Quick Comment
August 20, 2002

Yes.  It's a housing bubble.

Debate rages today about whether or not a housing bubble exists in the U.S.  The fact that there is even any controversy about the bubble's existence testifies to the power of the forces of misinformation and proves that the long habit of wishful thinking among the millions of victims of the so-called New Economy has yet to start to dissipate.  But we're used to that.  We recall the debate that we endured in the late 1990s on the existence of a bubble in stocks when iTulip.com first opened shop.  In those days, nearly everyone was in on the game of justifying the bubble.  Alan Greenspan said in testimony before the U.S. Congress Joint Economic Committee June 1999, "But bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong."  At the time, we dug up a similarly evasive statement by Professor Lawrence of Princeton University in September 1929 when he said, "[T]he consensus of judgment of millions whose valuations function on that admirable market... is that stocks are not at present over-valued.  Where is that group of men with the all-embracing wisdom which will entitle them to veto the judgment of this intelligent multitude?"  Today, Greenspan is in the no-bubble camp again, this time defending historically anomalous housing price appreciation with statements that are reminiscent of his defenses of stock valuations during the stock market bubble.  Who is the Fed to say that prices are too high?  Markets know best.

Fact is, housing bubbles, like stock market bubbles, are not at all hard to spot.  We grant that they are politically challenging to discuss in public, especially when they are needed to prevent the aftermath of a previous monetary disaster, the 1990s stock market bubble, from dragging the real economy into a deflationary depression.  Putting aside New Economy obfuscation, the measure of a stock market bubble is simple: prices rise much faster than future earnings possibly can.  A stock market bubble looks like this.

This is a stock market bubble

Hard to believe that anyone could have looked at a chart like the one above that was posted on iTulip.com March 2000, at the peak of the NASDAQ bubble, without seeing a bubble.  But most did not.  That's because when you are inside a bubble, pricing is normalized to bubble standards.  Bubbles are driven by their own internal logic.  Evidence that prices are reasonable are all around you. After all, are there not mobs of people who are willing to pay them?  In today's housing market, do hundreds of thousands of informed investors have it all wrong?

In a word, yes.  But how?

Bubbles often form out of legitimate bull markets.  They catch unwitting participants unexpectedly.  The U.S. stock market went from bull to bubble in 1995 without anyone ringing a bell alert investors that a change from investor's market to speculator's market had taken place.  In fact, a lot of interesting things started happening at the same time in 1995.

Foreign debt balooned...

The current account deficit balooned with it...

The personal savings rate suddenly went negative for the first time on record...

The stock market bubbled (see top of page).  Asset bubbles create economic and financial market imbalances, such as in the balance of trade, savings rates and household debt.  It doesn't take a genius to see a bubble in the extraordinary pictures above.  Nonetheless, it is apparently very hard to see a bubble if you are a central banker with an overpowering desire to be loved by Wall Street and Main Street and a religious belief in neo-liberal free-market theory.  Guess Greenspan never really got over the Ayn Rand stuff.

A real estate bubble has on at least one other occasion been a secondary effect of a collapsing stock market.  For example, the real estate bubble in Japan continued for about two years after the stock market crashed in 1990.  One likely reason Charles Kindleberger points out in his book Manias, Panics and Crashes, "When the stock market collapses, shareholders, especially those on margin, know they are in trouble.  Speculators in real estate initially feel no such compunction... They have real assets, not just paper claims."

Our ex-Fed contact tells us there is no housing bubble.  How does he know this?  "High housing prices are only occurring in certain markets on the east and west coasts."  "You mean," we responded, "where most people live?"  It's true that housing bubbles are regional phenomena, owing to the fact that no wife ever tells her husband, "Let's buy a house in America" but instead says, "Let's buy a house in the western suburbs of Boston around Lincon near my new job."  The fact that more than one regional housing bubble is going on in more than one place in the U.S. is telling.  Usually housing bubbles are concentrated in a single region of the country, such as northern California or Houson, Texas.  Now you can find prices showing bubbliness in the U.S., and most of Western Europe for that matter, just about anywhere near a shoreline or a body of water.

The list of rationalizations of recent residential real estate price increases usually carted out are as follows.

Low interest rates.  These have made homes seem more affordable, despite the increase in prices.

Tight supply.  The number of new homes for sale now is lower than it was at the Nasdaq's peak in March 2000.

Aggressive mortgage lending.  Lenders have loosened credit standards in recent years, allowing borrowers with relatively high levels of debt to get loans. Borrowers can also make much smaller down payments, in some cases as little as 3%, compared with the more customary 10% to 20% of years past.

Shift in investment strategies.  Many Americans, spooked by the stock market over the past year, appear to be shifting money into residential real estate. One indication is that average down payments have actually increased in the past two years, suggesting that many of the buyers are people with large sums of money that they previously would have put into the stock market. In June, according to Economy.com, the average down payment was $34,700, up from $30,500 last June and $28,700 in June 1999.

