|
|||
The Real Estate BubbleCraig Harris This article is part of a series of questions and answers. To catch up on questions already answered please refer to my archives. In this essay I'm attempting to answer question number 8. Question 8: What's going to happen with the much talked about real estate bubble? First of all I need to cover some background on how we have arrived at the present situation according to me. Prior to 911, the financial markets were already in trouble as the biggest stock market bubble in history was in the midst of a collapse. Post 911 the FED and Financial Engineers faced a potentially catastrophic systemic deflationary collapse and they knew it. In the January 25-26 meeting minutes, they indicate they considered a variety of "unconventional emergency measures" including the purchase of US stocks. I believe that most if not all of these "emergency measures" were taken and furthermore I believe these "emergency measures" are still in effect. In Japan the government is very open about open market purchases of equities...and I think the US is doing the same thing, it just isn't discussed in public. In order to ward off the collapse, one other thing out of the many that are being done was to lower interest rates to rock bottom levels and for the US government to start borrowing more on the short end to depress long term interest rates even further. In conjunction with that, the system was flooded with liquidity (a lot of money was printed). So at that point, we had mortgage rates spiraling lower, banks itching to lend some of that freshly printed money, and a real estate boom waiting to happen. The public at that point was very disenchanted with the share market, and they took the bait. There were very strong incentives to either refinance your current mortgage debt to reduce your monthly payments, buy a new home with interest rates approaching 40 year lows, or take out a second mortgage and go deeper into debt to obtain cash to spend now. All desirable outcomes for the FED to prevent the deflationary collapse and stabilize the financial system. The banks became healthier as a result because they borrow at rates near zero and lend much higher rates. The public became less healthy, further increasing an already heavy debt burden. The banksbeing flooded with money, began to relax their lending criteria because they wanted to make loans. They also relaxed their restrictions on debt to equity ratios. Appraisers were encouraged to appraise high enough to get the loan done which accelerated the inflation in prices. People were encouraged not only to refinance but to be creative...use an interest only loan or other creative loan if you can't afford the payments...take equity out of the home in the form of a bigger mortgage or a second mortgage....get an artificially high appraisal and finance the down payment.go out and spend some borrowed money to prop up the economy. Remember all of those post 911 urgings from even the President himself to go out shopping? These urgings were a short term fix for a longer term systemic problem. All of this created a supply demand imbalance in the housing sector. People were buying or wanted to buy homes at a rate greater than available supply. Both new construction and existing homes sold at a rapid clip. Home prices to soared in most areas. So, in a nutshell that's how we got to the point where we are today. If I had to summarize it in a short sentence I would say THE CURRENT HOUSING BUBBLE WAS ENGINEERED AS PART OF A PLAN TO SAVE THE FINANCIAL SYSTEM IN A POST 911 ENVIRONMENT...and it has worked pretty well, except when you consider that the public is now deeper in debt and less healthy as a result of this engineering, and home prices are considerably higher. Essentially what has happened is that there was a sort of stealth transfer of net worth from the public to the banks to help save the system. The public took on the risk, went further into debt, spent a lot of money....and the banks new properties have appreciated substantially. Score one for the Financial Engineers. But where do we go from here?....that's the hard part. First of all I have to lay some more groundwork. One of the reasons home prices have skyrocketed is that interest rates have plummeted. In some cases, the monthly payment for a 30 year fixed rate mortgage has remained relatively constant. In other words, interest rates went down, prices went up, payments stayed the same. It's important to recognize that among the masses, the monthly payment is the focus. Can I make the monthly payment? If you are like most people, you've probably looked at it that way yourself. I certainly know many people that look at the equation that way. In other words, the price they are paying for the home is not the focus...it's the monthly payment. The next important piece of groundwork is the stealth inflation. Although not captured in the CPI, the cost of construction is going through the roof. Furthermore the price of raw land has also been skyrocketing in many areas. So, I think it's time to lay out the things I think I know...I guess in Rumspeak they would be called known knowns? 1.) with the relaxation of lending criteria, there is a higher level of risk in those loans (ie a higher risk to the lender of foreclosure) also with the relaxations, there is a higher debt to equity ratio, and even assuming the high prices remain high, there is a higher incentive for the mortgage holder to walk away if unable to make the payments. If the prices were to decrease, many people would find they have negative equity and the incentive to walk away would be even stronger. 2.) although real estate prices have risen dramatically, the cost of construction has also increased dramatically 3.) mortgage rates aren't likely to go much lower than they already are because they have already just been to 40 year lows 4.) If interest rates were to rise substantially, some people with adjustable rate loans would find it difficult to pay and the rate of default would increase 5.) some of the risk of a systemic system collapse has been transferred from the banks to the public as a result of this financially engineered real estate bubble. They created the money and lent it to you, you spent the money to prop up the economy, and now they own the real property and you're on the hook to pay them back an inflated price for that property....they gave you a better rate but you paid more for the property which they now own until you pay them back. 6.) It is undeniable that the real estate sector is either overpriced or that legitimate inflation has pushed up prices at an astonishing rate. Prices in my area for example have appreciated on the order of 50-100% in some areas in the past several years. When you look at it this way, it's not good. We either have a huge bubble or have had a seriously inflationary bout that was not captured in the governments statistics. Neither explanation argues well for the future. So here's how I see the situation going forward. First of all, you can't answer the