Looking at Other Countries' Bubbles

America does not find itself alone in a housing bubble, a number of other first-world nations around the globe are also caught up in the midst of a real estate bubble, many of which pre-dated America's bubble. The chart to the right, from the Economist article The Global Housing Boom - It Comes in Waves, shows how real estate prices have swelled in a number of countries over the past couple of years - clearly the United States is not alone.

Two previously hot real estate markets - Australia and England - have been cooling down as of late, with prices in some areas stagnating and in others dropping. Can the U.S. look at these countries as examples as to what may lie ahead state-side? In the article, Britain May Offer Clues to Direction of Housing Prices, author Shelley Emling writes:

What will happen when America's housing bubble can't expand any more? For answers, homeowners and buyers might look to Britain. Housing prices here have risen 165 percent over the past decade, making it one of several countries in Europe and elsewhere that have outstripped even the soaring U.S. market.

In recent months, however, those prices have been stagnant or even dropping. Some studies show that the housing market may be overvalued by as much as 25 percent in Britain and that it can take eight weeks or longer to sell a property here. Some real estate experts warn that Britain could be among the first dominoes to drop in a global collapse in property prices.

Many point to Australia, where the once-booming property market has been in the doldrums for the past 18 months or so. In Sydney, the average house price has fallen about 15 percent since the end of 2003, according to the Commonwealth Bank of Australia.

A lot of people - those working in the real estate world, it seems - dismiss the likelihood of a price drop. Rather, they expect to see prices merely stagnate or grow slowly. "It would take a recession," many will argue, "to cause house prices to drop." This argument has some merit. Classically, house prices are more resistant to price drops as compared to, say, the equity market, because there is considerable effort and time and money involved in offloading a house. Furthermore, real estate often doubles as one's home, and people do need a place to live so even if prices start to turn sour, home owners will be reluctant to sell unless they must move for a job or cannot afford their mortgage payments anymore. The aforementioned Economist article, however, argues that while classically housing prices are slow to drop, there is a greater chance with this global housing boom will cause a precipitous drop in prices:

The rapid house-price inflation of recent years is clearly unsustainable, yet most economists in most countries (even in Britain and Australia, where prices are already falling) still cling to the hope that house prices will flatten rather than collapse. It is true that, unlike share prices, house prices tend to be somewhat “sticky” downwards. People have to live somewhere and owners are loth to accept a capital loss. As long as they can afford their mortgage payments, they will stay put until conditions improve. The snag is that eventually some owners have to sell—because of relocation, or job loss—and they will be forced to accept lower prices.

Indeed, a drop in nominal prices is today more likely than after previous booms for three reasons: homes are more overvalued; inflation is much lower; and many more people have been buying houses as an investment. If house prices stop rising or start to fall, owner-occupiers will largely stay put, but over-exposed investors are more likely to sell, especially if rents do not cover their interest payments. House prices will not collapse overnight like stockmarkets—a slow puncture is more likely. But over the next five years, several countries are likely to experience price falls of 20% or more.

And while house prices are still climbing here in the US, many countries world-wide are seeing a much greater slowdown in pricing increases, some quickly reaching a point of total stagnation (as the graph below illustrates).

The Smart Consumer Rents

In a previous blog entry, You'd Be Smarter to Rent, I looked at the startling rise of the average monthly mortgage costs to the average monthly rent. With such a disproportion between rents and housing prices, the person who's "out of the market" would be wise to stay there, and continue to rent. More proof of this can be found in a recent SFGate article:

"The average monthly rent for a one-bedroom apartment in the San Francisco-Oakland-Fremont metropolitan area was $1,070 for the three months that ended June 30, up 3.3 percent from the same period a year ago and up $14 from the first quarter, according to Novato research firm RealFacts, which tracks large rental properties. The average monthly rent for any type of apartment in the nine counties hit $1,290 in the second quarter, up 1.1 percent from last year.

...

While rents have stagnated or risen only slightly, the median price for a single-family home in the Bay Area vaulted 18 percent in June from the same month last year, hitting $644,000, research firm DataQuick said this week. The company also said the typical mortgage payment for Bay Area buyers in June was $2,651."

And with housing prices poised to, at best, stagnate, but more likely decline, buying now is an even less attractive option. The smart money doesn't buy at the top of the market. I'm no financial genius, but I know that the worst time to buy is when everyone else is wanting to buy; instead, the smart money buys when everyone else wants to sell. With the rapid growth in the real estate market over the last 5-10 years, it's a bit hard to believe that we'll ever get back to a point in time where everyone wants to sell, but markets are cyclical and what goes up must come down.

More great commentary from the same SFGate article:

"Ed Leamer, an economist at UCLA's Anderson Forecast, has illustrated the discrepancy between rents and median sale prices by calculating a price/earnings ratio for real estate.

