Sunday, August 28, 2005
Guest post -- Is the Housing Bubble Common Knowledge?
This is guest post by my friend, Steve Stohs, who is an economist at NOAA and a professor at UCSD. Steve, who is the most astute observer of the housing market I know, has been arguing that it is indeed a bubble and one that could burst soon, a bust that will have worldwide economic consequences. In the light of Alan Greenspan's comments at Jackson Hole about the bubble, this is a very timely piece. Yes, it is long, but is a must-read for anyone that cares about the global economy.
With the publication of two New York Times Op-ed pieces last week in the span of four days, Paul Krugman recently disseminated his view that the US housing market is in a bubble which, if not destined to pop, will at least hiss its way back down to size in the foreseeable future. Alan Greenspan, while still unwilling to mention the housing bubble by name, nonetheless issued dire warnings of the present risks in the US housing market at the Kansas City Federal Reserve Bank’s annual retreat to Jackson Hole this past Friday. Economists who were inculcated in graduate school with the rational expectations paradigm may wonder at this point whether "everyone" knows about the housing bubble and is in the process of adjusting their consumption and investing activities to reflect the risks inherent in the status quo.
Recent evidence I have seen suggests that, to the contrary, a majority of Americans are clueless, and are easily misled by the chorus of industry spokesmen who promote information that is deliberately intended to mislead. For instance, a recent Parade Magazine reader poll found 60%+ of respondents think that buying a home under current market conditions still represents a "good" investment. Many San Diegans do not have the faintest idea that there is anything atypical about double-digit real price increases year after year in the values of their homes -- they accept on faith the Realtor's various assurances: this is a great time to buy a home, prices in CA only go up, buy now or you will be forever priced out of the market, etc.
Only if one looks beneath the placid surface and pays attention to a multitude of extraordinary factors does one get the picture that a correction in housing is all but inevitable: (1) the explosive growth in Fannie Mae and Freddie Mac's share of the US mortgage market and its implications for eroding credit underwriting standards, (2) the historically high real price levels of housing in terms of price-to-rent ratio or price-to-income ratio, (3) the explosion (at least in CA) in the use of unsustainable creative financing strategies (I/O option ARMs, etc.), (4) hints of recent efforts at the Fed to cancel out the tsunami of speculation which they fostered in the early 2000s by dropping real interest rates to negative levels over an extended period of time, (5) the revelation from the National Association of Realtors that an estimated 36% of homes bought in the US during 2004 were second homes purchased for vacation or investment purposes (aka speculative purchases), and (6) the removal of the Chinese Yuan dollar peg, which should reduce future demand for Chinese government purchases of US government debt and mortgage backed securities. The above concerns have only recently emerged from the quiet discourse of elite policy circles into the bright spotlight of the popular financial press. Cocktail party discussion of capital gains on residential real estate investment have been quelled by a flood of popular media articles about how soon the housing bubble may burst, and how to protect oneself against the risk.
A correction appears to already be underway in the San Diego housing market – in my area of town (Rancho Bernardo / Poway) multiple "Open House" signs have sprouted up like weeds every recent weekend near the entrance from major traffic arteries into any and all housing tracts. Then there are the tiny but numerous “For Sale” signs which, on close inspection, appear on many lawns (small signs are less conspicuous, diluting the impression that many people are suddenly trying to cash out of their “investments”).
The inventory of San Diego homes for sale is currently at five times its level of eighteen months ago and steadily rising. Further, recent inventories have surpassed more than 75% of the decade long record of 19,280 homes on sale in July 1995, and appear to be on track to surpass this level in the near future given their current rate of increase. This is particularly ominous, as by 1995, Southern California prices had experienced several years of softening prices in the wake of a brutal recession. By contrast, the current rapid growth in inventory comes amid widespread economic optimism only slightly dampened by doubt over the recent slowdown in the housing market. Considering that this town is one of Paul Krugman’s so-called "Zoned Zones" where available land for residential development is highly limited, there are a phenomenal number of new single family homes and condominiums currently under construction which will soon swell the supply of homes for sale.
What appears to be the start of a correction may well go unnoticed to your typical San Diego home-buyer who can somehow stretch his household finances to purchase a house with a 100% financed interest-only option ARM loan in order to enjoy the prospect of making himself rich through double-digit future capital gains. Until the vast majority of area owner-occupant buyers and real estate investors have collectively realized that prices have stopped rapidly going up, we cannot conclude that the ultimate impact of any shift in market conditions has even begun to play out.
How is the unraveling of this bubble likely to occur? Initially the demand side of the market reaches a point of exhaustion, as there are no further creative financing tricks available to stretch budgets to afford new, ever higher price levels, and no affluent buyers left who are foolish enough to imperil their net worth by buying at a market top (this is where I believe we are currently). A slowdown in the rate of price appreciation merely initiates the adjustment process.
