Housing Bubble?
Preamble: The Bubble Muddle
Part Two: The Authentic Principles of Home Prices
Part Three: Bubble Trouble
In the last eighteen months, the financial air and print waves have been full of dire predictions of an exploding housing bubble, rising foreclosures, and distress in the lending world. The following are a set of principles applicable to any hot market for housing and its aftermath, not just the interval 2002-present.
Preamble: The Bubble Muddle
Most financial commentary in the US is the work product of economists and analysts at the great Wall Street investment houses and commercial banks. Their specialties are financial markets, but their housing experience tends to be personal and narrow, based on the outcome of their own home ownership and neighborhoods.
Especially in the bond market there is great hope that housing will fall so far and hard that it will cause a recession -- the economic event most profitable to bond holders and traders. Their eager pessimism is matched by all sorts of voices pleased at the prospect of punishment of housing profiteers -- Realtors, mortgage bankers, and nouveau-riche sellers.
Stock market participants are biased in a different way: they are worried by clients who in droves have pulled money out of brokerage accounts to buy one or more homes. Never underestimate the envy factor -- the embarrassment that the stock market traded at 1999 levels until 2007, and the Street's belief that the best way to sell your own product is to make the client frightened of the others'.
Good housing-market information is exceptionally hard to find also because so many authentic experts on housing work in the market (economists at Realtor and mortgage-banking associations, for example), and are not encouraged to speak frankly. In an obviously softening series of housing markets, "It's a great time to buy" commentary is more annoying than helpful.
Part Two:
The Authentic Principles of Home Prices
1. Value. The component of a home that appreciates in value over time is the land that it sits on. Houses themselves never appreciate: they depreciate constantly because of physical wear and tear and architectural obsolescence.
2. Land Scarcity. It is not an accident that the "bubble zones" are on the Atlantic and Pacific coasts, and in Pacific overflow to Arizona and Nevada. There will never be another foot of beachfront created. Property now close to the beach always will be, and land farther away will never move closer. We will not discover another Chesapeake Bay. Next hurricane season, as the Weather Channel team pans the camera up and down any beach, you will see a house or apartment building side-by-side on every parcel except in national and state parks.
3. Population. In August 2006, the three-hundred-millionth American was born (or more likely, immigrated). The population of the US is growing by at least 2.5 million people every year, two-thirds immigrants, mostly adults instantly competing in the housing market. Population growth is heavily weighted to the Atlantic and Pacific coastal zones, and half of the counties in the central US, from the Rockies to the Appalachians, are losing population -- and have appropriately low rates of price appreciation.
4. Hard Data on Prices. Visit www.ofheo.gov (OFHEO is the regulator of Fannie and Freddie), and study its "home price index." The price appreciation data there is based on repeat appraisals of the same homes, captured from thirty years of loan-file appraisals. Study any market (hard to find, but look for OFHEO's regional MSA engine) since the 1970s and you will see long flat spots followed by sudden spurts of appreciation followed by long flat spots. The longer the flat spot, the higher the following spurt; the higher the spurt, the longer the following flat spot. You will also see maps state-by-state; stare at them for a while and you'll note that states short of land (coastal!) have high rates of appreciation, and states that are land-rich have low rates.
5. Low-Base Appreciation. Land scarcity aside, a crucial aspect of booms in Arizona and Nevada especially has been the low starting point for prices. At ignition, the median single-family home price there was only about $180,000; in the case of Las Vegas, prices had been stuck in that range for almost twenty years. An upward explosion was long overdue. Las Vegas flattened in the summer of 2005 at average prices near $280,000 -- half the median price prevailing in nearby California.
6. Affordability. All of the bubble arguments point to declining affordability, median incomes versus rapidly rising home prices. Warning: bad mathematics! Home ownership in the US has never reached the 70% mark, and most of the non-owners are low income. Therefore, the top two-thirds of income earners are the ones competing with each other for housing, and the most intense competition for the best land is among the top one-third. The population with the highest one-third of incomes has enjoyed disproportionate income growth in the last fifteen years, and wildly larger growth on financial net worth, roughly three times the financial wealth of fifteen years ago. One last common-sense note on affordability: if homes are readily affordable, prices are supposed to go up.
7. Rents Versus Prices. All bubble criers point to the failure of rents to keep up with prices. See #6: Renters tend to be a lower-income population. Higher-priced homes, taken to high prices by competition among high-income earners, are never supposed to be sustainable by rents. Rents support values up to a certain price-point in all markets, and then rents flatten out; those able to pay higher rent become homeowners.
8. Too Many "Extra" Houses. Bubbleologists point to the rise in purchase of investment property and second homes as a sure sign of "speculation." This one is a favorite of financial-market types: to buy any of their investment products is the soul of prudence; to buy anybody else's... dangerous speculation. Since 2000, it has been true that mortgages for investment have risen from about 6% of the total to 10%, and for second homes from about 2% to 7%. However, there are alternate explanations; first, many people have become nervous about the stock market and would rather diversify investments into real estate; second, the vast increase in incomes and financial wealth enjoyed in the 1990s would be likely to show up as increased purchase of vacation homes. That said, I have no doubt that some investment buyers in the hottest markets are now over-extended, but that has been true toward the end of any hot market for anything.
