The game now is called managing the down-turn. This study is one of such attempt. The core premise of expectation of return on real estate investment of recent buyers are reasonable according to these guys. Schiller and Case did a study in late 2003 and found that buyers in hot housing markets for the next ten years expected an annual return of 13 to 18 %. The question to us all is then is such a return reasonable for real estate or any other asset? Historically, it has not been done before. Your judgement, your decision!
This whole topic reminds me of the old (and worn out) joke:
A man walks into a bar and spots a beautiful woman. He walks up to her and asks... "Will you sleep with me if I paid you a million dollars?"
The woman thinks a half second and says "Why yes I would!"
The man then goes to buy her a drink, returns and asks... "Tell me, would you sleep with me if I paid you a hundred dollars?"
The woman becomes angry and yells at the man..."WHAT DO YOU THINK I AM... A WHORE?!"
The man replies... "We established that with the first question, now it is only a matter of determining the final price..."
The question of 'when is a bubble, a bubble' is kind of like 'when is a whore, a whore'... Like the joke I think we are beyond definitions whether the RE types want to admit it or not... and are now only arguing about 'degree' & 'final prices'.
"NAR US home median home price 1970 $23,000, NAR US median home price 2005 $208,500, BLS CPI 1970 37.8, BLS CPI 2005 193.2. That yields a 906.52% nominal increase with a 411.11% inflation adjustment. With 73% of firsts showing an LTV of 71% or higher (2004 data from Mortgage Bankers Association), this is really a story of absolutely massive credit expansion. Who needs jobs, income, productivity or infrastructure when you can borrow ad infinitum."
The key point is the "massive credit expansion". Brad Setser had a post on Synthetic CDOs that pointed out that banks are retaining the most complex and riskiest tranches on their books. With bank assets concentrated in real estate to the tune of 60% of all assets and the opaque credit derivatives portoflios, what are the real systemic risks? Can the US taxpayer support another bailout of the banking system, if markets get unhinged?
df, that has been my attitude - call it what you want, a housing bubble, an overextended asset class, a credit bubble, whatever - I expect prices are still going to decline over the next several years. And I expect the housing slowdown to slow the general economy.
malabar, the US will make it through, but I don't know how widespread the problem will be - problems are always hidden during the good times and exposed when the economy slows down. Dr. Setser's piece actually scared me!
Far be it from me to suggest some sort of conflict of interest here, but it is interesting to note that Todd Sinai's views are shared by at least one of the major backers of the Zell Lurie Real Estate Center at Wharton, Sam Zell, who owns 128 million square feet of office space and 225,000 apartments in the United States.
Zell: No bubble here
Sam Zell, the nation's biggest landlord, has a message for real estate worrywarts: Relax.
Soft landing or crash?
S&P sees gradual unwinding of housing bubble
By John Spence, MarketWatch
BOSTON (MarketWatch) -- The popping of the red-hot U.S. housing market will likely play out as a steady deceleration of prices followed by stabilization, rather than a dramatic national downturn, Standard & Poor's said Monday.
"The bubble should end with a fizzle, not a bang," said S&P Chief Economist David Wyss in a conference call Monday, adding that it's difficult to nail down exactly when the market might weaken, and what the implications might be for the overall economy.
Still, Wyss indicated that rocketing home prices in several parts of the country are unsustainable and cannot go on forever. Looming interest-rate increases are another potential problem that may affect two sectors linked to the housing market: home-builder stocks and real-estate investment trusts.
Credit rating and investment-research agency S&P unveiled multiple reports on the global housing market Monday.
Currently, the average U.S. home price is roughly 3.1 times the average household income, the highest in history and up from an average of 2.6 times since 1960, according to S&P. Driven by low mortgage rates and looser lending standards, home-ownership levels of 69.4% are also at an all-time high.
Yet most of the price appreciation is concentrated in sizzling markets in California, Florida and the Northeast. For example, on both coasts, housing costs have risen at least 30% above the normal home price-to-income ratio, S&P calculated.
Despite regional dangers, S&P estimates it would take a 30% decline in national home prices, combined with a 50% drop-off in new-home starts, to drive the economy into even a slight recession, Wyss wrote in a recent report.
here's a CNN transcript from 2000 in which he describes the bubble he's "never seen":
Copyright 2000 Cable News Network
All Rights Reserved
CNN
SHOW: CNN STREET SWEEP 15:59
April 11, 2000; Tuesday
Transcript # 00041100V61
Sam Zell is chairman of Equity Office Properties. He joins us now from our Chicago bureau.
Welcome, Sam.
SAM ZELL, CHAIRMAN, EQUITY OFFICE PROPERTIES TRUST: Thank you, Jan.
HOPKINS: So what's going on with technology stocks?
ZELL: Well, I don't know what's going on with technology stocks, but I think that there is a -- a similarity to what happened to the real estate industry in the '80s. During the '80s, we overallocated capital to the real estate industry, and we distorted the economy, with the result being that every building built from 1985 to 1989 ended up being worth less when it was finished than what it cost.
And I think that in the same manner, the current tech environment represents a frenzy and a bubble very similar to the overallocation and distortions of the '80s in real estate, that we're seeing in the techs arena here in the early part of the 21st century.
