Posted on 04/03/2006 7:38:13 AM PDT by ex-Texan
With new home slaes down 10.5 percent in February, and with home prices declining for the fourth month in a row, it's high time for a sober look at the consequences of a major housing correction. The Federal Reserve, Wall Street economists, and other observers of the U.S. economy are closely watching the housing market because it has been a key driver of economic growth over the past several years.
Roughly a quarter of the jobs created since the 2001 recession have been in construction, real estate, and mortgage finance. Even more important, consumers have withdrawn $2.5 trillion in equity from their homes during this time, spending as much as half of it and thus making a huge contribution to the growth the U.S. economy has enjoyed in recent years (consumer spending accounts for two-thirds of GDP).
But consumers cannot keep spending more than they make. Eventually, home prices will flatten, the flood of "cash out" refinancings will become a trickle, and consumer spending will slow, as will job creation in housing-related industries. The big question is this: Will the housing sector experience a soft landing and slow the economy or a hard landing that pushes us into recession?
Countless articles in the financial and popular press have now been devoted to the question of whether we are in a housing "bubble." It is a favorite topic of many liberal economists, columnists, and bloggers, who argue that President Bush's tax cuts and other policies have created a hollow and unsustainable economy. They are laying the groundwork to hang a housing bust around the necks of President Bush and congressional Republicans.
Economic observers on the right have been strangely silent on this debate. A few conservatives have argued that the record appreciation of home prices is justified by economic fundamentals. Others, who apparently slept through the 80 percent decline in the NASDAQ, don't believe bubbles are possible in a free market economy. Certainly most conservatives have an innate optimism about America and the resilience of its free market economy, and a strong and well-justified aversion to doomsayers. And naturally, the White House and congressional Republicans have no interest in highlighting the vulnerabilities of the economy.
Yet the concerns about unsustainable growth in consumer debt and home prices are not easily dismissed. A weakening housing market could transform what has been a virtuous cycle into a vicious one, substantially reducing economic growth during the next couple of years (and going into the 2008 election). If economic analysts on the right ignore this risk, they may be blindsided by a weaker economy. They will also be unprepared to answer those on the left who will blame tax cuts for what could be a painful unwinding of a credit bubble that, in fact, was fueled by a loose monetary policy from 2002 to 2004.
THE CRUX OF THE DEBATE IS HOUSE PRICES. If the inflated prices are justified by economic fundamentals and sustainable, then the 82 percent increase in mortgage debt since 2000 will probably turn out to be innocuous and the risks to the economy minimal. If, on the other hand, prices are out of whack, painful adjustments lie ahead.
Unfortunately, the weight of the evidence strongly suggests a bubble. The price of the median home is up an inflation-adjusted 50 percent during the last five years, an unprecedented national increase. It is true, as Alan Greenspan and others have observed, that real estate is regional, and much of the country has not experienced significant price gains. However, prices are overextended in enough areas that a real estate correction would have national fallout. The mortgage insurance company PMI estimates that regions accounting for more than 40 percent of the nation's housing stock are overvalued by more than 15 percent. Other estimates of overvaluation are much higher.
Economists at international banking giant HSBC have identified 18 states and the District of Columbia as "bubble zones." (Chart not posted on web site) House prices in these zones look remarkably similar to the rise in the S&P 500 during the 1990s stock market bubble. They have dangerously diverged from historic valuation trends, and thus are very likely to drop during the next few years.
Just as cheerleaders of the high-tech bubble of the late 1990s developed ever more creative explanations for why traditional metrics of valuing stocks no longer applied, the same has been true during the housing bubble. Housing bulls point to immigration, building restrictions, Baby Boomer demand for second homes, and other seemingly plausible justifications for skyrocketing home prices. But examining the value of housing using time-tested and common-sense metrics such as price-to-income and price-to-rent ratios suggest the gains in the bubble areas can't be explained by economic fundamentals.
