May 25, 2005

In a real estate seminar in January, I stated that housing price increases reflected underlying conditions of reduced costs to finance homes.  For example, about 47 percent of all households nationwide could afford the median home selling nationwide for $190,000. 


To be sure, some pockets of excess exist.  In San Francisco, only 19 percent of all households can afford the $490,000 needed to buy the median home there.  Arizona, Nevada, the Northeast, Florida and second home havens in the Appalachians and along the coasts also have homes selling well above household affordable levels. 


Nevertheless, I was not too worried that a housing price bubble would be followed by a housing bust. 


Now, I am certain that a housing bubble has developed that could lead to serious housing price contraction

and possible financial problems in the future.


Certainly, the fact that 66 of the 138 reporting housing markets in the U.S. experienced double digit price increases in the first quarter contributed to my growing concern.  Discussions with builders who are selling out their condominium projects before the first spade is turned also raised my eyebrows.  Houses that have been sold two or three times before anyone occupied them also could not be ignored. 


Yet, all of these observations also are consistent with a hot housing market that is seeking a higher price point because of increased housing demand.  That more people want more of their assets in housing than in bonds or stocks does not mean, by itself, that a housing bubble exists. 


What has changed my thinking about the housing bubble is the financing of housing that increasingly is happening. 


Economist Hyman Minsky developed a theory of financial instability based upon what he called the “excess gearing” of asset financing.  What he meant is that as asset values increased, lenders became more willing to offer easy terms to finance those assets. 


Remember 1988 when real estate loans increased from 80 percent of asset value to 100 percent and, in some cases, even more than 100 percent.  Those who lived through the subsequent recession certainly remember the aftermath of that “excess gearing.”


Initially, the additional financing adds to the surge in asset values.  The South Sea Bubble, tulip mania, the utility holding company bubble that preceded the stock market crash of 1929 and many more benefited from rising loan to asset values as asset prices soared.  When the asset prices finally stalled (as they must when they become so far out of line with alternative values of wealth), those loans turned sour.  The subsequent collapse exceeded any gains created by the initial surge in asset prices. 


Minsky’s claim that financial markets are inherently unstable has not been established by many other economists, but his theories certainly help to explain the bubbles that have been observed. 


So, is there any evidence that “excess gearing” is happening in the financing of housing?


Can we say “interest only loans” and explain the rising percentage of variable rate mortgages. 


The percentage of new mortgages that are now based upon short term interest rates has tripled in the past two years.  Yet, short term rates have been rising while long term rates have remained relatively stable.  In other words, the “smart” house financing would be to lock in a fixed mortgage rate. 


Are home buyers not being smart?  No.  Lenders are being foolish.  Some lenders believe that rising housing prices will soon justify whatever loan they offer the homebuyer.  If the buyer defaults, the lender will foreclose and sell the appreciated housing asset. 

In isolation, a foreclosed house in a market of appreciating housing values is not a bad loan.  However, if a lot of foreclosures develop, the additional houses sold by lenders will undermine values.  A lot of home loans then will go bad very quickly. 


So why are homebuyers taking the interest only loans and the variable rate mortgages?  The lenders are qualifying the homebuyer based upon the buyer’s ability to service loans in the short run.  Variable rates remain lower than fixed rates, if only barely.  Interest only loans use even less of the monthly paycheck at the beginning of the loan than traditional loans. 


Low initial monthly payments allow buyers to purchase those inflated houses.  But short term rates probably will continue rising.  Soon, buyers will not be able to purchase the median home even with the variable rate mortgage or the interest only loan. 


I do not know when lenders will begin reducing the number of households qualifying for the median priced home, but it will be soon.  And we know from past experience that the impact of the subsequent price collapse will be financial as well as in the housing market. 

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