The Housing Market's Double Bubble: The Big One Still Has Yet To Pop

Look what the Republicans have done to our economy by following their core "trickle down" economic ideology, which really means borrow and spend. They have run up a massive debt which combined with no oversight, a near total removal of regulations on corporate conduct, and watched and let Neil Bush run a savings and loan (oh, sorry, that was that other Bush presidency -- when S&L owners and Republican campaign contributors robbed us blind and bribed Senators like John McCain and then got a massive government bailout.)

We have all been hearing a lot about housing prices falling, and about the effect housing prices have on the economy. The impact to date, while real, is actually overstated. Why? Well, housing markets and their impact are the turtle of economics, they happen very very slowly. Prices have to fall and people have to sell, when they sell they, if they get less than they expected, may not spend as much as they would have if they had reaped a huge profit.

Of course, the lack of higher equity is hurting those home equity lines people were tapping like McCain at an open bar. But ask yourself, honestly, how many people do you actually know who have either been forced to sell or have sold and not made a profit? Not that many -- yet. People are still holding out.

Unquestionably the economy is slowing. Consumer debt is massive, companies are cutting jobs, inflation is rising, unemployment is a full percentage point ABOVE where it was a year ago, and with a work force of 200 million plus, that's 2,000,000 newly unemployed Americans.

Just this morning, we saw that planned July Job Cuts skyrocketed to over 100,000 meaning that unemployment will continue to climb, the economic impact of those layoffs won't be felt till mid-fall at the earliest when severance packages run out and the reality becomes apparent, new jobs are hard to come by.

But now the time is arriving when we will start to see and feel the real impact of the slowing economy -- layoffs will pick up over the next year and the forecast is for increasing and increasing unemployment, it almost surely will be another point or more higher next year than it is now.

Slowing economies manifest themselves in many ways. But the most prominent is in the corresponding fall in housing prices. In every modern recession, the fall in housing prices follows the economy slowing down. What we have yet to see is the falling economy's effect on housing prices. So if you think prices have already dropped, and might even be reaching a bottom, we think it's the other way around: prices are about to start dropping.

Even Alan Greenspan agrees with us. Greenspan Says Housing Prices Not Yet Near Bottom

Former Federal Reserve Chairman Alan Greenspan said falling U.S. home prices are "nowhere near the bottom'' and the resulting market turmoil isn't showing signs of abating.

How can this be?

How can prices that have fallen 25% in Los Angeles year over year be about to start falling? Well, because unlike every other real estate boom of the past century, this past boom was, in fact, a boom and a bubble. This numbers below, from the Case-Schiller Housing Index showcase that and how the first bubble may have popped, the excess speculation bubble, but the underlying bubble remains, and now will begin to deflate.

Prices in San Francisco were set to an index of 100.00 in January of 2000.

By January 2004 prices had jumped to 155.93, a massive jump by historical standards. This alone is a real estate bubble.

By January 2007, they had already softened a bit but still were at 211.78. This is the second bubble.

Now the index stands at 162.70. Still up 60% since January 2000.

The prices have lost some of the home equity / no money down madness bubble, but have let to be impacted by the slowing economy. And they will be

How far will they go down? Well, economics is ruled by larger trends and post bubble, prices eventually revert to the historical mean.

For example in the ten years from January 1987 to January 1997, prices increased 22%. And, FYI, that's after inflation, meaning a house purchased for $400,000 in January 1987 was actually worth less, in real dollar terms, in 1997, ten years later.

That's not a rant, that's a fact, all of these prices don't include inflation.

In real dollar terms, house prices really don't escalate much. Some studies of ONE HUNDRED YEAR time frames of the US market show, in real dollar terms, that house prices remain flat.

How can that possibly be?

Well, we've been inundated with ten years of powerful powerful advertising messages that tell us, "housing prices always go up."

We borrowed money and spent it like good Republicans, because housing prices always go up.

We just know we can buy more and more because housing prices always go up.

But they don't.

So how can you estimate what the actual value of a house in San Francisco really is? How far can they fall? Another 40% to historical norms of growth? More? Well, Dave recently calculated how far prices in the San Francisco Bay Area could fall using three different methods.

The first was the rent to price ratio. With this method you take the average rent and calculate the amount of money you need to put into a decent investment to make the same amount. For example, if you are clearing about $833.33 per month ($10K per year) from a rental property unit (remember to account for maintenance and property taxes and something for your time...) then the price of the property would be around $100,000 for a 10% return ($10K is 10% of $100K) and $200,000 for a 5% return (sufficiently higher than a CD pays right now).

