Skip to comments.With Real Estate, This Time it Really is Different
Posted on 11/20/2005 12:23:42 PM PST by ex-Texan
As evidence mounts that the real estate boom has finally peaked, most economists, analysts, and industry professionals continue to predict simply a slowing of price increases, or perhaps, modest price dips. Apparently they have taken comfort from the irrelevant fact other than during the Great Depression there has never been a year in which national real estate prices declined.
While this ignores significant national price declines in other wealthy nations, as well as several noteworthy regional declines in the U.S. itself, it ignores the unprecedented run up in prices and credit excesses of the last six years. In fact, when it comes to real estate, this is one of the rare examples where this time it really is different.
Historically, national housing prices have increased no faster than the annual rate of inflation, as measured by the CPI. Though recent changes to that index, and several short-term anomalies, have resulted in the CPI underestimating inflation, the recent run up in real estate prices is still unprecedented even if one assumes inflation is double the official estimates. To expect the pendulum to swing so far in one direction, without completing a equal move in the opposite, is a leap of faith as extraordinary as the bubble itself.
To understand why the current real estate market is different, one must examine the unique circumstances that produced the bubble in the first place. Historically, many factors have combined to keep national real estate prices in check. However, due to a confluence of events, those traditional restraints have been temporarily removed, making the unprecedented price increases experienced during the last six years possible.
To their own hazard, the public has largely accepted arguments from partisan real estate boosters justifying absurd prices as resulting from legitimate market fundamentals (See my commentary entitled Housing Bulls Inadvertently Support the Bearish Case written Dec. 13, 2004 http://www.europac.net/archives.asp?year=2004&qtr=4#. ) However, as those restraints gradually return, and true market fundamentals reassert themselves, a price collapse is inevitable.
The recent run-up in home prices began during the latter stages of the 1990s stock market bubble, and kicked into high gear almost precisely when that bubble began to deflate. It is not without coincidence that the speculative fever born in the stock market mania seamlessly found new life in real estate. However, were it not for the irresponsible actions and omissions of the Federal Reserve, the Federal Government, Wall Street, and the mortgage industry itself, such speculation never could have produced the unprecedented national bubble just experienced.
The following is a list of those traditional safeguards that prevented national real estate bubbles from forming in the past, the abandonment of which has made this historically unprecedented bubble possible:
The Government -- The Fed
In an attempt to postpone the painful but necessary correction of the economic imbalances developed during the tech bubble, the Fed dropped interest rates to levels unprecedented in post-war America, and completely inconsistent with our nations low level of savings. Such actions not only temporarily reduced the cost of home ownership, but mortgage refinancing simultaneously enabled a greater share of household incomes to become available for other consumer spending, keeping recessionary forces at bay. The lower cost of home ownership, together with the artificial, short-term boost to the economy it provided, combined to enable homebuyers to bid up real estate prices.
Congress and the White House
In the aftermath of the bursting of the tech bubble and the tragedy of September 11th, the Bush Administration and the Republican controlled Congress did not want the painful, yet extremely necessary recession occurring on their watch. Though the problems actually developed during the Clinton years, public perception confused that mania with legitimate prosperity. Rather then exposing the false nature of the boom and preparing the public for the painful, yet necessary bust that lay ahead, the Administration and Congress enacted a series of tax cuts and spending increases. These measures succeeded in postponing the inevitable and exacerbated the severity of the adjustment that would ultimately be required. Also, exempting the first $500,000 in profits from home sales from tax (provided owners reside in their properties for two years) increased the after-tax gains on real estate speculation, further feeding the speculative appetites of homebuyers.
FannieMae and FreddieMac
By insuring increasingly risky mortgages under the presumption of an implied Federal Government guarantee, FannieMae and FreddieMac enabled the origination, resale, and securitizations of mortgages, which otherwise never would have been possible. The moral hazard inherent in separating lenders from the ultimate holders of the paper results in the irresponsible extension of mortgage credit, to non-creditworthy borrowers, on liberal terms and with insufficient collateral, fueling the speculative run-up in housing prices.
The Mortgage Tax Deduction (Not a factor unique to this time period, but a powerful force artificially increasing home prices for years.)