These factors beg the question, are home prices too high?  Phrased another way, are households purchasing homes they cannot afford?  To asnwer that question, let's first consider our society's relaxed view of debt in general.  Most home owners buy homes they cannot afford just as most car buyers now purchase cars that they cannot afford.  What's the definition of "cannot afford" when buying a car?

Purchasing an asset with debt makes sense when the value of that asset is likely to be higher at the end of the term of the loan than it was when the loan was taken out, that is, when the asset tends to appreciate.  This is the case with property, especially over the 15 to 30 year term of a mortgage.  The capital gain realized from the appreciation in the price of the property over the term of the loan should more than pay for the interest cost of the loan.  A car on the other hand is a depreciating asset because it is almost always worth less than the original purchase price when the time comes to sell it.  In fact a car depreciates around 20% immediately after it is purchased new.  Buying any depreciating asset with debt is simply a poor use of credit and bad household finance.  As with any depreciating asset, a car you can afford is the one you can pay for with cash.  But the practice of purchasing with debt a four wheeled depreciating asset or one with surround sound has become institutionalized.  The Fed even encourages this kind of behavior.  In a recent statement, Greenspan offered as a hopeful economic sign that households were using cash-out refis to pay down credit card debt.  Are we really supposed to believe this is a good thing?  If you use a credit card to buy a home entertainment system and then pay off the credit card with the cash you take out in a refi, you have in effect taken an asset that depreciates 80% in two years and put it on a 30 year mortgage.  Never mind that statistics show that more than half of the households that do this wind up building up their credit card balances again anyway.  In his next breath, Greenspan talks about the benefits of "financial literacy."  Hope he's not teaching the classes.

What's "cannot afford" mean when buying a home?  The historical average for the cost of a mortgage is 25% of gross income.  That's what the banks used to recommend, before they got desperate for households to sell mortgages to.  In bubbly real estate market like Boston's today the average mortgage has reached 44% of income.

That's a housing bubble.  Period.

Why is income growth rate versus price a valid measure of a housing bubble?  The out-of-whack relationship between income and price reveals the disconnect between price and risk in a housing market bubble the way the out-of-whack relationship between P/Es and price do in equity market bubbles.  An indication of the top of a bubble is a change in the tactics of sellers as they run out of buyers.  In the case of the stock market bubble, we saw the marketing of equity product in more and more rarefied packages, a mutual fund marketed to women, for example.  An example is Women's Equity Mutual Fund (FEMMX), a fund that's holding it's own well, by the way.  In the case of the housing bubble, the sellers are banks and mortgage companies.  When they start running out of mortgage buyers, they naturally start selling mortgages to more and more people who are less likely to pay them back.

Unlike Internet stocks, you don't own your house.  The bank owns your house until you pay off the mortgage.  While you're buying your house from the bank by paying off the loan, you get to live in the house.  Alternatively you can earn income from the house by renting it for a higher rate than the bank charges you to rent it from them, plus property management costs, to someone who isn't in a position to rent a house from a bank themselves.  Either way, it's not your house.  This fact is often lost on so-called "home owners" until one of three events happens.  The most rare of events is that they pay off the mortgage.  Then they truly become Home Owners.   A more frequent event occurs when they have to move for some reason -- for a new job, for example.  Let's say they have to do this after the real estate market has fallen.  Assume the resale price of "their" house is now 20% below the price they paid, a typical modest decline in a housing market downturn.  Now they're out part of their deposit and maybe some equity too and they're bummed out.  But they're not half as bummed out as the owners of homes purchased with 10% or less down, representing nearly 60% of all homes purchased in the past three years.   These folks will have to pay the bank another 10% or more than they got from selling the house just to pay off the mortgage.  In the past when groups of home owners with limited equity were faced with this situation they did not sell their homes at a loss and pay the bank off, too.  They dropped their keys off at the bank and said, Adios.

"...if the reason that the (housing) price is high today is only that the price will be high tomorrow - when "fundamental" factors do not seem to justify the price - then a bubble exists."  (Stiglitz, Joseph - Syposium on Bubbles 1990, 13)

Fannie Mae Foundation 1996 - Journal of Housing Research - Volume 7, Issue 2

Another event that occurs to remind "home owners" that they do not own their home happens when they lose their job and can't pay rent to the bank anymore.  They can try to reschedule the loan or they can default and lose their home and all their equity.  Now we finally get to why income to mortgage cost ratio is a measure of a housing bubble.  Typically banks try to minimize the risk of default by requiring that purchasers not buy a home that consumes more than 25% of gross income in mortgage payments and by requiring sufficient down payment, say 20%, to give the buyer an incentive to not walk away from the loan if the going gets tough.  But a couple of years ago banks ran out of people to sell loans to who met these obvious credit quality criteria.  The banks started to sell loans to people with next to no equity to offer and who had to pay so much of their gross income on a mortgage that the average rose to 44% of income from an historical average of 25%.  Both the "home owner" who is putting his or her credit and future income at risk and the bank that's putting its capital at risk don't apparently see much risk.  Instead the buyer sees a future of ever rising home prices and the bank sees a low risk, high profit loan.

