Reality setting in on real estate

American’s castles (homes) are middle class walls of separation from poverty and want. As goes the house goes the family’s ability to fend off tough times and leverage past wealth for opportunity. Borrowing to bridge low income periods, college costs, medical expenses, bail, renovations, retirement and unemployment are all common. This is the proper frame of discussion for the impending debt/depreciation storming of the castle. A few basic facts are worth repeating. $1.06 Trillion in residential mortgages were written in 2005. Nearly 70% of Americans own their residences. The home is by far the largest asset “owned” by the bottom 80% of citizens. For the last 10 years, and particularly the last 6, things have gotten pretty darn wild in the real estate world. Perhaps unreal estate would be a better phrase?

Housing prices, refinancing, building and improvement, buying and fixation have mushroomed. Many have made significant gains in home asset value- at least on paper. There is no longer debate that things have gone way beyond anything that might be sustained. Such debates are silly and are better handled by psychologists and psychiatrists than economists. As a member of the latter, I will defer to those equipped to comment from real knowledge and experience.

The coming return to earth will be uneven, disorderly and proceed in fits and starts. This we know from past episodes and our extensive and growing experience with bubbles- the new engine of the American Macroeconomy. The housing troubles ahead are serious and this is largely symptomatic of the greater shake-out in progress. A significant portion of the middle class is no more. Housing is about to turn onto another serious problem for these beset masses. It will join health coverage and cost, pension woes, massive debt, intergenerational demands and stagnant wages. All of these afflictions are related and interacting. Wages have not kept-up, health care costs run several times the rate of inflation, and college tuitions soar. Aging parents require help with medical costs, children cost more and their early career wages don’t come close to supporting a middle class existence. Thus, longer and more expensive support is often required. There are no savings and pensions are shaky. Rising house prices were a godsend to many- financially and psychically. This will soon run contrary.

Housing appreciation has been the lender of first and last resort to millions of families. Refinancing, cash out or interest rate lowering, has paid for more than meager gains in wages- even after some very modest tax relief. After tax income gain, skewed up by salary scales and taxation changes, was about $375 billion in 2005. Depending on which estimate you accept; approximately $550 billion was extracted through cash out refinancing. It is clear that housing appreciation has become the crutch for many limping families. Rising home prices- unsustainably above trend and already decelerating- have been an essential enabler of bill paying and consumption. Housing appreciation thus, did more for American families last year than wage and salary increases. This is set to reverse. Mortgage News Daily has recently reported an ominous sign of desperation:

During the first quarter the median ratio of old-to-new interest rates was 0.98 which means that one half of borrowers who were refinancing mortgages ended up with a new loan with a rate that was two percent higher than the old rate.[1]

Thus, refinancing is clearly driven by the need for cash from appreciated housing more than rate changes - which should be discouraging. Such refinancing reached record levels across the first quarters of 2006 and accounted for just under half of the mortgages owned by Freddie Mac. 17 consecutive interest rate hikes were no much for the needs and wants of home owners.

Financial firms and employment have been massively assisted by the housing bubble. They are vulnerable to price stagnation and decline. The most recent FDIC Quarterly Banking Profile, while upbeat, offers some remarkable numbers. Across Q4 2005 residential home equity lines and mortgages accounted for 38% of new loans and leases.[2] This simply states that families and financial institutions are dependent on housing price gains. Households also gained - many directly and some indirectly - from the employment generated by housing. Across the early years of the post equity market meltdown (2001-2004), housing and related sectors accounted for over 40% of US private sector payroll growth. Since rate hikes began to effect markets, housing and related sectors have tumbled to account for less than 15% of private sector payroll growth. This is an ominous trend. As housing has cooled new jobs creation has cooled in tandem.

The fragility and risk associated with housing gains is very serious. The Office of Federal Housing Enterprise Oversight (OFHEO) releases a housing price index (HPI) for every quarter. In the 21 most recent quarters (Q12001-Q12006), the mean annual increase measured each quarter was 9.32%. In the 21 proceeding quarters the mean quarterly increase was 4.8%. Thus, as economic growth and labor earnings growth cooled, housing price appreciation rates doubled. In the last 5 years the average house has increased in price by 57%. Over the same period real GDP growth was 15%. The most optimistic White House Estimate of real after tax compensation increased by 8%.[3] Unreal estate price increases are just that. Brace yourself for a dose of reality that will fall heavy on the shoulders of those least able to bare the load.

Here the risks are extreme and the potentially impacted group is large enough to have macro significance. ACORN, a community advocacy group released, The Impending Rate Shock, on August 15, 2006. This report examines 130 metro areas and offers a first glimpse at the extent of risk and fragility of housing finance for lower income Americans. In 2005 adjustable rate mortgages (ARM) accounted for 24% of all residential loans and 75% of sub-prime loans. One million households have either received sub-prime loans or are at risk of foreclosure from mortgage burden. The average sub-prime ARM term to adjustment is 2 years and the base rate is the London Inter-bank Offer Rate (LIBOR) with added charges often equaling 5%. As of today LIBOR is 5.40%. The short adjustment horizon of sub-prime ARM means that many face dramatic upward readjustment soon. This will produce difficulty paying, increased default and lost purchasing power in affected communities. In short, housing wealth effects are in the process of resetting to run in reverse. Clearly this will occur sooner and more extensively in some places than others. This will last several years and be more than large enough to have negative macro effects on a par with the positive effects that we have seen across this long boom- now over!

