Monday, July 26, 2004

Housing Bubble: How Big the Bust?

G. Morgenson, writing for the NYT, reports on a Goldman-Sachs analysis that indicates that relative to the currently accomodating interest rate and economic environment that housing prices are nationwide already 10% overpriced. This report was filed before the most recent news that median house prices in June had hit a record high at over 9% higher than the previous year.

Housing Bust: It Won't Be Pretty

Published: July 25, 2004

LET the stock market slide. Let the bond market sink. As long as home prices keep rocking, it's easy for Americans to feel fat and happy.

But what happens when the run-up in housing prices loses steam, or worse? The implications are sobering, not only for homeowners but also for the economy as a whole.

With the growth rate for home prices starting to slow, now may be the time to ponder what a bear market in real estate may bring. A recent study by two economists at Goldman Sachs provides some answers.

For now, prices are still climbing over all. The average home price in the nation rose 7.71 percent in the 12 months ended in March.

But the first three months of this year showed far slower growth than previous periods. Prices rose only 0.96 percent, according to the Office of Federal Housing Enterprise Oversight, which keeps an eye on Fannie Mae and Freddie Mac. The last time housing prices grew by less than 1 percent in a quarter was in the spring of 1998.

More ominous, six states showed declines in housing prices in the first quarter: Vermont, Alaska, North Dakota, South Dakota, Iowa and Nebraska. No state had price declines in the previous quarter.

To be sure, home values are still hot in many spots. In the most recent 12 months, prices have jumped by more than 15 percent in Hawaii and Nevada, by 14 percent in California, 11 percent in New Jersey and 10 percent in New York.

In nominal terms, United States home prices are up 60 percent since 1995; in real terms, adjusted for inflation, they are up 37 percent. Viewed historically, home prices are up twice as much now as they were in the bullish real estate markets of both the mid-1970's and the 1980's.

As a percentage of disposable income, home prices are more than 18 percent above the long-term average. Prices exceeded that average by only 4 percent in the 1970's and 8.5 percent in the 1980's boom.

Michael Buchanan, a senior global economist at Goldman Sachs, and Themistoklis Fiotakis, a research assistant there, reckon that at current interest rates, home prices are now overvalued by 10 percent, on average. Because this figure spans the entire nation, the hottest markets - California and New York - are obviously more overpriced.

The economists compute fair value in home prices by using a variety of measures, including interest rates, population and demographic data, and the overall health of the economy. If interest rates increased by one percentage point, the economists said, home prices in the United States would be overvalued by 15 percent.

None of this would be worrisome if homeowners had not turned the paper profits in their properties into cold, spendable cash. But withdrawals from home equities have recently totaled 6.3 percent of household disposable income, according to the Goldman study. In the late 1980's, equity withdrawals reached only 2.5 percent of disposable income.

Federal Reserve studies indicate that as much as half of the equity withdrawals went into personal consumption and home improvements. As a result, the Goldman economists estimate that equity cash-outs added 1.75 percent to the growth in the gross domestic product in 2003. That is a significant increase from the 1.25 percent kick that equity withdrawals added in 2002.

Consumption would slip 1 percent, Goldman estimated, if housing prices fell by 10 percent, to the fair value level. But if prices decline to well below that, as often happens when overheated markets go cold, consumption may fall by 2.4 percent, Goldman reckoned.

Such a housing crash took place in Britain in the early 1990's. At the market's low, home prices had fallen by 27 percent, 5 percent below Goldman's estimate of fair value at the time.

Such a decline is not expected here, said Dominic Wilson, a senior global economist at Goldman. That's because home prices in Britain had escalated much more than they have in this country, even now. And interest rates had soared into the high teens, which is unlikely here.

But even small declines in home prices could hurt the economy. "The precise degree of the vulnerability isn't going to be clear until we see house prices slow," Mr. Wilson said. "You've never seen consumers this stretched, operating at levels of leverage we've never experienced before. House prices are starting at a level that is pretty high relative to what we think fair value is going to be, and the economy as a whole has gotten a lot more sensitive" to housing-related spending.

Indeed, Goldman estimates that home equity lines of credit and the like have magnified the effect of housing wealth on consumption over the past decade, taking it to 10 percent from 4 percent.

Although rising home prices have been stopped dead in the past by sharply higher interest rates, the Goldman economists note that bear markets don't necessarily need major triggers to get started.

Small events can change the market's psychology, and asset bubbles sometimes just cave in on themselves.

One risk that looms large, however, is that United States policy makers would have few tools to cushion the fall if a housing decline gained real momentum. Interest rates are already so low and fiscal policy so loose that little could be done to ease the pain.

"This is one of a series of risks and imbalances that suggest there has been a price to the low-interest-rate policy that led the recession to be much shallower than it might otherwise have been," Mr. Wilson said. "Fiscal and monetary policy are both already fully utilized. If things go wrong from here, the U.S. finds itself in a more fragile position." [emphasis added]

The oldman thinks we're looking at a roughly 25% housing price correction, or four years at the long term trend of 6% appreciation of housing assets of stagnant prices. However that hides the true pain. As the article pointed out, a great deal of the houses that have appreciated in price have had their owners monetize those paper profits using home equity loans that they are still responsible for. I'm sure that they were planning on paying off that debt whenever they sold their house. About half that money according to the article went directly into consumption, meaning a lot of people are exposed to debt on their house value that after a stagnant or corrected market they could not recoup enough to pay that debt off from the price appreciation.

According to the article, a single point higher of interest rates would indicate that the housing was overpriced 15% rather than 10%. A mere return to late nineties rates which were routinely about 4%, which was thought of as overly accomodating at the time, would mean that a proportional 25% overvalued status could be attributed to the housing market to extrapolate that projection. Of course we don't know that if in the face of a 2-3% pull back in consumer consumption that Greenspan with the FOMC would raise interest rates to about 4%.

However we do know that any attempt to cut the interest rates, or even hold them steady in the face of a balky US economy, would lessen the value of the dollar and make our debt less attractive. As such we would experience higher consumer inflation from imports, and the fact that our interest rates would be low would be more than compensated for by monetized inflation eating away at our wages and asset price levels. In that case, the housing would still be overvalued by about 25% but the destruction of that value would be accomplished by inflation over a few years instead of by a absolute price deflation.

Either way the American people are screwed. Greenspan and the FOMC can choose the type of pain, but they cannot prevent the pain. Given Greenspan's past actions, he might choose to debase the currency and opt for the "social stability" of higher monetized inflation. If so we are going to find much fewer customers for our debt, and potentially face a budget crunch. Imagine if the purchasers of US Treasuries were sharply curtailed and our government actually had to balance their budget and live within their means. Spending cuts and tax increases would be on the table.

Combine this with the foreign commitment of the Iraq war which has consumed something like $200 billion so far, and you have a bad situation. Of course if interest rates were raised that would cause a budget crunch as well, something like doubling or tripling the debt service. Either way the budget by this time next year is going to start looking like a huge mess, though it'll take a few years to completely play out.

And to think, some people are still arguing that there is no housing bubble.


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