Visitors to the Golden State like to joke about “The Big One” turning Las Vegas into oceanfront property. But what if the “Big One” was an economic earthquake rather than a physical one?
Like a salmon swimming upstream, I figured I was the only person to raise an eyebrow when Alan Greenspan stoked the flames of adjustable rate mortages by suggesting that Americans were making a mistake in selecting fixed-rate loans over ARMs.
Since I panned one of Washington Monthly’s columnists recently, I thought it might be worth noting that I don’t always disagree with them. In fact, Benjamin Wallace-Wells’ article is one I could have written myself. I’ll save you the time and myself the effort by just linking to his excellent analysis of Greenspan’s comments and predictions on the fallout.
Why would Greenspan encourage anyone to select a variable rate mortgage when interest rates were at 50 year lows and virtually guaranteed to move higher in the near future? He’s aware that underwriting standards are low, savings are low, consumer debt is high, and that many mortgage products border on insanity. Negative amortization, interest-only, and 110% loans are just a few examples of an industry that has no compunction about letting anyone and everyone get way over their heads in debt.
This system works great — as long as home prices are going up. But unlike the poor sap who bought Enron at $90.56 per share in August of 2000, folks who have leveraged themselves into hot real estate markets run the risk of winding up on the street when interest rates shift. And talk about a break with reality — I’ve had the most surrealistic discussions with homeowners who refuse to entertain the notion that prices cannot continue to rise forever.
This isn’t a nationwide phenomenon. Real estate prices are reasonable throughout much of the country. Traditionally, it was just New York that was overpriced. Fine, it’s New York. Unique New York. The town’s so nice they named it twice. But San Francisco joined it ten years ago, followed by Los Angeles in the late 90s. Then Seattle, Chicago, Boston, and many other metropolitan areas started to rise. Wallace-Wells points out the disparity:
Truth is, in most of the country there’s no housing bubble. Perhaps the crucial ratio from which economists determine whether housing markets are out of whack is the ratio of home prices to annual income. In most of the country, it is modest, 2.4:1 in Wisconsin, 2.2:1 in Kentucky, 2.9:1 in Illinois. Only in about 20 metro areas, mostly located in eight states, does the relationship of home price to income defy logic. The bad news is that those areas contain roughly half the housing wealth of the country. In California, the price of a home stands at 8.3 times the annual family income of its occupants; in Massachusetts, the ratio is 5.9:1; in Hawaii, a stunning, 10.1:1.
Read the article. It’s quite eye-opening. I return to this topic so frequently because I think Southern California will be hardest hit. Not only is this state home to many of the overpriced areas, but we’re also facing serious infrastructure, education, and financial problems. Yet it’s not uncommon to see $500 a square foot for outlying communities and nearly $1000 per square foot in highly desireable areas.
I hadn’t considered the role FHLMC played in this ecosystem, but Wallace-Wells is right when he says:
Once banks knew they could automatically hand off the mortgages they wrote to Fannie and Freddie with basically no risk, the old incentive system dissolved. “Banks and other mortgage lenders are not watching home prices carefully because they rarely hold onto the mortgage paper they create–they just sell it upstream to mortgage investors,” John R. Talbott, a housing researcher at UCLA’s Anderson School of Business, has argued. “It is a dangerous situation indeed when neither home buyers nor the institutions that finance them are concerned with the ultimate price being paid for the housing asset.”
Amen, brother.
A particular kind of speculative frenzy ensues, captured in a recent story in The Washington Post which detailed a new phenomenon: home buyers camping out overnight for the chance to be the first in the next morning’s open house, ready to buy $700,000 houses in built-out, lush-lawned suburbs like Arlington. The phenomenon has created temporary, yuppie tent cities. The story’s authors interviewed several buyers in the tented line who planned to sell their purchases back into a steadily rising market, and concluded, dryly: “There is an element of speculation to the lines.”