Consider the price-to-income ratio (above, right), an obvious measure of affordability. This ratio has reached an unprecedented level in the bubble markets. While this ratio hovered around its average of 4-to-1 for the past 30 years, it has zoomed to nearly 8-to-1. The current figure is 3.6 standard deviations from its average level, which, if the data have a normal bell-shaped distribution, means the odds of the price-to-income ratio reaching this level would be less than 1 in 300. In other words, it is off the charts.
The National Association of Realtors recently produced an analysis of about 100 different metropolitan areas and found prices justified in every one. The NAR concludes it would practically take a depression for home values to drop 5 percent. But this is an awfully rosy scenario from a group that routinely warns of 15 percent declines should Congress even tinker with the home mortgage interest deduction.
Consider the case of the Washington, D.C., area. According to NAR, the price-to-income ratio has averaged about 2-1 for the past 25 years and now stands at a record 3.4-to-1, or 70 percent above its normal level. Assuming incomes grow 5 percent a year in the D.C. area (the average of the past decade), home prices would have to drop 25 percent for this ratio to return to its historic average within the next five years.
An even better indicator of how divorced home prices are from their underlying economic value is the price-to-rent ratio (see chart, top of next column). In the Washington, D.C., metro area, which had remained relatively constant for several decades, this ratio has soared since 2000. Yet home prices and rents should remain closely linked. Why would one buy a house, condo, or vacation home if it was significantly cheaper to rent it? Or why would an investor buy a property that rents for far less than his mortgage and other costs? Rent is a reality check because it reflects the actual earnings power of the asset.
Consider the example of a townhouse in Fairlington, a venerable apartment and townhouse community in the Virginia suburbs just a few miles from the nation's capital. It's an instructive example because there are hundreds of similar units, and those put on the market at the prevailing market price move quickly. A typical three bedroom townhouse in Fairlington recently sold for $575,000. Assuming the owner put 10 percent down and took out a traditional 30-year fixed-rate mortgage, the monthly payment would be just under $3,200. Add in property taxes, a condo fee, and the tax breaks for home ownership, and the cost of owning this unit comes to about $3,000 a month. (Note that this analysis takes into account the lower cost of owning due to low interest rates and ignores the $57,500 down payment.) Yet the very same place rents for no more than $1,700 a month, or just over half the cost of ownership.
Why own it? One powerful reason must be an expected profit down the road. People are buying in the face of sky-high prices because they've seen so many of their friends or relatives make a fortune in real estate; besides (they tell themselves), everyone knows real estate prices never fall. As with the stock market during the tech bubble, many are basing purchasing decisions not on underlying economic value, but on what they think they can sell a property for in the future--the very definition of a speculative bubble.
NOT ONLY ARE HOUSE PRICES at extreme levels by traditional measures, but the manner in which home purchases have been financed in recent years is also disconcerting. Consider the growth of interest-only and "pay-option" adjustable rate mortgages--loans that initially don't require borrowers to repay principal. With the latter, also known as an option-ARM, the outstanding balance owed can actually get bigger every month. A few years ago these loans barely existed. Last year they accounted for more than a third of new loans (see chart at right). What's worse, the vast majority of these loans were extended based on "stated income," which means the bank didn't verify the income of the borrower. Of course, consumers usually have to pay more if they don't provide tax and payroll records to the bank to verify their income. Common sense suggests many are fibbing about their income to qualify for a larger loan.
Such loans are risky because after an initial period of three or five years with low rates and no principal payments, the loans "reset," and consumers can experience 50 percent or even 100 percent increases in their monthly payments. About $2 trillion in loans, or a quarter of outstanding mortgage debt, will reset in this fashion during the next two years according to Economy.com. Therefore, millions of households are about to experience significant payment shock.
A recent study by First American Corp. shows that many of the borrowers who have taken advantage of the lowest teaser rates and are going to experience the greatest payment increases have little or even negative equity in their homes. Fully 22 percent of the borrowers who borrowed at initial rates of 2.5 percent or less during the past two years have negative equity in their homes, and 40 percent have less than 10 percent equity. The study also finds that a third of people who took out adjustable rate mortgages last year have negative equity and 52 percent have less than 10 percent equity. How is this possible? One reason is that 43 percent of first-time home buyers paid no down payment last year.