question of what's going to happen by looking at this in a vacuum. The real estate bubble was created by external forces and what happens going forward depends on what happens with these external forces. Look at the real estate bubble as a boat being tossed around by the wind and tide. One of the main factors is this. The price of real estate will not go below the cost of construction for any sustained length of time. That is...the cost of the builder for land, labor and the raw materials. Another factor is interest rates. If interest rates were to rise, this would exert downward pressure on prices. A final factor is the financial position of the buyers. If the buyers become less able to afford the real estate, demand goes down and this also exerts downward pressure on prices. So I think it's fairly easy to argue that there are substantial risks on the downside for prices 1.) rising interest rates The main risk on the upside is increasing labor and raw materials costs due to inflation. If you look at component prices for steel, concrete, copper, lumber, etc, these prices have risen very substantially in the past year. The laborers and craftsmen that build the homes are facing higher costs of living themselves...they will argue for higher wages. If I had to pick the most important factor in determining the fate of the real estate bubble, it would be interest rates. If interest rates rise, I expect real estate prices to come down. If interest rates stay the same and the monetary base continues to expand at a high rate I expect the bubble to continue. If we have a stagflationary environment, which is the environment I think we're in, I could see prices continuing to spiral higher for some time. If we do have some kind of financial catastrophe, and there are still no guarantees we won't... "I can't deny the possibility that the whole system might collapse. " -Alan Greenspan speaking in Berlin Jan 13, 2004 then all bets are off but it could argue for sharply lower prices like when real estate prices in Hong Kong, Japan or Malaysia collapsed. I think that for most people, the thing about real estate is that it's also the place you live. In other words, even if prices were to go down and interest rates go up, if you've got a fixed rate loan (and a job) and you're happy with your home it's not a catastrophe if prices were to decline 10, or even 20%. The only meaningful difference in your life would be that your paper net worth declined and you might feel less wealthy and therefore spend less. If there was a decline of more than 20%, then a lot of people would have negative equity, which could set off a wave of people walking away which could have a very depressing effect on prices (the snowball effect). Real estate speculation however is another story. If some of the downside risks emerge and we get a snowball effect, real estate speculators, especially ones with variable rate loans, could be in serious trouble. I haven't given any definitive answers here, because I don't have one. When answering this question I think it's important to put it in the context of the reality of most consumers, which is "what should I do regarding real estate?". The first thing that I think is important to consider is that over the very long term, real estate has arguably been the best investment and inflation hedge that most people ever make. As the world population continues to grow, they aren't making any more land. That's a supply demand chart of static supply and increasing demand. What makes sense to me is to buy a home that you can afford, lock in a low rate for 30 years so you can sleep at night, and don't borrow against the increase in the paper value of the home that may or may not be real in the long term. If you do that, so long as you have a job I think you'd be unlikely to have a real estate related problem. I think the people that could get into trouble down the line are people that are investing and speculating in real estate...which is not their primary residence....especially ones using creative financing and variable rate loans, and people who are mortgaged to the hilt against inflated prices that could come down. Owning a home and having negative equity is not a desirable situation because economically the incentive is to walk away. I also think that the lenders could be at risk if not properly hedged. Think about all the 30 year fixed rate loans that have been issued over the past several years at very low rates. If interest rates were to rise substantially, your lender could be in trouble. That argues a strong incentive for the financial engineers to not allow rates to rise, because if they do the risk to the banking sector and especially entities like Freddie and Fannie increases. One last thought on real estate relating to the "war on terror". . The Vice President of the United States has made the statement.... "I think that the prospects
of a future [terrorist] attack on the U.S. are almost a certainty."
- Vice-President Dick Cheney, speaking on Fox News, 2002-05-19 So, if you believe the booga booga...the location of your real estate holdings are going to be important too. "Almost a certainty" is a fairly vague term, but If I said that, I'd be talking a probability on the order of 98%. If you then consider the possibility of a radiological device at even 10%, that gives a probability of (.1*.98=9.8%) which brings it into the realm of probability that could merit consideration. The value of uninhabitable real estate contaminated for 200 years with radiation is what? Close to zero I'd say; and you can't live there either. Check your insurance...an act of war or terrorism probably isn't covered. So be choosy about your location unless you think Dick is full of it. Personally, I'm relatively risk averse....and I think the danger of terrorism based on the prosecution of the "war on terror" so far has increased because the US has made more enemies, inflamed existing ones, and created more potential terrorists since 911. I'm not talking about moving to Montana, but I'd stay away from DC, Manhattan and Chicago if I had a choice and at least 60 miles from a reactor. Craig Harris Mr Harris offers a free 30 day trial subscription to his daily market letter. For a free trial please contact bcharris@gate.net. The risk of trading commodity futures contracts can be substantial. You should therefore, carefully consider whether such trading is suitable for you in light of your circumstances and financial resources. If you choose to open an account with Harris Capital Management, a Risk Disclosure will be sent to you. Please read it carefully before you invest. ### Harris Capital Management, Inc. CTA is a futures broker and registered Commodity Trading Advisor, meeting the needs of futures traders worldwide. They provide a high level of personal service to discriminating clients around the world, while offering commission rates comparable to discount brokers. All clients are handled directly by Mr. Harris. Copyright ©1995-2004
Harris Capital Management Inc. All Rights Reserved. |