What he’s not mentioning is that these $700,000 homes and the lots they sit on are smaller than ever before. The same phenomenon is taking place here in Irvine. Even owners of pre-existing homes often attach conditions to the very showing of their property. I’m starting to see MLS listings with things like “seller states home is not to be shown until a prequalified offer is submitted in writing”. In other words, the owner wants you to commit to spending half a million dollars on his home before he’ll let you see it.
And yet people just refuse to see what’s coming down the tracks. “It will be different this time.”
They’re right, actually. It’s going to be much, much different.
The housing market in CA is absolutely crazy. When we sold our spacious 990 sq. ft. condo in the San Francisco Bay area 3 1/2 years ago, we were able to say, “We will accept offers for a week and then review them.” We accepted an offer that was 18K over ask.
We bought our 2185 sq. ft. home here in AZ for less then we sold our condo. And now we are already seeing our neighborhood changing. More retired couples are moving in as the young families are moving out. And this is Phoenix, not CA.
There is a lot of speculation in the california housing market right now. The attitude is, “You’d be insane not to buy a home, ANY home right now, because prices are rising and will always continue to rise.” Try telling these people that a turnaround in the market is possible and even likely…it will fall on deaf ears.
I loved the article and share the same opinion, but we are the few. Just this week two different people told me that “housing prices NEVER drop in California”. This kind of crazy talk leads me to believe many homeowners might be in for a rude awakening. This said, real estate still seems to be a good long term investment for those who can afford to hold onto it for better or for worse.
I too believe that Southern California housing prices are insanely over inflated and everyone has this dillusion that anything will only continue to increase in value. One person I know even believes that the $1.2 million place they are buying will be worth $2 million in 5 years. Yes, if you do a future value calculation based on the appreciation values over the past 5 years. However, I have to wonder if anyone has actually looked at the affordability ratios that lenders use for qualifying investors for loans (you know, the PITI to gross income ratio where you can’t exceed 28% or 36% including your total debt). If you run the numbers, when interest rates rise (they WILL rise), property values MUST drop in order for people to qualify for loans for the properties. Plus, how in the world will people be able to afford the already insane property taxes on $1.5 million homes that are basically a tear down?
We recently sold our place that appreciated an astonishing 150% over the past 4 years (it is on the Southern California coast) and are wondering if we should sit things out until the market stabilizes when interest rates rise. We are afraid, however, of everyone elses’s “irrational exuberance” on So. Calif. real estate and that if we don’t buy now, we will get pushed out of the market. It is a very scary and unrealistic time in the real estate market and I do believe that the many people who believe prices can do nothing but go up are in for a very rude awakening.
I get a kick out of hearing people say that the real reason housing prices are going up is due to demand far outstripping supply, especially in large cities like DC, LA, Boston, etc. Total Hogwash!! Many, many of the buyers that are part of the supply already own one or more homes. They are buying based on speculation so they are creating a shortage that actually does not exist. These people have gotten burned in the past and, if they hold too many properties like this now, will get burned in the future. This whole thing is not a new phenomena. It’s just historical fact.
My fiance and I are enjoying renting on the coast of CA right now (Redondo Beach). We have enough cash on hand for a six-figure down payment, but aren’t looking to buy. The last time I recall seeing a buying frenzy like this it was tech stocks in the late 90s. Hmm..I think we’ll just “sit back in the weeds” and watch this for a while. It’s nice hear, but a million dollar tear down on a postage stamp size lot that I would be “lucky” to get? You’ve got to be kidding.
This article really freaked em out, b/c I am a first-time home buyer in Woburn, MA. It’s a suburb outside of Boston, and close to Lexington and Arlington. I got a “good” deal on the home comparatively, but I’m unsure now if I’ll get the appreciation in the next few years that I was hoping for. I kind of agree that appreciations will lower, but I still believe (and pray) that they won’t go negative in the next 5 years. Luckily I’m planning on renting out a couple of rooms to cover some of my mortgage so I won’t be hit too hard. Does anyone have any speculations on what the yearly appreciation rates will be in the next 5 years around Boston? Thanks.