By subsidizing homeownership, the government artificially increases home prices. Rather than making homes more affordable, the mortgage deduction ironically makes them more expensive. (This point has been proven by the mortgage industrys lobbying efforts against the recently proposed changes in the tax code limiting mortgage deductions. Their principal argument: the move would cause home prices to collapse.) Sure those who quality for the tax deduction can write-off the mortgage interest they pay, but thanks to the subsidy those mortgages are a lot larger than they would be otherwise. Like all government subsidies, such as those to education and health care, the cost of what is being subsidized actually rises. In the case of student loans, the benefits go to institutions that benefit from higher tuitions, which in the absence of government guaranteed loans would be impossibly high. For their part, the students are burdened with staggering amounts of debt. In the case of health care, it is the medical establishment that has largely benefited by the separation of medical costs from those paying the bills. Such separation makes ever-increasing prices possible. In the case of housing, it is realtors and mortgage lenders that benefit from higher commissions and fees on inflated home prices, more frequent transactions, and larger mortgage balances.
The Mortgage Industry
Historically, housing price increases were restrained by the ability of buyers to come up with the required twenty percent down payment. As a result, housing prices could advance no faster than the typical familys ability to save. The existence of a twenty percent down payment limited the risks associated with default by: 1) restricting home mortgages to those who demonstrated the financial discipline to save; 2) limiting mortgages to those with a demonstrative ability to handle the responsibilities and costs of homeownership; 3) requiring buyers to have some skin in the game; and 4) providing an adequate cushion for lenders should foreclosure occur. With the twenty percent down payment now passé, this limitation on price appreciation has been removed, along with the protection it provided lenders.
Traditionally, lenders naturally wanted borrowers to fully document their financial capability to repay a loan, including proof of employment, income, financial assets, and credit history. As a result, the ability of borrowers to exaggerate their financial positions in order to qualify for mortgages was held in check. With the advent of the no-documentation mortgage that check has gone out some very highly leveraged windows. In addition, the allure of quick profits from real estate appreciation, and the ease of extracting those profits through cash-out refinancing, provided homebuyers not only with a substantial incentive to lie, but the means to get away with it. As more buyers gained access to mortgage credit by misrepresenting their financial conditions, home prices were bid much higher than would have been possible had full documentation been required.
With traditional thirty-year, fixed-rate mortgages, borrowers actually had to have enough income not only to pay the interest on their loans, but to repay the principal as well. The existence of interest-only and negative amortization loans has resulted in loans being made to borrowers who have no ability to repay them. Enabling people to buy houses they can not afford has artificially increased housing demand, exerting upward pressure on prices.
Adjustable rate mortgages
Traditional fixed-rate mortgages leave lenders holding the risks should interest rates rise. Adjustable rate mortgages transfer those risks to borrowers in exchange for lower initial payments, which borrowers have used to take on larger mortgages than they otherwise could afford, using the difference to bid up home prices. However, both parties have completely ignored the harsh reality that when higher monthly mortgage payments ultimately arrive, many borrowers will be unable to afford them. (See my commentary In Arms Way, written May 7th 2004 http://www.europac.net/archives.asp?year=2004&qtr=2# )
Payment and debt to income levels
Historically lenders have not allowed borrowers to devote more than one third of their incomes to meeting mortgage payments, property taxes, and other costs directly attributable to homeownership. During the current bubble lenders routinely allow such payments to consume as much as half of a borrowers income, contributing to the unprecedented rise in home prices. However, increasingly stretched borrowers will find it difficult to make mortgage payments, especially if their financial situations deteriorate. In addition, despite the fact that many of these loans are ARMs, lenders only apply income criteria to the initial payment period, even though there is no way that based on current incomes these borrowers could afford to make the higher payments once the loans reset.
Mortgage origination & securitization
In the past, mortgages were originated by savings and loans that held them to maturity. As a result they judiciously safeguarded depositors money by only making adequately collateralized loans to creditworthy borrowers. However, with mortgage originators quickly re-selling their loans, they are not concerned about the borrowers ability to repay them. Marginal homebuyers getting loans on terms that would not have been possible using traditional standards caused home prices to be bid higher than otherwise would have been the case, had fewer buyers been in the market. Buyers of these packaged products, such as hedge funds and foreign central banks, assume that their risks are minimized through diversification and implied federal government guarantees.