The ratio, which is more frequently applied to stocks, shows how much investors are willing to pay for a dollar of earnings. With stocks, one divides a company's share price by its annual earnings per share to arrive at the ratio. In housing, the price of the home is divided by the annual rent it could bring in.

The higher the ratio, the stronger the fervor for that particular type of asset. Last year, Leamer calculated, the P/E for a house in the Bay Area soared to 13.8 in the first quarter, compared with 7.2 in 1999 and 2000. Just as the price/earnings ratio for stocks jumped before the stock market crashed, Leamer and others worry this could signal that housing values are overinflated and due for a slowdown."

And I leave you with an 1875 depiction of economic bubbles, Currier & Ives's The Way to Grow Poor, The Way to Grow Rich (found via the blog post Quite a Salesman, Indeed over at Ben Jones's The Housing Bubble blog):

The Percentage of People Who Can Afford a Median Priced Home...

One common term/statistic many articles on the real estate market tend to throw around is this: "In insert location, only insert number percent of the population can afford a median priced home." In this recent article, San Diego not included in "treacherous housing markets" list, we find the quote: "The percentage of San Diego's residents able to afford a median-priced home dropped to 9 percent in May." What does this number tell us?

The median price is the price at which half of the homes cost less and half of the homes cost more. But what does this "median price" reflect? The median price of all homes in a particular market (i.e., San Diego), or the median price of homes that have been sold in a particular market? And what does "afford" mean? I assume that it takes the average person and reasons that they can afford a house payment of a 30-year fixed mortgage that is, say, no more than 33% of their monthly gross. Of course there are many "non-standard" mortgages, from interest-only choices to option ARMs.

Assume for a minute, though, that "affordability" is defined as what a given family really can buy, even given some of these whacky mortage vehicles, and that the "median price" is the median price of homes sold. Then it follows that the top 9% of San Diego's wealthy are involved in at least the majority of real estate transactions. Since the wealthy are typically financially wiser than the non-wealthy and would shudder at buying at the top of any market, I imagine this isn't the case, which means my assumptions on "affordability" and/or "median price" are incorrect.

What I fathom is that "affordability" is defined against a 30-year fixed mortgage benchmark and some predetermined percentage of the average person's monthly gross income. So, while only 9% of San Diegans may be able to afford a home here, people are simply buying what they cannot afford, stretching themselves too thin in order to "get into the market." Anyone who has been around the block more than once knows that virtually anytime you choose short-term gain with long-term pain over short-term pain with long-term gain you're going to end up losing. What's going to happen when those variable mortgage rates start rising? Or when you lose your job or have a financial emergency and cannot make those mortgage payments you're already stretching to make? And what if this happens after the bubble has burst, and your home is worth significantly less than what it was when you bought it?

Bloggin' 'bout the Bubble

There's an interesting article in the LA Times this week that made the front page on the business section: Bloggers Talk About the 'Bubble.' The article talks primarily about Ben Jones' very popular housing bubble blog, http://thehousingbubble2.blogspot.com/, which was the first housing bubble blog I started reading. It's a great resource because Ben adds links to various articles around the Web almost daily, if not several a day, and attracts so many readers that there are typically several dozen comments with each blog entry. Too, many of the entries center around the San Diego real estate market, which is of particular interest to me, although there are article links to housing bubbles all around the world.

It's interesting to read how Ben Jones got started blogging about the housing bubble. From the LA Times article:

A self-described "economic activist," Jones, 41, sees his mission as chronicling a seminal financial event, something future scholars can turn to just as historians today would read an anthology of letters written by Dutch tulip traders in the 1630s.

"In 100 years, economists may be studying the comments of this blog because this was a real-time skeptics' log in the middle of a financial mania," said Jones, who rents a house with his wife in Sedona, Ariz., and doesn't own any real estate.

The housing market today "is just like the tech bubble," said Jones, who holds economics and business degrees from Midwestern State University in Wichita Falls, Texas. "That's why it's a mania — because people have forgotten the fundamentals." Not wanting his family and friends to forget ... Jones started sending mass e-mails last fall with links to media reports and other housing market information along with his pointed observations. When the e-mailing duties became too onerous, he created the website to simplify the process.

You can subscribe to Ben's blog at http://thehousingbubble2.blogspot.com/atom.xml.

Looking Back at San Diego's Last Housing Bubble

For anyone who lived in Southern California during the early 90s, you know first hand what a housing bubble can look like. During the 80s real estate prices in Southern California flourished, but with the shaky economy in the early 90s and the reduction in defense spending thereby leading to closures of many bases and defense contractors in LA and San Diego, prices plummited. In San Diego, certain neighborhoods saw price decreases of over 36% from the late 80s highs to the mid-90s lows.