What ensues thereafter is a self-fulfilling prophecy for future price declines: A widespread awareness develops that prices are not going up anywhere near as fast any more. Next estimates of the value of owning a home are adjusted downwards to reflect lower anticipated capital gains from ownership. At this stage, recent speculative buyers have no further incentive to stay in the game, as their willingness to continue owning a property is predicated on an expected future capital gain sufficient to offset negative current cash flow.
The distortionary impact of "investing" activity shifts from the demand side to the supply side of the market. Inventory jumps, demand falls, and appreciation rates drop another notch, leading to a further downward revision to estimated future capital gains and, by extension, market values. Another vintage of speculative buyers now finds it more advantageous to sell than to hold on. This death spiral continues until it is widely understood that houses are not much better investment choices than stocks were circa 1999. At that point it may be worth considering houses as long-term investments once again, although reference to the Japanese housing market experience since the early 1990s shows that the next upswing can some times take many years to materialize ...
To fully gauge the risks of the housing bubble on the wider economy, we have to reckon with the large number of new jobs in the private sector in CA and other parts of the US created since 2001 in real-estate and related sectors, estimated by a recent Lehman Brothers study at over 70% across the US, and IMHO much higher in CA. (Lehman Brothers seem fond of the 70% figure, as that is also their estimated proportion of the rise in US net worth since 2001 due to surging home values.)
When the bubble deflates, the need for all these recently added jobs in the real estate sector will evaporate. This problem will be compounded by the incipient end of consumption spending fueled by cash out home equity financing. The US savings rate recently fell to 0%, and income has grown rather slowly in recent years, but homeowners nonetheless have been converting their home equity “savings” into consumption spending on Hummers, BMWs, SUVs, boats, and Super-sized McMansions. The argument that the housing market is protected from a serious downturn by a cushion of home equity appreciation seems highly questionable under the circumstances.
This spending is psychologically fueled by the Wealth Effect: appreciation on the value of long-term assets (stocks, bonds, and houses) whose values have risen inversely to the steady drop in long-term interest rates since 1982 makes US households feel richer, and thus freer to spend large sums of money on big ticket luxury items. Over fifty years of persistent (post-WWII) U.S. asset price inflation has inspired a folklore that the path to riches is to buy long-term assets and hold on, buying the dips if prices ever drop, since prices always go up over the long term. Few Americans seem to recognize that the deflation in asset prices which has occurred recently in Japan and historically in the 1930s and earlier periods in the US could ever recur.
Gone is the incentive to work hard and save money for the future, replaced by the realization that by borrowing or buying assets and holding on, we can all live in McMansions and share in the bounty created by the mass entry of cheap but highly skilled Asian labor to the global marketplace. With a critical mass of believers adopting this view, risk premiums on long-term assets have sunk to the point where yields are extremely low by historical standards. Only a continuation of high rates of capital gains fueled by steadily declining long-term interest rates could allow this trend to continue. But with soaring oil and gold prices screaming out of the headlines, and burgeoning levels of household, municipal, state, federal, and trade debt, what reasonable person can believe that inflation fears might not come out of hibernation soon?
Surging commodity prices against the backdrop of high debt levels place our government economic policy makers in a difficult position. Should they choose the politically unpopular course of higher taxes and lower spending over the temptation of whittling down the debt by sneaking in slightly higher future inflation rate which could eat away the debt through the magic of negative exponential growth? Casual empiricism leads some of us to wonder whether official inflation statistics might be somehow hiding inflation which is already underway, given steep increases in the costs of shelter and fuel which are large components of household consumption expenditures. If global debt markets catch even a whiff of higher inflation, they could punish the US bond market with higher interest rates as the inflation risk premium on long-term assets reverts to historical norms, bringing down the housing and stock markets in the process. Under a status quo continuation of the low rate conundrum, the US might retain low long-term interest rates at the risk of drowning under the weight of its future debt obligations.
The housing market is inherently inefficient, and the equilibrium adjustment process is glacially slow -- a far cry from the instantaneous equilibrium adjustment to new information envisioned by Efficient Market theorists. Your average US residential home buyer has neither the financial sophistication nor the long-term perspective on financial history necessary to weigh various conflicting opinions about whether a speculative mania has taken over the US housing market. Although even top officials at the Fed claim to be unable to answer this question except in retrospect, Alan Greenspan has become increasingly supportive of a precautious approach, and has repeatedly attempted in recent months to alert the public to the risks they face with progressively dire scenarios for the worst case which may ensue. The last time CA real estate hit a trough of affordability anywhere near as bad as the current one (1989), it took over six years for the Southern California market to bottom out. As valuations are much farther out of line with fundamentals this time around, it is hard to predict how long the correction will last, except to say that historically, larger bubbles have led to longer periods of correction. Only after this correction is well underway will the housing bubble truly become common knowledge.
