Housing: Too Good to Be True
Signs of a "new era" in housing are everywhere. Housing construction is taking place at record rates. New records for real estate prices are being set across the country, especially on the east and west coasts. Booming home prices and record low interest rates are allowing homeowners to refinance their mortgages, "extract equity" to increase their spending, and lower their monthly payment! As one loan officer explained to me: "It's almost too good to be true."
In fact, it is too good to be true. What the prophets of the new housing paradigm don't discuss is that real estate markets have experienced similar cycles in the past and that periods described as new paradigms are often followed by periods of distress in real estate markets, including foreclosure sales, bankruptcy and bank failures.
The case of Japan's real estate bubble is instructive. Japan had a stock market bubble in the 1980s that was very similar to the U.S. stock market bubble in the 1990s. As the Japanese stock market started to bust, the real estate market continued to bubble. One general index of Japanese real estate shows that prices rose for almost two years after the stock market crashed with prices staying above pre-crash levels for more than five years. The boom in home construction continued for nearly six years after the stock market crash. Prices for commercial, industrial, and residential real estate in Japan continue to fall and are now below the levels measured in 1985 when these statistics were first collected.
It has now been three years since the U.S. stock market crash. Greenspan has indicated that interest rates could soon reverse their course, while longer-term interest rates have already moved higher. Higher interest rates should trigger a reversal in the housing market and expose the fallacies of the new paradigm, including how the housing boom has helped cover up increases in price inflation. Unfortunately, this exposure will hurt homeowners and the larger problem could hit the American taxpayer, who could be forced to bailout the banks and government-sponsored mortgage guarantors who have encouraged irresponsible lending practices.
Once again, Fed Chairman Alan Greenspan has created a new-age economic panacea, and earlier this year he applauded his contribution to the economic recovery: "very low interest rates and reduced taxes, have permitted relatively robust advances in residential construction and household expenditures. Indeed, residential construction activity moved up steadily over the year."
The key to this panacea is the process of "equity extraction" that occurs when people refinance their homes; they take equity out and spend it to increase their standard of living. However, because variable rate mortgages are so low, their payments actually go down so they have more of their income to spend, or they can upgrade to a more expensive house. As Greenspan explained:
Other consumer outlays, financed partly by the large extraction of built-up equity in homes, have continued to trend up. Most equity extraction—reflecting the realized capital gains on home sales—usually occurs as a consequence of house turnover. But during the past year, an almost equal amount reflected the debt-financed cash-outs associated with an unprecedented surge in mortgage refinancings.
As is the norm, Greenspan hedges his statements. He also considers some of the potential drawbacks and pitfalls on the horizon for the new paradigm in housing, but in the end he concludes that we really have nothing to worry about. Low interest rates, rising home prices, and lower financing costs mean that we actually can have our cake (homes) and eat it too (equity extraction).
To be sure, the mortgage debt of homeowners relative to their income is high by historical norms. But as a consequence of low interest rates, the servicing requirement for the mortgage debt of homeowners relative to the corresponding disposable income of that group is well below the high levels of the early 1990s. Moreover, owing to continued large gains in residential real estate values, equity in homes has continued to rise despite sizable debt-financed extractions. Adding in the fixed costs associated with other financial obligations, such as rental payments of tenants, consumer installment credit, and auto leases, the total servicing costs faced by households relative to their incomes are below previous peaks and do not appear to be a significant cause for concern at this time.
The Housing Bubble
I first reported on the housing bubble in the U.S. at the beginning of this year when the bubble was already well under way, if not in full bloom. As the chart below indicates, real residential investment has jumped far above both its historical trend and even above its cyclical channel. This indicates to me that there is a bubble in residential real estate. The data for this chart stop at the beginning of 2003. We now know that investment in housing increased by 8.8% last year. This is a historically high rate of construction, but far from a record rate increase. However, 2003 marks the ninth year in a row that housing investment was positive, the first time that has ever occurred since the statistic has been collected. Frank Shostak and Christopher Mayer have also written very informative articles on the Housing bubble.
Recently I came across a piece of anecdotal evidence of a housing bubble. Last Sunday afternoon, a friend of mine put a "For Sale by Owner" sign in the front lawn of a small house he owned on a side street. It wasn't listed with a real estate agent or in the newspaper, but he nonetheless had a couple of calls that afternoon, with many more to follow, and within a couple of days he had multiple offers before finally accepting a bid that was over his original asking price.
