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:

"There
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? 

Median_home_prices_4
The well regarded Jeremy Grantham — the "G" in GMO — points out in his quarterly letter to
shareholders

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 . . . 

>

Sources:

Fed Up
Jeremy Grantham
GMO, October 2007
http://tinyurl.com/2gx779

Median Price Chart Source:
National Association of Realtors, U.S. Census Bureau, GMO
7/31/07

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

Minorities Hit Hard by Foreclosure Crunch
May 3, 2007
Anthony Ha
http://hollisterfreelance.com/news/contentview.asp?c=213141

Category: Credit, Derivatives, Federal Reserve, Fixed Income/Interest Rates, Real Estate

Radiohead Adapts Our Business Model

Category: Digital Media, Music

Mortgage Resets? Try Chapter 13 Bankruptcy!

Fascinating front page WSJ article today, titled More Debtors Use Bankruptcy To Keep Homes. It seems that Chapter 13 filings are gaining in popularity. Why? Because they halt foreclosure proceedings: “Last month, as the nation’s housing slump continued, consumer bankruptcy filings increased almost 23% from a year earlier – representing nearly 69,000 people — according…Read More

Category: Credit, Economy, Psychology, Real Estate, Taxes and Policy

Southern Cal Fire Resources

Category: Weblogs

No Free Lunch: Ongoing Ramifications of an Easy Fed

Category: Commodities, Currency, Federal Reserve, Inflation, Taxes and Policy

Gadget of the Day: Roth Music Cocoon

Category: Digital Media, Music

Cat Call

Category: Corporate Management, Earnings, Economy, Real Estate

Media Appearance: CNBC’s Morning Call (10/22/07)

Category: Media

Inflation ex-inflation to be Official Fed Policy?

Category: Commodities, Energy, Federal Reserve, Inflation

Bloomberg headlines from 10/27/1997

Category: Financial Press, Markets, Psychology