Thoughts on the Housing Bubble

John Mauldin | Thoughts from the Frontline
July 1, 2005

Looking at a recent magazine covers one is left with the impression that the whole world is concerned about US real estate prices. This is borne out by the fact that if you go to Google and type in sex you get 78,000,000 hits. If you type in real estate you get 110,000,000 hits, which makes housing about 40% more interesting than sex. Is there a greater sign of a bubble? But if you type in housing bubble you get "only" 1,120,000, so there is not much worrying going on. While the above facts do not constitute a scientifically valid study, they make a fun launching point for this week's letter. Are we in fact in a housing bubble? How long will prices continue to go up? Will they start to fall, or even crash, and when? We explore all this and more.

Housing values have been on my mind for the past month or so. In April, I was on a panel with Paul McCulley of PIMCO and Rob Arnott of Research Affiliates. Both are very smart and quite well off. Surprisingly, we were all in the process of either moving or getting a second home, and we all had decided to rent. They both live in the hot Southern California markets and find that renting is far more affordable than buying. In essence, we were all going short housing prices. As it turns out, I found a way to hedge my bet.

As long-time readers know, I currently lease my home. I have wanted to move for some time and next week will be the weekend I actually move. Because I do not want to move my 16 year old son out of his high school, I was limited in my choice of area. As it turns out, local developers are building a replica of an upscale Italian Village complete with shops and townhomes. One similar development in a neighboring town has done very well.

I am indeed leasing the townhome for two years (one year with an option for a second year) but have an option to buy the home at the end of that period at 5% above its current price. Right now my intention is to move in two years to a home I intend to live in for quite some time. If you put a gun to my head and made me make a prediction, I think the economy will have either come through a recession or still be in one. That means home values in two years should be lower, with 30 year mortgage rates well below 5% (see my conclusion as to how much below). Home values in the range that I will be looking for could be a great deal lower in a recession.

If I'm wrong, I get to flip the townhome or buy it and become a landlord. If I'm right, I'll just hand the owner the keys. In the meantime, I will get to live in a very nice home in a very nice neighborhood for a very reasonable price. Actually, it is cheaper to rent than to buy.

It is very possible that we could have a recession in the US and home values in Texas don't drop much at all (as well as other places where there has not been a bubble in home prices), as lower interest rates put a bottom under housing values.

Just the Facts, Ma'am

In doing my research for this week's letter, I rounded up an amazing list of facts and figures. I think we will just go through them by source, without trying to put any spin on the numbers and then add my commentary at the end. I throw in some opinions along with some facts, as it is good to look at what others are saying. Let's first start with good friend Gary Shilling, who always manages to come up with an assortment of data and charts. This is from his July 2005 letter, which came in just in time for this week's letter on housing.

No surprise, Gary is worried about their being a bubble and the possibility it could damage his prediction of a rather benign, if not in fact good, deflation. He starts out:

"The housing bubble is not local, but national--not surprising since it's driven by economy-wide forces: investor zeal for high returns but skepticism over stocks, ample cheap mortgage money, and lax lending standards. Indeed, these forces and the housing boom are global. Earlier U.S. housing booms-busts were driven by local business cycles such as the rise and fall of the oil patch along with oil prices in the 1970s and 1980s. Since houses are much more widely owned than stocks, the bubble's likely demise will shake the economy more than the early 2000s bear market. It could change the good deflation of excess supply we foresee to the bad deflation of deficient demand. The most likely bubble- pricking pin is massive speculation itself, and as prospective buyers stand aside, mounting inventories will precipitate a downward price spiral."

Here are some quotes and facts I highlighted as I read the 16 page letter:

"Last year, the price of the median existing house was up 9.3% and the average down payment was 9% with 91% borrowed. So, the average home buyer made 103% on his investment in one year, less maintenance costs, taxes, closing costs and interest payments. Wow!" [So much for hedge funds using leverage - or returns! - JM]

"...Earlier, Fannie and Freddie essentially set loan standards by specifying them on the loans they purchase. But with their shrinking share of the market, lenders with lower standards are gaining share. Fannie's analysis found that 24% of mortgages last year were subprime, i.e., made to people with bad credit histories. Also, on mortgage loans larger than the $359,650 that Fannie and Freddie are allowed to buy, full documentation fell to 49% in 2004 from 73% in 2001."