There will be trouble in the banks. Of that I have no doubt. I can imagine scenarios in which it is contained and resolved without a price tag worse than the S&Ls, but I cannot imagine any of those scenarios playing out under the Bush administration. Any remaining pollyanna sense anyone had that surely they wouldn't let us go there ought to have been wiped out by Katrina. They are not competent, they do not understand how government works, they do not understand how the economy works. Pork and eliminating regulatory scrutiny, they understand.
Ask anyone who worked for a thrift in those years, as I did: we knew. The regulators knew. Henry B. Gonzales knew. The public slept on and the administration sang lullabys until the whole system blew. (And I didn't even work for one of the criminal thrifts, mind you, just one of the garden variety undercapitalized recipients of supervisory goodwill with a porfolio of commercial REO and a management team of complacent country-club Republicans who thought Regulation B was a sign of imminent Communist Takeover.)
It's different these days, of course. Bank in the old days you could still read a financial institution's balance sheet without a James Bond Secret Decoder Ring. In the New Era, nobody has a barking clue what they're up to.
"Bank in the old days you could still read a financial institution's balance sheet without a James Bond Secret Decoder Ring. In the New Era, nobody has a barking clue what they're up to."
This in my mind is very troubling - the incredibly opaque nature of risks on balance sheets of financial institutions. When standout investment grade companies like Fannie Mae need 1500 people and yet cant publish their financials something is going on. When rating agencies cant really plow through the complexities of some of the assets and all the off balance sheet items yet provide investment grade ratings unknown risk get transmitted to investors. When regulators are always behind as financial "innovation" is miles ahead, any crisis response is too little too late. When financial institutions represent such a large percentage of S&P earnings and market cap any hiccup there has an market wide impact.
I am very interested to understand what risk management approaches can be applied by central banks if a "tail risk" scenario like the levee breach occurs?
As you all know I love analogies... this argument makes me think of one from my youth...
We used to go to a river near the Twin Cities (the St Croix River - beautiful & wild)... we would camp at a state park and dive off cliffs into the river... 40, 50, 60 or more feet into brown tannin stained water.
I can tell you one thing for sure... the 'hardness' of the surface of water is at least proportional to the height from which you jump... When you jump from great height (say 60 or 80 feet)... it feels like you jumped off the roof of your house onto pavement... even clean landings were VERY hard.
I think the RE bubble-not-bubble is like this... the higher we get, the bigger the jump, the harder the landing...
And with the clowns we got running this country I don't think the landing will be clean at all... more like a belly flop.
I just about gagged on this. It may be that I was one of the favored IT class offshored who has has worked at a $10 a hour job for one year of the last 4 years. Previously I had health insurence, a pension, and a stable job.
This is what made me gad.
"Nickell also said that low inflation, the rise in two-salary households and increased levels of job security and rapid prospective earnings growth may also make it more sensible for households to borrow more now than they have in the past."
What job security, what rapid earnings growth and I thought the 2 income household migration had completed decades ago.
The Chron was never great but it has never been worse that now. One writer, Abate, basically reruns the same "Bay Area Recovering" story every 2-3 months, Epstein quotes the AEI, Marinucci fawns over Arnold, and Lockhead gives us the party line straight from DC.
Housing prices have stopped rising in Connecticut- while at the same time there has been a significant rise in inventories. To say there is no bubble in in Califonrnia when a fixer upper is 600K+ sounds rather bizarre to me.
Conceptually, it's a rent versus buy analysis. In the cost of buying they include the opportunity cost of tying an hypothetical capital worth the value of the house compared to a risk free investment, they take into account the mortgage and property tax deduction, the cost of maintenance, a risk premium, and as mentionned in the first post an expected capital appreciation (though not any crazy increase average joe may hope for but rather what historically a particular local market has returned).
They do acknowledge that low real long term interest rates have a disproportionate effect on the "user cost" of owning. This may show that you don't have a real estate bubble unless you also have a bond bubble, as noted by a past contributor to this blog (Richard?).
They don't quite explain how they run their calculation, but I assume that the only variables that change are the mortgage rate and the opportunity risk-free rate, while the risk premium, tax rate, maintenance rate, and expected appreciation rate stay constant. So in effect their study is a study on how actual rents deviate from a hypothetical fundamental value based on interest rates.
Also I'm not clear at all when they use nominal versus real rates. There could be a substantial bias if they weren't consistent. Say, use real interest rate (currently low) to assess the opportunity cost, but use nominal mortgage rate to assess the tax benefit and use nominal appreciation trend rate to assess capital appreciation...
We got a call today from an appraiser. She had been asked by Centex to give a second opinion on an appraisal done two years ago. The first appraiser had valued a house at $372,000. We sold it for $219,000. Today it is for sale again at $240,000. Apparently, Centex wants to know how on earth the first appraiser could have possibly appraised the house at more than $140,000 above fair market value.
I had a discussion last week with another appraiser who told me that he almost went broke because he wouldn't overvalue properties at the price the lenders wanted the properties appraised at. "If you won't appraise the value at X, we'll find someone who will." And obviously they did.
