Housing Bubble Trouble

...Unfortunately, the weight of the evidence strongly suggests a bubble...

...It's no coincidence that the above chart closely tracks the growth in spending financed by mortgage debt, the drop in the savings rate, and the growth in the current account deficit...

...The nation's bank regulators have seen enough and have issued draft rules that will take effect this spring requiring banks to tighten standards on loans where the consumer isn't required to pay principal up front...

...They all are measuring the same phenomenon—spending outpacing income...

...About $2 trillion in loans, or a quarter of outstanding mortgage debt, will reset in this fashion during the next two years according to Economy.com...

...But even a gradual reversal of the housing boom could result in sluggish economic growth and painful adjustments for those in the bubble areas who incurred too much debt during the run-up in house prices...

...The National Association of Realtors recently produced an analysis of about 100 different metropolitan areas and found prices justified in every one...

...If home prices fall modestly, millions of homeowners will see their equity wiped out...

...In other words, it is off the charts...

...But consumers cannot keep spending more than they make...

...How is this possible...

...The Federal Reserve, Wall Street economists, and other observers of the U.S...

...Why own it...

...They will also be unprepared to answer those on the left who will blame tax cuts for what could be a painful unwinding of a credit bubble that, in fact, was fueled by a loose monetary policy from 2002 to 2004...

...Many of those with the least amount of equity, as we've already shown, are going to face significant increases in their monthly payments...

...Roughly a quarter of the jobs created since the 2001 recession have been in construction, real estate, and mortgage finance...

...Countless articles in the financial and popular press have now been devoted to the question of whether we are in a housing "bubble...

...A recent study by First American Corp...

...MEW comes from three sources...

...For the past five years, Americans have spent more than they have earned—last year, the net borrowing amounted to 3.7 percent of GDP, or over $500 billion...

...Assuming the owner put 10 percent down and took out a traditional 30-year fixed-rate mortgage, the monthly payment would be just under $3,200...

...What's worse, the vast majority of these loans were extended based on "stated income," which means the bank didn't verify the income of the borrower...

...Why would one buy a house, condo, or vacation home if it was significantly cheaper to rent it...

...People are buying in the face of sky-high prices because they've seen so many of their friends or relatives make a fortune in real estate...

...For example, if home prices stabilize and it takes two years for net mortgage equity withdrawal to slow to $259 billion—the level in 2001—this would subtract two percentage points from economic growth during the next two years...

...In the Washington, D.C., metro area, which had remained relatively constant for several decades, this ratio has soared since 2000...

...Economic observers on the right have been strangely silent on this debate...

...A typical three bedroom townhouse in Fairlington recently sold for $575,000...

...The current figure is 3.6 standard deviations from its average level, which, if the data have a normal bell-shaped distribution, means the odds of the price-to-income ratio reaching this level would be less than 1 in 300...

...But examining the value of housing using time-tested and common-sense metrics such as price-to-income and price-to-rent ratios suggest the gains in the bubble areas can't be explained by economic fundamentals...

...Consider the price-to-income ratio (above, right), an obvious measure of affordability...

...Of course, consumers usually have to pay more if they don't provide tax and payroll records to the bank to verify their income...

...As with the stock market during the tech bubble, many are basing purchasing decisions not on underlying economic value, but on what they think they can sell a property for in the future—the very definition of a speculative bubble...

...This ratio has reached an unprecedented level in the bubble markets...

...If this borrowing of home equity remains very high but slows from current levels, which is a near certainty if home prices flatten, it would have a depressing effect on the economy...

...Housing bulls point to immigration, building restrictions, Baby Boomer demand for second homes, and other seemingly plausible justifications for skyrocketing home prices...

...The price of the median home is up an inflation-adjusted 50 percent during the last five years, an unprecedented national increase...

...With the latter, also known as an option-ARM, the outstanding balance owed can actually get bigger every month...

...Note that this analysis takes into account the lower cost of owning due to low interest rates and ignores the $57,500 down payment...

