Thursday, June 16, 2005

The Meta-Bubble Bubble

The Meta-Bubble Bubble

We have reached the point of absurdity, where not only do we have a housing bubble, and a bubble in commentators discussing the housing bubble, we now have a bubble in commentators discussing the bubble in commentators discussing the housing bubble.

For the last word on this subject, Justin Khoo over at Advenix points out this article by disgraced high tech analyst Henry Blodget on the bubble in New York real estate.

Blodget does a good job of providing some historical context for today's frenzy, as well as some thoughts on what might happen. He also provides some age advice: "The bubble debate is academic: You can afford what you can afford, and no one knows what the market is going to do. As Keynes observed, prices can stay irrational longer than you can stay solvent."

I have placed extensive excerpts below for RSS readers who abhor clicking on links:

"In the past ten years, New York real estate has been a superb investment. According to the appraisal firm Miller Samuel, the median price of a Manhattan co-op has tripled since 1995, vastly exceeding the performance of, say, the S&P 500, which has merely doubled. If one takes a longer view, however, the picture changes. Miller Samuel says that the median Manhattan co-op cost the same in 1999 as it did in 1981, eighteen years earlier. Over this period, meanwhile, the S&P 500 rose tenfold (before dividends!).

Nor is it true that “real-estate prices never go down.” On the contrary, from 1986 to 1995, after the stock market crashed and the government eliminated some real-estate tax shelters, the price of the median co-op dropped by nearly half, from about $360,000 to about $200,000. Those who bought new pads in the mid-eighties were underwater for more than a decade (and weren’t talking about what a great investment real estate was)."

"The most compelling evidence that house prices are, if not a bubble, at least way ahead of themselves is the diverging relationship between prices and rents and incomes. Most people prefer to own rather than rent, but when prices get too far out of line, renting becomes irresistibly attractive. Similarly, bigger salaries allow you to afford more house, but if prices grow faster than incomes, eventually people get priced out.

Nationally, over the last few decades, house prices have grown slightly faster than the rate of inflation and in line with the growth of rents and incomes. In the past ten years, however, real-estate prices have shot way ahead of all three. Smaller divergences in the seventies and eighties were followed by corrections, in which home prices fell in real terms. So, nationally we’re probably headed for trouble."

"On a macro level, what all this boils down to is that despite record-low interest rates and surging house prices, we are spending more of our incomes on mortgage payments and owning less equity in our houses than ever before. We are richer than ever, but most of our wealth is the result of stock and real-estate appreciation, not savings, and, therefore, is exposed to declines in these assets. And for the first time since the forties, we are also spending more than we earn.
What’s more, our financial system is now highly dependent on us making good on our debts. According to Paul Kasriel of Northern Trust, mortgage-related assets now make up nearly 60 percent of all commercial-bank assets, versus about 15 percent in the sixties and 40 percent in the late eighties. As long as we can keep making our payments, we’ll be okay. If we can’t, we may take the banking system down with us.

So what might Chicken Little expect to see in the near future? Barring a terrorist attack, you’re not likely to wake up tomorrow to find your apartment worth half of what it is today. Real-estate markets don’t tend to crash as violently as stock markets. Instead, one day, prices just stop going up and properties sit on the market. Low offers come in, but sellers hold out or wait to sell until prices recover, which they don’t. Eventually, those who have to sell—because of payment shock, relocation, or job loss—take what they can get and prices recalibrate.

One of today’s optimistic arguments is that hordes of buyers will jump in when prices dip—an argument common in the 1999 stock market, as well. What this ignores is how quickly psychology changes when prices begin to fall. People are desperate to buy today, in part, because they fear that prices will be higher tomorrow. In a declining market, the reverse is true: Buyers have an incentive to wait. Furthermore, when guaranteed gains disappear, Johnny-come-lately speculators rush off to the next hot market, further dampening demand. Owners whose equity has been depleted feel poorer and start saving instead of spending, weakening the local economy. Real-estate brokers, mortgage brokers, appraisers, inspectors, architects, engineers, movers, contractors, appliance vendors, and other industry participants make less, and their reduced incomes and buying power further lessen demand. And so on. In the stock market, the saying goes, you don’t want to try to “catch a falling knife.”

For homeowners who haven’t taken on high payments or exposed themselves to rate shocks, a real-estate crash should be tolerable: You can just live in your bad investment and avoid taking a loss. However, if you have banked on further price appreciation to offset a lack of savings, or rapid salary growth to take the sting out of payments, then you may get screwed.

If so, in your misery, you’ll have company. American homeowners have grown so accustomed to raiding their home-equity piggy banks that many have already factored gains and cash-outs into their spending and retirement plans. This, combined with negligible savings and huge debts, could lead to a truly nasty scenario. If home-equity wealth and income drop, the financial squeeze might curtail other spending. This, in turn, would slow the economy, kneecapping the other American wealth repository—the stock market. Although stock performance has stunk for five years, the market is still expensive: It could fall by half and not reach the level at which other bear markets have bottomed. If real estate and stocks collapse, rising unemployment could trigger more defaults and, ultimately, another S&L-style bailout.

Even if a change in the price trend doesn’t result in disaster, it will likely reverberate through the local and national economies. In New York, real-estate taxes represent about a quarter of the city’s revenue. A decline in prices would not dent revenue immediately, but it would slow future growth. And with the city’s budget forecast already in deficit, this might force spending cuts, increased taxes, or both."

"For practical purposes, the bubble debate is academic: You can afford what you can afford, and no one knows what the market is going to do. As Keynes observed, prices can stay irrational longer than you can stay solvent.

The great error made in the nineties was not the failure to recognize that the stock boom might be a bubble: By 1999, in fact, most professionals thought that it might be a bubble but kept buying anyway, because they didn’t know when it would end. The great error was the belief that before the bubble burst, something would change that would tell everyone to get out—that somewhere, a light would turn from green to red.

Having lived through that bubble, and looked hard for the signal, I would respectfully suggest that this is wishful thinking. Lights were flashing yellow, of course—and had been for years—but conditions just kept getting better. Eventually, by the end of the decade, life had been so good for so long that almost no analyst or strategist on Wall Street saw anything that would bring the party to a halt. And in New York real estate, life has been good for quite a while."


Jack Krupansky said...

The simple reality is that there are far too many "vested interests" who are raking in significant profits, *and* there are far too many private investors (qualified investors no less) who have far too much cash that is "chasing yield".

Here's one bit of silence: Have you noticed how much less clamor there is for reining in the housing GSEs (Fannie and Freddie)? Maybe Wall Street has woken up and realized that financing the housing market isn't as great a deal as it was two years ago. Wall Street is still willing to collect fees and be in the middle, but taking a position is no longer something that interests them (as much).

-- Jack Krupansky

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