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<font color="#002864" size="1" face="Verdana"><strong>http://www.mises.org/fullstory.asp?control=1533</strong></font>
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<font face="Verdana" size="2"><font color="#002864" size="5"><strong>Housing: Too Good to be True</strong></font>
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<p class="MsoNormal"><font face="Verdana, Helvetica" size="4">By Mark Thornton</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">[Posted June
4, 2004]</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2"><img alt src="http://www.mises.org/images3/housebubble.gif" align="right" border="0" width="189" height="188">Signs
of a"new era" in housing are everywhere. Housing construction is
taking place at record rates. New records for real estate prices are being set
across the country, especially on the east and west coasts. Booming home
prices and record low interest rates are allowing homeowners to refinance
their mortgages,"extract equity" to increase their spending, and lower
their monthly payment! As one loan officer explained to me:"It's almost
too good to be true."</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">In fact, it is
too good to be true. What the prophets of the new housing paradigm don't
discuss is that real estate markets have experienced similar cycles in the
past and that periods described as new paradigms are often followed by periods
of distress in real estate markets, including foreclosure sales, bankruptcy
and bank failures.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">The case of
Japan's real estate bubble is instructive. Japan had a stock market bubble in
the 1980s that was very similar to the U.S. stock market bubble in the
1990s. As the Japanese stock market started to bust, the real estate market
continued to bubble. One general index of Japanese real estate shows that
prices rose for almost two years after the stock market crashed with
prices staying above pre-crash levels for more than five years. The boom in
home construction continued for nearly six years after the stock market crash.</font>
<font face="Verdana, Helvetica" size="2">Prices</font>
<font face="Verdana, Helvetica" size="2">for commercial, industrial, and
residential real estate in Japan continue to fall and are now below
the levels measured in 1985 when these statistics were first collected.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">It has now been
three years since the U.S. stock market crash. Greenspan has indicated that
interest rates could soon reverse their course, while longer-term interest
rates have already moved higher. Higher interest rates should trigger a
reversal in the housing market and expose the fallacies of the new paradigm,
including how the housing boom has helped cover up increases in price
inflation. Unfortunately, this exposure will hurt homeowners and the larger
problem could hit the American taxpayer, who could be forced to bailout the
banks and government-sponsored mortgage guarantors who have encouraged
irresponsible lending practices.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">More</font> <font face="Verdana, Helvetica" size="2">Greenspam</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Once again, Fed
Chairman Alan Greenspan has created a new-age economic panacea, and earlier
this year he applauded his contribution to the economic recovery:"very
low interest rates and reduced taxes, have permitted relatively robust
advances in residential construction and household expenditures. Indeed,
residential construction activity moved up steadily over the year."</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">The key to this
panacea is the process of"equity extraction" that occurs when
people refinance their homes; they take equity out and spend it to increase
their standard of living. However, because variable rate mortgages are so low,
their payments actually go down so they have more of their income to spend, or
they can upgrade to a more expensive house. As Greenspan explained:</font>
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Other consumer
outlays, financed partly by the large extraction of built-up equity in homes,
have continued to trend up. Most equity extraction—reflecting the realized
capital gains on home sales—usually occurs as a consequence of house
turnover. But during the past year, an almost equal amount reflected the
debt-financed cash-outs associated with an unprecedented surge in mortgage
refinancings.</font>
[/i]
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">As is the norm,
Greenspan hedges his statements. He also considers some of the potential
drawbacks and pitfalls on the horizon for the new paradigm in housing, but in
the end he concludes that we really have nothing to worry about. Low interest
rates, rising home prices, and lower financing costs mean that we actually can
have our cake (homes) and eat it too (equity extraction).</font>
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<font face="Verdana, Helvetica" size="2">To be sure, the mortgage debt of
homeowners relative to their income is high by historical norms. But as a
consequence of low interest rates, the servicing requirement for the
mortgage debt of homeowners relative to the corresponding disposable income
of that group is well below the high levels of the early 1990s. Moreover,
owing to continued large gains in residential real estate values, equity in
homes has continued to rise despite sizable debt-financed extractions.
