Sunday :: Aug 28, 2005

Economic Stormy Weather Ahead


by Mary

Alan Greenspan believes that housing boom has reached its peak and that housing prices will start to decline. So what does that mean? Well, to get full appreciation of what it means, you should have been watching the most recent NOW program on the housing pyramid scheme. David Brancaccio looked into the housing market in Santa Rosa, CA, where the hot California market has driven housing prices to unbelievable prices. One of the factors driving California housing prices is the array of mortgage vehicles, including the incredibly risky interest-only loan. Even back in 2002, Californians seeking to get into the housing market were flocking to the interest-only loans. Today, nearly half of the market for new mortgages in California are interest-only loans.

The interest-only loan means that one can buy a much more expensive house than one could buy on a standard loan because the payment only covers the interest. These loans were designed for the well-to-do who expected to live in the house for less time than the 5-year timeframe of the loan.

So, one of the families that Brancaccio featured is a family that bought a million dollar dream house using an interest-only loan on a combined income of a little over a $110,000 a year. They pay over $3000 a month to cover the interest and not one penny goes to cover the principal.

But what happens if housing prices start to fall? And what will happen now that interest rates are starting to rise? How does this family qualify for a new mortgage to pay off their home? And what will they owe when their lovely dream home is no longer worth a million dollars?

NOW held an extensive interview with Christopher Thornberg, senior economist at UCLA Anderson Forecast on this topic. Here are few excerpts from that interview (emphasis mine):

A real estate bubble, or any asset bubble is not a situation where you hear a pop. Everyone always associates bubble with a pop. They think, gee, if there's a bubble, there must be a pop! coming at the end. That's not what a bubble is. A bubble is when the price of an asset becomes misaligned with the fundamentals that truly determine the price of that asset.

Let me give you an example of what I'm talking about here. Amazon dot-com -- let's go back to the NASDAQ days. At one point in time, Amazon was worth $180, $190 a share. The big question is: was that stock worth $180, $190 a share? Well, what determines the price of a stock? It's the net present value of the profits that accrue to that stock in the future. That's what we teach our MBA students. When they buy that stock, you're buying a share of the profit stream that comes from that company today and in the future. Some bright economist at one point in time, sat down and said, "Well, gee. What if Amazon dot-com captured 100 percent of the DVD, book and CD market in the U.S.? Would they ever make enough profits today or in the future to justify a share price or the market capitalization implied by the share price of $180, $190 a share?" And the answer was no way.

So, when you're talking about a house, and when I say we have a housing bubble, what I'm talking about is that the price of a house is determined by the stream of profits that accrue to that property today and in the future. And that of course is determined by the rental value of that property today and in the future.

Now, the reason I go through all this is, because you have to ask yourself the question, are we in a bubble market or not right now? And the answer is, as I firmly believe, is we are in a bubble market. And the reason I believe that is, there is no justification, there's no underlying fundamental that would make me think that a house in California today is worth 40 or 50 percent more than it was two or three years ago.

Here's the evidence that he sees that the market today is a pyramid scheme.

So then you ask yourself, well why would anybody buy a house in this particular market? What would cause them to do that? And the answer is, there seems to be this expectation that housing prices are gonna go up by ten percent no matter what. What you have is, you have a buying public who are not thinking about the fundamentals, who just assume that housing price appreciation is a given without thinking about the fact that the price of a house is related to two very important factors: rent and mortgage rates. And both those factors say the housing prices should've been flat over the last two and a half years.

So, just like in the NASDAQ bubble, you have a circumstance in which people just expect appreciation, and as a result of thinking that there's just going to be appreciation and that's the way the world works no matter what, they're making bad financial decisions. And that's really why I call this a bubble.

What happens is, is people say "Gee, housing prices went up by five or ten percent last year. I gotta get into the market. This is a great place to make money." So, a bunch of people run into the market trying to buy houses. And lo and behold, the prices go up, thus fulfilling their expectations and causing more people to turn around and go, "Hey. I gotta get into this market." And they go rush into the market, thus causing the prices to go up yet again. You see how this works? It becomes this cycle.

This can only work as long as you have new people to enter the market and keep this pyramid growing. Functionally what it is, it's a pyramid. And the pyramid works as long as you keep entering people at the bottom end.

Now when you start thinking about interest-only, variable-rate loans, what your talking about is a market that is so distended and needs these new buyers [to] enter the market so desperately that these mortgage companies will do anything to make these people qualify for a home. And that implies getting them involved in very risky loan situations that they should not be in, because that's the only way they can get into the market.

What you're seeing is a market that's really coming close to its last leg. It's running outta people entering the bottom of the pyramid, and therefore is resorting to crazier and crazier financial instruments to get these people in. It's just like back in the stock market days of 1928-1929, just before that big crash, when all sorts of people were borrowing against their stock holdings, to buy more stock, thus inflating the making-- to a greater and greater and greater extent. And that's sorta the same idea of what we're seeing in this particular market, where these loans of a symptom of an overheated market, not a cause of it nor necessarily any verification that we're not in a bubble.

And there's more from Allen Fishbein of the Consumers Federation on the danger families run when they opt for the interest-only loans:

If you have an adjustable rate mortgage that's tied to an interest only mortgage, the prospects for higher monthly payments that can be 50 percent higher than your initial payment or more are very great, are very real and something that consumers need to take account in their financial planning. If somebody has a mortgage that's several hundred thousand, $200,000 or $350,000, if there is a run-up in interest rates and as a result they have to make higher payments and typically adjustable rate mortgages may allow adjustments of one and two percent over the course of a single year, that could result in the households having to pay hundreds of dollars per month more than their adjustable rate mortgage was when it was initially set.

Folks, think about that. If someone has a loan valued at $350,000, the increase in their payments could result in hundreds of dollars per month more. So what do you think the cost would be for the family who put out for their million dollar home? How many buyers are in that boat today? And when Americans no longer feel rich because the value of their home stopped appreciating and even starts to fall, what will be the result on the economy then? Add the problem of increased energy costs, and I'd say we are heading into some very stormy weather indeed.

Mary :: 3:14 PM :: Comments (15) :: TrackBack (0) :: Digg It!