Reality setting in on real estate

GlobalMacroScope ^ | September 2006 | Max Fraad Wolff

[GodGunsGuts]

Reality setting in on real estate

September 2006

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.)

[1] mortgagenewsdaily.com/532006_Mortgage_Rates.asp

[2] FDIC Quarterly Banking Profile (http://www2.fdic.gov/qbp/index.asp).

[3] www.whitehouse.gov/cea/lazear20060502.html

[A CA Guy]

It was the massive gains and losses of the stock market before that led to people investing in Real Estate.

Now RE is over valued and it appears to be flowing back somewhat to the stock again.

It's the way it goes.

I look first for the complete collapse in town homes and condos since they are the last to benefit from gains and the first to loose.
Next look at large rentals 8 or more units to take a hit by those who speculated with poor financing.
They will foreclose to the bank which in turn will make other near by places hard to rent and then most unit rentals will have depressed prices.

The end game is that this RE attitude about buy buy buy went beyond our nation and went international.
Usually we just get a big recession from all this and would maybe have to bail out Fannie Mae who has 95% of the loans, but we could see a world wide recession in the least. A world wide depression at most.

There is a supposed insurance backer for Fannie Mae, but that will fold like a stack of cards once there is any moderate hit to Fannie Mae IMO and then our treasury get the bill.

This is going to be one miserable ride down IMO. A world wide one at that.

[A CA Guy]

When a whole market collapses and the nation hits a bad recession/depression, are you in danger of loosing your job, having your pay reduced or job ended?

If you are the owner and have a lot less business and have laid off people, are all your possessions in more danger than prosperous times?

[GodGunsGuts]

All good points. I have a lot to say on the subject. Unfortunatley, I have to leave to go see a play. More when I return...

[Forgiven_Sinner]

Heh. I saw that chart on Yahoo stock boards. Look at it closely:

Note in the early 90's the housing prices collapsed (courtesy of the 1987 tax changes, which led to the S&L collapse.) Also, we had a recession in 1991, thanks to a tax increase. Yet the stock market climbed for 10 years to 2000. This does not indicate a cause effect relationship, as implied by that chart.

We bought our 2nd house in 1988 for $73,000 in Peoria. The market here was just picking up after a locally depressed economy. The house has more than doubled in value since then (4 bedrooms plus a family room on a 1/4 acre). We've refinanced twice, paying for a new roof and furnace, the last time getting a 15 year fixed rate loan at less than 5%. We have 11-12 years left on that.

As an earlier poster said, real estate is all location. If it's prime location, the value will not go down. If it's not prime location, it may go down--it depends upon the general economy. After the extreme run up of the last few years, real estate prices are due to level off for a while. I don't expect a "bubble" to burst and cause a recession, as this author seems to think.

[MrNatural]

..When a whole market collapses and the nation hits a bad recession/depression, are you in danger of loosing your job, having your pay reduced or job ended? ..

Absolutely. And losing my job would affect my ability to keep making a house payment, to say the least. But it would also affect my ability to make a rent payment if I were a renter.

I'm old enough to have seen a number of these real estate cycles. Some people who buy at the top without much margin do get burned when prices fall back, and they unexpectedly have to sell. But most people just weather it out. People who had planned on selling put it off a year or two, or rent the place. Most homeowners are not even selling their property at a given time, and are unaffected, like me.

I guess what I'm trying to understand from this thread is what is the special danger of owning real estate.

[muawiyah]

And because the 1 year ARM is just about the only kind "advertised", many people are unaware that there are 2, 3, 4 and 5 year ARMS ~ and they all have different rates, and didn't all come due for revision this year.

[Polybius]

I guess what I'm trying to understand from this thread is what is the special danger of owning real estate.

See Post 53.

There is no danger in owning real estate if you bought at a price that offered good value with financing terms you can afford.

The problem is buying at today's current prices that are being artificially inflated by buyers that are being offered large and very risky interest-only ARM loans.

Let's assume that Tony the Loan Shark has just loaned me $1 million that I can never hope to repay and I am offering $800,000 to buy the three bedroom house that you want to buy.

Rather than borrowing $1 million from Tony the Loan Shark yourself and outbidding me with a bid of $900,000, it would be better for you to wait until Tony the Loan Shark has me sleeping with the fishes, no fools are offering $900,000 for such a house and the price has dropped to a level you can afford with a fixed rated conventional mortgage.

If you just say "No" to ridiculous prices that you can only afford with risky mortgages, you have no danger.

[muawiyah]

That'll simply clear up a lot of property for redevelopment at a profit.

