Global Trend

Global Cash Surplus Fuels U.S. Housing Bubble

As we’ve forecasted previously in Trends, the prices of higher-end homes, which cost $1 million and up, have softened in recent months. But overall, U.S. housing prices have continued to rise, climbing 14.5 percent in the year ending June 30, 2005. That’s the fastest annual pace in 25 years.

Because of this rapid growth, the risk of price declines has increased in 36 of the nation’s 50 largest housing markets, according to the PMI U.S. Market Risk Index. The index is featured in the Summer 2005 issue of the Economic and Real Estate Trends report from the PMI Mortgage Insurance Co. It suggests that six markets are more than 50 percent likely to experience falling prices in the next two years: Boston, Long Island, San Diego, San Jose, Santa Ana, and Oakland.

As Marco Van Akkeren, an economist with PMI, explained, “We are continuing to witness record-pace home price appreciation in many markets without the necessary gains in income, home affordability, and rent inflation. This is causing the current home price environment to diverge from long-term economic fundamentals, which cannot be sustained indefinitely.”

Fortunately, the study still predicts only a 21.3 percent probability of an average house price decline within the next two years, across the 50 largest housing markets. Nevertheless, the five markets mentioned earlier are definitely showing signs of bubble conditions and the broader markets are still moving in that direction.

A big part of the reason why the housing bubble is growing is that speculators have inflated the market, purchasing homes and reselling them at a quick profit when prices go up. The National Association of Realtors estimates that 23 percent of homes purchased in 2004 were intended as investments.

Many investors buy homes and rent them out at a loss in the belief they only need to wait a year to resell them at a profit. In other cases, investors buy townhouses and condos and resell them even before they are built. As The Economist reports, about half of the condos in Miami are sold this way, and many properties are sold two or three times before anyone moves into them.

When we originally examined this housing boom back in November 2003, we expected Federal Reserve actions on short-term rates to combine with the growing Federal Budget deficit to drive up long-term rates. A 7 percent, 30-year, fixed-rate mortgage should have short-circuited exuberant speculation and caused prices to plateau nationwide by now.

However, the global cash surplus has kept inflation and long rates low, in spite of deficits and Fed action. So, the 30-year fixed rate is stuck at 5.75 percent. More importantly, with an ability to obtain interest-only, adjustable-rate mortgages, with teaser rates as low as 1.9 percent, the U. S. housing market remains a speculator’s paradise, and it’s leading to a housing bubble in several markets.

The most compelling evidence of a housing bubble is that prices are going up despite the fact that the growth in the number of homes is outpacing the growth in the number of potential buyers.

Every year, the number of new households in the U.S. is increasing by 1.2 million. But at the same time, the nation is now adding 2 million new houses and condos. According to Fortune, that leaves 800,000 homes per year that are not being used as primary residences; instead, they’re being used as second homes or they’re being rented out by investors to pay the mortgage payments and taxes.

As a result, there are plenty of rental properties on the market, and rents are staying flat even as the prices of homes are going up. Traditionally, the ratio of home purchase prices to rental prices is about 12.5. But, since 2000, the ratio has increased to 17.

In some of the larger cities on the East and West Coasts, it now costs about half as much to rent a home as it does to own one. Fortune found that the rent on the median-priced house in San Francisco is $1,532 a month, while owning the house costs $3,424 a month.

Since 1990, real-estate prices in the hottest market, California, have gone up by 131 percent, according to Fortune. In other words, a house that cost $300,000 15 years ago now sells for almost $700,000.

The run-up in prices is the result of rampant speculation, with buyers paying increasingly higher prices in the belief that they can profit as prices continue to climb. The risk is that buyers will overextend themselves by paying more than they can afford.

As we discussed earlier, buyers can currently afford these high prices because interest rates have remained at record lows. Consider that, in the past 15 years, the interest rate on 30-year, fixed-rate mortgages has plunged from more than 10 percent to less than 5.75 percent.

And, because these rates have made the payments affordable for many, even at today’s stratospheric prices there would not be too much need for concern if they all had conventional fixed-rate 30-year mortgages. But instead, variable rate, interest-only loans have surged in popularity. One-third of mortgages issued in the U.S. this year are now interest-only, according to The Economist; in California, where you have four of the six riskiest markets, it’s two-thirds.

These mortgages allow borrowers to make minimal payments in the first year of the loan in order to afford a home that might otherwise be beyond their means. During the second year, however, the rate increases. For people who believe home prices will continue to soar, the strategy is to sell before the rate increases.

But that strategy assumes that prices will keep going up ? and there’s plenty of evidence that won’t continue for much longer. For example, Yale economist Robert Shiller found that, even accounting for the strong increases in price during two real-estate booms ? in the period after World War II, and from 1998 to the present ? real home prices have historically grown only by 0.4 percent per year. Without those two boom periods, real home prices have been flat or they have declined.

Shiller explains that many people assume that housing prices always go up because they see the big difference between purchase prices and sale prices over time. In the new edition of his book Irrational Exuberance,7 he uses the example of a house that was purchased in 1948 for $16,000 and sold in 2004 for $190,000.

