Barrons piece on rising housing prices.
April 15th, 2002
Home Groan
Rising housing prices have kept the economy afloat. What happens if the bubble bursts?
By Jonathan R. Laing
The U.S. economy has become a street of broken dreams. Capital spending on
technology and telecommunications collapsed last year, sending the nation into
recession. The Nasdaq Composite seems permanently mired in a trading range
below 2000, more than 60% beneath its vertiginous peak above 5000 just two
years ago. Stock investors have suffered mightily.
Yet there's one investment area that is still booming, even after a year of
recession. And that's residential real estate, the very bedrock of the American
Dream.
Since 1995, helped by modest interest rates, median home prices across the
country have jumped nearly 40%, according to the National Association of
Realtors. The increases are materially higher in some cities, such as Boston, where
home prices have jumped 96%; San Francisco, up 83%; San Diego, up 74%;
Denver, up 70%; and the New York Metro area, which has risen 56%.
Nor does the housing boom show any
signs of flagging even with the current
economic slowdown, a volatile stock
market and the trauma of September's
terrorist attacks. Sales of both existing
and new housing established records last
year of 5.3 million and 909,000 units,
respectively. The most recent NAR data
showed that February's sales of existing
homes rose 11.6%, on an annualized
basis, to 5.9 million, with year-over-year
price gains of 8.2%.
These price jumps might not seem that
great when stacked up against the stock-market boom of the late 'Nineties. But
make no mistake, the residential realty market is showing sure signs of a bubble
psychology:
• Avid homebuyers have a sense of urgency: Buy now or risk having to pay more
later.
• Huge mortgage obligations don't matter when future investment gains are
perceived as a sure thing.
• Leverage is seen as an enhancement to eventual return rather than a liability.
Throw in that mortgage interest is tax-deductible, and it's no wonder that
homeowners who sell at fat profits invariably roll their gains into fancier new
properties rather than take money off the table. This despite the fact that the first
$500,000 in gains is tax-free.
Real estate seems a lot better deal than today's lackluster stock market or
low-yielding fixed-income vehicles. As a consequence, inventory levels of unsold
new and used houses now stand at near-record-low levels of around four months
of supply.
As Federal Reserve Chairman Alan
Greenspan has pointed out, the
red-hot real-estate market has done
much to make the current recession one of the mildest on record. Torrid
new-home sales have added hundreds of thousands of new jobs to U.S. payrolls,
and homebuilding stocks, such as KB Home, Centex and Pulte Homes, trade at or
near their 52-week highs. Likewise, sales of new appliances, furniture, carpeting
and other home furnishings have soared as a result of all the new and used house
sales. And the stocks of appliance makers Whirlpool and Maytag and
building-materials and home-furnishing retailers like Home Depot and Lowe's are
similarly at or near their 52-week highs in recent weeks.
But even more important to the economy, the strong appreciation in
owner-occupied home prices has kept consumer spending surprisingly strong
during the recession. Over the past two years, home-price growth alone has added
nearly $2 trillion in wealth to U.S. households' balance sheets -- not a trivial
amount in a $10 trillion economy. Homeowners were able to tap some of this new
wealth by means of home-equity loans and "cash-out" refinancings. Last year's
epic $1.2 trillion of mortgage refinancings not only saved Americans an estimated
$15 billion or so in annual debt service, but also allowed folks to take out an
additional $80 billion from their homes over and above the old mortgages they paid
off. In addition, the untapped equity makes Americans feel wealthier and therefore
willing to incur more debt and spend more than they might otherwise do because
of what economists call the wealth effect.
In fact, a recent academic study by economists Karl Case, John Quigley and
Robert Shiller of consumer-spending behavior in the U.S. and 13 other developed
nations indicates that the wealth effect from housing is twice as great on
consumer spending as comparable changes in stock-market wealth. In the U.S.,
for example, the academics found that a 10% gain in housing prices would
provoke an average 0.62% increase in consumption, while a similar jump in
stock-market wealth only elicited about a 0.3% to 0.2% increase in spending.
The study's data ended in 1999. Yet consumer spending, which has remained
relatively stable since then despite a slowing economy and a serious decline in the
stock market, seems to confirm the report's findings. The aforementioned $2
trillion rise in real-estate wealth between the first quarter of 2000 and the fourth
quarter of 2001, to $12 trillion, was seemingly more than enough to counter the
headwind of a $3.9 trillion decline in household stock-market investments, to $8.8
trillion, over the same period.
Co-author and Yale economist Bob Shiller, most celebrated for his early 2000
book Irrational Exuberance, which correctly predicted the bursting of the stock-
market bubble, offers a number of tentative theories to explain the anomalies
between real-estate-related and stock-appreciation-related wealth effects. He
theorizes that only a smattering of generally affluent Americans have large equity
portfolios, while home-ownership rates are high throughout the developed world.
Unlike the wealthy, the middle class is far more likely to be influenced in its
spending habits by major changes in net worth.