With the publication of two New York Times Op-ed pieces last week in the span of four days, Paul Krugman recently disseminated his view that the US housing market is in a bubble which, if not destined to pop, will at least hiss its way back down to size in the foreseeable future. Alan Greenspan, while still unwilling to mention the housing bubble by name, nonetheless issued dire warnings of the present risks in the US housing market at the Kansas City Federal Reserve Bank’s annual retreat to Jackson Hole this past Friday. Economists who were inculcated in graduate school with the rational expectations paradigm may wonder at this point whether "everyone" knows about the housing bubble and is in the process of adjusting their consumption and investing activities to reflect the risks inherent in the status quo.
Recent evidence I have seen suggests that, to the contrary, a majority of Americans are clueless, and are easily misled by the chorus of industry spokesmen who promote information that is deliberately intended to mislead. For instance, a recent Parade Magazine reader poll found 60%+ of respondents think that buying a home under current market conditions still represents a "good" investment. Many San Diegans do not have the faintest idea that there is anything atypical about double-digit real price increases year after year in the values of their homes -- they accept on faith the Realtor's various assurances: this is a great time to buy a home, prices in CA only go up, buy now or you will be forever priced out of the market, etc.
Only if one looks beneath the placid surface and pays attention to a multitude of extraordinary factors does one get the picture that a correction in housing is all but inevitable: (1) the explosive growth in Fannie Mae and Freddie Mac's share of the US mortgage market and its implications for eroding credit underwriting standards, (2) the historically high real price levels of housing in terms of price-to-rent ratio or price-to-income ratio, (3) the explosion (at least in CA) in the use of unsustainable creative financing strategies (I/O option ARMs, etc.), (4) hints of recent efforts at the Fed to cancel out the tsunami of speculation which they fostered in the early 2000s by dropping real interest rates to negative levels over an extended period of time, (5) the revelation from the National Association of Realtors that an estimated 36% of homes bought in the US during 2004 were second homes purchased for vacation or investment purposes (aka speculative purchases), and (6) the removal of the Chinese Yuan dollar peg, which should reduce future demand for Chinese government purchases of US government debt and mortgage backed securities. The above concerns have only recently emerged from the quiet discourse of elite policy circles into the bright spotlight of the popular financial press. Cocktail party discussion of capital gains on residential real estate investment have been quelled by a flood of popular media articles about how soon the housing bubble may burst, and how to protect oneself against the risk.
A correction appears to already be underway in the San Diego housing market – in my area of town (Rancho Bernardo / Poway) multiple "Open House" signs have sprouted up like weeds every recent weekend near the entrance from major traffic arteries into any and all housing tracts. Then there are the tiny but numerous “For Sale” signs which, on close inspection, appear on many lawns (small signs are less conspicuous, diluting the impression that many people are suddenly trying to cash out of their “investments”).
The inventory of San Diego homes for sale is currently at five times its level of eighteen months ago and steadily rising. Further, recent inventories have surpassed more than 75% of the decade long record of 19,280 homes on sale in July 1995, and appear to be on track to surpass this level in the near future given their current rate of increase. This is particularly ominous, as by 1995, Southern California prices had experienced several years of softening prices in the wake of a brutal recession. By contrast, the current rapid growth in inventory comes amid widespread economic optimism only slightly dampened by doubt over the recent slowdown in the housing market. Considering that this town is one of Paul Krugman’s so-called "Zoned Zones" where available land for residential development is highly limited, there are a phenomenal number of new single family homes and condominiums currently under construction which will soon swell the supply of homes for sale.
What appears to be the start of a correction may well go unnoticed to your typical San Diego home-buyer who can somehow stretch his household finances to purchase a house with a 100% financed interest-only option ARM loan in order to enjoy the prospect of making himself rich through double-digit future capital gains. Until the vast majority of area owner-occupant buyers and real estate investors have collectively realized that prices have stopped rapidly going up, we cannot conclude that the ultimate impact of any shift in market conditions has even begun to play out.
How is the unraveling of this bubble likely to occur? Initially the demand side of the market reaches a point of exhaustion, as there are no further creative financing tricks available to stretch budgets to afford new, ever higher price levels, and no affluent buyers left who are foolish enough to imperil their net worth by buying at a market top (this is where I believe we are currently). A slowdown in the rate of price appreciation merely initiates the adjustment process.