This is what I'm talking about. The changes in the law that took place in the 1980s, after the banking crisis, compromised and corrupted the appraisal process. Now the appraiser is given a copy of the sales contract (and with it a target price to meet) before the appraisal is done. Since no lender is going to approve a loan if the appraised value does not meet or exceed the sales price, there is pressure on the appraiser to overvalue a given house. [An appraisal that is not objective and truly independent is not worth the paper it's printed on.] That coupled with mortgage brokers pushing risky loans is, more than anything else, responsible to the exhorbitant rise in housing prices.
I've said it before and I'll say it again. We're not in a housing bubble. We're in a financing bubble. The prices of houses hasn't really risen that much, but the price of financing has.
We're heading inexorably toward another banking crisis.
The other part of the equation that doesn't make sense to me in the paper is this:
1) you have an opportunity cost of not being able to invest the price of the home in the treasury market.
2) you get a tax benefit because you can deduct the mortgate interest.
Which seem to imply you can pay cash and get a mortgage deduction. It's an illogical assumption. Either you factor a mortgage deduction, but then you should be using the mortgage rate for the cost of financing. Or you use an opportunity cost at treasury rates level, but then you should leave out the mortgage deduction. They are having it both ways here.
This inconsisteny is more important as rates gets lower. At the extreme if treasury rates are 0, and mortgate rates slightly positive then you actually earn money when buying (since you get no opportunity cost, but you have a tax deduction).
jl - the ultimate weakness in their analysis and the one ALL cost-of-ownership wonks ignore is dynamics... how things change over time. If they are going to make COO the basis for price justification then the inputs have to reflect the likely variance of conditions over the projected MAXIMUM time frame or window.
I don't know squat about RE really... but I know about costing. For parts that go into products & the plants that make them... And no one doing that kind of calculation looks at 'snap shot' time period conditions to justify a relatively long investment cycle... like property. Instead they perform 'sensitivity analysis' to see how the range of past conditions or possible future conditions effect the decision... and while the analysis might not always be pretty... it should never look suicidal. In many cases and many locations for many people... even a modest change in conditions (like rate increases) makes the current RE pricing become disasterous in far too many cases... If that happens for too many people at one time it turns into a complete panic and trashes all.
The prices people pay today have to still make sense in 5, 10 or maybe even 15 years from now. And the way you can judge whats likely to happen at some period 5, 10, 15 years from now is to look whats happened in the past over similar time periods and then use rational models to suggest a future range of likely conditions. We are at historic lows for interest rates... they can't get much lower.
And the argument that 'well, we'll just sell if it gets shitty...' is great if they can... or if they can afford the loss to sell at a discount. I remember times in the 80s were nice homes, in good neighborhoods, heavily discounted still took 3 years to sell.
The cost of ownership argument is one of the weakest out there unless done correctly... far weaker than just saying "I have the money and I want the property, I'm going to buy it!" Or... "I know it is a huge risk, but life is short and I'm willing to take the risk..." I can fathom those... but trying to say these prices are 'justified' by COO logic? No way - not if the COO is done right.
I've said it before and I'll say it again. We're not in a housing bubble. We're in a financing bubble. The prices of houses hasn't really risen that much, but the price of financing has.
Scott - don't kid yourself. Prices HAVE risen a lot... its the real VALUES of the houses that haven't risen... but that 'financing bubble' you accurately described (IMHO) is driving those price increases with or without long term sustainable value.
I mean nobody is really denying the price increases on both coasts... only arguing if it is 'supportable by fundementals' or a 'bubble'.
I can't help smiling. Prices don't even make sense today!
Ya jl - I know... makes ya wonder how they even get asked to write articles like that... and yet be able to claim with a straight face that it isn't pure pulp fiction.
I think what the fed study said was that housing is affordable given low interest rates. If interest rates were higher houses would not be affordable given current prices. This is essentially correct as far as I can tell. The authors note that house prices are very sensitive to interest rates. So fundamentally the housing market is not overvalued given the low interest rate environment. However, it is clearly vulnerable to interest rate increases.
By the way I just noticed that house for sale inventory on the uppper east side in new york went from 800 to over 900 in about a month.
Well, say a house is listed at $100,000. A buyer goes to a mortgage broker who promises to make him a deal, a "Smart Choice" loan. No down payment, no closing costs. Closing costs are 8% or $8000. Mortgage broker fees are 2% or $2000. So the buyer takes out a loan for $110,000 to buy a $100,000 house. The lender gets an appraisal. What do you think the odds are that the appraiser is going to value the house at $110,000 or more? The buyer pays $110,000 for the house (seller to pay buyer's closing costs and mortgage broker fees). The sales price makes it appear that the house sold for more than it actually did, unless one checks the seller concessions. I've seen hundreds of deals exactly like that over the last few years.
It is true that the prices of homes have risen dramatically, but only in certain areas (like the coasts). In my area, housing prices only rose 3.3% over last year. The cost of borrowing, to a fool (and only a fool would take out a loan as described above), has risen 10%.
Scott, I make my living writing mortgage credit guidelines and doing due diligence reviews of bulk loan acquisitions and securitizations. I do not get my information about lender guidelines from the web.