...But this is an awfully rosy scenario from a group that routinely warns of 15 percent declines should Congress even tinker with the home mortgage interest deduction...

...Not only are house prices at extreme levels by traditional measures, but the manner in which home purchases have been financed in recent years is also disconcerting...

...Consider the growth of interest-only and "pay-option" adjustable rate mortgages— loans that initially don't require borrowers to repay principal...

...besides (they tell themselves), everyone knows real estate prices never fall...

...Then there is the fact that about one-quarter of the job growth since the recession has been directly related to the housing boom, so a flat housing market could slow job creation and reduce economic growth even further...

...Yet the very same place rents for no more than $1,700 a month, or just over half the cost of ownership...

...Add in property taxes, a condo fee, and the tax breaks for home ownership, and the cost of owning this unit comes to about $3,000 a month...

...Even more important, consumers have withdrawn $2.5 trillion in equity from their homes during this time, spending as much as half of it and thus making a huge contribution to the growth the U.S...

...That's going to tighten credit in the high cost markets, reduce demand for housing and put downward pressure on home prices...

...shows that many of the borrowers who have taken advantage of the lowest teaser rates and are going to experience the greatest payment increases have little or even negative equity in their homes...

...A few years ago these loans barely existed...

...The study also finds that a third of people who took out adjustable rate mortgages last year have negative equity and 52 percent have less than 10 percent equity...

...The big question is this: Will the housing sector experience a soft landing and slow the economy or a hard landing that pushes us into recession...

...Fully 22 percent of the borrowers who borrowed at initial rates of 2.5 percent or less during the past two years have negative equity in their homes, and 40 percent have less than 10 percent equity...

...However, prices are overextended in enough areas that a real estate correction would have national fallout...

...One powerful reason must be an expected profit down the road...

...This is what has occurred in Great Britain and Australia, where home prices stabilized after a long boom...

...It's an instructive example because there are hundreds of similar units, and those put on the market at the prevailing market price move quickly...

...While this ratio hovered around its average of 4-to-1 for the past 30 years, it has zoomed to nearly 8-to-1...

...And naturally, the White House and congressional Republicans have no interest in highlighting the vulnerabilities of the economy...

...If the inflated prices are justified by economic fundamentals and sustainable, then the 82 percent increase in mortgage debt since 2000 will probably turn out to be innocuous and the risks to the economy minimal...

...House prices in these zones look remarkably similar to the rise in the S&P 500 during the 1990s stock market bubble (see chart below...

...Last year they accounted for more than a third of new loans (see chart at right...

...According to NAR, the price-to-income ratio has averaged about 2-1 for the past 25 years and now stands at a record 3.4-to-1, or 70 percent above its normal level...

...Consider the case of the Washington, D.C., area...

...The economy's average growth rate is about 3.5 percent per year, so all else being equal, this would cut economic growth to 2.5 percent...

...Economists at international banking giant HSBC have identified 18 states and the District of Columbia as "bubble zones...

...One reason is that 43 percent of first-time home buyers paid no down payment last year...

...Eventually, home prices will flatten, the flood of "cash out" refinancings will become a trickle, and consumer spending will slow, as will job creation in housing-related industries...

...A few conservatives have argued that the record appreciation of home prices is justified by economic fundamentals...

...economy has enjoyed in recent years (consumer spending accounts for two-thirds of GDP...

...Alan Greenspan estimates that about half of MEW gets spent, so in 2005 that was about $375 billion...

...They have dangerously diverged from historic valuation trends, and thus are very likely to drop during the next few years...

...area (the average of the past decade), home prices would have to drop 25 percent for this ratio to return to its historic average within the next five years...

...The crux of the debate is house prices...

...Such loans are risky because after an initial period of three or five years with low rates and no principal payments, the loans "reset," and consumers can experience 50 percent or even 100 percent increases in their monthly payments...

...Others, who apparently slept through the 80 percent decline in the NASDAQ, don't believe bubbles are possible in a free market economy...

...This figure was up from about $306 billion in 2004, which means spending financed by withdrawing home equity added 0.6 percent to GDP in 2005...