Adding in the fixed costs associated with other financial obligations, such
as rental payments of tenants, consumer installment credit, and auto leases,
the total servicing costs faced by households relative to their incomes are
below previous peaks and do not appear to be a significant cause for concern
at this time.</font>
[/i]
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">The Housing
Bubble</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">I</font> <font face="Verdana, Helvetica" size="2">first
reported</font> <font face="Verdana, Helvetica" size="2">on the housing
bubble in the U.S. at the beginning of this year when the bubble was already
well under way, if not in full bloom. As the chart below indicates, real
residential investment has jumped far above both its historical trend and even
above its cyclical channel. This indicates to me that there is a bubble in
residential real estate. The data for this chart stop at the beginning of
2003. We now know that investment in housing increased by 8.8% last year. This
is a historically high rate of construction, but far from a record rate
increase. However, 2003 marks the ninth year in a row that housing investment
was positive, the first time that has ever occurred since the statistic has
been collected.</font> <font face="Verdana, Helvetica" size="2">Frank
Shostak</font> <font face="Verdana, Helvetica" size="2">and</font> <font face="Verdana, Helvetica" size="2">Christopher
Mayer</font> <font face="Verdana, Helvetica" size="2">have also written
very informative articles on the Housing bubble.</font>
<p class="MsoNormal" align="center"><font face="Verdana, Helvetica" size="2"><img alt src="http://www.mises.org/images3/Thornton1.gif" border="0" width="437" height="262"></font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2"> </font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Recently I came
across a piece of anecdotal evidence of a housing bubble. Last Sunday
afternoon, a friend of mine put a"For Sale by Owner" sign in
the front lawn of a small house he owned on a side street. It wasn't listed
with a real estate agent or in the newspaper, but he nonetheless had a couple
of calls that afternoon, with many more to follow, and within a couple of days
he had multiple offers before finally accepting a bid that was over his
original asking price.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Mainstream
economists who discount the possibility of a housing bubble would dismiss such
evidence. But they also ignore all the macro evidence of the current housing
boom and see it as a positive development. For example, the number of new
homes being constructed is at an all-time high, despite a"soft"
labor market. In the graph below, the annualized rate of new home construction
is shown to have surpassed the two surges of the 1970s when inflation was out
of control.</font>
<p class="MsoNormal" align="center"><img alt src="http://www.mises.org/images3/Thornton2.gif" border="0" width="447" height="267">
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">The prices of
houses are also up, but mainstream economists have generally ignored this
development as well; and as noted above, Greenspan sees this as a positive
development. Some economists can even point to the Consumer Price Index which
shows that the housing component in the CPI is steady or falling. And yet
reports are coming out nearly every day saying that housing prices are up
dramatically and setting records all across the country. Record prices have
been recently reported in the San Francisco Bay Area, Denver, Boston, Las
Vegas, the state of Washington, and even Buffalo, New York.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Nationally, the
price of a median family home was up 15% between 2001 and 2003, with regional
increases of 30% in the Northeast, 8.5% in the Midwest, 14.4% in the Southeast,
and 20.4% in the West. Over the last year, increases have been reported as
18.7% in the Northeast, 1.9% in the Midwest, 3.8% in the Southeast, and 10.7%
in the West, or 6.5% for the nation as a whole. Interestingly, the median
price has actually dropped 7.2% in the Midwest and 7.3% in the South since
peaking in the 3<sup>rd</sup> quarter of 2003, while prices have been
generally flat in the West. Statistics from the last couple of quarters might
therefore suggest that the housing bubble may have topped out, or at least
temporarily cooled down, in most of the country.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Why have home
prices been increasing?</font> <font face="Verdana, Helvetica" size="2">David
Lereah</font><font face="Verdana, Helvetica" size="2">, chief economist
with the National Association of Realtors, explained:"It's a simple
matter of supply and demand…We continue to have more home buyers than
sellers in most of the country, which results in tight housing inventories and
higher rates of home price appreciation." Of course the cause of
higher home prices is that the Federal Reserve has kept interest rates, and
thus mortgage rates, at historically low rates so that people find it easier
to finance homes. In fact, despite an 18% increase in home prices since 2001,
the median monthly payment remained the same at $789/month and the
"median payment as a percentage of income" has actually fallen. This
is the magic of monetary inflation, courtesy of Alan Greenspan.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2"><strong>Price
inflation follows monetary inflation</strong></font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">The price of
just about everything I buy is going up these days. Gasoline is higher, dairy
products are higher, paper products and just about everything else—higher.