I don't know exactly what you mean by "Smart Choice," but if you mean Quicken's program called "Smart Choice," you are misrepresenting it. (Quicken uses that name but as far as I know didn't trademark it.)
I, personally, have seen some squirrelly guidelines in my time, but I have never seen a lender who doesn't base LTV on the lesser of sales price or appraised value for a purchase. Nor have I ever seen a lender who doesn't use GSE (or very similar) rules for interested party contributions, especially if they're offering 100% financing. Those rules limit seller-paid costs to 3.00% of the lesser of value or price if the LTV exceeds 90%.
The way your example works, if the contract sales price is $100,000, the appraiser can appraise for anything between $100,001 and three billion; it won't matter unless the appraisal comes in under the sales price.
However, if the seller is paying $8,000 in concessions, that exceeds the limits by $5,000, so the lender is going to reduce the sales price to $95,000 for LTV purposes. If the lender offers a 100% LTV loan, that means the borrower can finance up to $95,000. The borrower doesn't pay $110,000 for the house. The borrower pays $100,000 for the house but has to make a down payment of $5,000, which is the equivalent of making no down payment but paying his or her own $5,000 in closing costs.
If you jack up the sales price to $110,000, you still have excess contributions (7.2% of sales price instead of 8%, assuming that the dollar amount of the contributions doesnt increase with the new sales price, as it will if youre paying percentage-based costs.)
You complained about appraisers getting a copy of the sales contract: that requirement prevents the scenario you describe. It doesn't make appraisals more likely to be inflated, but less, since the appraisal has to take into account the fact that the sales price may need to be discounted by the concessions (which only appear in the sales contract, not in the list price).
In the bad old days before FIRREA, it was all too common for an appraisal to support an inflated value because the appraisal did not address the fact that the only reason the property was moving on the market was that the seller offered to carry back a second, pay closing costs, leave the lawnmower and the 8-track tape deck, rent the buyer's U-Haul and sacrifice his firstborn. (Irony alert!) Since FIRREA, guidelines require an appraiser to take such non-price inducements to sale into account in estimating fair market value. The value for a property with too many concessions or too much creative financing gets adjusted downward to meet the terms of comparable sales. If the comparables all involve excessive concessions as well, the lender generally declares a weak market and changes its LTV limits therein.
I'm happy to say I'm wrong if you can find me a link for a lender who does what you describe. Of course, if they are or they sell to a regulated institution, I may have to report them for writing fraudulent HUD-1s.
You are misrepresenting what the study says. It does not talk about affordability. What the study does is to compute a "fundamental" yearly cost value based on a formula, and compare that to the actual rent cost observed during the past 24 years. On based on this, they suggest current prices in most market are not above trend.
I have two concerns on their study.
1) I think their formula is underestimating the opportunity cost in relation to the mortgage deduction benefit. And this error gets worse as rates get lower (like today).
2) Their notion of fundamentals assumes that only interest rates variation explains price variations. According to this definition, it would not be surprising to find out prices should be higher if interest rates are lower. I don't see how this definition is inherently better than the price to income or price to rent ratio, given that interest rates are expected to rise. Now if they were explaining why interest rates will be permanently lower, they could be onto something.
I think one can make the case that economics have driven much of recent housing price increases. The problem with this though is that they can just as easily drive price decreases in the future and that this is more likely than a continuation of the former. It is the unnamed assumption that prices can only go up, or if they don't it won't matter, I have problems with.
CR, care to rebut this one? Yes, it's from the WSJ opinion page, but the original study comes from the NY Fed.
I think they raise a good point by noting that annual cost-to-rent ratios are more important than price-to-rent ratios for determining affordability, but in so doing they seem to understate the risk that rising interest rates pose (this being the implicit assumption that homebuyers and investors are making as they continue to heap on cheap mortgage debt).
I think they raise a good point by noting that annual cost-to-rent ratios are more important than price-to-rent ratios for determining affordability
Sorry they just make this assertion. Their data does not prove that cost-to-rent ratios should be more important that price-to-rent ratio when assesing the fundamental value of a house. It's just something they take for granted.
I have read the original study, and there is absolutely no explanation why user cost should be more relevant than price to rent ratio, except to say other people often makes this mistake... As you may realize the main difference is interest rate. Factoring interest rate in the fundamental value of a house is a matter of opinion.
As an extreme example, I buy a car that I finance for 5 years with 0% interest loan. You buy the same car and you pay cash. Has the way we financed it changed the fundamental value of the car? It's still the same model, the same parts and the same brand.
The game now is called managing the down-turn. This study is one of such attempt. The core premise of expectation of return on real estate investment of recent buyers are reasonable according to these guys. Schiller and Case did a study in late 2003 and found that buyers in hot housing markets for the next ten years expected an annual return of 13 to 18 %. The question to us all is then is such a return reasonable for real estate or any other asset? Historically, it has not been done before. Your judgement, your decision!
This whole topic reminds me of the old (and worn out) joke:
A man walks into a bar and spots a beautiful woman. He walks up to her and asks... "Will you sleep with me if I paid you a million dollars?"
The woman thinks a half second and says "Why yes I would!"
The man then goes to buy her a drink, returns and asks... "Tell me, would you sleep with me if I paid you a hundred dollars?"