"...Furthermore, many first-time and repeat buyers couldn't care less about the lack of principal retirement, negative amortization on their mortgages, or the potential leap in interest changes in future years. Why? Because they plan to flip their houses soon for quick profits, long before all those future onerous mortgage costs kick in. This explains the zeal for Adjustable Rate Mortgages, which accounted for 46% of new mortgages last year and 37% of applications vs. 29% and 19%, respectively, in 2003. It isn't that long mortgage rates are rising and driving borrowers to the short end of the spectrum. Oh no, long rates are falling, but despite the flattening yield curve, are still above short rates. So, ARMs reduce their interest costs, at least for now. Last year, two-thirds of new mortgages were ARMs and interest-only mortgages.

"Better still, many believe, are option ARMs, which further minimize initial monthly payments. Option ARMs allow the borrower each month to make a payment that covers interest and retires some principal, to pay interest only, or to make a minimum payment that's less than the interest and results in an increase in the principal, or negative amortization. Their popularity is clear. Today, more than 40% of prime rate mortgages that are pooled and sold to investors, or securitized, are option ARMs, up from less than 1% two years ago."

"...It's fascinating that the zeal for homeownership has pulled people out of rentals so that rents in many areas are falling as house prices soar. This, however, doesn't bother those who buy extra houses as investments, and 9% of total mortgages in the first four months of this year were taken out by investors, up from 6% in 2001. They, too, figure they'll flip these houses quickly at big profits, so low rental income in the meanwhile is of little concern. Neither does the fact that single-family rental vacancies topped 9% at the end of 2004."

Gary looks at a recent FDIC report that shows that 34.7% of US market valuation is in just 22 top housing markets, up from 24% in 1995. But if you add up the top ten markets, you find 31% is in just those ten! In 1995 it was just 20.2%. Elsewhere I find that there are 362 markets. More on this later.

"...The national scope of the housing bubble is no surprise given its driving forces. They aren't local economic booms. Indeed, there's nothing anywhere in the country today to rival the oil patch boom in the 1970s, the Cold War aerospace spending jump in the late 1980s or the dot com bubble of the late 1990s. Instead, the driving forces, discussed earlier, are national-- the appeal of real estate as an alternative to stocks and low interest rates. And lax lending standards. The leap in subprime loans from 9% of total mortgage originations in 2003 to 20% last year, according to the FDIC, is telling. So are the high loan-to-value, interest-only and option ARMs mortgages mentioned earlier."

And moving on to other sources, the National Association of Realtors estimates that 23 percent of U.S. homes purchased last year were for investment. Another 13 percent were second homes. About 23 percent of home buyers nationwide are using interest-only loans, according to Loan Performance, a company that tracks loan originations. Interest-only and other types of adjustable-rate mortgage loans allow borrowers to pay no principal and sometimes little interest for an extended time while gambling that home prices will keep rising. (Washington Post)

And this amazing note, which I will comment on later. The Rocky Mountain News notes that homeowners can lock in 30 year fixed rate mortgages that often are less expensive that short-term adjustable rate mortgages. If you have excellent credit, they write, you can get a 5% 30 year mortgage with a 1% fee. Five and ten years ARMS are at 5.125%.

