Housing Bubble Trouble: Have We Been Living Beyond Our Means?

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 Even more important, consumers have withdrawn $2.5 trillion in equity from their homes during this time, spending as much as half of it and thus making a huge contribution to the growth the U.S. economy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.

The Weekly Standard now is proclaiming the housing bubble is real. This is not an editorial from the liberal mainstream media. It is a conservative publication considered 'must read' material by many White House staffers. [Yada, yada] Before this editorial was published, it was revealed that speculators may have driven up Nevada land prices in prime regions. Last month, Nevada land prices suddenly fell an average of 47%. But many here on FR would argue that land cannot go down in value and only the structures man erects on the land can go down. Yeah, right. I would argue that The Weekly Standard is behind the times. Just like cab drivers became great sources for stock tips in the 1990's. The buzz is all over the street. Millions of home owners with exotic loans are "about to experience significant payment shock."

I suspect that this issue -- and not cheap labor -- is the primary reason why this country insists on allowing a flood of illegal immigrants to pour across the border every year. A massive population increase is the single most effective means of propping up an inflated housing market during a period of rising interest rates.

Buy Low and Sell High - The easiest phrase to say and the hardest thing to do in real life. Housing - bubble or not - is very high. It could go higher but the phrase is not "buy high hope it goes higher." It is to buy when everyone else is selling (like today's US automotive stocks) and to sell when everyone else is buying (hello $500,000 1 bed condo in DC).

Please excuse my stupid typo in line one and another slip in my opening comment. My comment should have said "last month it was revealed that land prices in Nevada fell 47% in the fourth quarter of 2005."

yada yada yada. Watch some of the major home builders' stock prices rise 30% this year. They continue to have strong sales and earnings.
The sky is falling!

I get so bored listening to/reading diatribes from people who want to speechify about how there's a "housing bubble". Maybe there is, maybe there isn't, but why the speechifying about it? (which accomplishes what?)

If you believe there's a "housing bubble", fine, put your money where your mouth is. If you're in one of those front-loaded mortgages, sell your house and start renting (which is the closest equivalent of "short-selling" on housing). If you have any investments in real estate, get out of them and into bonds. Whatever. And if none of that applies to you, so much the better (because there's a "bubble").

Either way, there's nothing to talk about.

I suspect that what we are seeing is a direct and inverse result of the FED continuing to bump up interest rates.

If the FED continues this trend for another 1/2 to 3/4 of a point, I further expect to see a precipitous drop in both new home sales as well as existing home turnover.

ARMs a great - until interest rates rise. Once rates start bumping up, they're killers. 30 yr and 20 year fixed rate mortgages are your friend.... (if you got them under 6%)

People have been trying to talk this real estate bull market down for at least two years. Fretful, almost frantic articles such as this one suggest that we have another leg up ahead of us.
Bull markets "climb a wall of worry". {Joe Granville}

Show me the recent "this is different" {a la the internet bubble rationalization} articles. They could make me nervous.

Are they referring to price to annual income as a ratio?

"last month it was revealed that land prices in Nevada fell 47% in the fourth quarter of 2005."

Just what good is all that desert in Nevada anyway? Why did people pay an overinflated price? I don't feel much sympathy for these people who don't know what they are buying.

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.

I've signed on for two car loans and four mortgages in my life, and every time I had to provide actual pay stubs and tax forms and the like to verify income, as well as documenting my savings and sources for down payments or potential money reserves.

What kind of places are just handing out money to anyone who claims to make X dollars?

It all depends what market you are in. Here in southeastern Wisconsin, things are slightly over-valued, maybe by 5%. No biggie.

You are right, this correction began months ago.

I wish that thing would hurry up and pop already...

On the other hand, if it keeps going another 6-10 months, my wife and I will have a much bigger down payment saved up when we buy.

I am recommending you go out tomorrow and buy this tiny 400 sq. foot cottage in Provencetown, MA. Keep telling yourself there is 'no bubble.' This beautiful house was listed for sale at $600,000. Just think: If you beat the seller down on his price by $ 100k, you may be able to pay cash for a brand new GMC automobile. And pay off all your credit cards. Yada, yada, yada.

The one problem that I know is inflating housing prices are interest only mortgages.

Yeah, okay, great, you now have a $500,000 home that you can mortgage for $1,500 a month. You never build up equity. You never own anything. You're making a rent payment. You're floating your variable interest rates on LIBOR instead of prime. You still have to refinance or face a balloon payment in 10-15 years that you can never pay.

Interest only mortgages are what's driving ever rising housing prices. This is true in most "hot" housing markets where they are 33-50+% of financing in the DMA.

This is a bubble, no ifs ands or buts about it.

Liquidity is the key to financial well being. Interest only mortgages allowing you to have a home above your means is a recipie for disaster.

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.

I don't believe this. Based upon my observation of the world I live in, and my analysis of IRS "income" tables.... I conclude that "income" in this country is GROSSLY understated. Imagine that. We tax on income, but... somehow, it doesn't all get reported. I'm ready for the Fair Tax!

Anyway... the gist of the article certainly rings true. See my other posts on other similar threads. I'm not worried though... because, I asked my realtor neighbor about these negatively amortizing loans, and he said.. "Oh, those are only given to people with very high incomes who could easily manage a negative change". Ok... now I can sleep better. ;-)

Being in the construction biz I watch the rents to price ratio closely as it's been for me the most accurate indicator. It's starting to climb in Portland Metro, so I predict we'll see a 'market adjustment' before the other states.

We are not immune here as the largest single "group" of buyers are from out of state.

Incomes alone in Oregon cannot support these price increases. But I'll be working my business till the fit sits the fan. I've been to this rodeo a couple of times before. Ain't* no biggie.

*With apologies to Miss Barnett my 8th grade English teacher.

Have you seen all those TV shows on "Flip this house" etc?

The public is under the impression that if you want to make money, and you are handy, buying and selling a house is almost a sure thing. They are showing people on these shows making 30 or 40 grand for a month's work.

Lots of amateurs getting involved. Professionals know the ins and outs of the market, are usually prepared on what to expect and have a cushion in the bank or enough committed rental properties to see them through.

A guy bought my old house last August for about 10000 undermarket, and put in around 10. He's been trying to sell it since November for 30000 more. I've been watching....

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