So if houses in your area are renting for about $1400-1500 per month this is a rough way to tell that similar houses might be worth around $150K at best. If you double that and they rent for $2800-3000 then house prices would be $300K. And those prices assume that rental prices are not dropping.

James lives in a rental house in Boston which at market peak might have sold for $800,000 or $900,000 but now rents for $2,400. What does the landlord clear? Not $28,000 because he pays the taxes so more like $20,000. If you had $400,000 in the bank would you be happy with 5% return? Perhaps. But that's the highest amount you can estimate the house is worth in the market. And guess what? 10 years ago, the house was worth about $350,000. So it actually is about the right value.

The next method involved the average person in the area's income affording an average priced property. Look around at prices in your area, and average wages. At what price can the average person (or husband-wife) (or husband-husband/wife-wife in Dave's California and James' Massachusetts) buy a house? Right: uh-oh.

The third method is to look at the historic mean plus inflation. When prices triple in a few years, then when they correct they have to fall to 1/3 of the peak (plus inflation). It's just the way it is.

When Dave calculated these for the Bay Area all three methods came out the same and showed that prices can still fall as much as 30-40%. We say "can" but an economist might say "should."

If it falls 30% from that index where it is now, it only drops to 112. Can't happen? Well, remember that 1987 -- 1997 DECADE, it was up 22%. Now, after 8 years, it would be up 12% on that index. That's pretty normal growth to be honest.

And what is cumulative inflation of the past 8 years? Let's make it easy on ourselves, and we'll say an average of 3%. The 100 Index goes from 100 to 126 with the combined effect of eight years of Inflation at 3%.

You see, housing is not the perfect "always goes up" investment. And it is clear that the housing prices in San Francisco and many more places could have 30% - 40% to go down from where they are today.

But, you guessed it, the news is actually worse than this. First, there is a huge amount of excess housing inventory on the market. So this needs to be factored into your thinking about where prices can go. On top of the need for prices to revert to the mean, these extra houses have to find buyers before prices can stabilize. This is supply and demand, nothing more, nothing less.

Next is the effect of gas prices. Many, many housing developments have gone up in areas that are far from city centers and far from non-automobile transportation like light rail or even buses, and buyers are going to be factoring the price of gas now. Along with this, the price to heat and cool the monster homes that developers tended to build will become a consideration and will reduce demand for these houses.

Another factor is that the "boomers" are starting to retire, and will be selling the larger homes in which they raised their families or ended their careers, looking for apartments, condos and even senior facilities. This will also reduce demand.

And, just as the price of energy was not considered when these houses were designed and built but has lately become a factor, one day the implications of global warming will start to sink in. In particular, is the house sufficiently above sea level? Is it located near an area that is experiencing increased fire danger? LOTS of Californians are starting to think about these issues.

But if you think we're wrong, and the above factors are non factors. Consider the recent decline in the stock market, General Motors and their 15.5 billion dollar quarterly loss, that's the recession that's here.

This is the big one: A falling economy always forces housing prices to fall. Even when housing prices are not in a bubble to start with, a recession forces prices down. And this hasn't even started acting on housing prices yet -- the falling prices we have seen are not because the economy is slowing, they are causing the economy to slow. The slowing economy will make this worse as people are laid off around the country. The foreclosures we are seeing today are not the result of people losing their jobs, but they are causing people to lose their jobs. THEN the foreclosures that come FROM people losing their jobs will start.

There are no, none, nada, zilch factors that we see driving any hope for a "bottom" in housing prices any time soon.

Thanks Republicans for ignoring the country's problems for so long, refusing to regulate the financial companies, refusing to address the need to find alternative energy sources, refusing to fund mass transit alternatives and refusing to provide oversight and enforcement of our laws. Thanks for bringing us to where we are today.

They borrowed and spent. We borrowed and spent and drove the housing prices up through a double bubble. One bubble may have popped. The next one will soon.

Post-Script: We worked on this post last week and over the weekend. This morning, The New York Times has this article: Housing Lenders Fear Bigger Wave Of Defaults. It echoes many of our arguments in this piece.

Comments

[LammertMacroeconomics]

The Practicalities of Lammert Fractal Macroeconomics

Interest rates; lending parameters; debt growth; reciprocal money growth; asset production and overproduction; asset valuation and overvaluation; wages and jobs dependent on money growth and contraction and dependent on asset valuation growth and contraction; and asset devaluation based on oversupply, defaults on debts, contracting money supply, and constricted lending and lending terms - all of these dynamic and interactive elements that make the global macroeconomic system so complex in a multifactorial manner - are summated into simple rotating quantum valuation fractal patterns of various asset classes within various nations that make the global macroeconomic system and global macroeconomics knowable, understandable, manipulatable, and in fact with the predictable quantum patterned nonlinear behavior of its various rotating asset valuation classes to saturation growth and decay limits - a true science.