This seems like a tremendous investment return, until one considers that the Consumer Price Index increased by 800 percent from 1948 to 2004. The cumulative real increase in value was 48 percent, or less than 1 percent compounded annually. You’d have done better putting your money into a U. S. Savings Bond.

Given the average real increase of 0.4 percent annually, the last year’s 14.5 percent rate of appreciation cannot possibly be sustained.

What, then, can we expect as the housing bubble expands a bit longer, and then inevitably bursts? Here are six forecasts:

First, many smart investors will sell their homes and rent, freeing up cash for higher returns we expect to see in equities.The best strategy in the short term is to sell your home, take the profit, and rent a home at half the cost. The bottom line is that for many Americans, the real-estate boom has increased their wealth, at least on paper. When your greatest source of wealth is tied up in a risky market, however, the smart move is to diversify. By selling your home now, you can lock in the profit before prices inevitably fall or plateau and invest the money in stocks.

Second, mortgage rates will remain low and the collapse of housing markets in the most outrageously overvalued areas will chasten speculators in the remaining markets, leading to a “national plateauing of prices” rather than a catastrophic price decline. In the six overvalued markets we mentioned ? Boston, Long Island, San Diego, San Jose, Santa Ana, and Oakland ? prices will fall rapidly and send a shock wave through the rest of the U.S., which will cause prices to level off. Overall, prices will fall by about 20 percent ? enough to hurt many investors, but far from the catastrophe envisioned by some observers, such as Robert Shiller, who predicts a plunge in prices of 50 percent.

Third, there is a strong possibility that we will see widespread foreclosures on interest-only mortgages, especially in transactions involving speculators.Consider these statistics, compiled by Merrill Lynch economic analyst David Rosenberg.Two out of five first-time homebuyers last year did not make a down payment. In the hottest real-estate markets, half of the new mortgages are adjustable-rate mortgages. Nearly two-thirds of new mortgages in California are interest-only loans or option ARMs, which allow homebuyers to make minimum payments without building up equity. More than a third of homebuyers are spending more than a third of their incomes on their mortgage payments, while 12 percent are spending more than half their incomes on this single expense. Because of these practices, an increase in interest rates would push the monthly mortgage payment beyond the means of many homeowners. The wave of defaults would send home prices crashing down. For those who choose to rent for now, this could be a golden opportunity to pick up a bargain.

Fourth, this correction in the real-estate market will not trigger a recession, contrary to the warnings of many economists. While we’re often told that American consumers are supporting their spending habits by dipping recklessly into their wealth, the reality is that this is not the case. U.S. personal consumption as a percentage of household net worth is less than 18 percent. This figure is below the historical average of roughly 20 percent, and it has been dropping over the past two years while housing prices have increased. According to an August 2005 BCA Daily Insight, this means that even a 20 percent decline in housing prices would have little impact on consumer spending. At the worst, it would simply return the consumer-spending-to-net-worth ratio back to the traditional level. This is good news for the U.S. economy.

Fifth, the housing bubble is reinforcing the trend to relocate to the exurbs. As we’ve discussed previously in Trends, the U. S. population dispersion to lower-priced areas beyond the suburbs is going to cause a major shift in the nation’s population, away from large cities and suburbs to smaller towns with a better quality of life. The higher prices for homes in the hottest markets have fueled this movement because many Americans have discovered the paradox of high real-estate prices: They can profit by selling their current home, but they can’t afford to buy another home in the same area. The only way to retain the profit from selling a home in one of these markets is to buy a new home in a different area, where prices are lower.

Sixth, Americans’ relative investment in real estate will decline as the stock market accelerates over the next two years. The real opportunity right now is in equities. We will discuss the stock market in our analysis of the trend that follows.

References List :
1. To access the publication “Economic and Real Estate Trends,” visit the PMI Mortgage Insurance website at: www.pmigroup.com/lenders/media_lenders/pmi_eret05v3s.pdf2. Barrons, July 25, 2005, “Up and Down Wall Street,” by Alan Abelson. ⓒ Copyright 2005 by Dow Jones & Company, Inc. All rights reserved.3. The Economist, June 16, 2005, “The Global Housing Boom.” ⓒ Copyright 2005 by The Economist Group. All rights reserved.4. Fortune, July 25, 2005, “The Great Real Estate Debate,” by Shawn Tully and Jon Birger. ⓒ Copyright 2005 by Time Warner, Inc. All rights reserved.5. Fortune, June 27, 2005, “Is It Time to Cash Out?” by Shawn Tully. ⓒ Copyright 2005 by Time Warner, Inc. All rights reserved.6. The Economist, June 16, 2005, “The Global Housing Boom.” ⓒ Copyright 2005 by The Economist Group. All rights reserved.7. Irrational Exuberance by Robert J. Shiller is published by Princeton University Press. ⓒ Copyright 2000 by Robert J. Shiller. All rights reserved.