If this isn't a housing mania, why have so many people embraced financing schemes that leave them vulnerable to higher interest rates or even a modest correction in home prices? The nation's bank regulators have seen enough and have issued draft rules that will take effect this spring requiring banks to tighten standards on loans where the consumer isn't required to pay principal up front. That's going to tighten credit in the high cost markets, reduce demand for housing and put downward pressure on home prices.
WHILE THE EVIDENCE OF A HOUSING BUBBLE is overwhelming, it isn't definitive. But what isn't debatable is that one cannot forever spend more money than one earns--yet this is exactly what consumers have been doing. For the past five years, Americans have spent more than they have earned--last year, the net borrowing amounted to 3.7 percent of GDP, or over $500 billion. The high level of spending compared with disposable income is also in uncharted territory.
It's no coincidence that the above chart closely tracks the growth in spending financed by mortgage debt, the drop in the savings rate, and the growth in the current account deficit. They all are measuring the same phenomenon--spending outpacing income.
The chart (below, right) shows mortgage equity withdrawal (MEW) as a share of disposable income. MEW comes from three sources. It comes from cash-out refinancing, from home sales where people put down a smaller downpayment for the new house than the equity in the old place, and from home equity loans. According to ISI, a Wall Street research firm where I work, last year MEW amounted to $751 billion, more than 8 percent of disposable income and twice the peak reached in the late 1980s. Alan Greenspan estimates that about half of MEW gets spent, so in 2005 that was about $375 billion. This figure was up from about $306 billion in 2004, which means spending financed by withdrawing home equity added 0.6 percent to GDP in 2005. Add in employment and other factors, and the housing boom has added up to one percentage point to economic growth in each of the past few years.
If this borrowing of home equity remains very high but slows from current levels, which is a near certainty if home prices flatten, it would have a depressing effect on the economy. For example, if home prices stabilize and it takes two years for net mortgage equity withdrawal to slow to $259 billion--the level in 2001--this would subtract two percentage points from economic growth during the next two years. The economy's average growth rate is about 3.5 percent per year, so all else being equal, this would cut economic growth to 2.5 percent.
Then there is the fact that about one-quarter of the job growth since the recession has been directly related to the housing boom, so a flat housing market could slow job creation and reduce economic growth even further. This is what has occurred in Great Britain and Australia, where home prices stabilized after a long boom. In Britain, for example, consumer spending slowed dramatically and GDP growth fell from about 4 percent in 2003 to half that the following year.
Even flat home prices would therefore slow economic growth unless other parts of the economy rapidly accelerate. But a hard landing--meaning a recession--is a real risk. If home prices fall modestly, millions of homeowners will see their equity wiped out. Many of those with the least amount of equity, as we've already shown, are going to face significant increases in their monthly payments. So what has been a virtuous but unsustainable cycle for the economy--higher home prices, more borrowing against home equity, higher spending, increased job creation, even higher home prices--could easily reverse and become a vicious cycle--higher monthly payments, declining home prices, less spending, job losses, foreclosures, even lower home prices.
To be sure, there are some very positive trends in our economy, especially strong productivity, and most likely a housing correction won't push the economy into recession. But even a gradual reversal of the housing boom could result in sluggish economic growth and painful adjustments for those in the bubble areas who incurred too much debt during the run-up in house prices. Conservatives ought to seriously consider these risks so they won't be surprised or caught flat-footed if a housing correction occurs.
Andrew Laperriere is a managing director in the Washington office of ISI Group, a Wall Street economic research and brokerage firm.
Are you always this grouchy?
Are you always THIS dense and nasty?
How much did the guy pay for it? The market is definitely slowing down, but the scenario you've described only indicates that this guy is asking too much for his home. That could happen in a red-hot market as well as a slow market.
We have people in our neighborhood asking way too much for their homes, and consequently they aren't selling. We listed ours at a market price, and had two full price offers in two days. We made a nice gain on it too.
you forgot the 'no-doc' loan.
"you forgot the 'no-doc' loan."
The term I used is "stated-stated" and that is the terminology in the loan business, so I am told.
It means no documents are required to verify what the borrower states.