How can the understanding of the scientific laws of quantum fractal saturation of asset valuation growth and decay and the underlying cycles of monetary growth and decay of the global macroeconomic system benefit individual nations and collectively the world of nations? A balanced and thoughtful refection on this query is the potential utility of this new macroeconomic science.

[joebhed]

Definitely.

Let's discuss it.

But you need to put a little meat on them bones.

[larry278]

Those who look for a bail out by a nanny state may be surprised when the size of the defecit limits government aid including bail outs of people in foreclosure. Banks are staring to fail. FDIC gets stuck with them & has to look for a solvent bank to take over a failed bank. Banks with 10% or more of mortgages in the non-performing column could have to eat those loans which won't be paid. Selling foreclosed houses in a recession/depression isn't profitable. The prices the houses will bring may not cover 50% of the defalted mortgage loan. The Chinese could stop buying US bonds. If Uncle Sugar can't raise money, bye bye nanny state.

[tinakori]

Do you mean the nanny state that bailed out the banks and corporations? I don't see a nanny state for people anymore, just a trail of bread crumbs.

[SwampeastMike]

Excellent article gentlemen. The situation may be worse than you think.

In large areas of the country like where I live, housing prices rose too high, but not so high for the pricing bubble to burst. The main effect I've seen so far is higher end homes have virtually stopped selling with a glut of spec homes that are simply too big and too expensive. New construction has slowed greatly.

Poor lending practices, however, [seem] to have been just as common. It's almost like homeowners and bankers alike thought, "Hey--we're in an area that always seems to lag behind the times and those big values increases will start trickling down to here."

Sales tax revenues--which account for the vast majority of city services other than education--have gone flat and may be in decline. Worse still, both city and state government has given enormous tax breaks to build infrastructure to support an explosive growth of big box stores that only recently ended. Promised road and infrastructure improvement--funded by sales tax--have been scaled back considerably due to explosive increase in material cost.

Higher wage jobs are leaving; our little remaining industry is scaling back production and hours; full-time positions are being replace with part-time. Employer provided health insurance benefits are being reduced.

Shold the economy continue to deteriorate much longer and those dual bubbles burst here, I fear that collapse of the entire economy will be inevitable.

[Oldtimer]

Well Dave and James. It sounds to me like you've been reading my comments the last six months.

[kcnativnla]

I'm making more money than I've ever dreamed of making - and yet I live in an area where I don't like to go out at night, in a school district I would never send my kids to - all because a bunch of greedy fools (mortgage brokers AND home buyers) artificially inflated the los angeles real estate market. I hope it all crashes and burns....then, I'm moving to Malibu!

[montemalone]

This mess is not solely the result of selling homes at ever higher prices.
Too many people were supporting their shopping habits with the refi ATM.
GM and Ford were selling $50,000.00 trucks and SUVs to yokels that kept refinancing their tract homes. Even some family that got one of Ty Pennington's free houses on TV lost it because they borrowed $450,000.00 and couldn't repay the loan.
Greedy mortgage brokers collected huge commissions on each refi, with no worries because they sold off the note before the ink was dry. Some people were refinancing multiple times per year, squeezing more dollars for toys.
Now, they want a bailout. Let 'em have a garage sale instead. I'll give $50.00 for that 50" flatscreen!

[dadw5boys]

NOT ONLY THAT !
To sell homes at an every higher value you need to have them appraised at an ever higher value!!!!!!

To get them appraised at an ever higher value there has to be collusion between the loan maker and the appraiser !!!!!!

Collusion is fraud!!!!!!!!!

[Sundialsvc4]

Perhaps some serious consideration should be given to the notion of "re-pricing" both the houses and the loans that have been made against them.

Let's say I've got an "$800K house" that has suddenly become "a $650K house." What am I gonna do? Exactly... I'm gonna walk, and frankly, "you can whistle for it." I'm neither going to pay the $800K nor the $650K.

Unless...

Unless (perhaps) you re-appraise the house, establish that it's a $650K house, AND forgive $150K of my outstanding loan. That's right... forgive it. Now I have a $650K loan against a $650K house, and if the market continues to fall you do it again.

For your own protection you apply covenants, that I will not sell the house at a huge windfall-profit and that I will remain in the house for at least a year.

