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 Even more important, consumers have withdrawn $2.5 trillion in equity from their homes during this time, spending as much as half of it and thus making a huge contribution to the growth the U.S. economy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.
I just bought a house with a 'no doc' loan. As in, "no documentation required."
just to get in. then refinanced with a 30 year conventional.
I lived in Chicago ( and I do mean IN CHICAGO, not the burbs and NOT in any pukey neighborhood, but in the Gold Coast, on Lake Shore Drive )for seventeen years. Prior to that, I lived in N.Y.C., as had many previous generations of my family and extended family; some of whom still do.
Why is housing more expensive in BIG cities? Because lots and lots of people actually want to live there! The highest paying jobs are in BIG cities, not to mention the fact that some businesses are ONLY located in these locals. You want to be at the top of the ladder? You aren't going to reach that rung of success in outerslobovia, U.S.A.! And then, there is all that energy and a feeling of being ALIVE, that is felt nowhere else.
As far as being "packed in like sardines", I'm willing to bet that the places I've lived in, in each of these two places, were larger than any house you live in now, or have ever lived in and no, my apartments aren't the largest places to be found in either city; however, they are quite large. :-)
Most cities, but especially N.Y.C., provides far MORE value, than the podunk places you seem to think are "heaven on earth".
There is a LOT of crime in rural, exurban, and urban areas in this country. You're propagating a rather OLD canard, stating that cities are dangerous, bad places, but that there is no crime in the rest of the country.
Prices of everything, have to do with many factors and since people don't all have the same wants, needs, and tastes, you really need to NOT allow your own biases and emotions color your high handed, error filled, factless, and flawed pronounceomentos.
Unlike you, I posted facts. The readers of all the posts, should take that into consideration.
The supposed "HOUSING BUBBLE" articles have been posted to FR for years now. While it is certainly true that there ARE areas of America that are in bursting real estate bubbles, that just isn't the case for the entire nation and as I have said many times before, unless we enter a nation wide depression, of vast proportions, that just isn't going to happen.
Actually that's not entirely true. The crime rate is higher in the urban areas, I will agree, but crime is virtually non-existent in the rural areas. Granted there are crimes committed in the rural areas, but the crime rate is not such that it poses a huge problem.
I read a story in the Rapid City Journal a couple years ago about this couple from San Diego who retired at a young age, sold their modest home for nearly $1.5 million, and moved to Sioux Falls, South Dakota and bought an even nicer home than the one they sold in San Diego, for $320,000, and the rest of the money they had left over, they put in their bank account.
Around here, most people either work from their home, own their own brick-and-mortar business in town, or commute 100 miles roundtrip to work for the local telephone company/internet service provider, which happens to be the largest employer in a 5 county area.
Thanks, I didn't mean to leave Sioux Falls, or Rapid City off my list. Great Places, to be sure.
I'd say you did quite well in you're posts to Oueen know it all. Has she bought her own country yet?
With all that property she owns no mortgage, maybe she can take some of that equity and help the troops
I totally agree with you though the big cities will spiral downward because of the masses of people living in such small quarters,
As well as the increase in traffic, crime cost of living....
As a native Californian, people are leaving and flocking to areas where they do not live on top of their neighbors where they can live crime free as well as having quality of life...I would rather open my door and see a gorgeous mountain view or a beach sunset or the smell of orange blossoms on a warm balmy day...I guess other's would like to open their door to horns and sirens a blaring, buildings obstructing any view of mother nature but what the heck they are the city dwellers looking at things rising rising rising! LOL..
LOL. I like it. Da Queen from the Gold Coast of Chicago.
Seriously, she shouldn't have brought a knife to a gunbattle of wits.
I used the following simple formula: I had 2 car payments. When I finished paying 1 car off, I used that amount to pay of the second car off faster. Now that I have paid off the second car, I am using BOTH payments to accelerate my mortgage payments (5% fixed). I will own my condo free and clear in 5 years. It is worth apx $400,000 (I live in Los Angeles), more than 4 times what I paid for it.
People who mortgaged their new "equity" are flat out nuts. Interest only is the second most nutso thing to do.
Your broken water pistol doesn't count, pet. :-)
Look, the entire point is, that what is GREAT for some people, is TERRIBLE for others. Sadly, you are incapable of even recognizing that and that has colored your posts here. Based on absolutely NOTHING but your own emotions and biases, you stated, as though it was based on fact, that the big cities are the ones which are going to be hit and hit badly by a supposedly imminent, exploding real estate bubble. This is just NOT the case. As has been reported in various and sundry news papers, magazines, and on line real estate sources, which I quoted, real estate prices ARE still steadily going up, right now, whilst prices in some places, where the BUBBLE is bursting, such as South Florida, the heady days of speculation, when bidding wars were spiraling out of control, these past four years, has not only stopped, but turned around and nosedived.
There ARE, indeed, areas with highly inflated real estate, which are, right now, as we "speak", seeing that BUBBLE burst. As I have pointed out, repeatedly, Neither N.Y.C. nor Chicago part of that and it is extremely doubtful, based of hard, cold facts, that either place shall be hit by a bursting bubble, in anytime, in the near future; for various reasons, some of which I have also posted to this thread.
You may be thoroughly delighted to be where you are living, at present; however, that has less than nothing whatsoever, to do with whether or not the price of your home will go up or down in value. Again, you are posting your own emotional and biased position, based only on how YOU feel.
I shan't tell you where I live, but I shall tell you that 1)you couldn't pay be enough to have me switch places with you...if you wanted to 2)I still bet that your house is smaller than mine is 3)I have far more acreage than you do 4) and absolutely NONE of these things is determinate in whether you or I are in a real estate BUBBLE. LOL
Da Queen from the Gold Coast of Chicago has spoken.
Keep going sweetie. Everybody enjoys a good laugh, and you are it.
Da Queen from the Gold Coast of Chicago has spoken.
Keep going sweetie. Everybody enjoys a good laugh, and you are it.
Don't read #209. Whatever you do, don't read #209.
And, laney aka missyme, since I happen to know the places where YOU have lived/live now, you really shouldn't enter into this debate; especially since, as usual, you have less than no idea what you're talking about. Your likes and dislikes have NOTHING whatsoever to do with whether there is a real estate bubble in a city or not. And FYI...many people who live in N.Y.C. and Chicago, have a far better view ( The Hudson River, or the East River or Central Park, or a gorgeous skyline, or two of that least those views/ Lake Michigan, a gorgeous skyline, Grant Park, Lincoln Park, or at least two of those views ) than you have! LOL...their real estate is also worth a whole lot MORE than yours is too!
Well it appears that by what I have read, you seem to think as always *You* are the only one that knows about what cites have real estate *BUBBLES* and if so many New Yorkers and folks in Chicago have such beautiful skylines why are so many of them in California and Florida?
I will agree there are some beautiful areas in Chicago and New York but I doubt that those real estate markets can compete with some areas in over priced Los Angeles and San Francisco.
Also if you have never been to proudpapa's estate how do you know you have more acerage than him?
Some places in Eastern Washington and Idaho I am sure you could not afford to buy..but maybe you can, I never have seen where you lived and neither have you seen where anyone has lived on this thread.
Oh yes, indeed, everyone DOES "enjoy a good laugh" and YOU have been laughed at, on this thread, for DAYS! LOL
As always...you're a dollar short and a day late, as the saying goes. ;^)
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.