The Biggest Bubble Ever

From the November 2004 Trumpet Print Edition

No one disputes that housing prices in the United States since 1995 have soared way beyond inflation. However, that alone does not reveal a housing “bubble.” Escalating home prices could be caused by a shift in fundamental economic factors that leads people to value home ownership more than they did before, in relation to other goods and services. On the other hand, if home prices rise without regard to real value, then we have a bubble in the making. A bubble forms as rising prices lure more buyers into the market who are looking to build equity before prices rise further, regardless of the real value of the asset. This increases demand, prices rise even more, and the cycle continues.

Before the technology stocks (for example, “dot-coms”) crashed in 2000, many economists argued that such stocks were on the verge of cutting-edge technology that would revolutionize business. They were not overvalued, they said. There was no stock bubble, they insisted, in spite of outrageous price-to-earnings ratios compared to historical standards. But they were wrong. Since the dot-com bust, the technology stocks have not recovered and the stock market as a whole has been stagnant.

Likewise today, some argue that there is no housing bubble. How can we know if there is, and if so, what are the ramifications if it bursts—not only for the U.S. but for the many countries around the world that have experienced similar trends in housing in recent years?

A Merrill Lynch economist, David Rosenberg, identifies six characteristics of any kind of asset bubble: overheated prices, over-ownership, too much debt, speculation, complacency and denial. Let’s examine these factors in light of the U.S. housing market.

Evidence of a Housing Bubble

Overheated prices. Until 1995, housing prices largely kept pace with inflation. In the last nine years though, home prices on average have spiked 35 percent after adjusting for inflation. In some areas (mostly coastal cities) home prices have skyrocketed by incredibly higher margins than that. In San Diego County, for example, the median price of a home is now $472,000. (That means that half the homes sell above that price and half of them sell below it.) That represents an increase of 129 percent in just five years! Yet the county’s median income, at $52,000, has gone up only by about 11 percent during that time.

On the national level, the average house now costs 3.4 times as much as the median family income—a new record—19 percent above the average that stood for a quarter of a century between 1975 and 2000. Home prices cannotperpetually rise faster than incomes. Since they have for four years now, it suggests that a bubble has formed and prices would have to drop substantially to return to the average long-term ratio.

Another indication that homes are overpriced is that the real costs of owning compared to renting have diverged dramatically in the last few years from the long-standing normal pattern. If demographic forces were driving the demand for housing, the surge in housing would be reflected in both the housing and rental markets. But that is not the case. There is plenty of housing available on the supply side of the equation. Rental vacancy rates hover around 10 percent, the highest since the Census Bureau started recording the statistic. In the downtown areas of some major cities, rental rates have been declining since 2001.

According to the Economist, the ratio of house prices to rents is a very good indicator of whether homes are fairly valued. “[T]he price of a house should reflect the future benefits of ownership, either as rental income or in the rent saved by an owner-occupier. America’s ratio of house prices to rents is at a record high,26 percent above its average over the 25 years to 2000” (September 11; emphasis mine throughout).

Some say that this is an anomaly attributable to very low mortgage interest rates. That actually supports the view that housing prices are in a bubble since interest rates cannot stay low indefinitely, especially with high federal government budget deficits projected into the foreseeable future. Without substantial growth in disposable incomes to offset interest rate increases, current prices are unsustainable.

Over-ownership. According to a study by the Center for Economic and Policy Research (August 5, 2002), the housing share of total consumer expenditures increased sharply in the ’70s and early ’80s and the rate of increase slowed suddenly in the mid-to-late ’80s. This corresponds directly with the history of the baby boomers that were starting families in the ’70s and early ’80s and were largely living on their own by the late ’80s. Using data from the Bureau of Labor Statistics, the study shows that as baby boomers approach retirement, the housing share of consumer expenditures should be falling (under normal circumstances). That’s not what is happening.

Furthermore, the average rate of home ownership for a quarter of a century has been 65.2 percent. Currently, 68.6 percent of Americans own their own homes. That represents several million households above the norm. It would not be a concern if this were due to rising incomes. But it’s not. Rather, it is because more people with marginal credit histories and low incomes are qualifying for home loans. For example, low-income families can now borrow 103 percent of a home’s price from the Federal Housing Administration! In summary, sub-prime lending (to home buyers with poor credit) has gone up by 25 percent in the last decade.