The woman becomes angry and yells at the man..."WHAT DO YOU THINK I AM... A WHORE?!"
The man replies... "We established that with the first question, now it is only a matter of determining the final price..."
The question of 'when is a bubble, a bubble' is kind of like 'when is a whore, a whore'... Like the joke I think we are beyond definitions whether the RE types want to admit it or not... and are now only arguing about 'degree' & 'final prices'.
JS had this to say in an earlier thread:
"NAR US home median home price 1970 $23,000, NAR US median home price 2005 $208,500, BLS CPI 1970 37.8, BLS CPI 2005 193.2. That yields a 906.52% nominal increase with a 411.11% inflation adjustment. With 73% of firsts showing an LTV of 71% or higher (2004 data from Mortgage Bankers Association), this is really a story of absolutely massive credit expansion. Who needs jobs, income, productivity or infrastructure when you can borrow ad infinitum."
The key point is the "massive credit expansion". Brad Setser had a post on Synthetic CDOs that pointed out that banks are retaining the most complex and riskiest tranches on their books. With bank assets concentrated in real estate to the tune of 60% of all assets and the opaque credit derivatives portoflios, what are the real systemic risks? Can the US taxpayer support another bailout of the banking system, if markets get unhinged?
df, that has been my attitude - call it what you want, a housing bubble, an overextended asset class, a credit bubble, whatever - I expect prices are still going to decline over the next several years. And I expect the housing slowdown to slow the general economy.
malabar, the US will make it through, but I don't know how widespread the problem will be - problems are always hidden during the good times and exposed when the economy slows down. Dr. Setser's piece actually scared me!
Best Regards.
Far be it from me to suggest some sort of conflict of interest here, but it is interesting to note that Todd Sinai's views are shared by at least one of the major backers of the Zell Lurie Real Estate Center at Wharton, Sam Zell, who owns 128 million square feet of office space and 225,000 apartments in the United States.
Zell: No bubble here
Sam Zell, the nation's biggest landlord, has a message for real estate worrywarts: Relax.
MONEY Magazine: Your Home 2005: Bubble, shmubble - May. 19, 2005
Zell tells of optimistic outlook on real estate
USATODAY.com - Zell tells of optimistic outlook on real estate
Todd Sinai's paper on the bubble can be found on the Zell/Lurie Real Estate Center at Wharton's website
Zell/Lurie Real Estate Center at Wharton : Research
Soft landing or crash?
S&P sees gradual unwinding of housing bubble
By John Spence, MarketWatch
BOSTON (MarketWatch) -- The popping of the red-hot U.S. housing market will likely play out as a steady deceleration of prices followed by stabilization, rather than a dramatic national downturn, Standard & Poor's said Monday.
"The bubble should end with a fizzle, not a bang," said S&P Chief Economist David Wyss in a conference call Monday, adding that it's difficult to nail down exactly when the market might weaken, and what the implications might be for the overall economy.
Still, Wyss indicated that rocketing home prices in several parts of the country are unsustainable and cannot go on forever. Looming interest-rate increases are another potential problem that may affect two sectors linked to the housing market: home-builder stocks and real-estate investment trusts.
Credit rating and investment-research agency S&P unveiled multiple reports on the global housing market Monday.
Currently, the average U.S. home price is roughly 3.1 times the average household income, the highest in history and up from an average of 2.6 times since 1960, according to S&P. Driven by low mortgage rates and looser lending standards, home-ownership levels of 69.4% are also at an all-time high.
Yet most of the price appreciation is concentrated in sizzling markets in California, Florida and the Northeast. For example, on both coasts, housing costs have risen at least 30% above the normal home price-to-income ratio, S&P calculated.
Despite regional dangers, S&P estimates it would take a 30% decline in national home prices, combined with a 50% drop-off in new-home starts, to drive the economy into even a slight recession, Wyss wrote in a recent report.
"We think such a scenario is unlikely," he said.
More on the real estate bubble at Wharton
Could Risky Mortgage Lending Practices Prick the Housing Bubble?
Could Risky Mortgage Lending Practices Prick the Housing Bubble? - Knowledge@Wharton
Re, the old Zell links, I did this awhile ago but I guess it's time to ressurect. He claims he's "never seen" a bubble in this link:
MONEY Magazine: Your Home 2005: Bubble, shmubble - May. 19, 2005
here's a CNN transcript from 2000 in which he describes the bubble he's "never seen":
Copyright 2000 Cable News Network
All Rights Reserved
CNN
SHOW: CNN STREET SWEEP 15:59
April 11, 2000; Tuesday
Transcript # 00041100V61
Sam Zell is chairman of Equity Office Properties. He joins us now from our Chicago bureau.
Welcome, Sam.
SAM ZELL, CHAIRMAN, EQUITY OFFICE PROPERTIES TRUST: Thank you, Jan.
HOPKINS: So what's going on with technology stocks?
ZELL: Well, I don't know what's going on with technology stocks, but I think that there is a -- a similarity to what happened to the real estate industry in the '80s. During the '80s, we overallocated capital to the real estate industry, and we distorted the economy, with the result being that every building built from 1985 to 1989 ended up being worth less when it was finished than what it cost.
