It is important to realize that the housing market today is similar to the stock market of three years ago - highly leveraged and highly overvalued. It shares many characteristics of any paper asset market, subject to the same laws of supply and demand. The prudent investor realizes that neither trees nor markets grow to the sky and understands that just as there is a time to buy and a time to hold, there also comes a time to sell.
Pop Goes the Bubble - Part II
Sell Your House Now!
26 December 2002 * M.A. Nystrom
It is an audacious claim to make, "Sell your house now," and I don't expect anyone to do any such thing without serious consideration. But in my continuing quest to bring financial understanding to the less financially inclined, I would like to challenge another oft-held assumption - that real estate prices only go up. In Part I of this three part series, I stated that even after 3 years of declines, the U.S. stock market is still overvalued, and poised for more massive declines next year. This week I will make the case that the housing market is at the peak of bubble that is just beginning to burst.
The Value of a Home
A home has traditionally been one of the best real investments that a person can make in his or her lifetime. Not only have home values appreciated steadily and handsomely in the postwar period, homes provide an individual with a stable, secure place to live and raise a family. Home ownership is a source of pride and psychological well being - a fundamental piece of the American Dream. But in the post-bubble era, the American Dream could quickly turn into the American Nightmare for millions of homeowners who have been careless with their financial decisions. Many will find themselves "underwater" in their mortgage - owing more than their house is worth. As the general economic depression deepens, many more will be forced to sell their homes at distressed prices or find their homes repossessed as a result of being unable to pay their mortgage.
Popping the Bubble is a Process
The popping of the financial bubble is a process that is taking years to unfold. In 2000, we saw the most speculative stocks - the so called "dot-coms" begin to implode as "dot-bombs." In 2001, even the stalwart technology sector saw cracks, and so began the "tech-wreck." And in 2002, the selling hit the blue chips. In retrospect, is it all so crystal clear: the stock market was one, big bubble! How did we miss it?
But in the last three years the housing market has been a bright spot, we are told. With low interest rates as the driver, housing prices have continued to rise steadily and impressively, even as the stock market implodes. And despite over 2,000,000 layoffs since the beginning of this recession, with plunging interest rates and rising home prices as the driver, the U.S. consumer has continued to spend and keep the economy growing. How is this possible, I am often asked, if we are in the beginning of the Second Great Depression?
The Mechanics of Consumption
We are told that consumer spending accounts for 66% of U.S. GDP, and that current levels of consumption must be maintained in order for the American, and arguably the world economy to continue growing. The only problem is that the American consumer is tapped out. He has no savings, and his credit cards are charged to the gills. His net worth is negative, and yet the weight of the world economy rests on his shoulders. Knowing this, the Federal Reserve has done the only thing it could, lowering interest rates so many times that we have lost count.
By lowering interest rates, the Fed is tapping into the last untapped source of wealth in this country: the great American home. It is the last frontier of savings in this country of non-savers. It is the second to last bubble to pop (the last being the dollar itself, to be discussed in part 3) in this rolling, ongoing process of deflationary depression. Homeowners without money in the bank can borrow against their inflated home at less than 6% interest to buy anything they would like - a new car, a new kitchen, a vacation to Europe. With mortgage interest rates at 40 year lows, the illusion of prosperity is maintained in this sector. Home ownership is available to more people now than ever! Low interest rates and aggressive lending means that even people with low income, bad credit, and large debts can now buy a home. Loans can be structured that require no money down, with a buyer's existing credit card debts being rolled into the mortgage at closing.
Low interest rates - i.e. the increase in availability of borrowed money - have created an artificial, unsustainably high demand for homes. In other, more colloquial terms, a bubble.
"One of the hallmarks of this and other investing booms has been how stubbornly both pros and amateurs refused to see what now seems so obvious. Warning signs either were ignored, or they were buried in cloudy accounting that made it even more difficult for investors to make sound choices"
-The Wall Street Journal, on the dot.com boom/bust, December 16, 2002
Warning Signs of a Bubble
Just as the majority of people were blind to the stock market bubble at the time, we are now only fooling ourselves if we think that the housing market is not a bubble. There are certain signs which are always present at a market top, whether the market is tulip bulbs, tech stocks or residential homes.
1. Everyone wants a piece of the action at the top. Suddenly everyone has to own a house. And if they own one, now is time to buy another. Suddenly everyone is a real estate expert, rattling off their favorite cliché's about why the housing market will never fall: "Everyone has to live somewhere," they say, "and last time I checked, they're not making any more land." Heh heh, they chuckle at their own intelligence.
2. A flood of weak offerings comes to market. At the end of the dot-com boom, any company with even a hint of involvement with the internet commanded a top dollar IPO price. "Investors" were hungry, desperate to get in on the action and there were more than enough suppliers to accommodate the suckers. The same is true today as the housing market is being flooded with brand new, cheaply built, flimsy condos that are commanding top dollar - even more than venerable single family homes. A 1200 square foot condo with a peek-a-boo view and monthly condo dues in excess of $500 sells for over $400,000 in my dowdy Seattle neighborhood (Greenwood).
Real estate version of the dot.com IPO - brand new, cheaply built, overpriced flimsy condo.
Like the IPO's of yore, depreciation will begin immediately after purchase, and bring the rest of the market down with it.