They are both wrong, at least in the short term.

iTulip.com market bubble definition: A market is in a bubble when participants foresee ever rising prices even though prices are well above historic peak levels while at the same time foreseeing either minimal or declining risk even though risk is exploding.
The measure of a residential real estate market bubble then is simple: property prices rise much faster than incomes possibly can.  A real estate bubble looks like this:

This is a housing market bubble

Here are four residential real estate markets where property prices are rising between four and six times faster than incomes over the past year.  In Washington D.C., for example, property prices increased 20% while incomes increased 5%.   Housing prices rose in line with incomes until a few years ago but now are rising faster than incomes because the monthly payment on the average mortgage is falling because of mortgage rates are artificially low.  Just as artificially low interest rates fueled the stock market bubble, artificially low interest rates are fueling a real estate bubble.  The market went from an investors' market to a speculators' market and no one rang a bell this time, either.  We agree that rising residential real estate prices are caused by scarcity, but not the scarcity of housing relative to demand.  Housing prices are rising because of the scarcity of housing relative of the money supply.  Cheap credit is creating a housing bubble.

We're not alone blaming the Fed again, but among holders of this opinion we don't have much company in the U.S.  The Australian Financial Review said recently: "...critics of Dr. Alan Greenspan's Federal Reserve say it may be repeating its mistake of the late 1990s.  They blame the Fed for creating the speculative frenzy in tech stocks of 1996-2000 by keeping interest rates too low for too long, creating the stock market bubble that burst disastrously last year.  Now they fret that even as the economy recovers from the last bubble, another is forming in the price of housing - which has defied recession to grow by a national average of 20 per cent in two years."

"DEFLATION is a disquieting word and has been bandied about rather recklessly of late until in the process of constant reiteration it has assumed the form of a threatening bogey."

Financial World (June 26, 1929)

Will home prices collapse like dot com stocks once the era of cheap credit and low unemployment ends?  According to David Berson of Fannie Mae, "You have to go back to the Great Depression to find the last time that house prices in the US actually fell."  The Great Depression was the last deflationary event in U.S. history that caused a sustained loss in home prices nationally.  Home prices fell on average more than 80%.  Mr. Berson's statement offers little reassurance when you consider that in Japan residential real estate sells for around 40% of peak prices ten years after the real estate market collapsed there.  While the residential real estate market is essentially different in Japan, a recent statement by Bill Gross suggests that such a decline could happen here.  Gross runs what is now the largest actively managed mutual fund as of last week, succeeding Bob Stansky and his Fidelity Magellan. Pimco Total Return, a fixed-income fund, reached $61.2 billion in assets under management.  In an interview for the Boston Globe August 18, 2002, Gross said, ''The overarching force today is this potential for deflation, not only in the US but the global economy,'' he says. ''That's the danger.''

We have reason to believe the deflationary collapse Bill Gross fears will not come to pass.  What the Fed and Treasury seem to lack in common sense they make up for with a seemingly endless bag of tricks.  Recall the discontinuation of the 30 year bond a couple years ago, designed to limit the availability of long term government bonds in order to raise prices and supress yields to get mortgage rates down and a housing bubble going.  Clever.

What if that's the last great trick in the bag?  We may be in for a housing market collapse on a par with previous real estate bubble collapses, such as in Houston Texas when one million men, women, and children lost homes throughout Texas between 1985 and 1990.  Such a deflation of the residential real estate will mark the beginning of the second deflationary stage predicted by iTulip.com Ka-Poom Theory as competitive asset liquidation moves from businesses to households.  The high technology industry is already familiar with deflationary processes.  Assets of high tech start-up companies that sold for several billion dollars two years ago now sell for several million.  Commercial real estate that rented for $60 per square foot now rents for less than $10.  Where once prices reflected the expectation of unlimited future demand, now they reflect expected future demand near zero.  If you don't think this can happen to home prices, ask yourself this: In 1998 when iTulip.com predicted an average 87% decline in Internet stock prices, that forecast seemed utterly unintuitive to most readers.  We even though it was extreme.  Think back to that time and recall how it felt to be in it.  The market had been rising for so many years, a reasonable person might conclude that the prevailing conditions must be normal.  Then ask yourself, if iTulip.com is right that the housing market is a bubble about to collapse, what can the Fed do about it when short term interest rates are already at 30 year lows?  U.S. households aren't sitting on a few trillion dollars in savings like their counterparts were in Japan when their housing bubble popped, in fact they are sitting on piles of short term debt.

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If you want to learn more about the housing bubble and the likely effects of the aftermath of its eventual collapse, see Center for Economic and Policy Research paper The Run-Up in Home Prices:  Is It Real or Is It Another Bubble?, August 5, 2002.