IMHO:
Minneapolis / St. Paul Metro, Minnesota is also overpriced. I was living in one neighborhood where new homes were going for near US$1 million!!! And its very cold here!!! You don’t want to know the extra expenses and upkeep in this climate (not to mention that they charge you $130 per credit/unit at community colleges here – US average is $50) I also met many people who had more than one house and many stories in the local news of real estate speculators.
I currently rent and will continue to do so until this whole thing blows over. Where I rent now, I pay 70%* less than what I would be paying if I bought the place!!!! The people around here used to say that its cheaper to buy than rent….well, they can’t say that anymore. The real estate prices just went through the roof and kept on going up and up and up!
I may stay here or more to a cheaper metro area in the South. I don’t know if I want to stay in Minnesota…the land of hype and the land of $3/lb tomatoes and $2 /lb zucchinis.
*includes mortgage payments, taxes, insurance, association dues, interior upkeep on a condo.
Cliff,
Appreciation in Boston over next 5 years – around -6% per year for a total of around -25%.
This is based on predictions in The Economist about required price drops in Boston area to reach the long-run ratio of house prices to rents and incomes assuming the latter grow in line with historical trends over the next 5 years.
Sorry but you’ve made a huge mistake. On a brighter note, if you plan to stay in Woburn 15-20 years, you might just come out even.
I think this market is very crazy. It’s very scary…(I meant it for those have money and afraid loose money if market crashes. But for those who has nothing, they don’t care.) Both my and my wife are both engineers and making 120k/year. we can’t still buy it. It’s crazy. We rent now, and waiting for it to crash.
housing price rises are not reaching for a bubble, because the rise is due to the deflation in the US dollar. Worldwide the buying power of the dollar has fallen at the rate of rise in the US housing market. the reason for this is that most mortgage makers sell their paper into the housing bond market, a market which follows the present discounted value of the cost of money.
irrational exuberance,
Thanks so much for that extremely positive outlook on the appreciation here in Massachusetts over the next 15-20 years. I’ve talked with lots of people, and the vote is 50/50 on what’s going to happen. It’s not maxed out here yet I don’t believe. People can still afford homes, and there’s lots of money in this area to be made. Over the past few years, rent has not increased as much as real estate prices for sure, but I see rent increasing as the interest rate starts going up and less people can afford homes. So, I hope you are dead wrong, and the poster “me” is dead on.
Things in Massachusetts might be different than they are here in Southern California, Cliff. There are certainly still parts of the country where housing is affordable. I believe the national median price for a home is near $200,000. But there are increasing numbers of metropolitan areas where the median is approaching $1 million and housing prices have tripled over the past five years.
home prices have been at an all time high, but the last few months, july,aug,sept,oct 2004 home prices have been going down, in las vegas the hotest housing market in the u.s. ive seen house prices drop four or more times with out any buyers. home builders here are lowering the new home prices 25%. alan greenspan or his replacement, has to raise interest rate because of the soaring federal deficit which is out of control, somebody got to pay it back. also inflation has to be delt with.
The prices in Andover MA are insane. A 1936 dog house is on market for 500k! New 2BR apartment is on market for 411k; speculators flip these apartments for 20% profit in 6 month. Buyers look like hunters of dot bomb stocks in late 1999. They compete for what is left below 1/2 Mil, which is not much now.
They drove 2BR townhouses that were bought for 230k three years ago to 410k now tell me this will continue? Japan once said they can buy America if they sell their real-estate, that was 15 years ago and it is still falling..
Most young buyers leverage themselves to the point where a mild recession will force them and other speculators at large to sell all at once. One only has to realize that 1% rise in 30 Year rate has to take out 10% of the price of the house to keep the same payment. Now, will it rise at least 2% in the next two years, you bet. Greenspan will now have to fight a dollar slide to prevent a real bad crash. He won’t have a choce this time, if dollar falls he’ll have to rush much faster then he wants.
I don’t know about you, but I better rent until I see prices drop at least to the mean.