Traditionally appraisers were hired by lenders that intended to hold loans to maturity, and as such were concerned that they be adequately collateralized. If a loan was too large given the value of its collateral, lenders wanted to know about it. If appraisals were out of line with purchase prices, lenders would not fund the loans or would require larger down payments. However, mortgage originators, only concerned about getting loans funded, could not care less about the real value of the collateral behind them, and only hire appraisers that would validate sale prices. Appraisers, aware of this reality, are pressured to appraise high in order to be assured of future employment. This perverse relationship has helped fund transactions at prices higher than what otherwise might have been the case given more honest appraisals.
The ability of over-stretched homeowners to pull cash out of their homes, either though refinancing or home equity loans, has turned houses into virtual ATMs, temporarily suppressing foreclosures. Financially distressed homeowners are able to extract enough cash to make monthly mortgage payments in circumstances that otherwise might have resulted in default. Reduced foreclosures have contributed to escalating home prices and helped keep the mortgage spigots open.
Publicly-traded mortgage lenders and home builders have gone to extremes to meet unrealistic earnings expectations, all in an effort to maintain overvalued markets for their stocks, enabling unprecedented levels of insider selling. Lenders have scraped the bottom of the barrel and abandoned all standards, in an effort to keep lending and maintain short-term earnings growth. Homebuilders continue to overbuild to maintain the illusion of future earnings despite growing evidence that no profitable market will exist for their product.
Homebuyers -- The bubble mentality
The speculative mentality that has enveloped homebuyers has so clouded their judgments that they will pay any price for real estate, which is not only seen as a cant lose investment, but thanks to incredible leverage, the equivalent of a ticket to easy street.
With houses now regarded as sources of income rather then expenses, many people see no cost to homeownership. If a typical homebuyer in Southern California expects a $500,000 condo to appreciate by $100,000 per year, does he care if the $2,000 monthly mortgage payment consumes half of his salary? Of course not, as the anticipation of extracting an extra $100,000 per year in tax-free income means the house is expected to add to, rather than subtract from monthly income. In fact, with home ownership now perceived to be more lucrative than employment, is it any wonder that potential homebuyers will pay outrageous prices, and say or do anything to qualify for mortgages?
The unbridled speculative fever that has turned everyday citizens into river boat gamblers has created an artificial property shortage, as speculators buy properties they have no intention of living in, and for which no viable rental market exists. The concepts of rental income and positive cash flow are now as passé as earnings and dividend yields were during the tech bubble. Negative cash flows, easily offset through cash-out refinancing, are regarded as acceptable trade offs for price appreciation. No one even questions why a property that is already so over-priced that it produces a negative cash flow would appreciate in the first place. This Ponzi scheme, greater-fool mentality typifies bubbles (see my commentary entitled Still Not Convinced There's a Real Estate Bubble, Read This! written April 20th 2005 http://www.europac.net/archives.asp?year=2005&qtr=2 .)
Homebuyers are so confident in the certainty of price appreciation, that they will buy homes using ARMs or interest only mortgages knowing full well that they can not afford to make the payments when higher interest rates arrive or principal payments kick in. The strategy is to either cash out equity to supplement income, or sell the property for a quick profit. Such homebuyers are clearly real estate speculators in disguise. The fact that they occupy properties while speculating on short-term price appreciation in no way alters this reality. As a result, housing speculation is actually far more rampant than official statistics reflect (see my commentary Housing Speculation is More Rampant than You Think written July 5, 2005 http://www.europac.net/archives.asp?year=2005&qtr=3 )
The end result of all this speculation is higher prices. The idea that it is impossible to over-pay for real estate means no price is too high. The mentality is to pay whatever it takes, because someone else will always be willing to pay more. The perception is that the only way to lose in real estate is not to own any. Is it any wonder that we have experienced the mother of all manias?