Bloomberg shows that one year ago a 30 year mortgage was 5.87% and a one year ARM was 3.41% Today they are at 5.11% and 3.6%, respectively. (The following link is a good one to save. You can click on it and get up to the minute info on interest rates, mortgages, etc. I just wish they did not have those annoying pop-ups, although my pop-up blocker gets them about half the time. http://www.bloomberg.com/markets/rates/index.html)

Celia Chen writes for the Dismal Scientist a more sanguine note than Shilling: "Yes, housing is overvalued. Yes, there will be more painful adjustments in the most heated regional housing markets, but for the national economy, house prices are likely to adjust down to a more sustainable level through slowing or flattening in price appreciation. ....This correction would not take on the shape of a sharp drop off in house prices: as has been pointed out many times, while the recent rapid gain in houses is being compared to a stock market bubble, housing is nowhere near as easily transferred an asset as stocks. There is an inherent downward stickiness in home prices, as many homeowners can simply take their product off the market rather than sell at a price lower than they desire. Consequently, house price growth would slow for a good year before any declines would be visible. The market would remain in a trough for a few years, before the cycle turns up again. The longer and higher the price gains persist during this boom, the more severe the correction would be." (http://www.economy.com/home/article.asp?cid=15477)

For a more contrary opinion, one only has to go to a recent statement by those smart guys at Comstock Partners. "In our view a housing bubble with national implications definitely exists, and the risks to the economy are enormous. The Fed and other depositories are acutely aware of the situation leaving them with the dilemma of what to do about it. If they tighten enough to really halt the rapid rise in home prices the economy could very well go into a nosedive, a particularly scary situation, considering that all the debt still remains on the books. On the other hand if they do little or nothing, the boom could get even further out of hand, making the eventual economic and financial unraveling even worse. So far the Fed is raising the fed funds rate at the so-called "measured pace", and, along with other agencies, recently started a policy of moral suasion. If this doesn't work the question is whether the Fed will follow through with more actual tightening. If Paul Volcker was still heading the Fed we would know the answer, but given Greenspan's consistent reluctance to pull away the "punchbowl" we just don't know. Either way the outcome is likely to be extremely unpleasant for the economy and for stocks."

A Little Irrational Math

But investors are nothing if not optimistic. The LA Times, in a recent survey, reports that local homeowners expect to see housing prices rise by 22% annually for the next ten years. Now this is a group, while admirably optimistic, that clearly didn't pay attention in math class. Compounding at 22% a year for ten years is an 800% appreciation, doubling every 3.27 years. 22% doesn't sound like much. Let's just project today into the long term future. Not doing the math, they do not realize that means homes would have to go up in value 8 times! But such is the nature of bubbles. That is why it is called "irrational exuberance."

A UBS/Gallup poll shows that only 13% foresee a decline in housing prices over the next 6 months. 67% of investors see real estate investments as more profitable, and 77% see such investments as safer than the stock market.

Stephen Roach of Morgan Stanly writes: "With a saving-short US economy now hooked on an increasingly frothy property market, risks of the ultimate post- bubble shakeout are mounting. That's because, unlike the equity bubble of the late 1990s, the housing bubble has been built on a mountain of debt (see my 24 June dispatch, "From Bubble to Bubble"). The history of asset bubbles tells us they almost always last for longer than we think. That was true with the dot-com mania and is most assuredly the case today. The bursting of bubbles remains a great mystery. Macro offers two leading possibilities -- rising interest rates or a shortfall of income growth. In my days as a bond bear, I used to think that rising interest rates would wean America from the excesses of asset bubbles once and for all -- not just piercing the housing bubble but also triggering an unwinding of "carry trades" that stoke ever-frothy fixed income markets. As a newly converted bond bull, I now believe the imminent threat of such a possibility has receded. While that buys time, it does so with one more slug of bad growth. By dodging the interest-rate bullet, the debt-intensive Asset Economy may well get another lease on life -- making for an ever more treacherous endgame.

"The Fed is the swing factor in this outcome. And so far, it has swung its support repeatedly in favor the multiple bubbles of the Asset Economy. It set the stage in the late 1990s, with Alan Greenspan backtracking on his initial concerns over "irrational exuberance" and then going on to be a leading cheerleader of the New Economy and the monetary accommodation it "deserved." The bursting of the equity bubble then forced the Fed into an aggressive mode aimed at preventing a repeat of Japan's experience -- a 550 basis point slashing of the federal funds rate to a 46-year low of 1%. As the post-bubble US economy appeared to heal, the central bank belatedly began to normalize its policy rate. This normalization has been feeble, at best. During the five-year period since the equity bubble popped, the Fed has kept the real federal funds rate at, or below, the zero threshold. This extraordinary monetary accommodation has led to bubble after bubble. But this time, the 'echo bubbles' had something the original bubble never had -- a monstrous debt wave."