A recent article at the San Diego Union Tribune, Previous Bubble Burst May Provide Clues, examines the real estate downturn in the 90s. The article, sadly, doesn't provide any insight into the current bubble, but rather looks back in history 15 years, enumerating the causes of the last real estate bubble and the resulting outcome.

The last bubble was precipitated in part by jobs moving out of the area, and in many articles I've read the 'experts' have said that a bubble bursting is unlikely now in SoCal thanks to a strong economy with a growing job base. However, I wonder if the market could still take a hit even in today's economy solely because of the speculative buying with these silly 'no money down' loans such as the Option ARM. The Federal Reserve has even sounded the alarm on risky loan vehicles, like the Option ARM and Interest-Only Loan. From Feds No Longer Dismiss Talk of Housing Bubble:

In May, the Fed and four other regulatory agencies issued an unusual joint statement, warning that financial institutions "may not be fully recognizing the risk" inherent in aggressive lending secured by rapidly rising home values. ... Regulators are working on additional guidelines for non-traditional loans issued by primary mortgage lenders, a spokesman for the Federal Deposit Insurance Corp. said. The proliferation of interest-only, "negative amortization" and various hybrid loan products is capturing the attention of regulators because they rely heavily on rapidly increasing home values and appeal to buyers who otherwise would not be able to afford a home. Because borrowers who get these loans pay no principal — and often put little or no money down — they easily could find themselves "underwater" if home prices decline, meaning they owe the bank more than the home is worth.

One has to look no further than the San Diego skyline to see building after building of condos being erected. I read that over a third of new downtown condo purchases were being done speculatively: with little or no money down for the purpose of investing, armed with the knowledge that the rent these places can ask is drawfed by the mortgage / property / HOA fees costs. What happens to these people and to these properties when the bubble does burst? And what will that do to prices in general in the market here in SoCal?

Interesting questions that will be, I'm afraid, answered soon enough.

Option ARMs Scare Me

Is it just me or is anyone else scared by the financial mishaps option ARMs seem to encourage? An option ARM is an adjustable rate mortgage that is dubbed as being "flexible" because the borrower has the "option" as to how much he or she wants to pay in a given month. In essence, you can opt to pay less than the minimum interest payments that would be due in a given month. This, of course, pushed the debt burden forward. Just like with minimum payments on a credit card, with an option ARM you could end up taking decades longer to pay down your house, increasing the total owed.

Do option ARMs ever make sense? For that matter, do interest-only loans ever make sense? I love how realtors/lenders interviewed always make comments about how the interest-only products (and option ARMs) are well-suited for certain people - salesmen who get paid on commission, investors who need to have finer control over monthly cash flow... Hrm, maybe these are the types of people who these products are designed for, but then why did more than 40% of the home purchases last year use interest-only loans? I can't fathom that the country's salesmen are buying up the marketplace so that means either a marked increase in investors purchasing properties (intelligent choice, guys - hey, the top of the market has been reached, let's buy now!!) or people who shouldn't be using interest-only loans are taking out interest-only loans in droves. Not only shouldn't these people be taking interest-only loans, but it's a poor financial decision to boot if you plan on living in your purchased home for any significant amount of time. Why in the world would you get an interest-only loan that reamitorizes every month when long-term interest rates are at historic lows!? Wouldn't this be the time to get a 15- or 30-year fixed loan?

Regardless, people using these techniques are significantly increasing their risk. What happens if a job loss occurs, or medical bills pile up? And if such large percentages of home buyers are taking this level of risk, that puts a good chunk of the housing market at a risk level that's far from prudent.

Bubbles and Recursive Definitions

Determining if an economic bubble has happened in the past - such as the dot com bubble of the late 90s - is easy enough: simply examine the emperical data and you should find an unrealistic swelling followed by a sudden 'burst,' a dramatic drop-off in the economic vehicle's valuation. But how do you tell if you are currently in a bubble? Sure, you can point to past data, such as the vast swells in home prices, and say, "Ah-ha! This irrational rise in prices is proof enough that we are in a bubble," but how can you know for certain?

One thing neat about bubbles is that defining if you are in the midst of one can only be done rescursively. That is, one metric for determining if you are living through a bubble is... if people are talking about whether such a bubble exists or not. I don't think it really matters how the "we're in a bubble" vs. "we're not in a bubble" numbers work out - if there's sufficient discussion in the marketplace about the potential of a bubble, there's probably already one.

This sentiment was expressed more eloquently in The Wichita Eagle's Is It a Housing Bubble? Act as If It Was article, where the author wrote:

Ocean sailors have a rule about reducing sail when the wind picks up: "If you wonder whether it's time to reef, you already should have." Sure, the wind might ease, but calling it wrong can be fatal. Which brings us to the current debate about whether we're in a housing bubble: If you think we might be, better act as if we are. As I said in a recent column, if we could identify bubbles for sure, they'd never form. Surely, though, one sign of a bubble is that more and more people start debating whether one exists -- and these days, it's near impossible to pick up a financial publication that doesn't have a bubble story.