The Bubble Economy
Contributing to the housing mania is the artificial boost to consumer spending (80% U.S. GDP,) the bubble itself has produced. This acts as a self-perpetuating, virtuous circle where increased consumer spending drives housing prices higher, which in turn provides the impetus for still more consumer spending. Through the wealth effect, growing home equity both increases the willingness of homeowners to spend while reducing their perceived need to save. The bubble mentality is why save when my house is doing it for me.
In the past being a homeowner increased the need to save, as inherent in homeownership are costly repairs. Today homebuyers not only do not need any savings to buy a house, they no longer need any to maintain one either. Is it any wonder that our national savings rate is negative, homeownerships so wide-spread, and real estate prices are so high?
The impetus to spend is not simply the result of a state of mind. The ability to cash out equity enables homeowners to convert paper appreciation into real purchasing power. However, since this extra purchasing power was not derived from legitimate increases in American productivity, the result has been a massive, unsustainable, and completely unprecedented rise in our nations trade deficit.
In addition, lower interest rates, and the proliferation of adjustable rate mortgages, have allowed homeowners to temporarily suppress mortgage payments, freeing up additional income for discretionary spending. This temporary boost to consumer spending has been a shot in the arm to the economy, increasing employment, incomes, housing demand and home prices, enabling additional cash-out refinancing, and thus perpetuating the cycle.
If owning one house is a good investment, then owning two must be an even better one. Rising real estate prices are self-perpetuating, as increased home equity gives homeowners the ability to afford more property, putting added upward pressure on prices and creating additional equity with which to bid them even higher. Rising prices ratify buyers expectations of indefinite price appreciation. They confuse the bubble with their own savvy as real estate investors, and their short-term success further clouds their judgment, enabling them to easily dismiss the warnings of skeptics who have missed out on all the profits. In the past if a homeowner lost his job or fell on hard times he might be forced to sell his house to make ends meet. Now he simply buys a vacation home, using the expected appreciation to supplement his income or replace lost wages. Is it any wonder that ownership of second and even third homes is at record highs?
In the final analysis the temporary factors artificially elevating real estate prices will subside. Rising interest rates and inflation, and a resumption of savings as home equity fades, will combine to suppress consumer spending, leading to recession, job losses, and reduced demand for housing. The supply of unsold houses will continue to rise as higher interest rates, tighter lending standards, and higher down payments price more potential buyers out of the market. Without the expectation of routine cash-out refinancing, homebuyers will no longer be willing to devote staggering percentages of their incomes to mortgage payments. In addition, the expectation of lower prices will bring more sellers to the market, just as buyers are backing away.
Once the trend reverses, falling prices will purge speculative demand from the market. Once speculators become sellers, supply will overwhelm demand. As lenders see housing prices fall and inventories rise, increased default risk will result in tighter lending standards, restricting access to mortgage credit. As more mortgages go into default, the secondary market for mortgage backed securities will dry up as well. This will act as a self-perpetuating, vicious cycle, as tighter lending standards reduce housing demand, leading to lower home prices, more defaults, fewer qualified buyers, lower prices, tighter standards, ad infinitum. In addition, the collapse of consumer spending associated with higher mortgage payments and vanishing home equity, will plunge the economy into a severe recession, further exacerbating the collapse in real estate prices, worsening the recession, and continuing the vicious cycle.
The housing mania, like all manias that have preceded it, is finally coming to a long overdue end. Time tested principles of prudent mortgage lending will inevitability return, and houses will once again be regarded merely as places to live. However, the country will be a lot poorer as a result of the unprecedented dissipation of wealth and accumulation of consumer and mortgage debt which occurred during the bubble years. Before real estate prices can return to normal levels, they will first have to get dirt cheep. It has been a wild party, but in the end all that will remain is a giant hang-over.
Excellent warning! I know you have become unpopular with some people for beating the drum on this topic, but I think you will be proven to be on the right side of history..
Reno area is much more FReeper friendly, especially home prices, which are still affordable. Good luck there. My FReeper friend writer33 and his wife live there.
Congress will be called upon to bail out the people that took the "interest only" loans in order to buy more house than they could normally afford. Just watch!
I was gonna say something, but you beat me to it : )
Well, if you feel the need to counter the risk you perceive, just don't hand your money over to the hack that wrote this, then.