We believe a pronounced housing slowdown will be followed by localized absolute declines in mean residence price. Given the exaggerated macro benefit that robust housing appreciation, refinance and associated activity have had, we are looking for a virtuous cycle to turn vicious with national and international implications. Low and middle income Americans will have to cut back on all forms of discretionary spending. The coming drastic reduction in purchasing of exports by suffering members of middle class- and soon to be former middle class Americans- will have global impact. Those who earn their keep producing and distributing to these masses will share in the pain as consumption spending is ratcheted down to levels at which America's families can service debts and stay within modest and pressured incomes.

What is good for housing may have been good for America. Likewise we fear the return of reality to real estate will exert a pronounced downward pull on national economic performance and have global economy implications.

(Max Fraad Wolff is a Doctoral Candidate in Economics at the University of Massachusetts, Amherst and editor of the website GlobalMacroScope.)

Beleive me, I've heard the argument ad nauseum and memorized it. My point, supply and demand works.

That depends on what you mean by "works".

It is amazing what can be in "demand" by the American public.

Word spread very quickly about Ponzi’s great idea and within a few short months the lines outside the door of his School Street office began to grow. Thousands of people purchased Ponzi promissory notes at values ranging from $10 to $50,000. The average investment was estimated to be about $300. (That was a big chunk of pocket change in those days.) ..........With an estimated income of $1,000,000 per week at the height of his scheme, his newly hired staff couldn’t take the money in fast enough. They were literally filling all of the desk drawers, wastepaper baskets, and closets in the office with investor’s cash. ..........By the summer of 1920, Ponzi had taken in millions and started living the life of a very rich man. Ponzi dressed in the finest of suits, had dozens of gold-handled canes, showered his wife in fine jewels, and purchased a twenty-room Lexington mansion. ........On July 26, 1920, Ponzi’s house of cards began to collapse. .......An estimated 40,000 people had entrusted an estimated fifteen million dollars (about $140 million in U.S. funds today) in Ponzi’s scheme.

The law of supply and demand often works by separating the fool from his money and Forums such as these are a way for such individuals to either be lured into folly or be steered away from it.

If something is overpriced, don't buy it, and don't take out a ridiculous loan to leverage something you can't afford.

In other words, pay attention to value. That is what I have advised in my posts.

However, approximately 50% of all housing sales in California are now being financed by interest-only ARM loans which means that a lot of people are not following such sound advice and such fools are driving prices to ridiculous levels.

Buy something small and out of the way and you'll do fine.

Not necessarily. Both of the properties I own free and clear are good properties in good locations but I bought at good value at terms I could afford without resorting to gimmick loans.

Buying "small and out of the way" is not a guarantee of good value if the price is more that you should be paying for such a property at such a location.

Unlike the doomsayers, there is plenty of real estate under $150,000. Plenty.

Don't look at price. Look at value.

Although I own two houses free and clear, I am now living in a rented house where the seaweed washed up on the beach by last night's high tide is 10 yards away from the window of this room.

It is a fantastic house being rented at a cheap price (at least for me but not for most other people in this geographic area). However, I would never buy this house as it is not a good value. It is TOO close to the ocean and the house next door was flooded at high tide one stormy night. Why buy such a risk for mega-bucks when the owner is taking the risk and I live in his house at an extremely reasonable price because that rent is all the local supply and demand can support?

The bottom line is that, when value is not there, you don't HAVE to buy. You can simply rent and let the owner take foolish financial risks.

And if you can't find it in the place you want, well, when the dreaded "crash" comes, there will be.

Exactly. There is no hurry to buy and, when the interest-only ARM's begin to explode in people's faces when the grace periods expire, there will be plenty good value to be found.

Approximately 50% of all recent California house sales fall into that description.

A Growing Tide of Risky Mortgages..........In 2004, fully 50.4% of the mortgage loans issued for purchases of single-family homes in Georgia were to pay interest only. California was second, at 47.1%.......The trouble comes when the interest-only feature expires, which is often after 10 years. If it's a 30-year loan, then the entire principal has to be paid off in the final 20 years. So the monthly payment could abruptly jump by 50% -- even assuming no increase in the interest rate (nearly all interest-only loans have adjustable rates, so the borrower can get whacked if they rise as well). .........Interest-only mortgages were designed for wealthy families who used the loans as cash-flow management tools and could, if necessary, pay off the entire sum by liquidating some stocks and bonds. ........Trouble is, the sheer numbers indicate that the loans are also being taken out by a much bigger sector of the public -- people who are struggling to get into a rising housing market and feel that they couldn't get the properties they want any other way.......... But even some parties that benefit from the rage for interest-only mortgages, like homebuilders, are wondering if the trend may have gone too far. "In most of those cases, buyers have no idea how they're going to pay" the higher payments that will be owed once principal payments begin, says William J. Pulte, founder and chairman of Pulte Homes

Buyers are now starting to say "No" to artificially inflated house prices and starting to say "No" to the foolish interest-only ARM's that make such prices possible.

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