Today’s frenzy to purchase a home aided by lenders’ willingness to lower the standards will result in tomorrow’s spate of foreclosures. Too many are over-extended, and that ties in to the next point proving the housing bubble is real:

Too much debt. About half of the lowest-income households pay out at least 50 percent of what they earn toward housing—far more than the long-standing guideline of 28 percent suggested by the Federal National Mortgage Association (“Fannie Mae”). In addition, homeowners borrowed a record $138 billion against the equity of their homes last year, helping them buy new cars, appliances and other goods.

One of the most remarkable statistics is that mortgage debt has climbed even faster than home values. The ratio of homeowners’ equity compared to market value was more than 67 percent for three decades during the ’60s, ’70s and ’80s. In the last 20 years, it averaged 61 percent. Today, it stands at a mere 55 percent, which is particularly striking since the population is quite a bit older, on average, than in prior decades. This shows that people’s homes are far more leveraged today than they have been historically.

Meanwhile, in the last three years, despite record low interest rates, “[t]he number of mortgages more than 90 days past due is up 20 percent, the number of foreclosures is up 18 percent, and the number of household bankruptcies is up 33 percent …” (Time Magazine, September 13). These figures will soar as interest rates climb and as housing prices level off and start to decline. Many home buyers who have not qualified to lock in to a fixed interest rate will find themselves in trouble with more mortgage debt than they can handle—and unable to sell their home at a high enough price to recoup their investment.

Speculation. One way people have traditionally built wealth is through home equity. Now, however, in order to be able to increase their consumption today, many forego that future wealth hoping their homes will continue to rise in price to an unreasonable degree. Several recent studies show that people are counting on their homes to provide a lot of wealth in the future. Many older people, for example, anticipate selling their home and moving into a smaller one, hoping that the net equity proceeds from the sale will provide a large part of their retirement income. A bust in the housing bubble could shatter those dreams.

It’s also worthy to note that after the dot-coms crashed in 2000, home prices really started to soar, especially in coastal areas. This suggests that speculative money jumped from stocks to real estate. What this indicates, along with the other factors discussed earlier, is that many people are buying houses as investments they hope will rise in value, rather than, above all, as places to live. A major factor driving up sales is the expectation that prices will be higher in the future.

Complacency. It’s never been easier to buy a home, but many borrowers are getting hooked on risky loans. Lenders are continually coming up with more unusual (and risky) mortgages to allow less-qualified buyers—even those with limited cash and shaky credit—to purchase a home. Many “predatory” lenders are making offers that are practically irresistible. The banks and mortgage companies are often complacent themselves because more than 75 percent of the single-family mortgages they originate are sold in the secondary market to either Fannie Mae or Freddie Mac—government-sponsored private corporations that assume all the risk.

A recent survey commissioned by the Consumer Federation of America (cfa) shows that many Americans, especially low-income families and minorities, don’t understand the risks inherent within adjustable-rate mortgages (arms), for example. The payments on these mortgages increase as interest rates climb. “Given the high probability of interest rate increases, an adjustable-rate loan made to a family which can barely afford the initial monthly payments represents a ticking time bomb,” said cfa Executive Director Stephen Brobeck (Los Angeles Times, August 1).

arms are now preferred by 30 to 35 percent of mortgage purchasers, yet most people couldn’t tell you how high their mortgage payment could go when interest rates rise, according to Catherine Williams, vice president of financial literacy for Consumer Credit Counseling Service of Greater Chicago.

Denial. Some economists deny there is a housing bubble, especially if they work for realtor associations. According to cbs MarketWatch, even Freddie Mac’s deputy chief economist insisted there is no housing bubble (September 8). One argument some forward is that housing prices are strictly regional in nature so a national housing bubble is impossible. However, the Economist refers to a study that shows home prices are overvalued in 20 states that represent more than half of America’s population (op. cit.). When enough regional bubbles start popping so that their impact is felt nationally, no one will question that a genuine national housing bubble exists.