Don't know what he paid. I know that I purchased my house back in 1993. We did extensive work on it in side and out. I redid the entire landscape. I got over double for it when I sold in January. The market was starting to go down then. I got, according to my agent, probably $20,000 less than I could have got maybe 4-6 months ago.
I've bought in oversupply. I bought in MA in 1990 and according to the pumpers of the day, much like we see in this thread, said prices wouldn't fall any more. I paid 155k, sold in 1993 for 135k and had to pay the buyer's closing costs. My experience was far from worst case. After I bought in VA in early 1994, my value went nowhere for about 4 years. The expansion may continue in Phoenix in particular, but the bubble has ended and the retracement will being shortly. Prices will revert to the long term average increase which may well increase as inflation really kicks in. But for most areas like Phoenix that means a price correction or many years of price stagnation. The only scenario in which that could change is a highly inflationary one if the Fed decides to reopen the spigots.
About 15%. About what I'd figure for maximum drop before sellers get stubborn and refuse to sell.
Phoenix I think is now about the same price range as Las Vegas, but still cheaper than California, despite an average of 40-50% gains last year. I expect prices to be flat (forecast is 5% gain), but I seriously doubt they'll fall. California is forecast to fall, and it needs to. It wouldn't surprise me for my house to continue to rise more than average because of location.
As long as growth continues, even a little growth, then it's difficult to be "overbuilt", because the market will just fix the housing starts to match growth. It's when growth stops entirely, or reverses as it did in Houston that the real trouble starts. Phoenix is continuing to grow, and there's several reasons to think it will continue.
Your prices may progress on a higher long term average growth, but even if that long term average is an unlikely 10%, you will will have a couple of stagnant years or a drop before resumption of increases. I would not consider the market orderly enough to perform flat or small increases considering the carrying costs of investors are greater and they won't want to wait for years.
It's not lack of growth that is your problem, it's amateur investors who want to get rick quick. It doesn't take very many of them wanting to get out to start bidding down asking prices. I would also note that growth did not stop in Boston, although there was a realignment out of some industries as DEC and Data General faltered. But the main problem, as it is now, was speculation.
Fully 22 percent of the borrowers who borrowed at initial rates of 2.5 percent or less during the past two years have negative equity in their homes, and 40 percent have less than 10 percent equity. The study also finds that a third of people who took out adjustable rate mortgages last year have negative equity and 52 percent have less than 10 percent equity. How is this possible? One reason is that 43 percent of first-time home buyers paid no down payment last year.
Holy &=@%ing $#!+!!!
Ladyjane, don't feel bad. You just can't argue with a fool...
Nopardons asks me,"You live in Washington state...what do you REALLY know about the real estate markets in Manhattan and Chicago?"
Answer: I only lived for 10 of the last 15 YEARS in the 312 area code. Let's see that would be in a part of Chicago called the Loop. Maybe you've heard of it.
I still have many friends, clients and relatives that live throughout the city and suburbs. I visit Chicago annually, usually around Thanksgiving.
I've also travelled to all 50 states in the last 16 years and I've been to NYC several times.
It's my strong opinion that there is excellent reason to believe that many parts of the US are indeed in a RE bubble. It is also my opinion that many cities are in the largest of bubbles.
In January, I saw a nice, simple home in Anaheim that had just sold for 750k. In December I saw a nicer home in Killeen,Texas that was for sale. Only $89,000.
At some point people in Boston, NY, Seattle, Chicago, LA and Frisco say 'wait a minute'. I could sell my shack for 450,000-1.5 mil. And move to Wilcox Arizona, Moab Utah, Killeen Texas, Dothan AL, heck even Medford Oregon.
They end up with a nicer home, less taxes, money in the bank, less crime and a lot less traffic.
Of course there will be some, like nopardons, who won't figure it out until after the bubble bursts around them and they'll be the ones crying the loudest.
Like you, though I no longer live there, I still have family living in Chicago, as well as many friends, and unlike you, I visit there several times a year, talk with people who live there daily and just happen to be there RIGHT THIS VERY MINUTE.