Yes, it feels like a 140k income is only enough to buy a dog house in tomorrow’s prices, but what that means is that 99% of those that were not lucky to buy between 1998 and now are already priced out; who is than that next wealthy fool to buy from the lucky speculator? Perhaps only another dumb specualtor that hasn’t been burned enough in 2000 to bet on another 20% when rates are rising.
For those still in denial I recommend this new book by a guy who predicted a crash in March 2000.
http://www.pupress.princeton.edu/titles/7922.html
I have family in Tucson and Scotsdale. My cousin has a few houses and is hot for more. He tells me that if he doesn’t reach immediately, the house is gone! What people don’t think about is the rising cost of property tax. The burden is great. I live in downtown Atlanta in what is considered a very “hot” area. My house is paid for but the increasing property taxes might force me out! Its unreal. You work to pay for a house and then must leave because of property taxes. If the city needs money because of years of corruption..fine..just get it from the property owners. It is cheaper to rent than buy. Think carefully before buying.
What a great discussion. I think everyone should take a deep breath and look at the situation, at least in the hottest markets like So. Cal, as if it was playing itself out on a game board. The basic reason all this has happened is exactly as the original post states—The Rules Have Changed. Banks can, and will, loan out inventive (some might say crazy) financing schemes as long as it’s insured. This is, IMHO, the number one factor in appreciation of real estate in California. I look at this stuff everyday as an amateur investor (own three properties—and looking for a fourth) and this is how I see it: four years ago a 300K to 400K home would have drawn interest from families of above average to well above average incomes. At 6.5% fixed payment for 30 years a $350K loan would bring a payment of $2,212 + Prop. Taxes and Ins. = $2,515. That $350 home today is probably going for about $600K. Why? Well, it’s not higher incomes, and it’s not even lower interest rates—the fixed 30 yr. mortgage is almost 6% right now. What is completely different and off the charts is the fact that, with reasonably good credit, you can finance this $600K home with little money down (say $10K) and get a 1.25% payment based loan (real rate about 4%)—that’s basically all interest. The new payment? Well, that works out to $2,000 + Prop. Taxes and Ins. (taxes are higher due to higher price, usually 1.25% of value)= $2,600. Let me sum it up—that was $2,515 a month in 2002 and $2,600 in 2005. Some of these loans actually give you a choice of making a SMALLER payment! Yes, less than interest-only (Neg. Amortization)—so if you feel like making the absolute lowest payment maybe that would be around $2,300—that’s about what most are paying for rent in a nice neighborhood. The lender will tell it like this—you start with a $600K loan—worse thing that happens is that at the end of the year you’ve added a few thousand to the principal—now you have a $605K loan—but the $600K house is now worth $700K. That’s why prices are higher—people are willing to take risks like never before—and banks are willing to take the loan and I guess it’s insured so who cares. There’s a lot of ways of looking at this—many people will say that this isn’t true, that there’s a lot of people getting conventional loans etc.. Yes, this is true, not being on expert on this or being a lender I’ll assume that this is correct. However, SOMEONE is getting in and buying someone’s home for an outrageous price with one of these crazy loans and helping that owner go into his next home with a conventional loan. Maybe not every transaction is like this, but I bet many of them are—I’d love to see the numbers on all this stuff. The bottom line is that the Koolaid is being passed around and we’re all drinking it. The question is for how long will we continue to have this party; and remember that in the long run real estate is probably the best bet period.
Pop. Pop. Pop! Housing shortage driving prices up???? Get real. My fiance and I just moved to California and we decided to rent. Why? Because there’s a lot of rental units available, a lot of decent rental units. And now that “affordable starter homes” in Southern California are considered to be 1,100 s.f., 2 bedroom, $400-500K units, why bother buying? I had multiple owners of condos calling me back asking me if I was still interested in renting their units (not to mention regular apartment managers calling as well?). Most of the people I know who bought homes recently were 1) making close to or above six figures; 2) made $150K – $250K gain from selling their small 2-bedroom that they previously owned. So, are today’s purchasers of those very expensive 2-bedroom units going to be able to sell their places in a few years at a $200K gain and buy up? I don’t I don’t think so. And when the bottom tanks, so will everything else.