Where was the Bubble: Houses, Rates or Credit?

One of the things I have consistently pointed out was that the so-called Housing Bubble was in reality two bubbles: Credit and Interest Rate.

We can define a bubble as a “trade in high volumes at prices that are considerably at variance from intrinsic values." By that definition, I’m not so sure Housing was a true bubble — the run up in prices, a doubling over the course of about 7 years, was actually a rational market response to interest rates being dropped to generational (46 year) lows. Trading volumes moved up, but proportionately so. Compare that with the Nasdaq, which doubled from October 1999 to March 2000 on a dynamic of a new paradigm. Trading volumes skyrocketed. When it was over, the Nazz had plummeted 78%.

Nonprime_delinq_2House prices normally fluctuate in response to interest rate changes due t how they are financed. An example I used a few years ago: The first house I owned had a $300,000 mortgage. Back when interest rates were over 9%, the monthly payment would equal $2,632.71 (30 year fixed 10% mortgage). When mortgage rates plummeted, a buyer could finance a $500,000 purchase with a 6% fixed mortgage for a monthly payment of $2,997.75.

That example has the home price appreciating ~67%, but the monthly mortgage payments up only 14% (Source: Don’t Buy Housing Bubble Propaganda, 5/26/2005). 

But this only explains some of the pricing run up from 2001-04. It does not explain the next phase of price increases. To do that, we have to understand how everyone in the lending community got so drunk on securitization they simply abandoned their traditional risk metrics and repayment concerns.

This drop in lending standards and absurdly easy credit is where things truly went awry: Despite the incredibly accommodative interest rates, lenders simply stopped being concerned about the borrowers’ ability to repay loans. My favorite example: California strawberry picker Alberto
Ramirez, who despite earning just $14,000 a year, was able to obtain a mortgage to buy a home for $720,000

The assumption appeared to be that lenders could simply sell the mortgages to Wall Street to be securitized, without worries about delinquencies, defaults and foreclosures.

Since that abandonement of nearly all lending criteria, 173 major U.S. lending operations have "imploded."

You can see the decrease in lending standards over time: With each subsequent year of mortgage issuance, more and more homes began defaulting earlier in their ownership/repayment cycle. Have a look at the nearby chart — it shows the delinquencies in the non-sub-prime loans. These were supposed to be higher quality loans. Apparently, these loans also succumbed to a lack of traditional lending metrics.

The results speak volumes to where the bubble was.

Indeed, the destruction of mortgage lenders and capital is much more akin to the result of a bubble popping than the relatively mild decrease in Housing Prices so far. Credit was where the speculative mania was, and that is where the pain is being felt most acutely today.

We can also look at the Home Builders’ stocks as a speculative bubble; their share prices are now down nearly as much from their 2005 peaks as the Nasdaq was from 2000-02. They will not "bottom" until they clear out excess inventory, and see improvements in their cancellation rates.

Strangely, Houses themselves are more of an extended asset class than a true bubble. As we noted back in 2005:

are bubbles in debt, credit and interest rates. There is the oil
bubble, the import bubble, the China bubble and the current account
deficit bubble. In short, we have a veritable bubble in bubbles.
Indeed, it is astonishing how many people who failed to either
acknowledge the tech bubble in the 90s — or at least failed to act on
it — now have no hesitation to declare real estate to be a bubble.
This despite their lack of expertise or past track record in spotting
bubbles on a timely fashion.

The bubble du jour though is the
housing bubble. From Greenspan’s testimony to CNBC’s Housing special to
(uh-oh) this month’s Fortune magazine cover, it seems to be all anyone
wants to talk about.

My position is that housing is not in a
bubble — yet. But it is an increasingly extended asset class that may
be subject to a significant correction in the future. But a 25%-35%
retracement is a very different situation than a bubble (recall that
the Nasdaq dropped 80%), primarily because there are very different
consequences for both homeowners and investors."

That thesis has been borne out by subsequent events.

How is this likely to play out over the next few years? 

The well regarded Jeremy Grantham — the "G" in GMO — points out in his quarterly letter to

that home prices are trading several standard deviations
above their "fair value."  Grantham notes that the 2000 tech  bubble
was statistically a 3-standard deviation, 100-year event. As his nearby
chart shows, House prices are also at 3 standard deviations from their
intrinsic values.   In order to return to more appropriate levels,
prices need to drop 25% — or just stay flat for 5 years.

Why "only" a 25% correction, versus the nearly 80% whackage of technology stocks?

The main difference is intrinsic value. Outside of Love Canal or Detroit, house prices simply do not go to zero. You can always live in or rent out a house. Compare that with certain internet stocks whose only asset was a sock puppet.   


Some people have complained that I am splitting hairs in distinguishing between home prices versus rates and credit as where the bubble lies.

But this is a distinction with a significant difference. A 25% correction in home prices would ultimately be tremendously Bullish for home builders, for lenders, and for the overall economy. As we have seen, price decreases generate real buying interest. It clears out the huge amounts of excess inventory (i.e., overhead supply). And it would kick off a virtuous cycle of economic activity . . . 



Fed Up
Jeremy Grantham
GMO, October 2007

Median Price Chart Source:
National Association of Realtors, U.S. Census Bureau, GMO

Don’t Buy Housing Bubble Propaganda
Barry Ritholtz
RealMoney.com, 5/26/2005 2:04 PM EDT    http://www.thestreet.com/p/rmoney/barryritholtz/10225437.html

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