3. No attention paid to return on investment (ROI). When many dot-coms came to market, the story was "We'll figure out how to make money later." Today, many homes being purchased for their 'investment' potential are being purchased under the Greater Fool Theory: Hopefully there will be a greater fool than you to purchase it at a higher price later. Even as housing prices climb, rental prices are falling and rents are nowhere near high enough to pay the mortgage. New rental property owners are hoping to make up the difference until prices appreciate enough to sell at a profit. Good luck.
4. Ownership passes from strong hands to weak. In certain old Seattle neighborhoods, property values have risen so much that the retired couples who have lived in the houses for decades can no longer afford to pay their property taxes on fixed incomes. They have seen their equity climb thousands of percent: Homes purchased at $10,000 in the 1950's are now selling for $400,000. The old timers who own such property - paid in full, of course - are selling out to the weak buyers - the no money down, young, low-level high-tech employee who is about to lose his job but doesn't yet know it.
History Lesson From Japan
When I lived in Japan from 1990 to 1992, I was witness to the bursting of the largest speculative stock and real estate bubble to date. Neither I, nor anyone else in the country noticed a thing. The stock market had peaked on the last day of 1989, and the 1990's saw the market go nowhere but down for the entire decade. But in 1992, when the market decline was still young, it was thought of as merely a breather, a healthy correction of an overheated market. Real estate prices, after all, remained strong.
By 1994, housing prices in Japan finally began to crack. Conditioned by decades of rising prices, my Japanese relatives in Yokohama rushed in to buy when prices finally came within their grasp. With the help of low interest rates and a two-generation mortgage (!), they hurried to purchase their first home ever. They were in a rush, lest prices once again shoot upward, beyond their reach forever. But instead of squirting up and away, home prices in Japan fell further, and then continued to fall and fall and fall. They fell so much that by the time I visited again in 1998, the value of their home was less than half of what they had paid for it just four years prior. Others saw the value of their homes deteriorate by 90%. Deflation had established its foothold in the land of the rising sun.
First Signs of Decline
The first signs of the decline in the U.S. are already apparent to those paying attention. Sales of homes worth $1,000,000 or more - a leading indicator of the housing sector - plunged 10% in the third quarter. Prices are falling as well - some by as much as half. The price increase of all single family homes sagged to under 1% in the 3rd quarter, and prices actually fell in seven states and 33 metro areas, according to Martin Weiss' Safe Money Report.
Nationally, the number of buyers who are in default on their mortgage is at an all time high and foreclosure rates are at their highest level in 30 years and rising. Lenders are scraping the bottom of the barrel to get every last marginal buyer into the market, and after that, there will be no one left to buy. Exacerbated by hard economic times, the marginal buyers will be the first to default, and defaults will turn the tide from rising prices to falling prices. Falling prices will create a self reinforcing cycle, causing new buyers to wait and defer their purchases.
How long will the decline take? Years, perhaps even a decade or more. Property values collapsed along with the depression of the 1930s, and according to Robert Prechter, many values associated with property - such as rents - continued to fall through most of the 1940s even after stocks had recovered substantially.
Sell Your House Now?
This is a question which should be given serious consideration. If it is your only home, and it is for consumption only, and you are comfortable with the payments, there may be no need. But if you have a second home or condo as an investment property, the sooner you sell the better. If you are thinking of selling your home in the next few years, there is no better time than now. Before long, many will be forced to liquidate property, and at fire sale prices! But in a bear market, liquidity can quickly become a problem. As Robert Prechter states, "At least in the stock market, when your stock is down 60 percent and you realize you've made a horrendous mistake, you can call your broker and get out…With real estate, you can't just pick up the phone and sell. You need to find a buyer for your house in order to sell it. In a depression, buyers just go away. Mom and Pop move in with the kids, or the kids move in with Mom and Pop. People start living in their offices or moving their offices into their living quarters. Businesses close down. In time, there is a massive glut of real estate."
At this point, the housing market is still liquid, but this will not last forever. Think back to how quickly economic times went from good to bad. It was the twinkling of an eye. When liquidity dries up, yawning price gaps will appear as desperate sellers are forced to part with their property under any circumstances.
Selling a home is a substantial and important undertaking. This article is not intended to make you decide to sell your home, only to inform you of some of the factors contributing to bubble, and the likely outcome when it pops .
Low interest rates have artificially inflated home values beyond their actual useful, or investment value. The housing market has become like a paper asset market on 100% margin. But for the beleaguered borrower, there is less incentive to pay back money borrowed if there is no equity in the home. At the first sign of trouble, a weak buyer with no equity will likely return the home to its rightful owner - the bank. (This spells trouble for the banks down the road, but that is another story altogether!)
As interest rates rise, those who refinanced at adjustable rates will find their mortgage payments swelling beyond what they are able to pay. If you have recently refinanced your home, make sure you are aware of the terms under which you refinanced. If you have an adjustable rate, you will be at risk of losing your home when rates begin to rise again.
Families who took the advice of aggressive bankers and borrowed as much money as they could, to get all the house they could 'afford' based on two incomes will find themselves at risk of losing the house if one of the incomes is lost as the depression deepens.
Any distressed sale of a home will contribute to deflation. As I concluded the last article, I will state again: In every case of financial excess the final bottom comes below the original starting point. There is no reason to expect that the housing market will be any different.
This is Part II of a three part series examining the steps to take to position for the coming second great depression. Part I examined the overvalued stock market, and Part III looks at the tenuous value of the U.S. Dollar. For Parts I and III, click below.