But... what's in it for you? Well, the loan (although smaller) is still "good." I'm not "scroo'd," therefore, neither are you. Someone, sure, absorbs a paper-loss of $150K but it's not a hard-loss of $800K and a valuable piece of real-estate isn't sitting unsold and empty.

[EinChicago]

Here's the problem with your analogy. You're assuming a loss on that $800K house is a full $800K. it's not. Not even close. even if the bank takes a 30% loss, that still puts them at 600K, which is around what you're asking. Plus they have a chance of it being higher. And the carrying costs for that $800k house, including principle and interest, taxes, etc are probably around $3000 per month, so to forgive $150K is to forgive 50 months of carrying costs. The bank could hold that house for 4 years while the market recovers and still come out ahead from your proposed solution.

[Oldtimer]

The operative word comes at the end of your comment where you say "the bank COULD" hold it for 4 years and come out ahead. Who says the price will increase
so quickly once again? Let's try a different analogy. I manage rentals for owners.
I can rent a vacancy for $2000 but it might take longer. In fact it could be vacant for
2 or 3 months.
OR
I could lower the rent to $1800 and rent it this week or next. Now I'm getting $1800
for three months while you sit empty. It would take ten months to make up the loss
of one month vacant.
The fed needs to force the banks to unload these bad loan properties.
Let the "free market" free fall and let buyers decide when a house is worth buying instead
of banks and owners deciding when a house is worth selling.

[castlerider]

Mbafromharvard wrote: "More calls from the libs for the "nanny state" to help. Sorry Boyce, there's not going to be any more handouts for those who made irresponsible choices."

Man, talk about sticking your head in the sand. Another rightwinger who thinks he's smarter then anyone else, therefore is so entitled to tell us all how we're wrong, as he returns to his quiet little hole.

Nobody expects to get ANY handouts, junior.. All most of us ever wanted was a fair days pay for a fair days work, and ever since your chimp took a hold of the wheel, we're finding we've been more then misled, and now we find ourselves bogged down with little or no wheels to roll.

It's idiots like this that have helped and are helping the corporate rich elite to perform one of the greatest scams and transfers of wealth ever placed in this country's history.

There's still plenty of money out there, it's just in the hands of fewer people.

But make no mistake about it, you're right, this IS a recession, and more. -Probably much closer to a second depression. It's that severe. Too many have lost all they have.

Thanks. Great post.

[nezumi]

Great post. And I think that there will also come a time when house prices will become seriously undervalued, when the recession deepens, as much as they were overvalued during the time of the bubble. Just because no one will be in the mood or be capable of buying.

Only good thing is, that most if not all people can shed their debt quickly and they are not followed around by it for decades (the bank will foreclose the house, but not touch other assets or grab all cash from you until you die). And that is a good thing. The geatest loss will be with the banks that hold the exotic securities.

And, as a aside, strange that no one cared much about inflation when housing prices rose....

[DuganS1]

Housing is local. The areas of weakness are centered in areas of California, Miami, Las Vegas, and Arizona. Outside those areas housing is OK. The recession is centered in those same areas where housing is already weak. The economy is actually quite strong in much of the industrial MidWest (outside MI), the Midlands (particularly Texas), the Mountain west areas (i.e. Montana), and the DC area among others. Also, the rent vs value ratio is a bit misleading because those values are often counter-cyclical - rent goes up when housing goes down and vice versa. Last, we can't forget that there were huge runups in housing prices and consumer in California (and a few other places) in the 70s and late 80s as well, and those problems worked themselves out through population growth and increased household formation (we are currently seeing a large increase in folks reaching the years of household formation), and time. Considering new home construction starts are at historic cyclical lows, we could see the inventory come down quickly as soon as confidence comes back into the market, particularly -again because of the large number of new folks reaching peak years of household formation. Last, most of these problems have nothing to do with the Republican party. If anything it can be blamed on the law passed by Democrats a few decades ago to increase the number of loans given to poor and minority households -- subprime loans.

[DanBest]

"Last, most of these problems have nothing to do with the Republican party. If anything it can be blamed on the law passed by Democrats to increase the number of loans given to poor and minority households "
So according to your logic, all of these defaults are the result of poor people and minorities? Can you back up that statement with some hard facts?
So if we had just kept those irresponsible people from getting homes none of this would have happened?
The investment firms who packaged mortgages into exotic vehilcles like CDOs are simply the victims of do-good liberalism that demanded that people who couldn't pay be given loans?
The mortgage lenders that gave out "ninja" loans (no income, no job) because they were interested only in the fees generated and not the actual repayment of the loans bear no responsibility?
As usual a rightwinger has looked past his own pet party and its culpability to blame some legislation that was passed decades ago. Come back next time armed with your wits, not your tired unsubstantiated rhetoric.