And last, but certainly not least, is this summary of a major piece on housing by Martin Barnes of Bank Credit Analyst. Martin is no Cassandra, but his writings sound a clear warning tone not normal for his usual more optimistic and sanguine style. Please note each of the four points carefully.

"U.S. housing is in a bubble in several important regions with prices moving far beyond fundamentals and with escalating signs of speculation... The growing gap between the cost of owning and renting should eventually cool prices in the most overheated markets. However, the conditions for a major bust may not exist for a while, and the risk is that prices will continue to rise in the coming year... An end to the housing boom will remove a huge prop to the economy and will represent a deflationary shock. The authorities dealt with the tech stock collapse by creating a new bubble in housing. There will not be the same policy room for maneuver when the housing bubble bursts... The view that the securitization of mortgages means there will not be major systemic financial risks associated with a housing downturn is too complacent given record consumer leverage."

But What Do I Really Think?

First of all, there are clearly bubbles in some areas of the country. That being said, the average home is still affordable by the average person, according to the housing affordability index. But not in the bubble areas. Only 17% of the US can qualify for a mortgage on a median priced home in California. In certain areas it is much worse. This is not surprising for certain wealthy enclaves, but this is for an entire state!

But if much of the growth in housing values has been in a few select areas, and data suggests that is the case, then it also means that much of the ability of homeowners to use their homes for refinancing is also in those areas. So much of the US economic growth that was created by the asset bubble in housing is coming from a small (yet significant) number of areas in the country. Various estimates are that this adds as much as 2% to overall GDP. Further, economists at the Fed estimate that the economy would slow by 0.2% for every 1% drop in housing values. A softening in housing values in those bubble areas would significantly affect the whole country in a negative way just as their growth influenced a positive growth.

Last year we built 2 million new homes. Yet we added only 1.2 million new households. That means we absorbed about 800,000 homes either as second homes or for investments. Given various studies, it is probable that around 500,000 homes were bought for investment over and above the number of new households.

That is a major part of the bubble. If new homes were rising in line with the growth in households, there would not be the potential for supply to outstrip demand. When, not if, we enter a recession with a significant overlap of excess supply while unemployment is rising, that could cause a sharp break in housing values in certain areas.

We live in a cash flow society. We look at our income and then judge how much we can afford to spend. As noted above, rents are actually falling while prices rise. When home prices fail to rise every year, when investor confidence breaks, households will look at their cash flow and realize that they might be better off renting.

But that may not be for some time. I remember writing about how the NASDAQ was overpriced in the 4th quarter of 1998. I watched the stock market take wings after that. Bubbles which are caused by investor expectations and irrational exuberance can last a long time.

This is especially true if interest rates stay low. It goes double if mortgage rates drop from here.

Let me outline a very plausible scenario, and one which will illustrate why the Fed is in such a bind. If the Fed stops raising rates at 3.5% (meaning one more 25 basis point increase in August), what impetus will there be for long rates to rise?

The economy is still growing nicely, up a revised 3.8% in the first quarter. The ISM number rebounded today. Unemployment is down. Inflation ex-energy is benign, and soon we will be at a place where the oil prices from a year ago will not reflect the significant rise that they do now. It is highly likely that we print a lower inflation number in the last half of this year than we did in the first. And with all the good news, long term rates are still low.

(As an aside, the BLS uses rent and rent equivalents and not housing prices when they figure inflation [CPI], which means that housing inflation in terms of housing prices is just not in the CPI number.)

The world is awash in capital, and it seems to want to find a home in US fixed income instruments. The US government deficit is dropping, which means we are making less new government paper for foreign central banks to buy, yet they (and foreign private citizens) are buying more of our debt, putting more downward pressure on interest rates.