Anybody who is thoroughly freaked out about the bubble thing should go to Everbank.com and open up a CD denominated in Swiss Francs, a gold-backed currency.
At least you won't be paying commission to some fear-mongering @-hole who's fanning the flames for his own benefit.
But, to complicate matters for the dollar-collapse crowd, the dollar has been rising of late. This will eat into any putative return you might make on any foreign currency denominated account. Sooner or later, the dollar will ease again, which would increase the rate of return, provided that the currency you chose remained stable or rose.
And, no, I have no affiliation with Everbank. I do have a couple of CDs there, including one denominated in Swiss Francs. Just in case the you-know-what ever really does hit the fan, lol.
Even if Congress can bail out the interest only people, at this stage of the game our entire economy is so dependent on real estate that a major recession may be inevitable. That's what most people overlook, the impact on the economy.
What's this guy talking about? Loans over 80% have been routine for decades. Even ignoring the obvious example of FHA loans, 81% - 95% conventional loans with PMI have been a huge portion of originations for at least 25 years.
Anybody who still has an ARM in the present environment of unbelievably low fixed rate mortgages deserves what they get. There is no excuse.
I suspect that housing price rises have been closer to the inflation rate than officially shown. The average rise in the price of gold is a pretty accurate measure of the rate of inflation. That shows a doubling in maybe 6 years.
The official CPI removes inconvenient factors by being re-presented as the "core" rate of inflation, i.e those prices that are rising faster than the desired pereived rate are removed from the calculation. Oil and housing are thus not included. That's like in a famine saying that all-in-all people are healthy and happy as shown by the "core" rate of health because food availability has been removed from consideration due to its abnormal situation.
The 500K tax exclusion added at least 20% premium. This analysis ignores that.
In the past 25 years, someone taking a variable rate loan has not had to pay a rate higher than he would have under the fixed rate at the time he took the loan.
There is a premium paid for the security and the market prices the fixed rates above the expected future variable rates.
In other words, fixed rates are for suckers.
"81% - 95% conventional loans with PMI have been a huge portion of originations for at least 25 years."
I bought my first house in 1993, with a "sweat equity" down payment equal to 5%, with closing costs paid by the builder. It took five years to get rid of the PMI. Even with PMI, it was still cheaper than rent. I've got around $90,000.00 equity in it now, even though the market in my area was flat for three years, 2000 - 2003. Not bad for no money out of pocket.
Nope. I bought my two houses at sane prices with good, old-fashioned, 15 year fixed rate loans and I no longer have to worry about such matters.
Three million home owners with ARM loans just got a BIG surprise in the mail.
That's nothing compared to the orchietomies that those who have stretched their budgets to buy over-priced real estate with Interest Only loans will get when the "interest only" grace period expires.
You're right - and if they flip after two years (this might have changed again) the profit isn't taxed. The money can be invested. When (or if) the housing market slows, the interest only loan can be switch to a fixed rate and the "renter" becomes a home owner in 30 years... Looks like a win-win to me.
The economy is doing great.
The housing bubble is a separate issue that will explode in the face of a certain percentage of Americans who made foolish decisions.
Wanna buy a Beanie Baby for $25,000?
Well, I've only been in the real estate business, including as a broker, owner of a mortgage company, appraiser, secondary marketing, (including sale of mortgage-backed securities and servicing), and every other aspect of the business for over 30 years. Enlighten me some more. Especially the part about how having an adjustable-rate loan is smarter than taking a 30-year fixed-rate loan (presently around 5.5%).
"In other words, fixed rates are for suckers."
That was true when interest rates were stable or declining. It's not true now, when interest rates have risen a full point in a month's time, with further increases anticipated.
House prices are ultimately determined by how much the buyer can afford to pay per month.
The drastic lowering of that payment with "$0 down/interest only" gimmicks, has allowed sellers to charge highly inflated prices that the buyer will not be able to afford once the grace period expires.
If you like their house, save up your cash for the day the "interest only" grace period ends and they are forced into foreclosure.
We're all going to be eating dirt some day.
Try and enjoy the ride until then.
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