Mainstream economists have sounded surprised by the recent upturn in
price inflation and they have offered us every excuse to ignore signs of
inflation: Ignore rising oil prices. Ignore rising food prices. Ignore rising
health care costs. Ignore higher taxes and government fees. And then there is
their dirty little secret about housing prices.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Higher price
inflation should not have been a surprise given that the Fed has increased the
money supply by 25% during the period 2001-2003. In addition, the price of
basic commodities has been rising for many months and these higher commodity
prices eventually turn up in the price of goods and services. One leading
indicator of higher commodity prices is the Dow Jones Commodity Index (stock
prices of major commodity producers). It has been rising since the fourth
quarter of 2001 and has doubled in value since that time. This stock index is
now higher than it has ever been, outside of the blip that occurred in
mid-2002.</font>
<p class="MsoNormal" align="center"><img alt src="http://www.mises.org/images3/Thornton3.gif" border="0" width="533" height="221">
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Only recently
have commodity prices begun influencing government price indexes like the
Producer Price Index and the Consumer Price Index. For the first four months
of 2004 CPI-inflation increased at an annual rate of 4%, which is a higher
rate than we have"experienced" in the last few years. The Producer
Price Index actually decreased in 2001, but has increased in 2002 and 2003.
Over the last year, prices for finished producer goods increased 3.7% while at
earlier stages of production the prices for intermediate goods increased by
5.1% and the prices of crude materials index surged 20.4%. This would suggest
that there is plenty of price inflation still in the pipeline. The experience
of the 1970s would suggest that price inflation adds fuel to housing bubbles
because tangible assets like homes serve as a hedge against inflation.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2"><strong>The
Dirty Secret</strong></font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">While this price
inflation did not surprise me, the delay in its arrival did. That is, until I
came across the dirty little secret in the CPI. With prices increasing all
around us, there is one thing in Auburn, Alabama that seems to be in abundance
with stable, if not declining prices. This"good" is now being
advertised on most streets throughout the town, whereas in the past it did not
require much, if any, advertising over the twenty-plus years I have lived in
this college town. This abundant good is apartments and rental houses.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">It is a truly
odd market when houses and apartments move in opposite directions. After all,
houses and apartments are just different products in the same"market for
housing." In Auburn, it is nearly impossible to find the kind of house
you want to buy despite frantic building by construction companies, and yet
rental properties (which include many smaller houses) seem to be readily
available in all shapes and sizes. Has the population changed? Have people
become anti-rent? Or are we just in a"new housing paradigm"? Is
this a"new era" of homes?</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Greenspan's low
interest rates have driven renters to become homeowners and knocked the market
out of equilibrium. Underneath this Fed-inspired distortion rests the dirty
little secret of how the cost of housing has served to limit increases in
measured inflation. The Consumer Price Index has underreported price inflation
because the government uses the rental value of housing, rather the actual
price of houses, in their index.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">In the basket of
goods used to calculate CPI, the goods that have increased slower than housing
include food and beverages, recreation, and education, which total to about a
30% weighting of the CPI basket of goods. Housing accounts for 42% of the
basket, with housing"prices" representing almost 25% of the entire
basket. However, housing prices are calculated with"Owner's equivalent
rent" which is an estimate of the rent that people would have to pay for
their houses. With home prices rising and rental rates stagnant, CPI
underestimates the real rate of price inflation over the last year by about
50%.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Do Housing
Bubbles Burst?</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Housing prices
never, or rarely, go down. That is the conventional wisdom and the
conventional wisdom is correct. Housing is always a good investment, isn't it?