The article also includes some good data on rising home prices, definitely worth reading.

A Little Extreme, But a Good Read

Recently stumbled upon this article over at TheTrumpet.com (a religious publication from the Philadelphia Church of God): The Housing Bubble: Everybody's Talking. The article makes some great points but goes a bit overboard on the consequences. The article does a good job stressing some of the signs of a bubble:

"In California, interest-only loans accounted for 61 percent of new home mortgages in January and February—compared to less than 2 percent in 2002! A conventional 30-year fixed-rate mortgage for a median-priced home is out of reach for 82 percent of California households, even though interest rates remain very low by historical standards."

They also bring up some great points on the effect the housing bubble has had on the economy: "Since 2001, a whopping 43 percent of all net private sector jobs created have been in housing-related industries! Today, more than 60 percent of bank assets are tied to mortgages." Eep, that's some scary data. If the current state of the economy is tied as closely to the real estate market, as this article suggests, it makes one trepid as to what will happen to our national economy as well as the global economy when housing prices being their inevitible trek back down.

Armed with this information, the article's author argues that the housing bubble's bursting will spell hard financial times. "Prepare now to reduce your standard of living," the author warns at the article's end. To me that sounds a bit preachy and over the top, but then again I'm not one who's extended his standard of living based on the equity in his home. Such dire warnings may, indeed, ring true for those who have placed too much trust that the current trends will continue unabated.

Would it take a burst to impact the economy? No, says Merrill Lynch - even a slow down could spell trouble for the economy. From Even With No Bubble, Housing Could Be Trouble:

“The reality is, you do not need home prices to go down – all you need is for housing prices to stop going up,” said David Rosenberg, chief North American economist for Merrill Lynch. He calculates a flattening of housing prices could trim U.S. economic growth, currently running about 3.5 percent a year, by a full percentage point.

Rosenberg
Rosenberg figures that over the past five years rising home values have added $4 trillion to the nation’s net worth, or 70 percent of the total rise in household wealth in that time frame. That “wealth effect” probably has translated to about $50 billion in additional consumer spending a year, adding half-a-percentage point to growth every year.

“A lot of the economy’s fortunes hinge on the housing market, and yet it doesn’t look like it’s all that stable to me,” Rosenberg said. “The last leg has been fueled by a mountain of leverage and a lot of speculation.”

Feds Continue to Raise Rates

The Feds continued with their planned quarter point short-term interest rate rise, raising the short-term interest rate to 3.25% yesterday. One of the reason, many argue, that housing prices have seen such a sharp increase over the past several years was due to the fact that we've been enjoying the lowest interest rates in history. With borrowing money being so cheap, many folks have been able to afford more house or refinance, pulling equity out of their current home and, perhaps, actually lowering their monthly debt burden while doing it.

However, with the continued rise in rates, the gravy days of the past few years will soon be history, and such a rise in interest rates will make homes more 'expensive' since it will cost more to borrow the same amount. Of course, the short-term interest rate doesn't directly effect long-term interest rates, as evidenced by the past few months which have seen fixed-rate mortgages sink to the lowest rates in years. However, adjustable-rate mortgages are more closely aligned with short-term interest rates, and the Fed's increases in these rates may put pressure on those who were able to buy more house than they could afford using an ARM.

From an MSN Money article, How High Will the Fed Go?, there's the following foreboding omen for those who overextended themselves and used an ARM (emphasis mine):

"Rates on ARMs are primarily tied to short-term indexes, such as LIBOR, the one-year Treasury or the 11th District Cost of Funds. As the Fed boosts short-term interest rates, ARMs are far more sensitive after the fact than fixed-rate mortgages. For borrowers facing rate adjustments, the relevant comparison is the current level of the underlying index, plus the loan's margin, vs. the initial start rate. As short-term interest rates rise, this contrast will expand and lead to some unpleasant rate adjustments for borrowers who took out ARMs at record-low interest rates. Consider a one-year ARM taken out in June 2004 when the prevailing national average was 4.4%. Now facing the first rate adjustment, with the one-year Treasury yield currently 3.37% and a loan margin of 2.5%, the rate could jump to 5.87%. For a buyer who borrowed $200,000 one year ago, the monthly payment increases by $176. Further interest rate increases mean the borrower is likely to face another increase next year. ... It is important for borrowers using ARMs to consider the impact on their monthly payments once the interest rate adjustments begin."

Another way to finish that paragraph: Remember when you asked the piper to play you a tune? Well, he's done now, and you need to pay him.

Could we see an uptick in motivated sellers and even foreclosures over the next several years as the Fed continues to bump up the short-term interest rate and those who bought property with ARMs quickly find that the new, increased monthly debt burden is more than they can handle? And could this be the catalyst for the housing bubble to pop?