And I think that in the same manner, the current tech environment represents a frenzy and a bubble very similar to the overallocation and distortions of the '80s in real estate, that we're seeing in the techs arena here in the early part of the 21st century.
There will be trouble in the banks. Of that I have no doubt. I can imagine scenarios in which it is contained and resolved without a price tag worse than the S&Ls, but I cannot imagine any of those scenarios playing out under the Bush administration. Any remaining pollyanna sense anyone had that surely they wouldn't let us go there ought to have been wiped out by Katrina. They are not competent, they do not understand how government works, they do not understand how the economy works. Pork and eliminating regulatory scrutiny, they understand.
Ask anyone who worked for a thrift in those years, as I did: we knew. The regulators knew. Henry B. Gonzales knew. The public slept on and the administration sang lullabys until the whole system blew. (And I didn't even work for one of the criminal thrifts, mind you, just one of the garden variety undercapitalized recipients of supervisory goodwill with a porfolio of commercial REO and a management team of complacent country-club Republicans who thought Regulation B was a sign of imminent Communist Takeover.)
It's different these days, of course. Bank in the old days you could still read a financial institution's balance sheet without a James Bond Secret Decoder Ring. In the New Era, nobody has a barking clue what they're up to.
Well put Tanta.
"Bank in the old days you could still read a financial institution's balance sheet without a James Bond Secret Decoder Ring. In the New Era, nobody has a barking clue what they're up to."
This in my mind is very troubling - the incredibly opaque nature of risks on balance sheets of financial institutions. When standout investment grade companies like Fannie Mae need 1500 people and yet cant publish their financials something is going on. When rating agencies cant really plow through the complexities of some of the assets and all the off balance sheet items yet provide investment grade ratings unknown risk get transmitted to investors. When regulators are always behind as financial "innovation" is miles ahead, any crisis response is too little too late. When financial institutions represent such a large percentage of S&P earnings and market cap any hiccup there has an market wide impact.
I am very interested to understand what risk management approaches can be applied by central banks if a "tail risk" scenario like the levee breach occurs?
On the argument over 'hard vs soft' landings...
As you all know I love analogies... this argument makes me think of one from my youth...
We used to go to a river near the Twin Cities (the St Croix River - beautiful & wild)... we would camp at a state park and dive off cliffs into the river... 40, 50, 60 or more feet into brown tannin stained water.
I can tell you one thing for sure... the 'hardness' of the surface of water is at least proportional to the height from which you jump... When you jump from great height (say 60 or 80 feet)... it feels like you jumped off the roof of your house onto pavement... even clean landings were VERY hard.
I think the RE bubble-not-bubble is like this... the higher we get, the bigger the jump, the harder the landing...
And with the clowns we got running this country I don't think the landing will be clean at all... more like a belly flop.
I just about gagged on this. It may be that I was one of the favored IT class offshored who has has worked at a $10 a hour job for one year of the last 4 years. Previously I had health insurence, a pension, and a stable job.
This is what made me gad.
"Nickell also said that low inflation, the rise in two-salary households and increased levels of job security and rapid prospective earnings growth may also make it more sensible for households to borrow more now than they have in the past."
What job security, what rapid earnings growth and I thought the 2 income household migration had completed decades ago.
The Chron was never great but it has never been worse that now. One writer, Abate, basically reruns the same "Bay Area Recovering" story every 2-3 months, Epstein quotes the AEI, Marinucci fawns over Arnold, and Lockhead gives us the party line straight from DC.
Housing prices have stopped rising in Connecticut- while at the same time there has been a significant rise in inventories. To say there is no bubble in in Califonrnia when a fixer upper is 600K+ sounds rather bizarre to me.
The more they tell people not to worry, the more theyll worry. This could be a good thriller folks, pass the popcorn.
I think the Charles Himmelberg, Christopher Mayer, and Todd Sinai
is interesting. At least they provide a rationale to why prices may be supported by some fundamentals.
Conceptually, it's a rent versus buy analysis. In the cost of buying they include the opportunity cost of tying an hypothetical capital worth the value of the house compared to a risk free investment, they take into account the mortgage and property tax deduction, the cost of maintenance, a risk premium, and as mentionned in the first post an expected capital appreciation (though not any crazy increase average joe may hope for but rather what historically a particular local market has returned).
They do acknowledge that low real long term interest rates have a disproportionate effect on the "user cost" of owning. This may show that you don't have a real estate bubble unless you also have a bond bubble, as noted by a past contributor to this blog (Richard?).
They don't quite explain how they run their calculation, but I assume that the only variables that change are the mortgage rate and the opportunity risk-free rate, while the risk premium, tax rate, maintenance rate, and expected appreciation rate stay constant. So in effect their study is a study on how actual rents deviate from a hypothetical fundamental value based on interest rates.
Also I'm not clear at all when they use nominal versus real rates. There could be a substantial bias if they weren't consistent. Say, use real interest rate (currently low) to assess the opportunity cost, but use nominal mortgage rate to assess the tax benefit and use nominal appreciation trend rate to assess capital appreciation...