Part Three: Bubble Trouble
1. Easy Mortgage Money. The bubble criers say that new and risky mortgages have inflated purchasing power, pointing to interest-only and zero-down loans. There is truth here, but limited to the edge of "sub-prime" products, and a few ill-advised 100% financing schemes (see #12). The interest-only and negative amortizing ARM is the oldest ARM in the US (1980), the 3%-down FHA is the oldest fixed-rate mortgage in the US (1934), and the 100% VA loan dates to 1944. If these products were the cause of this supposed bubble, we would have seen many other bubbles, long before. There is bad lending, too much shoehorning of buyers into homes they can't afford, and rapid rises in prices have masked the outcome. However, there is nothing new or unusual about that, and most is confined to lower-price ranges.
2. Adjustable Surprise. One risk to the housing market can't be quantified, but the potential shock to consumers in this national cycle does increase the risk of a blown bubble. The first ARMs appeared in 1980, and a general interest-rate decline began in 1982 and concluded in 2002. During that span, Fed-driven indices never rose more than two years in a row, and each rise was followed by a stair-step decline to a new low. The Fed funds rate reached a 50-year, emergency low at 1% in 2002, and have now risen to the middle of the "normal" range at 5.25% -- a two-year rise not likely to be followed by a substantial decline (I hope it won't ... a steep decline in ARM rates could be caused only by an equally steep decline in the economy).
The rollover of housing prices from steep gain to flat in the fall of 2005 coincided precisely with the moment that the Fed's rate hikes extinguished the ARM-fixed spread so favorable to ARMs, even the artificial teaser-based demand.
However, at this writing and noted below, long-term rates are so low that ARM borrowers have an easy escape hatch. However, the few with shaky credit or little equity may have an impossible time fitting through the hatch -- that is the foreclosure prototype, as yet not spreading to other classes of borrower/owner.
The rate-reset problem can get worse, but I doubt it. The Fed is close to a 15-year high for its rate, "A"-paper adjustments are taking loans to the 7.5% range, low in any historical context except 2002-2004, and low-fee fixed-rate loans are available for refinance in the mid-6% range. To date, the re-sets for all except sub-prime are more embarrassment at missed fixed opportunity than a source of foreclosure.
3. Liquidity Versus Price. One part of financial market participants' bubble worry is an honest misunderstanding. If buyers disappear for a particular financial product, its price will quickly fall until buyers reappear (called a "clearing" price, for clearing the market of all the accumulated sellers). Financial products have no utility beyond price -- they either have near-term potential for gain in price or they are toast. Housing, on the other hand, has considerable utility beyond price: you can live in it, no matter how bad your market may be from time to time. If you must move, you can rent the place instead of discounting its sale. This alternate-use phenomenon is the reason that regional real estate markets tend to go flat for years and years, even in the presence of accumulating "for sale" inventory.
Certainly, the last buyers in a boom party are vulnerable, and the OFHEO data shows a pattern of modest price decline in the year after a boom peak. However, for home prices to fall significantly, the local economy supporting the housing market must weaken enough to produce large numbers of "involuntary" sales. So far, involuntary pressure has been limited to those owners with little or no equity; most owners are protected by the huge appreciation in bubble zones prior to 2005.
In all the "prices are falling" shouting, note the difference between declines in asking price versus actual value. If a market has been appreciating 20% per year for a few years, sellers expect the market to continue to do so; hence 20% declines in asking price are common. The key question to ask any post-peak participant or observer: could this home be sold today for the same price as paid last year? So far, the answer in the bubble zones is the 1%-3% decline that history would expect.
The length of the flat-price intervals ahead in the bubble zones is going to surprise in some areas used to near-constant appreciation or very rapid rebound from bad markets. California is the leading example.
4. Exogenous Shocks. You will see in the OFHEO price series occasional short intervals of significant price decline. In the areas of the country that I know best, the declines coincided with outside shocks: oil industry collapse in '83, S&L collapse '87-'88, stock market collapse '87, earthquake '90, defense- and auto-industry contractions, and bad recessions '73-'74 and '79-'82. Overheated housing markets go flat; they do not burst unless there is some significant extraordinary shock.
The two possibilities today for outsize shock: the Fed and the supply of credit. At this writing the Fed has been on "pause" for one year, and seems unlikely to do anything soon. Long-term interest rates are extraordinarily low, and that has buffered the Fed's tightening from 1% in 2004 to today's 5.25%.
The most dangerous potential shock: a credit spiral, in which rising loan defaults raise the price and underwriting standards of mortgage credit. Some of that pullback is inevitable. The percentage of American home-ownership has risen from a record 66% to 69% in just five years, and I fear that much of the increase was caused by sub-prime and other (better-designed) affordability mortgage programs, and will not be sustained.
Mortgage credit standards are rising in 2007 (at last), but there is no sign of significant crowding out of buyers by a shortage of mortgage money. They are readily adjusting, finding gifts of downpayment, co-signers, and discovering the meaning of "FHA." We have lost things like 100% financing on "no-document" terms, but that's not a great loss, just a healthy adjustment.
At this time the local economic news is all good: jobs restored, even technology hiring showing life, low unemployment, falling vacancy rates for offices and apartments, and population migration to the state. Two drags remain: the extraordinary excess of land subdivision south of Virginia Beach, and flat prices for homes -- the excess of subdivided land the primary cause of those flat prices, and the cause of the foreclosure plague.