It is clear that all the signs of a classic bubble persist in the current housing market. When it will pop is another question. Where interest rates are headed next may reveal the answer.

Interest Rates Are Key

In essence, the housing bubble emerged as a result of loose monetary policy designed to stimulate the stagnant economy. From January 1996 to June this year, the Federal Reserve increased the supply of cash by 69 percent and bank deposits grew by 111 percent. When there’s more money circulating, the cost to borrow it (interest) goes down. Consequently, banks have been able to instigate a massive borrowing boom thanks to lower interest rates and deposits that more than doubled in just eight years! This encouraged consumers to keep spending (although it was a debt-fed consumption) and was especially helpful in the short term: both after the 2000 tech-stock crash, and after the economy slumped in 2001. It also helped mitigate the damage from 9/11. But quick and easy economic solutions usually have a side effect. The cheap credit spurred by remarkably low interest rates also helped inflate the housing bubble big time.

Perhaps the best indication that the bubble is going to pop is that interest rates are heading back up (see May Trumpet, “When the Debt Bomb Explodes” on theTrumpet.com under Issue Archives) and many economists foresee that mortgage rates will likewise climb in the next few years. The Federal Reserve, even with the recent rate hikes, is still lending to banks below the inflation rate. The average lending rate for 20 years has been more than 2 percent above inflation. The pressures coming to bear could push the rates up by as much as 2 percent within a year or two and even higher thereafter.

Why is that important to the housing market?

First, more and more people are financing their homes with adjustable-rate mortgages. Compared to traditional fixed-rate mortgages, the monthly payment is less initially. However, as interest rates climb, so does the monthly payment. A variation that’s becoming more popular, especially in the most expensive markets, is interest-only loans that require buyers to pay only interest for a fixed period of time.

To illustrate the danger of escalating interest rates, suppose you have a 30-year $100,000 arm, currently at a 6 percent interest rate. Your mortgage payment would be about $600 a month (not including taxes and insurance). Were rates to go up by 2 percent, your payment would increase to $734 a month—about $1,600 per year more. A 4 percent increase would cost you $878 a month, or about $3,330 more per year. For a $200,000 mortgage, you can double the amounts. While many arms limit how much interest rates can go up (usually in the neighborhood of 5 percent), some arms have no caps! Even with a cap though, your mortgage payment could increase by 50 percent or more. Too many Americans are not familiar with the risk they have taken.

According to the cfa study referred to earlier, Americans who say they prefer arms over the traditional fixed-rate mortgages are generally younger, poorer and have less education. This suggests a lack of financial knowledge associated with the preference for arms. Yet in a bid to keep business booming, lenders and bankers have shoveled out these loans almost like the free suckers you can pick up at the bank teller window.

In 2003, about 19 percent of all home mortgages issued were arms, although in the fourth quarter, it had shot up to 27 percent. By the second quarter of this year, 35 percent of new home mortgages were arms. And in some of the most expensive markets, arms are now the most popular type of mortgage! In California, close to 75 percent of home buyers in August used arms. Of the total home mortgage debt outstanding in the U.S., about 20 percent—more than $1.3 trillion—is financed by an arm. That is rather shocking.

Yale economist Robert Shiller, author of the book Irrational Exuberance, which accurately forecast the stock market bubble just before the crash of 2000, is weighing in on housing. He believes the popularity of arms is creating the risk of a “serious debacle” and that the current housing market, showing signs of “irrational exuberance,” bears all the hallmarks of a housing bubble.

The Federal Deposit Insurance Corporation (fdic) in its spring outlook letter expressed concern about the trend toward arms because more people with “high leverage, volatile incomes or limited wealth” are being lured into the housing market.

When interest rates go up on these arms, a lot of people won’t be able to manage the payments because they have purchased homes they can barely afford. Foreclosures and bankruptcies will soar. The housing bubble will start to deflate and prices will begin to fall.

Rising rates would also affect potential new home buyers, pricing them out of the market, unless home prices were to drop enough to compensate. According to Business Week, if 30-year fixed-rate mortgages were to rise by just 1 point from 6.2 to 7.2 percent, for example, house prices would have to fall by 11 percent to keep mortgage payments the same. A rate of 8 percent would require a 20 percent drop in prices to keep payments level (July 19).

