Barron's, Monday, April 15, 2002 Cover Story
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 the mortgage market could weigh on home prices in the months and years ahead, according to New York investment research boutique Graham Fisher. In a report issued last summer provocatively entitled "Housing in the New Millennium: A Home Without Equity Is Just a Rental With Debt," Graham Fisher's Josh Rosner delineates several disturbing trends. Perhaps most important, says Rosner, has been a decided easing in credit standards in the mortgage market, which has worked to artificially pump up demand for housing in the last five or six years or so.
The main players in this effort have been the two giant government-sponsored enterprises for housing, Fannie Mae and Freddie Mac that between them own or guarantee nearly half of all outstanding U.S. mortgages. They are the proverbial 900-pound gorillas in the conventional and increasingly sub-prime arenas. Indeed, they now set the "conforming" standards that all the players in the market from banks and savings and loans to increasingly mortgage brokers must follow if they want to do business with Fannie or Freddie in the secondary market.
Both Fannie and Freddie have further cemented their hold on the U.S. mortgage market by creating automated credit underwriting systems which quickly became the mortgage-industry standard. Under the new underwriting standards, an applicant is required to submit only one month of bank statements and pay stubs rather than the traditional three months worth. The programs also allow higher debt-to-income ratios than the old standards and permits increasingly lower down payments than even five years ago. And a record of prompt utility and rent payments can now be substituted for the traditional credit report to establish a potential borrower's financial responsibility.
Immigrants, who are likely to comprise about a quarter of the new homebuyers in the next decade, receive special treatment under the looser underwriting standards. Under special government and philanthropic programs, low-income immigrants can frequently obtain low-interest loans to cover down payments and closing costs that are later "forgiven" after a set period of years. Lenders also don't require two years of documented work history from immigrant families in recognition of their frequent "off the books" work history. Past rent payments are often sufficient to establish credit histories even when the borrower's name doesn't show up on the apartment lease.
Such measures helped push the homeownership rate in America from 64% to 68% in the 'Nineties after decades of holding firm at the lower number. Now Fannie is looking to boost the rate to above 70% by 2010. "This liberalization of credit standards may have an admirable social intent and most certainly it will help Fannie and Freddie continue to grow and wow Wall Street investors," observes Rosner. "But the lax standards also have the potential to make the housing market and general economy far more unstable."
Likewise, Rosner is concerned about the growing adulteration of the home-appraisal process, the very bedrock of prudent lending. Sound appraisals act as governor on home-price appreciation. Inflated appraisals, on the other hand, ineluctably skew home prices higher than market forces might otherwise dictate. Appearance can affect reality in relatively inefficient markets like residential real estate, he contends. The shoddy appraisal creates a new phony sale price that becomes an inflated comparable used to justify, in turn, ever more unreasonable sales prices in a self-reinforcing cycle.
He points to several secular changes that are impelling this process. Lenders in many markets no longer use "blind pools" of appraisers to insure independence and objectivity. Instead, lenders and brokers often use appraisers amenable to "hitting the bid" to justify higher loan amounts.
Traditional lenders, such as banks and savings and loans, sell far more mortgages into the secondary market these days than they keep in their portfolios. Hence, they retain little risk. And mortgage brokers, who account for an ever-growing share of the home-loan originations, have every incentive to gun the size of the loans they arrange. Their fees are based on the size of the loan made.
Rosner also claims that some lenders are increasingly "modifying" or otherwise recasting the mortgages of troubled borrowers to artificially reduce delinquencies, defaults and foreclosures.
Often, months of missed mortgage payments are merely tacked on the mortgage balance and the length of the loan is extended to get a borrower back on track. Sometimes, the delinquent mortgage holder can even garner a lower interest rate, making his monthly payment the same or lower, depending on the loan's unpaid principal balance.
The prevalence of modifications is a closely guarded secret.
Fannie Mae, wrapping itself in the flag, boasted in a recent press release that it was able to "work out" some 16,000 loans, or 52% of its 30,000 seriously delinquent loans last year. Four years earlier, only 12,000, or 35% of its 34,000 in troubled loans escaped foreclosure.
The number of worked-out loans is likely far higher for both Fannie and Freddie. The originators and servicers of their mortgages don't even have to report modifications if less than $15,000 is added to the loan balance, the term of the loan is extended by seven years or less and the interest rate isn't raised. A number of banks and sub-prime specialists like Household International have increasingly been resorting to work-outs, too.
There are dangers in all of this, according to Rosner. Modifications may merely postpone an inevitable default. Relapse rates for troubled mortgage borrowers are likely as high as those of coke heads coming out of rehab, one skeptic recently noted. Too, modifications probably paint a false picture for regulators and investors looking at mortgage-delinquency, credit-loss and foreclosure data. "Modifications are seriously distorting the optics of the mortgage markets," Rosner argues.
These modifications notwithstanding, 3.13% of all prime mortgages were delinquent in last year's third quarter, the most recent for which data is available. This was the highest total since the 1991 recession when loan delinquencies stood at 3.26% for this upper crust, according to the Mortgage Bankers Association.
In the mythology of the American Way of Life, homeownership has long been deemed the sine qua non for producing better citizens. An owner has a bigger stake in society than a mere renter. A home is an essential piece of the American Dream. One can only hope that in the months ahead, falling home prices and disappearing home equity don't end up making homeownership part of a new American Nightmare.
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