...So what has been a virtuous but unsustainable cycle for the economy—higher home prices, more borrowing against home equity, higher spending, increased job creation, even higher home prices—could easily reverse and become a vicious cycle—higher monthly payments, declining home prices, less spending, job losses, foreclosures, even lower home prices...

...While the evidence of a housing bubble is overwhelming, it isn't definitive...

...Even flat home prices would therefore slow economic growth unless other parts of the economy rapidly accelerate...

...To be sure, there are some very positive trends in our economy, especially strong productivity, and most likely a housing correction won't push the economy into recession...

...If this isn't a housing mania, why have so many people embraced financing schemes that leave them vulnerable to higher interest rates or even a modest correction in home prices...

...Consider the example of a townhouse in Fairlington, a venerable apartment and townhouse community in the Virginia suburbs just a few miles from the nation's capital...

...In Britain, for example, consumer spending slowed dramatically and GDP growth fell from about 4 percent in 2003 to half that the following year...

...Common sense suggests many are fibbing about their income to qualify for a larger loan...

...economy are closely watching the housing market because it has been a key driver of economic growth over the past several years...

...Yet the concerns about unsustainable growth in consumer debt and home prices are not easily dismissed...

...Certainly most conservatives have an innate optimism about America and the resilience of its free market economy, and a strong and well-justified aversion to doomsayers...

...If economic analysts on the right ignore this risk, they may be blindsided by a weaker economy...

...It is true, as Alan Greenspan and others have observed, that real estate is regional, and much of the country has not experienced significant price gains...

...They are laying the Andrew Laperriere i^ a managing director in the Washington office of ISI Group, a Wall Street economic research and brokeragefirm...

...Therefore, millions of households are about to experience significant payment shock...

...Rent is a reality check because it reflects the actual earnings power of the asset...

...Conservatives ought to seriously consider these risks so they won't be surprised or caught flat-footed if a housing correction occurs...

...Or why would an investor buy a property that rents for far less than his mortgage and other costs...

...The high level of spending compared with disposable income is also in uncharted territory...

...But what isn't debatable is that one cannot forever spend more money than one earns—yet this is exactly what consumers have been doing...

...Herb Stein With new home sales down 10.5 percent in February, and with home prices declining for the fourth month in a row, it's high time for a sober look at the consequences of a major housing correction...

...The NAR concludes it would practically take a depression for home values to drop 5 percent...

...An even better indicator of how divorced home prices are from their underlying economic value is the price-to-rent ratio (see chart, top of next column...

...Assuming incomes grow 5 percent a year in the D.C...

...It is a favorite topic of many liberal economists, columnists, and bloggers, who argue that President Bush's tax cuts and other policies have created a hollow and unsustainable economy...

...Yet home prices and rents should remain closely linked...

...It comes from cash-out refinancing, from home sales where people put down a smaller downpayment for the new house than the equity in the old place, and from home equity loans...

...Just as cheerleaders of the high-tech bubble of the late 1990s developed ever more creative explanations for why traditional metrics of valuing stocks no longer applied, the same has been true during the housing bubble...

...The chart (below, right) shows mortgage equity withdrawal (MEW) as a share of disposable income...

...But a hard landing—meaning a recession—is a real risk...

...groundwork to hang a housing bust around the necks of President Bush and congressional Republicans...

...The mortgage insurance company PMI estimates that regions accounting for more than 40 percent of the nation's housing stock are overvalued by more than 15 percent...

...If, on the other hand, prices are out of whack, painful adjustments lie ahead...

...Other estimates of overvaluation are much higher...

...According to ISI, a Wall Street research firm where I work, last year MEW amounted to $751 billion, more than 8 percent of disposable income and twice the peak reached in the late 1980s...

...A weakening housing market could transform what has been a virtuous cycle into a vicious one, substantially reducing economic growth during the next couple of years (and going into the 2008 election...

...Add in employment and other factors, and the housing boom has added up to one percentage point to economic growth in each of the past few years...