Likewise, says Shiller, real-estate wealth is easier to get at through home-equity
loans and cash-out refinancings than much stock-market wealth that's locked
away in retirement accounts. "It's astonishing the number of ads one sees today
inviting people to take equity out of the home for a fancy vacation and the like,"
marvels Shiller.
The outsized impact of housing prices on consumer spending makes the health of
the housing market of crucial importance to the economy. Any serious dip in
home prices could abort the U.S.'s fledgling economic recovery and perhaps
trigger a second leg in the recession. Fed Chairman Greenspan has worried in
recent testimony that housing this time around may not contribute as much zip as
usual to the recovery. And some experts have even theorized that homeowners
experiencing realized or unrealized capital losses on their properties cut back
consumption more than they boost spending as result of a commensurate capital
gain. This is known in the trade as asymmetric response.
Many observers, while conceding the unusual strength in home prices since 1995,
dispute that the housing market is a bubble about to burst. David Berson, chief
economist of the mortgage-giant Fannie Mae, thinks stronger- than-expected
population growth bolstered by strong immigration, combined with subdued
inflation and affordable mortgage rates will continue to push housing prices up by
5% to 6.5% a year. And Morgan Stanley's chief U.S. economist, Richard Berner,
wrote in a recent report: "There's little chance, in my opinion, for a crash in home
prices nationwide. Unlike the past, there's little overhang of supply of either new
or existing homes and a collapse in demand under the circumstances seems
unlikely…so the bears on the U.S. economy are just going to have to find
other reasons to doubt the staying power of the current recovery."
These opinions ignore a simple economic fact, however. For housing prices to
continue rising, either incomes are going to have to move up at an unrealistic rate,
or interest rates are going to have to fall sharply. Because ultimately, home prices
can only rise as fast as people's ability to pay for them.
Ingo Winzer, editor of Local Market Monitor in Wellesley, Mass., tracks the
changing relationships nationally and locally of per capita income to housing
prices. And he thinks home prices are headed for a fall. "There's a big weakening
coming in home real estate," he asserts. "We'll see slightly higher prices this
spring, and that's going to be it on the upside for a long time. I see more
overpricing in home prices now than existed in the early 'Nineties."
In particular, he sees trouble ahead for such cities as Boston, San Diego, Fort
Lauderdale, Detroit and Oakland.
By the same measure, he thinks that home prices in Syracuse, Hartford, Austin,
Dallas and Charlotte are underpriced.
Other observers offer harsher views. Ian Morris, chief U.S. economist of HSBC
Securities in New York, contends that if the economy makes a strong recovery in
the second half of the year, then rising mortgage rates would be sufficient to "pop
the housing market" by deterring new buyers and increasing the debt-service
burdens of existing homeowners. In a controversial recent report, "The U.S. Real
Estate Cycle, The Other Bubble?," Morris maintains that falling housing prices
could administer the coup de grâce to fragile consumer confidence, in effect
creating a negative wealth effect and blighting any incipient recovery.
Alternatively, says Morris, any prolonging
of the current recession would likely push
unemployment rates high enough to crimp
income growth and cause home prices to
fall. About the only way out of a
housing-price trap would be to have a
sluggish recovery in which interest rates
would continue to slide and employment
stabilize. Then already-low mortgage rates
would continue to decline, encouraging
both sales and refinancings. In this
scenario, housing prices would continue
to rise to increasingly unsustainable levels
until economic recovery and higher
mortgage rates finally burst the bubble.
Determining the tipping point for any market is tough at best, as anyone who
watched the Nasdaq grow increasingly overvalued in the late 1990s can attest. But
Morris, thinks the sign of a top is clear, based on a sort of price-to-earnings ratio
that he has developed for home prices. The analyst has constructed a chart that
traces the ratio of real-estate wealth to disposable personal income over the past
50 years. And these days, he notes, the ratio of residential real estate to disposable
personal income is 1.62, the highest level ever.
Morris's ratio is based on the Federal Reserve's estimate of $12 trillion value for
individually-owned residential real estate and $7.4 trillion in annual disposable
personal income. And today's ratio recently ticked up above its previous high of
1.59, achieved in 1989, at the height of the 'Eighties property bubble.
While the median price for existing homes has never fallen nationwide on a
nominal basis during the post-World War II era, prices after that 1989 peak did
decline on an inflation-adjusted basis for the next five years. The carnage in many
inflated local markets was even more pronounced. Boston and San Francisco saw
a decline of some 17% (before inflation) and Los Angeles and Hartford dipped
27% and 23%, respectively. Prices in those cities took eight to eleven years to
bounce back to their late-'Eighties peaks.
High-valuation levels aren't the only reason that residential real estate is
vulnerable. Homeowners' balance sheets have never been more engorged with
mortgage debt. Down-payment requirements steadily dropped during the 'Nineties,
providing far less of an equity cushion. Today, the 20% down payment has all the
quaintness of Ozzie and Harriet and Hula Hoops. According to a U.S. Census
Report, over 50% of all mortgages in 1999 had down payments of 10% or less,
compared with 7% in 1989. Sometimes, new homebuyers can borrow to pay the
closing costs in 103% loan-to-value special mortgages. Sub-prime lenders at times
even make 125% loans just to consolidate credit-card and auto debt into one loan
package. The second mortgages give sub-prime lenders the hammer of additional
liens on a borrower's property and effectively take away his option to refinance at
lower interest rates.
