In the first post of this series, The Coming Bear, I looked at interest rates and explained why I think they are heading higher. With that in mind let’s take a look at the housing market which has been the engine of growth for the economy in recent years — I will discuss how important the housing boom was on the economy in Part 3 of this series.
The Creation of the Housing Bubble
Many contend that the housing bubble was inflated due to the Federal Reserve lowering the funds rate from 6.5% in January 2001 to 1% in June 2003 — a level not seen since 1958 which was maintained until June 2004 when rates were hiked. This pressured mortgage rates to fall to levels not seen in fifty years.
Even during the Fed’s subsequent hiking campaign, mortgage rates continued to decline — most likely due to the Chinese and Japanese purchasing hundreds of billions of dollars worth of bonds which completely offset the Fed’s efforts to cool down the mortgage market. It should also be noted that real mortgage rates have continued to fall recently even though nominal rates have started increasing due to inflation concerns.
The fall of the Nadaq by 70% during 2000-01 also helped the housing sector since it caused many tech investors to shift their funds and trading mentality to real estate which they considered to be a risk-free investment. According to Robert Shiller:
Once stocks fell, real estate became the primary outlet for the speculative frenzy that the stock market had unleashed. Where else could plungers apply their newly acquired trading talents? The materialistic display of the big house also has become a salve to bruised egos of disappointed stock investors. These days, the only thing that comes close to real estate as a national obsession is poker.
Another factor that propelled the housing bubble was the deterioration of mortgage lending standards. According to the RealEstateJournal:
Investment banks and other firms have been buying mortgage loans from lenders and packaging them into securities for sale to investors since the 1980s. But investor demand has surged in recent years, largely because in an era of low returns, mortgage-backed securities offer yield-starved investors much higher returns than government bonds.
Investors’ strong demand for mortgage debt, besides allowing lenders to offer many borrowers better terms, has also made it easier to offer mortgages to borrowers who might not easily qualify for a loan. The growth of the mortgage markets spreads the risks around. But some mortgage-industry analysts say lenders have become less stringent in their loan terms because they can sell almost any type of loan to those who package mortgage securities for investors.
“Loose lending standards are probably the single biggest thing fueling the speculative fever we have today” in housing, says Kenneth Rosen, an economist who is chairman of the Fisher Center for Real Estate at the University of California at Berkeley.
The buyers of these mortgage-backed securities include hedge funds — who use the “carry trade” to borrow at low rates — and Asians, specifically the Chinese and the Japanese — who seek to diversify their foreign reserves away from Treasuries.
Proof that increased demand for mortgage-backed securities are leading to a loosening of lending standards can be seen in the growth of “exotic” mortgages such as interest-only loans.
Why the Housing Bubble is Unsustainable?
It is unlikely that Americans can continue buying houses at the same pace. First, house prices have risen too much for most people to afford. The NAR’s latest housing affordability index level of 102.8 is at a 15-year low.
Second, rental vacancy rates hit record levels in 2004 causing rents to fall relative to home prices. This has made renting more attractive to potential homebuyers.
Third, interest rates are likely to increase due to reduction in bond purchases from China and Japan. As a by-product, the decrease in demand for mortgage-backed securities will cause lenders to tighten their lending standards.
The Bubble Has Already Popped
Recent data suggests that the party is over in the housing sector. Over the last 12 months, housing starts were down 13.3%, existing-home sales were down 11.2% , median home prices were up only 0.9% (down in real terms), 30-year mortgage rates were at 6.52% up from 5.70%, and housing inventory levels are up 3.2% in July from June’s levels which represents a 7.3 month supply at the current sales pace.
How Much Will Prices Fall?
Until the mid-nineties home prices hardly ever increased in real-terms. Robert Shiller estimates that house prices in America rose by an annual average of only 0.4% in real terms between 1890 and 2004. But since 1995 it has increased by 50%. Therefore, over time mean reversion suggests that real prices should fall by around 50%.
Looking at the price-to-rent ratio for homes — which is a similar valuation metric as the price-to-earning ratio used for equities — indicates that the ratio is about 50% higher than its long-term average. Most likely in the future we will see both an increase in rents and a decrease in prices.
My own expectation is for home prices to fall by around 50% in real-terms over the next 5-10 years. Prices should fall more on the coasts where homes benefited more from the bubble. Since markets tend to oscillate between being overvalued and undervalued, I expect the upcoming real estate bear market to produce some terrific deals. I personally plan to keep my powder dry until then in order to buy a nice beachfront property that will probably still be selling at today’s prices.
To get a sense of how uncommon my expectations are for the housing market, I need to look no further than Wall Street economists. The WSJ’s economics forecasting survey for August showed that economists on average are expecting housing prices to increase by 4.87% in 2006 and 1.82% in 2007.
I think the economists are overly optimistic — my own forecast is for nominal house prices to increase by no more than 2% this year and drop in 2007. That is, real prices will fall this year and continue falling for the rest of this decade.