Mainstream economists who discount the possibility of a housing bubble would dismiss such evidence. But they also ignore all the macro evidence of the current housing boom and see it as a positive development. For example, the number of new homes being constructed is at an all-time high, despite a "soft" labor market. In the graph below, the annualized rate of new home construction is shown to have surpassed the two surges of the 1970s when inflation was out of control.
The prices of houses are also up, but mainstream economists have generally ignored this development as well; and as noted above, Greenspan sees this as a positive development. Some economists can even point to the Consumer Price Index which shows that the housing component in the CPI is steady or falling. And yet reports are coming out nearly every day saying that housing prices are up dramatically and setting records all across the country. Record prices have been recently reported in the San Francisco Bay Area, Denver, Boston, Las Vegas, the state of Washington, and even Buffalo, New York.
Nationally, the price of a median family home was up 15% between 2001 and 2003, with regional increases of 30% in the Northeast, 8.5% in the Midwest, 14.4% in the Southeast, and 20.4% in the West. Over the last year, increases have been reported as 18.7% in the Northeast, 1.9% in the Midwest, 3.8% in the Southeast, and 10.7% in the West, or 6.5% for the nation as a whole. Interestingly, the median price has actually dropped 7.2% in the Midwest and 7.3% in the South since peaking in the 3rd quarter of 2003, while prices have been generally flat in the West. Statistics from the last couple of quarters might therefore suggest that the housing bubble may have topped out, or at least temporarily cooled down, in most of the country.
Why have home prices been increasing? David Lereah, chief economist with the National Association of Realtors, explained: "It's a simple matter of supply and demand…We continue to have more home buyers than sellers in most of the country, which results in tight housing inventories and higher rates of home price appreciation." Of course the cause of higher home prices is that the Federal Reserve has kept interest rates, and thus mortgage rates, at historically low rates so that people find it easier to finance homes. In fact, despite an 18% increase in home prices since 2001, the median monthly payment remained the same at $789/month and the "median payment as a percentage of income" has actually fallen. This is the magic of monetary inflation, courtesy of Alan Greenspan.
Price inflation follows monetary inflation
The price of just about everything I buy is going up these days. Gasoline is higher, dairy products are higher, paper products and just about everything else—higher. Mainstream economists have sounded surprised by the recent upturn in price inflation and they have offered us every excuse to ignore signs of inflation: Ignore rising oil prices. Ignore rising food prices. Ignore rising health care costs. Ignore higher taxes and government fees. And then there is their dirty little secret about housing prices.
Higher price inflation should not have been a surprise given that the Fed has increased the money supply by 25% during the period 2001–2003. In addition, the price of basic commodities has been rising for many months and these higher commodity prices eventually turn up in the price of goods and services. One leading indicator of higher commodity prices is the Dow Jones Commodity Index (stock prices of major commodity producers). It has been rising since the fourth quarter of 2001 and has doubled in value since that time. This stock index is now higher than it has ever been, outside of the blip that occurred in mid-2002.
Only recently have commodity prices begun influencing government price indexes like the Producer Price Index and the Consumer Price Index. For the first four months of 2004 CPI-inflation increased at an annual rate of 4%, which is a higher rate than we have "experienced" in the last few years. The Producer Price Index actually decreased in 2001, but has increased in 2002 and 2003. Over the last year, prices for finished producer goods increased 3.7% while at earlier stages of production the prices for intermediate goods increased by 5.1% and the prices of crude materials index surged 20.4%. This would suggest that there is plenty of price inflation still in the pipeline. The experience of the 1970s would suggest that price inflation adds fuel to housing bubbles because tangible assets like homes serve as a hedge against inflation.
The Dirty Secret
While this price inflation did not surprise me, the delay in its arrival did. That is, until I came across the dirty little secret in the CPI. With prices increasing all around us, there is one thing in Auburn, Alabama that seems to be in abundance with stable, if not declining prices. This "good" is now being advertised on most streets throughout the town, whereas in the past it did not require much, if any, advertising over the twenty-plus years I have lived in this college town. This abundant good is apartments and rental houses.
It is a truly odd market when houses and apartments move in opposite directions. After all, houses and apartments are just different products in the same "market for housing." In Auburn, it is nearly impossible to find the kind of house you want to buy despite frantic building by construction companies, and yet rental properties (which include many smaller houses) seem to be readily available in all shapes and sizes. Has the population changed? Have people become anti-rent? Or are we just in a "new housing paradigm"? Is this a "new era" of homes?
Greenspan's low interest rates have driven renters to become homeowners and knocked the market out of equilibrium. Underneath this Fed-inspired distortion rests the dirty little secret of how the cost of housing has served to limit increases in measured inflation. The Consumer Price Index has underreported price inflation because the government uses the rental value of housing, rather the actual price of houses, in their index.
In the basket of goods used to calculate CPI, the goods that have increased slower than housing include food and beverages, recreation, and education, which total to about a 30% weighting of the CPI basket of goods. Housing accounts for 42% of the basket, with housing "prices" representing almost 25% of the entire basket. However, housing prices are calculated with "Owner's equivalent rent" which is an estimate of the rent that people would have to pay for their houses. With home prices rising and rental rates stagnant, CPI underestimates the real rate of price inflation over the last year by about 50%.
Do Housing Bubbles Burst?
Housing prices never, or rarely, go down. That is the conventional wisdom and the conventional wisdom is correct. Housing is always a good investment, isn't it? It's an inflation hedge and it's an investment that you get to use everyday, plus you get a great tax break. And the home, after all, is a big part of the American dream.
However, government can screw up just about everything. Given enough power and time it will screw up everything. Housing and real estate in America is just the latest example. The Federal Reserve and the Mac-May family (Freddie, Fannie, Sallie, etc.) have conspired to create a housing bubble in the U.S. and as the old saying goes, "what goes up must come down." It's only a matter of time.
Housing bubbles typically do not pop like a balloon; they don't even crash like stock markets. Rather, the air in housing bubbles tends to leak out slowly—painfully slowly—while in commercial real estate markets there is a more noticeable hiss. We really don't know the current value of our homes until we sell them. They are not traded on a daily basis, like shares of stock in Wal-Mart. Some never get exchanged in the market, but are passed on within a family from generation to generation. The market value of a home may drop 20% and the owner might never realize it.
Worse yet, when the market for real estate collapses, prices are less likely to collapse because when buyers fail to make offers houses simply don't sell. Sellers often resist cutting their prices in favor of just leaving the house on the market or taking it off the market. Traditionally the market adjustment to a collapse in real estate markets has come from the quantity side, not the price side—fewer houses are sold—while price reductions tend to come gradually. This doesn't mean that housing bubbles can't exist or that the bust is any less painful, only that it doesn't make as much noise.
It is difficult to predict how long bubbles will last and when they will go bust. The best indicator is interest rates, because when the Fed forces rates down it tends to create bubbles, and when rates are forced upward bubbles tend to pop. My guess is that Greenspan will raise rates after the election. The rates of interest on long-term bonds have already "spiked" up from their historical lows. The chart below shows the recent increase in the interest rate on 10-Year Treasury bonds to the highest levels in almost two years.
Prior to this spike up, interest rates had been falling since the early 1980s. As mentioned above, lower rates have coaxed people into refinancing their homes and drawing equity out of their homes to spend on other purchases, like cars, boats, renovations, vacations, or even investments in the stock market. As a result, owner equity as a percentage of real estate value is now at an all-time low.
Here is the unmentioned problem with Greenspan's panacea. What happens to all these "equity poor" homeowners if the return of monetary inflation establishes a new trend of higher prices and higher interest rates over the coming years?
An ever-increasing proportion of mortgage financing has come in the form of variable-rate mortgages, where the payment increases as interest rates increase. In my experience, variable-rate mortgages come with a "cap" that only allows the variable rate to increase by a certain amount. Even with the cap, however, your mortgage payment could increase by around 50%. I have recently learned that many variable-rate loans are now offered without a cap. If rates were to explode upward, mortgage payments for these folks could double or triple. And if this did happen, the housing market would collapse with sellers swamping buyers.
Given the government's encouragement of lax lending practices, home prices could crash, bankruptcies would increase, and financial companies, including the government-sponsored mortgage companies, might require another taxpayer bailout.
Of course inflation might not materialize. Interest rates could stay low. In a recent column, I reported on a new book that even predicts that deflation will reign in our financial future. Greenspan has suggested that his economic panacea has given American homeowners greater economic "flexibility." I would suggest that it is not flexibility he offers, but the shackles to an economic nightmare. Stick with the fixed-rate mortgages, keep the equity in your homes, or go get one of those cheap apartments.
Mark Thornton [send him mail] is an economist who lives in Auburn, Alabama. He is author of The Economics of Prohibition, is a senior fellow with the Ludwig von Mises Institute, and is the Book Review Editor for the Quarterly Journal of Austrian Economics. He is co-author of Tariffs, Blockades, and Inflation: The Economics of the Civil War. Comment on this article on the economics blog.