[MrNatural]

Re: Your post 87

That all makes sense. Some of the other posters were making it sound like anyone buying real estate was just throwing their money away. Thanks.

[A CA Guy]

A lot of people speculated in second home buying and leveraged it with the equity in their own home.

That would be a candle burning on both ends IMO.

[MrNatural]

..A lot of people speculated in second home buying and leveraged it with the equity in their own home..

Anyone doing that really needs to have everything go right.

There do seem to be a lot of get-rich-quick real estate seminars out there that want to teach you how to do stuff like that. I always figured if it really worked, and they knew how to do it, they'd have done it, and become too rich to need put on seminars :)

[A CA Guy]

All the get rich quick people like the "Rich Dad Poor Dad" author make all their money from seminars and sales of books or DVDs.
They often have had to file bankruptcy several times.

[goldstategop]

I live in the Carson Park Area of Long Beach. My home's value has decreased by $20,000 since February and it won't fetch higher than comparable homes in my neighborhood since it has only 1 bathroom. Plus at under 1,000 square feet, its a small house.

"Show me just what Mohammed brought that was new, and there you will find things only evil and inhuman, such as his command to spread by the sword the faith he preached." -Manuel II Paleologus

[goldstategop]

ARMs are fine if you'll live in a house less than 10 years. If you won't live it in long enough to enjoy it, its better to just pay the interest until you sell. When you do, it should be enough to pay off the mortgage balance thanks to real estate appreciation. On the other hand, of you plan to stay in the home the rest of your life, a conventional fixed rate mortgage is definitely the route to take. There is no single mortgage product any more since every home buyer's needs are different.

"Show me just what Mohammed brought that was new, and there you will find things only evil and inhuman, such as his command to spread by the sword the faith he preached." -Manuel II Paleologus

[mrsmith]

Max Fraad Wolff

His "housing is doomed" article from last year: "Curtain call for housing
April 14, 2005 " http://www.prudentbear.com/archive_comm_article.asp?category=Guest+Commentary&content_idx=42272

His father's "CURRICULUM VITAE
AND
LIST OF PUBLICATIONS"
http://www.umass.edu/resnick-wolff/Wolff_curriculum_vitae.pdf
Look at the stuff he and his mother wrote with his father! No wonder the guy is such a screwed up little marxist. Like his parents.

[rwilson99]

Do you have documentation that Robert Kiyosaki has filed for bankruptcy?

If not, a retraction of your comment would be in order.

[osideplanner]

could you look at a couple of southern california listings for me and let me know what they're "really" worth. Right after you renew your broker's license, I look forward to your attendance in an econ class.

[Polybius]

ARMs are fine if you'll live in a house less than 10 years.

Unless you bought at an inflated priced fueled by money that interest-only ARM's put into the hands of people who cannot afford those prices.

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. ........"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

Then, even if you have cash in the bank to purchase a house outright, you are getting poor value as the price is being artificially elevated by the irresponsibility of others.

If you won't live it in long enough to enjoy it, its better to just pay the interest until you sell.

However, the artificially inflated prices are making it impossible for many people to afford the payments on a fixed mortgage when the people bidding against you are getting easy money from interest-only loans.

The choice for new buyers is now either a risky interest-only loans with low monthly payments (until it blows up in your face and drives you to foreclosure) , a conventional loan with prohibitively high monthly payment or, as buyers are now doing, saying "No" to prices that they can only afford by putting themselves in either one of those two bad financial positions.

Once the interest-only grace periods begin to expire by the tens of thousands, the foreclosures will begin and the seller will have the choice of either losing money or bankruptcy.

[A CA Guy]

False statements in Rich Dad Poor Dad by Robert Kiyosaki
http://www.johntreed.com/false.html

What Kiyosaki is really doing is operating a cult of personality.
http://www.johntreed.com/Kiyosaki.html

The making of a financial genius
There are probably many ways to became a financial genius, but Kiyosaki has certainly chosen an unlikely route:

• flunked sophomore year of high school and had to repeat
• U.S. Merchant Marine Academy
• 3rd mate oil tanker (or was it “Love Boat” type cruise ship as he said in one of his books?)
• Marine helicopter pilot (or was it fighters?)
• refused to return to ship when it was ordered to return to combat (or just missed the boat)
• Xerox salesman
• failed businessman (nylon surfer wallets)
• failed businessman (rock and roll memorabilia)
• failed author (1993 book If You Want to Be Rich & Happy, Don’t Go To School?)
• failed MBA applicant
• homeless person
• bankruptcy (or maybe not)

[Petronski]

Behold Au, the Gold Bull,
the face of their shiny metal god: