Overcooking a recovery ripens a housing bubble
Housing market stimulus must be removed before house prices cross the threshold from recovery to new housing bubble.
[dfads params=’groups=165&limit=1′]Asset prices exhibit normal values established by historically tested and conceptual sound valuation metrics. When asset prices differ from their normal values, either overvalued or undervalued, the market value of these assets generally reverts to the mean over time and reestablishes an equilibrium price at levels determined by fundamentals. The key characteristic of an asset bubble is an extremely overvalued condition ripe for a major decline. If analysts correctly identify and quantify the fundamentals, asset bubbles can be identified in advance of the price collapse; however, opinions differ on the soundness of even the most tried and true methods of valuation, and during a financial mania, people knowingly ignore sound valuation metrics and participate in a financial mania. Animal spirits rule.
Many conjecture the United States may again be showing the signs of another bubble in housing. Mark Hanson and Nobel prize winner Robert Shiller warn of housing bubble, and I recently noted troubling evidence of a new Coastal California housing bubble; however, based on my analysis of current market pricing relative to historic norms, the bubble simply isn’t there — at least not yet. (See: OCHN Housing Market Update: Is OC forming a bubble?)
Carefully examine the chart below. Note the orange line which represents the historic norm relative to rents in Orange County, CA. The period from 1993 to 1999 shows little or no deviation from this fundamental value. The bookend housing bubbles of the early 90s and 00s is apparent, and apparent also is the overshoot to the downside from 2010 through 2013. But if you look at where we are today, the market is fairly valued; yes, it’s expensive, but relative to rent, the market is right where it should be.
The stimulants that prompted the strong recovery rally back to fundamental value are slowly removed; the federal reserve tapers the interest rate stimulus through quantitative easing; the institutional buying wanes due to high prices; and more supply trickles on the market as loanowners emerge from under their debts — these factors, particularly the removal of the interest rate stimulus, slows the momentum of the market. If it doesn’t slow down, if house prices rise as quickly this year as they did last year, if stimulants are allowed to overcook the recovery, lenders could ripen another rancid housing bubble.
The blunt instrument of market stimulants
The tools available to politicians, bureaucrats, and bankers to reflate the housing bubble lack precision; market manipulators apply stimulus to all markets equally, not only to those in need. The strength or weakness of various housing markets differ, and stimulus succeeds most where it’s needed least. The chart below illustrates how this plays out.
One recent attempt to reign the stimulus effect comes from Washington Bureaucrats: FHA lowers the boom on Coastal California housing markets. The FHA lowered the conforming loan limit without advance warning, no trial balloons floated in the press. Interestingly — and probably not coincidentally — the areas most effected are those where house prices have recovered the most.
I am usually cynical about the competence and motives of bankers and bureaucrats; however, the recent fed taper and the FHA lowering the loan limits appear to be reasonable measures taken to avoid inflating a new housing bubble. I hope it works; others have their doubts.
WASHINGTON — IN November, housing starts were up 23 percent, and there was cheering all around. But the crowd would quiet down if it realized that another housing bubble had begun to grow.
Almost everyone understands that the 2007-8 financial crisis was precipitated by the collapse of a huge housing bubble. The Obama administration’s remedy of choice was the Dodd-Frank Act. It is the most restrictive financial regulation since the Great Depression — but it won’t prevent another housing bubble.
I believe it will (See: New mortgage regulations will prevent future housing bubbles)
Housing bubbles are measured by comparing current prices to a reliable index of housing prices. Fortunately, we have one. The United States Bureau of Labor Statistics has been keeping track of the costs of renting a residence since at least 1983; its index shows a steady rise of about 3 percent a year over this 30-year period. This is as it should be; other things being equal, rentals should track the inflation rate. Home prices should do the same. If prices rise much above the rental rate, families theoretically would begin to rent, not buy.
Housing bubbles, then, become visible — and can legitimately be called bubbles — when housing prices diverge significantly from rents.
I completely agree with the reasoning here; in fact, it’s the basis of my housing market reports.
In 1997, housing prices began to diverge substantially from rental costs. Between 1997 and 2002, the average compound rate of growth in housing prices was 6 percent, exceeding the average compound growth rate in rentals of 3.34 percent. …
Today, after the financial crisis, the recession and the slow recovery, the bubble is beginning to grow again. Between 2011 and the third quarter of 2013, housing prices grew by 5.83 percent, again exceeding the increase in rental costs, which was 2 percent.
Many commentators will attribute this phenomenon to the Fed’s low interest rates. Maybe so; maybe not. …
Both this bubble and the last one were caused by the government’s housing policies, which made it possible for many people to purchase homes with very little or no money down. …
To make mortgages affordable for low-income borrowers, Fannie and Freddie reduced the down payments on mortgages they would acquire. By 1994, Fannie was accepting down payments of 3 percent and, by 2000, mortgages with zero-down payments. Although these lenient standards were intended to help low-income and minority borrowers, they couldn’t be confined to those buyers. Even buyers who could afford down payments of 10 to 20 percent were attracted to mortgages with 3 percent or zero down. By 2006, the National Association of Realtors reported that 45 percent of first-time buyers put down no money. The leverage in that case is infinite.
This drove up housing prices. Buying a home became preferable to renting. A low or nonexistent down payment meant that families could borrow more and still remain within the monthly payment they could afford, especially if it was accompanied — as it often was — by an interest-only loan or a 30-year loan that amortized slowly. In effect, then, borrowing was constrained only by appraisals, which were ratcheted upward by the exclusive use of comparables in setting housing values.
Today, the same forces are operating.
The Federal Housing Administration is requiring down payments of just 3.5 percent. Fannie and Freddie are requiring a mere 5 percent. According to the American Enterprise Institute’s National Mortgage Risk Index data set for Oct. 2013, about half of those getting mortgages to buy homes — not to refinance — put 5 percent or less down.
When anyone suggests that down payments should be raised to the once traditional 10 or 20 percent, the outcry in Congress and from brokers and homebuilders is deafening.
They claim that people will not be able to buy homes. What they really mean is that people won’t be able to buy expensive homes. When down payments were 10 to 20 percent before 1992, the homeownership rate was a steady 64 percent — slightly below where it is today — and the housing market was not frothy. People simply bought less expensive homes.
If we expect to prevent the next crisis, we have to prevent the next bubble, and we will never do that without eliminating leverage where it counts: among home buyers.
Lenders simply can’t afford the implications of lower home prices and less leveraged home buyers. The creation of leverage is a one-way street. If lenders overdo it — which they clearly did during the housing bubble — the federal reserve will intervene to prevent deflation by lowering interest rates and quantitative easing if necessary. If house prices were allowed to remain low — and affordable — then our banking industry would eventually need to write off hundreds of billions of dollars in bad debt secured by houses that never get back above water. Since that would bankrupt our entire banking system, everyone involved conspires to reflate the old bubble to the degree they can. Let’s hope they don’t inflate a new bubble in their efforts to remediate the last one.
23201 VIA GUADIX Mission Viejo, CA 92691
$479,900 …….. Asking Price
$224,500 ………. Purchase Price
2/4/1999 ………. Purchase Date
$255,400 ………. Gross Gain (Loss)
($38,392) ………… Commissions and Costs at 8%
$217,008 ………. Net Gain (Loss)
113.8% ………. Gross Percent Change
96.7% ………. Net Percent Change
5.1% ………… Annual Appreciation
Cost of Home Ownership
$479,900 …….. Asking Price
$16,797 ………… 3.5% Down FHA Financing
4.54% …………. Mortgage Interest Rate
30 ……………… Number of Years
$463,104 …….. Mortgage
$135,808 ………. Income Requirement
$2,357 ………… Monthly Mortgage Payment
$416 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$100 ………… Homeowners Insurance at 0.25%
$521 ………… Private Mortgage Insurance
$114 ………… Homeowners Association Fees
$3,508 ………. Monthly Cash Outlays
($609) ………. Tax Savings
($605) ………. Principal Amortization
$28 ………….. Opportunity Cost of Down Payment
$80 ………….. Maintenance and Replacement Reserves
$2,403 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$6,299 ………… Furnishing and Move-In Costs at 1% + $1,500
$6,299 ………… Closing Costs at 1% + $1,500
$4,631 ………… Interest Points at 1%
$16,797 ………… Down Payment
$34,026 ………. Total Cash Costs
$36,800 ………. Emergency Cash Reserves
$70,826 ………. Total Savings Needed