Finally, climbing rates will impact consumers who have used their homes as a sort of atm machine—drawing money out with home equity loans to purchase items they couldn’t otherwise afford. This has helped prop up the U.S. economy (consumer spending is 70 percent of gross domestic product) only temporarily. Generally, homes that have been leveraged already cannot continue to be leveraged, especially when prices level off and then start to nose-dive.

In relation to personal disposable income, total homeowner debt payments (mortgage and credit card) currently stand at 15.5 percent. Only once in the last quarter century did they go over 16 percent—at the end of the recession in the fourth quarter of 2001. This indicates that there is little room to maneuver when interest rates go up. It will most likely cause homeowners to slow their spending. That will be a drag on the economy.

While interest rates are key to the status of the housing bubble, there’s more to it than that.

Uncharted Territory

There is a school of thought that says even if interest rates don’t go up, asset bubbles like housing are prone to burst when the pool of real funding begins to shrink.

Between 1970 and 1994, changes in the federal funds rate (the rate at which the Federal Reserve lends money to banks) were followed by corresponding changes in industrial production, always within 12 months. When rates were low, production increased. When rates were high, production decreased. In 1995 (the same year housing prices began to outpace the inflation rate), the correlation ceased. Normally, with interest rates so low, industrial production should increase. But production has been depressed since 1995 (relative to the federal funds rate) and steadily declining for the last four years. This suggests that real funding is drying up.

In other words, when the Federal Reserve flooded the economy with new money (doubling bank deposits in just eight years), much of the excess liquidity found its way into housing, followed by consumer spending that was supported by home equity, rather than increases in production and wages. The wealth that was created is an illusion—not based on real productive activities. Hence, the housing bubble is bound to pop, the thinking goes, even if interest rates don’t go up.

Either way, chances are that the housing bubble will explode! And not just in the United States. The Economist calculated that home prices are at all-time highs in relation to average incomes in two thirds (by economic weight) of the world it tracks (op. cit.). Countries such as Britain, Ireland, Australia, South Africa and Spain have witnessed triple-digit percent increases in just the last seven years! Many others have seen double-digit increases during that same time. The value of property worldwide is now estimated to be $50 trillion, including about $15 trillion of U.S. housing (compared to roughly $30 trillion worth of property stocks in the world). The effects of a severe housing bubble collapse could be disastrous for the entire world economy.

Merrill Lynch economist Rosenberg calculates that if housing prices in the U.S. were to drop just 10 percent, it would inflict more damage to the economy than a 1 percent rise in interest rates or a $10-per-barrel increase in the price of oil. Some, including famous investor Sir John Templeton, predict that, when the bubble bursts, housing prices will plummet at least 20 percent just for starters. He expects that 20 percent of homeowners with a mortgage will lose their homes when the bubble pops and has even told investors to prepare for a crash similar to the stock market crash of 1929 that led to the Great Depression! (Daily Reckoning, April 1 and August 18).

Does that sound extreme?

Let’s briefly take a broader view of the U.S. economy. The budget deficit this year is a new record, and the gap between what the U.S. produces compared to what it consumes (the trade deficit) is also smashing records. The personal savings rate is at near historic lows. Total homeowner indebtedness compared to disposable income is very close to the highest it’s ever been. Homeowner equity compared to market value is way below normal even though prices have been skyrocketing! Despite ultra-low interest rates, industrial production is dropping and employment growth is stunted to an unprecedented degree. Real wages for the American worker are 6 percent lower than a quarter century ago.

Never before have we witnessed the confluence of so many negative economic factors to this degree. We are truly in uncharted territory. Yet the U.S. economy has been perking along largely because it’s been propped up by the greatest housing bubble ever known. We’ve shown how that simply cannot continue. When it starts to unravel, it will likely lead to the biggest bubble bust in world history, hurtling the U.S. economy into chaos, reminiscent of the Great Depression—or worse! The shock waves could lead to a major global recession like we’ve never seen. Prepare now to reduce your standard of living.