What ensues thereafter is a self-fulfilling prophecy for future price declines: A widespread awareness develops that prices are not going up anywhere near as fast any more. Next estimates of the value of owning a home are adjusted downwards to reflect lower anticipated capital gains from ownership. At this stage, recent speculative buyers have no further incentive to stay in the game, as their willingness to continue owning a property is predicated on an expected future capital gain sufficient to offset negative current cash flow.
The distortionary impact of "investing" activity shifts from the demand side to the supply side of the market. Inventory jumps, demand falls, and appreciation rates drop another notch, leading to a further downward revision to estimated future capital gains and, by extension, market values. Another vintage of speculative buyers now finds it more advantageous to sell than to hold on. This death spiral continues until it is widely understood that houses are not much better investment choices than stocks were circa 1999. At that point it may be worth considering houses as long-term investments once again, although reference to the Japanese housing market experience since the early 1990s shows that the next upswing can some times take many years to materialize ...
To fully gauge the risks of the housing bubble on the wider economy, we have to reckon with the large number of new jobs in the private sector in CA and other parts of the US created since 2001 in real-estate and related sectors, estimated by a recent Lehman Brothers study at over 70% across the US, and IMHO much higher in CA. (Lehman Brothers seem fond of the 70% figure, as that is also their estimated proportion of the rise in US net worth since 2001 due to surging home values.)
When the bubble deflates, the need for all these recently added jobs in the real estate sector will evaporate. This problem will be compounded by the incipient end of consumption spending fueled by cash out home equity financing. The US savings rate recently fell to 0%, and income has grown rather slowly in recent years, but homeowners nonetheless have been converting their home equity “savings” into consumption spending on Hummers, BMWs, SUVs, boats, and Super-sized McMansions. The argument that the housing market is protected from a serious downturn by a cushion of home equity appreciation seems highly questionable under the circumstances.
This spending is psychologically fueled by the Wealth Effect: appreciation on the value of long-term assets (stocks, bonds, and houses) whose values have risen inversely to the steady drop in long-term interest rates since 1982 makes US households feel richer, and thus freer to spend large sums of money on big ticket luxury items. Over fifty years of persistent (post-WWII) U.S. asset price inflation has inspired a folklore that the path to riches is to buy long-term assets and hold on, buying the dips if prices ever drop, since prices always go up over the long term. Few Americans seem to recognize that the deflation in asset prices which has occurred recently in Japan and historically in the 1930s and earlier periods in the US could ever recur.
Gone is the incentive to work hard and save money for the future, replaced by the realization that by borrowing or buying assets and holding on, we can all live in McMansions and share in the bounty created by the mass entry of cheap but highly skilled Asian labor to the global marketplace. With a critical mass of believers adopting this view, risk premiums on long-term assets have sunk to the point where yields are extremely low by historical standards. Only a continuation of high rates of capital gains fueled by steadily declining long-term interest rates could allow this trend to continue. But with soaring oil and gold prices screaming out of the headlines, and burgeoning levels of household, municipal, state, federal, and trade debt, what reasonable person can believe that inflation fears might not come out of hibernation soon?
Surging commodity prices against the backdrop of high debt levels place our government economic policy makers in a difficult position. Should they choose the politically unpopular course of higher taxes and lower spending over the temptation of whittling down the debt by sneaking in slightly higher future inflation rate which could eat away the debt through the magic of negative exponential growth? Casual empiricism leads some of us to wonder whether official inflation statistics might be somehow hiding inflation which is already underway, given steep increases in the costs of shelter and fuel which are large components of household consumption expenditures. If global debt markets catch even a whiff of higher inflation, they could punish the US bond market with higher interest rates as the inflation risk premium on long-term assets reverts to historical norms, bringing down the housing and stock markets in the process. Under a status quo continuation of the low rate conundrum, the US might retain low long-term interest rates at the risk of drowning under the weight of its future debt obligations.
The housing market is inherently inefficient, and the equilibrium adjustment process is glacially slow -- a far cry from the instantaneous equilibrium adjustment to new information envisioned by Efficient Market theorists. Your average US residential home buyer has neither the financial sophistication nor the long-term perspective on financial history necessary to weigh various conflicting opinions about whether a speculative mania has taken over the US housing market. Although even top officials at the Fed claim to be unable to answer this question except in retrospect, Alan Greenspan has become increasingly supportive of a precautious approach, and has repeatedly attempted in recent months to alert the public to the risks they face with progressively dire scenarios for the worst case which may ensue. The last time CA real estate hit a trough of affordability anywhere near as bad as the current one (1989), it took over six years for the Southern California market to bottom out. As valuations are much farther out of line with fundamentals this time around, it is hard to predict how long the correction will last, except to say that historically, larger bubbles have led to longer periods of correction. Only after this correction is well underway will the housing bubble truly become common knowledge.
