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I suppose it has been a bit over a year ago that I started thinking about deflation. I mean, look at it as it was then. Interest rates very low. No inflation. Stock market bubble popped, and effects still rippling through the system. And a recession in place. Well, deflation looked like a distinct possibility.

But, I said both to myself and to others - on this and other boards - it seems a manageable risk. If a deflationary round were to get started, it would practically have to start with the real estate market, and it was kind of hard to see how that might happen.

After all, one of the great attractions of real estate is that all markets are local. What happens in Piqua has no effect on Peoria. Heck, in the current marketplace, I have multifamily properties with 100% occupancy, while just a couple of miles away I have others that are below 50%. Occupancy is a very local phenomenon, usually.

So it might be that in Podunk the factory has closed, and as a consequence everyone has moved out of town and gone to Smallville, ten miles down the road, where a new factory has opened. Too bad for the real estate market in Podunk, but great for Smallville. And, when the average for the county is taken, there is no net effect because Smallville offset Podunk.

So, even with the recession and the vacancies that was engendering, even with these housing programs that are causing such grief, it seemed unlikely that widespread catastrophic deflation could get started. There might be some bubble busting, locally, in a lot of locales, but it would happen by fits and starts and relatively slowly as the rental market adjusted to a no-inflation low-rate environment. Consequently, the macro economic environment wouldn't be shocked and the overall impact would be moderate.

As recently as about six weeks ago, I posted on the CREOnline message board (www.creonline.com) that "I don't want to sound like a Cassandra; the risk of deflation seems to me to be greater now than it ever has been in my lifetime, but I think that risk is manageable and it doesn't seem likely that a serious round of deflation will get started." I have made similar sounding posts around TMF in the last six months or so.

Now, there have been occasions in the past where widespread real estate collapses have occurred, and usually the heavy hand of the Federal Gov't can be seen as precipitating it - such as happened when the various tax law changes led directly to the S&L collapse in '86. But it just didn't seem to me that this could happen again in '02.

But suddenly, this insurance problem has been surfacing like a submarine making a battle-surface, which is to say: very quickly and without warning. The shock wave is just starting to move through the system and, given the stress the multi-family market has been feeling, the shock will be severe. Suddenly, when I look at the risk of deflation, it seems very real and very imminent.

Again, all real estate markets are local. When I was actively purchasing, I made it a point to purchase in a geographically diverse fashion so that I was in several different markets. The idea of course was to not have all my real estate eggs in one marketplace basket. That idea has paid off; as I say, I do have 100% occupancy some places. But the overall market is weak enough that my system-wide occupancy isn't acceptable.

However, if I were to separate my system into neighborhoods and look at each one separately, I could say "this one can stand the insurance heat; this one is marginal; and this one won't make it." In fact, I am doing that - and it is driving my selling plans.

Just like that, around the country some areas will cry a bit but otherwise be unaffected, while other areas will go under. My fear is that the areas that will go under are too widespread for the economic health of the United States, since the underpinnings of the marketplace have been eroded by the Gov't housing programs as well as the usual business cycle effects.

If the collapse starts, it will snowball quickly. Weaker properties will appear on the market, and won't sell for enough to permit the owners to escape with a whole skin. Either that, or they won't sell at all, bankrupting the owners and causing banks to become landlords. This will happen in some regions quickly enough and extensively enough to collapse many regional and perhaps one or two national banks.

A national bank collapse will dry up credit overnight. The attempt to liquidate all these distressed properties will drive the prices down very quickly. Cash buyers will be able to step in for a song - if they dare - and fill the properties at very low rents, thus pressuring the local housing markets which will already be distressed by the credit crunch.

The whole thing will trigger layoffs and dislocations - hence more foreclosures, and the effects will spread nationwide very quickly. We then would most likely enter a depression.

Now, when the S&L crisis hit, Congress stepped up to the plate and funded a bailout. Key to that bailout was the health of the banking system, which made it possible to liquidate the damages with virtually no impact on the rest of the economy. But what happens if the banking system itself is what is ailing?

This insurance situation needs to be dealt with, and quickly. The shock is starting to move through the system. The system probably can't take it.

To put it in clear perspective, my insurance cost per unit per month used to be about $14. It is now $29 per unit per month, in one step, and I have a much greater exposure to risk than I used to have.

You do the math.
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