Housing Bubble Trouble

Will Housing Sector Have Soft Or Hard Landing?

(Weekly Standard) 

Why own it? One powerful reason must be an expected profit down the road. People are buying in the face of sky-high prices because they've seen so many of their friends or relatives make a fortune in real estate; besides (they tell themselves), everyone knows real estate prices never fall. As with the stock market during the tech bubble, many are basing purchasing decisions not on underlying economic value, but on what they think they can sell a property for in the future — the very definition of a speculative bubble.

Not only are house prices at extreme levels by traditional measures, but the manner in which home purchases have been financed in recent years is also disconcerting. Consider the growth of interest-only and "pay-option" adjustable rate mortgages — loans that initially don't require borrowers to repay principal. With the latter, also known as an option-ARM, the outstanding balance owed can actually get bigger every month. A few years ago, these loans barely existed. Last year they accounted for more than a third of new loans. What's worse, the vast majority of these loans were extended based on "stated income," which means the bank didn't verify the income of the borrower. Of course, consumers usually have to pay more if they don't provide tax and payroll records to the bank to verify their income. Common sense suggests many are fibbing about their income to qualify for a larger loan.

Such loans are risky because after an initial period of three or five years with low rates and no principal payments, the loans "reset," and consumers can experience 50 percent or even 100 percent increases in their monthly payments. About $2 trillion in loans, or a quarter of outstanding mortgage debt, will reset in this fashion during the next two years according to Economy.com. Therefore, millions of households are about to experience significant payment shock.

A recent study by First American Corp. shows that many of the borrowers who have taken advantage of the lowest teaser rates and are going to experience the greatest payment increases have little or even negative equity in their homes. Fully 22 percent of the borrowers who borrowed at initial rates of 2.5 percent or less during the past two years have negative equity in their homes, and 40 percent have less than 10 percent equity. The study also finds that a third of people who took out adjustable rate mortgages last year have negative equity and 52 percent have less than 10 percent equity. How is this possible? One reason is that 43 percent of first-time home buyers paid no down payment last year.

If this isn't a housing mania, why have so many people embraced financing schemes that leave them vulnerable to higher interest rates or even a modest correction in home prices? The nation's bank regulators have seen enough and have issued draft rules that will take effect this spring requiring banks to tighten standards on loans where the consumer isn't required to pay principal up front. That's going to tighten credit in the high cost markets, reduce demand for housing and put downward pressure on home prices.

While the evidence of a housing bubble is overwhelming, it isn't definitive. But what isn't debatable is that one cannot forever spend more money than one earns — yet this is exactly what consumers have been doing. For the past five years, Americans have spent more than they have earned — last year, the net borrowing amounted to 3.7 percent of GDP, or over $500 billion. The high level of spending compared with disposable income is also in uncharted territory.

It's no coincidence that the above chart closely tracks the growth in spending financed by mortgage debt, the drop in the savings rate, and the growth in the current account deficit. They all are measuring the same phenomenon — spending outpacing income.

The chart shows mortgage equity withdrawal (MEW) as a share of disposable income. MEW comes from three sources. It comes from cash-out refinancing, from home sales where people put down a smaller down payment for the new house than the equity in the old place, and from home equity loans. According to ISI, a Wall Street research firm where I work, last year MEW amounted to $751 billion, more than 8 percent of disposable income and twice the peak reached in the late 1980s. Alan Greenspan estimates that about half of MEW gets spent, so in 2005 that was about $375 billion. This figure was up from about $306 billion in 2004, which means spending financed by withdrawing home equity added 0.6 percent to GDP in 2005. Add in employment and other factors, and the housing boom has added up to one percentage point to economic growth in each of the past few years.

If this borrowing of home equity remains very high but slows from current levels, which is a near certainty if home prices flatten, it would have a depressing effect on the economy. For example, if home prices stabilize and it takes two years for net mortgage equity withdrawal to slow to $259 billion — the level in 2001 — this would subtract two percentage points from economic growth during the next two years. The economy's average growth rate is about 3.5 percent per year, so all else being equal, this would cut economic growth to 2.5 percent.

Then there is the fact that about one-quarter of the job growth since the recession has been directly related to the housing boom, so a flat housing market could slow job creation and reduce economic growth even further. This is what has occurred in Great Britain and Australia, where home prices stabilized after a long boom. In Britain, for example, consumer spending slowed dramatically and GDP growth fell from about 4 percent in 2003 to half that the following year.

Even flat home prices would therefore slow economic growth unless other parts of the economy rapidly accelerate. But a hard landing — meaning a recession — is a real risk. If home prices fall modestly, millions of homeowners will see their equity wiped out. Many of those with the least amount of equity, as we've already shown, are going to face significant increases in their monthly payments. So what has been a virtuous but unsustainable cycle for the economy — higher home prices, more borrowing against home equity, higher spending, increased job creation, even higher home prices — could easily reverse and become a vicious cycle: higher monthly payments, declining home prices, less spending, job losses, foreclosures, even lower home prices.

To be sure, there are some very positive trends in our economy, especially strong productivity, and most likely a housing correction won't push the economy into recession. But even a gradual reversal of the housing boom could result in sluggish economic growth and painful adjustments for those in the bubble areas who incurred too much debt during the run-up in house prices. Conservatives ought to seriously consider these risks so they won't be surprised or caught flat-footed if a housing correction occurs.

Andrew Laperriere is a managing director in the Washington office of ISI Group, a Wall Street economic research and brokerage firm.