We got a call today from an appraiser. She had been asked by Centex to give a second opinion on an appraisal done two years ago. The first appraiser had valued a house at $372,000. We sold it for $219,000. Today it is for sale again at $240,000. Apparently, Centex wants to know how on earth the first appraiser could have possibly appraised the house at more than $140,000 above fair market value.
I had a discussion last week with another appraiser who told me that he almost went broke because he wouldn't overvalue properties at the price the lenders wanted the properties appraised at. "If you won't appraise the value at X, we'll find someone who will." And obviously they did.
This is what I'm talking about. The changes in the law that took place in the 1980s, after the banking crisis, compromised and corrupted the appraisal process. Now the appraiser is given a copy of the sales contract (and with it a target price to meet) before the appraisal is done. Since no lender is going to approve a loan if the appraised value does not meet or exceed the sales price, there is pressure on the appraiser to overvalue a given house. [An appraisal that is not objective and truly independent is not worth the paper it's printed on.] That coupled with mortgage brokers pushing risky loans is, more than anything else, responsible to the exhorbitant rise in housing prices.
I've said it before and I'll say it again. We're not in a housing bubble. We're in a financing bubble. The prices of houses hasn't really risen that much, but the price of financing has.
We're heading inexorably toward another banking crisis.
The other part of the equation that doesn't make sense to me in the paper is this:
1) you have an opportunity cost of not being able to invest the price of the home in the treasury market.
2) you get a tax benefit because you can deduct the mortgate interest.
Which seem to imply you can pay cash and get a mortgage deduction. It's an illogical assumption. Either you factor a mortgage deduction, but then you should be using the mortgage rate for the cost of financing. Or you use an opportunity cost at treasury rates level, but then you should leave out the mortgage deduction. They are having it both ways here.
This inconsisteny is more important as rates gets lower. At the extreme if treasury rates are 0, and mortgate rates slightly positive then you actually earn money when buying (since you get no opportunity cost, but you have a tax deduction).
jl - the ultimate weakness in their analysis and the one ALL cost-of-ownership wonks ignore is dynamics... how things change over time. If they are going to make COO the basis for price justification then the inputs have to reflect the likely variance of conditions over the projected MAXIMUM time frame or window.
I don't know squat about RE really... but I know about costing. For parts that go into products & the plants that make them... And no one doing that kind of calculation looks at 'snap shot' time period conditions to justify a relatively long investment cycle... like property. Instead they perform 'sensitivity analysis' to see how the range of past conditions or possible future conditions effect the decision... and while the analysis might not always be pretty... it should never look suicidal. In many cases and many locations for many people... even a modest change in conditions (like rate increases) makes the current RE pricing become disasterous in far too many cases... If that happens for too many people at one time it turns into a complete panic and trashes all.
The prices people pay today have to still make sense in 5, 10 or maybe even 15 years from now. And the way you can judge whats likely to happen at some period 5, 10, 15 years from now is to look whats happened in the past over similar time periods and then use rational models to suggest a future range of likely conditions. We are at historic lows for interest rates... they can't get much lower.
And the argument that 'well, we'll just sell if it gets shitty...' is great if they can... or if they can afford the loss to sell at a discount. I remember times in the 80s were nice homes, in good neighborhoods, heavily discounted still took 3 years to sell.
The cost of ownership argument is one of the weakest out there unless done correctly... far weaker than just saying "I have the money and I want the property, I'm going to buy it!" Or... "I know it is a huge risk, but life is short and I'm willing to take the risk..." I can fathom those... but trying to say these prices are 'justified' by COO logic? No way - not if the COO is done right.
I've said it before and I'll say it again. We're not in a housing bubble. We're in a financing bubble. The prices of houses hasn't really risen that much, but the price of financing has.
Scott - don't kid yourself. Prices HAVE risen a lot... its the real VALUES of the houses that haven't risen... but that 'financing bubble' you accurately described (IMHO) is driving those price increases with or without long term sustainable value.
I mean nobody is really denying the price increases on both coasts... only arguing if it is 'supportable by fundementals' or a 'bubble'.
I vote for the 'bubble'.
dryfly,
The prices people pay today have to still make sense in 5, 10 or maybe even 15 years from now.
I can't help smiling. Prices don't even make sense today!
I can't help smiling. Prices don't even make sense today!
Ya jl - I know... makes ya wonder how they even get asked to write articles like that... and yet be able to claim with a straight face that it isn't pure pulp fiction.
I think what the fed study said was that housing is affordable given low interest rates. If interest rates were higher houses would not be affordable given current prices. This is essentially correct as far as I can tell. The authors note that house prices are very sensitive to interest rates. So fundamentally the housing market is not overvalued given the low interest rate environment. However, it is clearly vulnerable to interest rate increases.
By the way I just noticed that house for sale inventory on the uppper east side in new york went from 800 to over 900 in about a month.
Well, say a house is listed at $100,000. A buyer goes to a mortgage broker who promises to make him a deal, a "Smart Choice" loan. No down payment, no closing costs. Closing costs are 8% or $8000. Mortgage broker fees are 2% or $2000. So the buyer takes out a loan for $110,000 to buy a $100,000 house. The lender gets an appraisal. What do you think the odds are that the appraiser is going to value the house at $110,000 or more? The buyer pays $110,000 for the house (seller to pay buyer's closing costs and mortgage broker fees). The sales price makes it appear that the house sold for more than it actually did, unless one checks the seller concessions. I've seen hundreds of deals exactly like that over the last few years.