I also happen to know the real estate history of that city and even though there were down turns, in real estate, the ONLY major real estate BUBBLE, which burst badly, happened in the mid 1800s! And please don't bring up what happened during the GREAT DEPRESSION, because even though there had been real estate speculation prior to the "CRASH of '29", it was the GD, that forced not only real estate prices to do a nosedive, but everything else as well.
Visiting someplace isn't the same as actually living there, for an extended period of time. And I really doubt, HIGHLY, that you know anything whatsoever about Manhattan real estate. OTOH, I do. :-)
And while it IS true that that market has slowed down a bit ( places aren't selling in one day, with a fierce bidding war, as they were up until January; it now is back to a much more NORMAL pace ), in N.Y.C., one would be very hard pressed to find a place there, whose price had crashed and crashed hard.
You obviously HATE city life.
Some people thrive on it...high taxes and having to have the bother of living in a blue state and all that that entails. It's the price they pay, for living where they want to. Not everyone yearns to live in the places you've mentioned.
You "believe" that big cities are in a real estate BUBBLE, because YOU want then to be. You are basing your position solely on your own bias and emotion; not fact. OTOH, I am posting hard, cold, FACTS!
It is a fact that the North East is not only stable, pricewise, but NOT in any kind of BUBBLE at all.
It is also a fact, that there are real estate BUBBLES in various regions of this country...Southern Florida for one...which IS, indeed CRASHING somewhat. And nary a place there, is what one would call a BIG city. Heck, they aren't even middle sized cities!
One reason that Manhattan and the tri-state area's real estate is far from CRASHING, is that the market had a good year last year and this year, with the enormous dividends and stock that the seat owners got, when the NYSE merged AND went public, with the IPO, there is now vast sums of money burning holes in a lot of people's pockets!
And some of the Chicago exchanges went public, BEFORE the NYSE did, making those people extremely wealthy. And look for yet another Chicago exchange to go public in a year.
But of course, there are people like you, who post on FR, bloviating about all manner of things they neither know much , if anything at all about, calling other people, who actually DO know what they are talking about, "fools". That only makes YOU and they the fool.
And BTW...you have NO idea just WHERE I live, nor what I may or may not get caught in. All you are doing is assuming and wishing me ill. Yet YOU live in Washington state...a very BLUE state. LOL
And then there are others who think they are in a different category. They think they're the one with the real 'truth' and think everyone around them is stupid.
LOL. The more NP writes, the more obvious it is that NP knows zip.
I don't understand the anger level. Life is so much easier with a positive attitude.
I personally am thrilled that some people see the real estate market as only going up.
I understand that some people can't see the warning signs until after the train has struck them.
Usually, we call them liberals.
It's okay NP, we still love ya.
"You obviously HATE city life."
Yes, that is why I chose to live in Chicago for 10 years. [sarcasm]
Honestly, I don't think most cities provide a good value. Housing should be a lot less expensive when you're scrunched together like sardines. It's not.
Yes, we still visit cities, for business or pleasure. In the last 4 months, I've been to Seattle, Portland, SLC, San Antonio, Phoenix, LA, and Vancouver. Next month I'll be travelling to New Orleans. I for one wouldn't buy in a city again unless I was convinced it was a better value.
With high taxes, traffic and crime, prices would need to come down a lot to counter those negatives.
One key thing you leave out of your analysis of big cities and their relative value: in general, most of the good paying jobs are in cities. While you can certainly find cheaper housing in smaller towns, you won't find many high-paying jobs.
Instead of getting upset when people don't agree with you, think about how much easier life is when people disagree with you.
I used to get upset that some of my colleagues chose to spend their money on vacations and depreciating assets and never had enough money to buy their own home. Then I became a landlord, catering to those who chose to drive Mercedes and live in nice places they couldn't afford to buy. Their choices made my life a lot easier. A lot easier.
Think about it, if everybody felt the market was going to continue to spiral higher we'd all be jumping in to buy and we would be competing with you.
Your best friends are those who disagree with you. They're selling or they've already sold. If they're wrong, you win.
Good point. However, trends tell us otherwise, VC. More and more people are working out of the comfort of their own homes. I
Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.