the excessive build up of debt from 2000 to 2006. Real price of housing has to come into line with incomes - something close to the 2.3 ratio of the past 30 years, which is happening. However, since real incomes are continuing to fall, the price of housing has to continue to fall until this equilibrium is achieved. And, the fall in business revenues and profits has to bottom-out and the coming problems in commercial lending have to pass. I think it is going to be a long, slow process.

So, how did this happen?  Who should have been watching the "housing price to income" ratio?   Who should have called a halt to lending on the construction of "Mac Mansions"?  These are very good questions, and if there is sufficient reader interest, ones we can explore in future columns.

John Hayes is an Atlanta businessman who has been part of four "blue ocean" opportunities - technology companies that create new markets in "oceans" not bloodied by competition. The first was computer-based work processing which Hayes created with Wang Laboratories. He organized the team that created the first mass distributed accounting application for personal computers, a product now called Peachtree Software, which continues to be a market leader after 30 years. He organized the team to put legal research on the web, thereby opening online research to all lawyers. In 2004, he organized FTRANS which is creating a new credit system for small and mid-size businesses. Hayes is a graduate of Georgia Tech and Emory Law School.