It is true that the prices of homes have risen dramatically, but only in certain areas (like the coasts). In my area, housing prices only rose 3.3% over last year. The cost of borrowing, to a fool (and only a fool would take out a loan as described above), has risen 10%.
Scott, I make my living writing mortgage credit guidelines and doing due diligence reviews of bulk loan acquisitions and securitizations. I do not get my information about lender guidelines from the web.
I don't know exactly what you mean by "Smart Choice," but if you mean Quicken's program called "Smart Choice," you are misrepresenting it. (Quicken uses that name but as far as I know didn't trademark it.)
I, personally, have seen some squirrelly guidelines in my time, but I have never seen a lender who doesn't base LTV on the lesser of sales price or appraised value for a purchase. Nor have I ever seen a lender who doesn't use GSE (or very similar) rules for interested party contributions, especially if they're offering 100% financing. Those rules limit seller-paid costs to 3.00% of the lesser of value or price if the LTV exceeds 90%.
The way your example works, if the contract sales price is $100,000, the appraiser can appraise for anything between $100,001 and three billion; it won't matter unless the appraisal comes in under the sales price.
However, if the seller is paying $8,000 in concessions, that exceeds the limits by $5,000, so the lender is going to reduce the sales price to $95,000 for LTV purposes. If the lender offers a 100% LTV loan, that means the borrower can finance up to $95,000. The borrower doesn't pay $110,000 for the house. The borrower pays $100,000 for the house but has to make a down payment of $5,000, which is the equivalent of making no down payment but paying his or her own $5,000 in closing costs.
If you jack up the sales price to $110,000, you still have excess contributions (7.2% of sales price instead of 8%, assuming that the dollar amount of the contributions doesnt increase with the new sales price, as it will if youre paying percentage-based costs.)
Moreover,
You complained about appraisers getting a copy of the sales contract: that requirement prevents the scenario you describe. It doesn't make appraisals more likely to be inflated, but less, since the appraisal has to take into account the fact that the sales price may need to be discounted by the concessions (which only appear in the sales contract, not in the list price).
In the bad old days before FIRREA, it was all too common for an appraisal to support an inflated value because the appraisal did not address the fact that the only reason the property was moving on the market was that the seller offered to carry back a second, pay closing costs, leave the lawnmower and the 8-track tape deck, rent the buyer's U-Haul and sacrifice his firstborn. (Irony alert!) Since FIRREA, guidelines require an appraiser to take such non-price inducements to sale into account in estimating fair market value. The value for a property with too many concessions or too much creative financing gets adjusted downward to meet the terms of comparable sales. If the comparables all involve excessive concessions as well, the lender generally declares a weak market and changes its LTV limits therein.
I'm happy to say I'm wrong if you can find me a link for a lender who does what you describe. Of course, if they are or they sell to a regulated institution, I may have to report them for writing fraudulent HUD-1s.
dali lama,
You are misrepresenting what the study says. It does not talk about affordability. What the study does is to compute a "fundamental" yearly cost value based on a formula, and compare that to the actual rent cost observed during the past 24 years. On based on this, they suggest current prices in most market are not above trend.
I have two concerns on their study.
1) I think their formula is underestimating the opportunity cost in relation to the mortgage deduction benefit. And this error gets worse as rates get lower (like today).
2) Their notion of fundamentals assumes that only interest rates variation explains price variations. According to this definition, it would not be surprising to find out prices should be higher if interest rates are lower. I don't see how this definition is inherently better than the price to income or price to rent ratio, given that interest rates are expected to rise. Now if they were explaining why interest rates will be permanently lower, they could be onto something.
I think one can make the case that economics have driven much of recent housing price increases. The problem with this though is that they can just as easily drive price decreases in the future and that this is more likely than a continuation of the former. It is the unnamed assumption that prices can only go up, or if they don't it won't matter, I have problems with.
CR, care to rebut this one? Yes, it's from the WSJ opinion page, but the original study comes from the NY Fed.
I think they raise a good point by noting that annual cost-to-rent ratios are more important than price-to-rent ratios for determining affordability, but in so doing they seem to understate the risk that rising interest rates pose (this being the implicit assumption that homebuyers and investors are making as they continue to heap on cheap mortgage debt).
Maqo,
I think they raise a good point by noting that annual cost-to-rent ratios are more important than price-to-rent ratios for determining affordability
Sorry they just make this assertion. Their data does not prove that cost-to-rent ratios should be more important that price-to-rent ratio when assesing the fundamental value of a house. It's just something they take for granted.
I have read the original study, and there is absolutely no explanation why user cost should be more relevant than price to rent ratio, except to say other people often makes this mistake... As you may realize the main difference is interest rate. Factoring interest rate in the fundamental value of a house is a matter of opinion.
As an extreme example, I buy a car that I finance for 5 years with 0% interest loan. You buy the same car and you pay cash. Has the way we financed it changed the fundamental value of the car? It's still the same model, the same parts and the same brand.
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