Low inflation, excess world savings coming to the US (for whatever reason) and a flat Fed policy is a prescription for lower long-term rates. This means the environment for housing prices could be quite good for some time to come.

But let's say the Fed is worried about the housing bubble and wants to slow it down, as well as create a more classically normalized interest rate scheme. So they signal they will continue to raise rates. The market fears the Fed will continue until they cause a recession (as they historically have) and in anticipation they begin to buy long bonds, dropping long rates.

Either way, I think the chance of significantly rising long term rates which would kill the housing market is less than 20% in today's environment. By that I mean I do not think the ten year will rise to over 5.5%, which is what is needed to really slow the housing market, if that is your objective. (This could all change of course if say China and the rest of Asia were to start doing something else with their dollars, but that is not a likely short-term scenario.)

Bill Gross and others speculate about a 3% ten year note, which would roughly mean a 4% 30-year mortgage. Can you imagine the wave of re-financing? Every mortgage in America would be re-financed. I think that could easily happen in the next recession. It would certainly soften the usual recession cycle again, postponing the ultimate day we hit the debt re-set button. It would trigger what Roach calls another round of Bad Growth (growth based on debt).

That is just another reason why I think it will probably take two recessions (and thus a long time) to get to the ultimate bottom of the stock market (in terms of valuation) and to hit the re-set button on debt. It is also why I think the Muddle Through Economy will be the paradigm for the rest of this decade, at the least.

And this worries me. Because the above scenario is a prescription for deflation. Staving off deflation, which is evidently part of the programmed DNA transfer that is required when you become a member of the Fed, will not be as easy the next time as it was last time. Ben Bernanke, who is the man I think will be the next Fed chairman, will have his job cut out for him. I fully believe him when he says that the Fed would "move out the yield curve" in a fight against deflation. He will help the market bring down mortgage rates to help stimulate the economy. Simply lowering short term rates may not be enough.

But what would you have them do? Sit to the side and do nothing as the US slides into a steep deflationary recession? You can argue that there should not be a Fed, but that is not reality. There is and they will act to fight deflation. The die was cast when they decided to use housing asset inflation to offset the bursting of the stock market asset inflation bubble. The fact that it became a bubble was not helpful.

In hindsight, Stephen Roach is probably right. They should have raised rates faster and kept a lid on the housing bubble developing in certain parts of the country. But that is water under the bridge. Now, their choices are fewer, and their weapons are less. Get ready to get the lowest mortgage rate of your lifetime in a few years. But it will not be a sign of a healthy economy. While 4% will be good for us as individuals, we will not like the overall economy and the stock market. Can we hear it for Muddle Through?

Now that is what I really think.

Moving On Up and Going Nowhere

Next weekend I move into a new house. We originally wanted to move over this three-day weekend, but some carpet manufacturer missed a delivery so next weekend it is. This will be my first home without a yard since college. Only six years ago, I lived in a home where we planted 3,000 flowers each spring on almost an acre of ground with a pool, Japanese gardens and lots of massive trees. I moved to a smaller place as kids moved out, and now move to yet a smaller venue (although it is still not all that small). Now, there will be a few plants outside the front door. But I will also not have to spend weekends messing with a lawn, or fixing something or improving something. Maybe it will give me enough time to write a new book. (Just kidding!)

And I do not travel anywhere until late in July. Home for almost five weeks! I am enjoying the time at home and looking forward to watching a few bal games with friends.

One of the nice things about having an office in the Ballpark in Arlington is that the Texas Rangers almost always play on July 4th. After watching a game from my office balcony with my family and friends, we get to walk outside and watch some massive fireworks while standing almost directly under them. I am a huge fireworks fan, and really enjoy being able to get this close. And my kids love it! And the "adult" ones the most.

Washington, Adams, Jefferson, Franklin and Hamilton might all wonder at what we made of their Republic, but I think they would enjoy the celebrations. I trust you will have you own, and let's raise a glass to them and to all those who have made our freedom possible.

Your wondering how to get rid of all that extra stuff before he moves analyst,

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