[sdskelton03]

I hate to bring a ray of sunshine to the conversation, but here goes. There are a couple of points I would like to make.

Houses are not purchased solely as a commodity to be resold at a profit. They are lived in, and their value is really only important on the day they are sold. I put 5% down on my house a year ago and today would have to come up with about 10% to pay a commission and sell. But that's okay. Every month my mortgage balance goes down and the situation becomes better.

Also, a drop in housing prices is not all bad. First time homebuyers will benefit tremendously.

[bobbyvassallo]

I have to agree. The exception seems to be Texas oil centers. A recent trip to Houston found the city booming! Oil money is back, just like the early '80's. Interestingly, the upper-end homes are doing well, while the lower end is suffering. Dallas is like Houston, balancing on the bubble, supported all the while by the oil companies and new-found disposable income. Dallas builders, McCowen-Sainton is having a banner year in their high-end homes, from Las Colinas to Southlake to Highland Park. Other builders are saying the same things.

Double bubble is the best way to explain it.

[joebhed]

Dave and James,
Me thinks you guys are making a molehill out of a mountain.

It's not that you're wrong about the 'second-coming" of the housing failure ka-boom, but your cause and effect are off.

To be sure, we have begun to enter that synergistic, not quite biofeedback, loop of interplay between the various sectors of the economy. But, the root cause of the next bursting bubble in the housing sector will not be the unemployed. They are more of an effect.

The big one yet to drop is minimally related to the unemployment caused by the first wave of "sub-prime" failure activity.

Rather, the cause of the next "bigger-one" , and the "even-bigger-one" after that, is the same as the cause of the first one.

The holders of the MBS's and other derivatives of these uneconomic mortgages must take a "haircut" for the simple reason that they have no idea what their stuff is worth.

The people holding EACH CLASS of these MBS's must in turn shake out a huge contraction of debt, the result of which is a further deepening crisis of credit, that, in turn, has impacts on businesses and therefore workers. Yes, there will be much greater unemployment.

The next at-bat in the housing credit crisis belongs to the "Option-ARM" segment partly because, like Sub-prime, they were 'UNECONOMIC" to begin with.
And partly because it's their turn. The Option is up !

[joebhed]

Part II

It never made sense to lend people more money than their house is worth, while asking them how much they want to spend (the Option) for a payment.

So, here comes inning 2, the Option-ARM inning. This option belongs to the holder, not the customer.

To be followed next by the ALT-A inning for the same reason.

By the time the ALT-A inning is fully upon, so will be the beginning of the next to last, the Commercial lending inning. Again, for the same reason.

The various outcomes of EACH of these crises will be based on the structural components of the players and the instruments.
When do they begin re-pricing?
How are they going to be re-priced?
How many are owner-occupied where there might by a workout?
And how many are total walk-aways?

Due to rotten financial fundamentals, it is the failure of the FINANCIAL markets that will cause greater and greater unemployment, and not the other way around.

The great fear I have right now is this.
The Treasury and the FED are about to run out of chips.

The international community will say either NO MORE, or require a greater interest payment, for "backstopping" the collapse.
This will happen concurrently with a run on the Fed GSE's.

The GSE's are the cause of a financial calamity, PROOF that there should be no government involvement in the coming INTERNATIONAL WORKOUT.

Hang on to your sovereignty, America.

[Liberal2]

"...Another factor is that the "boomers" are starting to retire, and will be selling the larger homes in which they raised their families or ended their careers, looking for apartments, condos and even senior facilities. This will also reduce demand...."

I once tried to explain the real effect baby boomer retirements will have on asset values, including the stock market. There is insufficient disposible income in the hands of Americans to maintain stock prices. Foreign sources (sovereign funds for example) will be buying up US equities if equities maintain their dollar denominated value. In ten to twenty years America will look like the remains of the Soviet or Roman empires

[Robert59]

Excellent post, so thanks.
I'm convinced all we're seeing is a stalling action on the part of Wall Street and Republican leadership to put off the recession until after the election. Democrats like Pelosi need to remember the last economic stimulus package skews economic data and doesn't fix the economy. If anything it aids Republicans by delaying the recession.
The more we allow the Republicans and Wall Street to squeeze out of the economy false positive numbers the more it hurts Democrats come November. It forces the debate to be on Iraq and national security which many Americans erroneously believe McCain has a better handle on.
As far as I'm concerned it's time to let the economy tank now rather than after November so we can focus on the number one issue, the economy and how Republicans have been horrible at managing it.