It's an inflation hedge and it's an investment that you get to use everyday,
plus you get a great tax break. And the home, after all, is a big part of the
American dream.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">However,
government can screw up just about everything. Given enough power and time it
will screw up everything. Housing and real estate in America is just the
latest example. The Federal Reserve and the Mac-May family (Freddie, Fannie,
Sallie, etc.) have conspired to create a housing bubble in the U.S. and as the
old saying goes,"what goes up must come down." It's only a matter
of time.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Housing bubbles
typically do not pop like a balloon; they don't even crash like
stock markets. Rather, the air in housing bubbles tends to leak out slowly—painfully
slowly—while in commercial real estate markets there is a more noticeable hiss.
We really don't know the current value of our homes until we sell them. They
are not traded on a daily basis, like shares of stock in Wal-Mart. Some never
get exchanged in the market, but are passed on within a family from generation
to generation. The market value of a home may drop 20% and the owner might
never realize it.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Worse yet, when
the market for real estate collapses, prices are less likely to
collapse because when buyers fail to make offers houses simply don't sell.
Sellers often resist cutting their prices in favor of just leaving the house
on the market or taking it off the market. Traditionally the market adjustment
to a collapse in real estate markets has come from the quantity side, not the
price side—fewer houses are sold—while price reductions tend to come
gradually. This doesn't mean that housing bubbles can't exist or that the bust
is any less painful, only that it doesn't make as much noise.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">It is difficult
to predict how long bubbles will last and when they will go bust. The best
indicator is interest rates, because when the Fed forces rates down it tends
to create bubbles, and when rates are forced upward bubbles tend to pop. My
guess is that Greenspan will raise rates after the election. The rates of
interest on long-term bonds have already"spiked" up from their
historical lows. The chart below shows the recent increase in the interest
rate on 10-Year Treasury bonds to the highest levels in almost two years.</font>
<p class="MsoNormal" align="center"><img alt src="http://www.mises.org/images3/Thornton4.gif" border="0" width="460" height="280">
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Prior to this
spike up, interest rates had been falling since the early 1980s. As mentioned
above, lower rates have coaxed people into refinancing their homes and drawing
equity out of their homes to spend on other purchases, like cars, boats,
renovations, vacations, or even investments in the stock market. As a result,
owner equity as a percentage of real estate value is now at an all-time low.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Here is the
unmentioned problem with Greenspan's panacea. What happens to all these"equity
poor" homeowners if the return of monetary inflation establishes a new
trend of higher prices and higher interest rates over the coming years?</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">An
ever-increasing proportion of mortgage financing has come in the form of
variable-rate mortgages, where the payment increases as interest rates
increase. In my experience, variable-rate mortgages come with a"cap"
that only allows the variable rate to increase by a certain amount. Even with
the cap, however, your mortgage payment could increase by around 50%. I have
recently learned that many variable-rate loans are now offered without a cap.
If rates were to explode upward, mortgage payments for these folks could
double or triple. And if this did happen, the housing market would collapse
with sellers swamping buyers.</font>
<p class="MsoNormal"><font face="Verdana, Helvetica" size="2">Given the
government's encouragement of lax lending practices, home prices could crash,
bankruptcies would increase, and financial companies, including the
government-sponsored mortgage companies, might require another taxpayer
bailout.</font>
<font face="Verdana, Helvetica" size="2">Of course inflation might not
materialize. Interest rates could stay low.</font> <font face="Verdana, Helvetica" size="2">In
a recent column</font><font face="Verdana, Helvetica" size="2">, I
reported on a new book that even predicts that deflation will reign in our
financial future. Greenspan has suggested that his economic panacea has given
American homeowners greater economic"flexibility." I would suggest
that it is not flexibility he offers, but the shackles to an economic
nightmare. Stick with the fixed-rate mortgages, keep the equity in your homes,
or go get one of those cheap apartments.</font>
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<hr align="left" width="33%" SIZE="1">
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<p class="MsoBodyText" align="left"><font face="Verdana, Helvetica" size="2">Mark
Thornton [send him mail] is an
economist who lives in Auburn, Alabama. He is author of <em>The Economics of
Prohibition</em>, is a senior fellow with the Ludwig
von Mises Institute, and is the Book Review Editor for the Quarterly
Journal of Austrian Economics. He is co-author of <em>Tariffs, Blockades,
and Inflation: The Economics of the Civil War</em>. Comment on this article on
the economics blog.
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