Three great tidal waves of refinancings during the 'Nineties also pushed U.S.
mortgage debt higher, as homeowners have increasingly used cash-out
refinancings to suck additional equity out of their homes. According to figures
from Fannie Mae, Americans took $80 billion in equity out of their homes last
year, compared with $50 billion and $28 billion, respectively, in 1998 and 1993 --
the previous refinancing peaks. Meanwhile, home-equity loans jumped to more
than $630 billion in 2000 from $289 billion in 1995. Increasingly, borrowers pay
interest but don't bother paying down principal on their home-equity balances.
A few statistics highlight the huge buildup of mortgage debt. Twenty years ago,
annual consumer-debt payments -- basically mortgages, credit cards and auto
loans -- stood at around 60% of disposable personal income. That ratio has since
risen steadily to slightly above 100% of personal income in the fourth quarter of
last year, according to the latest Fed data. At $5.6 trillion, mortgage-debt accounts
for the lion's share of total household debt of $7.7 trillion.
As a consequence of this mortgage-debt buildup, homeowners' equity, or market
value in homes in excess of debt, has sunk to just under 55% of total residential
real-estate worth from over 70% in the mid-'Eighties. At the end of World War II,
homeowners' equity stood at 85%. Consumer debt-service payments as a
percentage of disposable personable income likewise stand at the high end of the
20-year range of payments-to-income of between 12% and 14%.
Housing bulls draw some solace from the latter two statistics. After all, Americans
collectively still have more than 50% of home equity to borrow against. And
debt-service payments of 14% of annual income hardly seem a backbreaking
burden.
Yet these arguments ignore several salient facts. First, over 35% of all American
homeowners have no mortgage debt at all. As a result, it's estimated that
homeowners with mortgages are, on average, in hock to the tune of around 65%
of the value of their homes. The burden is effectively over 70% when one factors
in the real-estate commissions and other closing costs the indebted homeowner
would face in the event of a voluntary or involuntary liquidation.
In other words, most American homeowners have little margin of safety should
home prices stop levitating or, heaven forbid, actually decline. According to the
latest available census data, of the 38.6 million homeowners with one or more
mortgages, two million, or more than 5%, had no equity or negative equity while
another 2.6 million, or the next 7% of mortgage holders, had less than 10% equity.
What's more, the Fed's computation of the consumer's debt-service burden
assumes that borrowers only make minimum monthly payments on their credit
cards, which is the figure that typically appears at the left hand side of the top
portion of the bill. Currently around 2.5% of the monthly balance, the minimum
payment involves practically no paydown of principal balances.
Any significant jump in interest rates
would significantly hurt many debt-ridden
homeowners. Interest rates are variable
on over half of all credit-card accounts.
Adjustable-rate mortgages that re-price in
one- to- five years account for an
estimated 15% of all outstanding
mortgages. The more than $630 billion in
home-equity-line loans have floating rates.
To be sure, many and perhaps most
American homeowners have a sufficient
financial cushion to meet most
contingencies. Yet the market prices for
homes could still be hurt by the debt
problems of that distinct minority living on the edge, particularly in an environment
of rising interest rates or continuing job losses. Falling home prices would, in turn,
cut off many of the equity cash-out junkies from their fixes.
Already, trouble seems to be brewing at the lower end of the housing food chain.
Delinquencies on Federal Housing Administration mortgages have soared to an
epic 11%, the highest level by far in the 30 years that the data have been gathered.
The FHA guarantees mortgages for many low-income, first-time homeowners.
Also the sub-prime mortgage market, catering to borrowers with poor credit
histories, has seen a significant jump in its 90-day-plus delinquencies and
foreclosure rates to 7.11% and 4.43% respectively, according to
LoanPerformance, a San Francisco mortgage-information service that tracks both
prime and sub-prime debt. The above numbers compare to delinquency and
foreclosure numbers of just 3.83% and 2.52% in 1997.
One can argue that FHA and sub-prime loans represent only the low end of the
quality spectrum. Their clientele, largely blue-collar and vulnerable to bad
economic times, live in a world far removed from the more financially secure
prime-mortgage customers.
But it's hardly an obscure, insignificant precinct. FHA loans account for about
16% of the $5.6 trillion in U.S. mortgage debt currently outstanding, while the
sub-prime market comprises about 8% of the mortgage market.
What's more, the fate of affluent homeowners, ensconced in gated communities,
suburban mansions and fancy downtown pied-à-terres, is tied more closely to the
less fortunate than the well-to-do might realize. Without a healthy move-up market
in all price ranges, the residential real-estate market will eventually founder at all
levels. After all, whales ultimately depend on plankton for sustenance.
Yet other structural changes in ...
(see next post)
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