Fibonacci

COLLECTIVE INSANITY
Betting Against the House
The only thing crazier than buying in a bubble? Gambling on when it's going to pop.
FORTUNE
Tuesday, May 31, 2005
By Justin Fox


As any Londoner with a lick of sense will tell you, house prices in the British capital—up 200% over the past decade—are overdue for a correction. And thanks to the miracle of modern derivatives markets, London's real estate pessimists can, unlike their sadly disadvantaged counterparts in New York City or Los Angeles, put their money where their fears are by hedging their houses with warrants that will pay off if British housing prices drop.

Only ... Londoners aren't buying. Trading in the put warrants on the London Stock Exchange is scant, and prices have dropped steadily since they were issued last year. "People in London are all saying the bubble has peaked and it's going down," says Yale economist Robert Shiller, who plans to introduce similar securities in the U.S. "But they don't do anything about it."

Can you really blame them? Pessimists have been warning for years that house prices can't keep rising at their current torrid pace-15.1% a year in the U.S., according to the National Association of Realtors. Someday they will be proved right. But ever since the Dutch went nuts over tulip bulbs in the 1630s, figuring out when a bubble will burst has proved a task too difficult for even the finest minds (and finest computers). The end may be inevitable, but there's no telling when or how it will occur.

This is the strange reality of financial bubbles. When one really gets going, the people who—correctly—warn that it won't go on can be wrong year after year after year. Meanwhile, the overenthusiastic, ill-informed sorts who cast such worries to the wind can get seriously rich. Conventional economic theory holds that market prices are set by prudent and rational buyers and sellers. When all the profits flow to the imprudent and the irrational, though, they set the prices—and economic laws temporarily cease to apply.

Yale's Shiller, the world's leading expert on asset prices gone wild, argues that this is happening in real estate markets right now. The second edition of his bestseller, Irrational Exuberance, includes a new chapter making the case that we are in a housing bubble. But there's still that pesky question of when it all will end. At least part of Shiller's stellar reputation these days can be attributed to the fortunate coincidence that the first edition of his book hit stores just as stock prices peaked in March 2000. "When I came out with the second edition, I was wondering if I would be as lucky in timing the real estate market," Shiller says. "I don't think I will be. Real estate in the U.S. has enough upward momentum to keep going for a while."

At a conference on behavioral finance put on in May by Yale's School of Management, Shiller delivered a keynote speech on the parallels between the stock bubble of the 1990s and the real estate craziness of today. Tellingly, though, the rest of the day's discussions barely touched on bubbles at all. It's not that the assembled Yale professors, Wall Street traders, and hedge fund managers disagreed with Shiller's arguments. It's just that they have come to despair of finding a reliable way to make money off the periodic insanities of the markets.

In the late 1990s, for example, there was no shortage of smart Wall Streeters who thought the stock market was overvalued. But those who bet against stocks too early were wiped out, or at least lost clients by the boatload. As a result, markets came to be dominated not by smart Wall Streeters but by the nitwits who thought prices would go up forever. Until, as was inevitable, prices stopped rising.

Why was this inevitable? Because an asset derives its true value from the income that it will throw off in the future. With a stock that means, strictly speaking, the dividends it pays. With an owner-occupied house, it's what economists call "imputed rent"—what you would have to pay to rent an equivalent house.

This means that growth in asset prices cannot sustainably outstrip economic growth, because profits and rents tend over time to rise in step with—or often a couple of steps behind—the economy as a whole. Assets can sometimes be revalued upward when investors reassess the riskiness of those income flows, as seems to have happened with stocks during the second half of the 20th century. But that's a one-time jump. Asset prices simply cannot keep growing faster than the economy ad infinitum.

To bring the argument back to houses: In many U.S. markets today, the monthly cost of buying a house is significantly higher than the monthly rent on an equivalent house. So by the "imputed rent" test, it makes no sense to buy. People buy anyway because they assume that house prices will keep rising, meaning they can sell out later for a profit. That of course requires that another buyer will come along who also assumes that prices will keep rising, which will require yet another such optimistic buyer down the road, and so on, and so on. This happens to be the definition of a Ponzi scheme.

In reality, the long-run rate of housing price appreciation in the U.S. and elsewhere dramatically trails economic growth. That's because, over time, the main determinant of house prices has been building costs, and as the productivity of the construction industry has risen, inflation-adjusted costs have dropped. In the most expensive real estate markets today it is land scarcity that is driving prices up. But that can't go on forever: At a certain point the high price of land will drive away the very economic activity that made the land valuable.

In other words, this real estate market craziness cannot continue. But to make a bet about when it's going to end—now that would be really crazy.


http://www.fortune.com/fortune/subs/...066846,00.html

zamo

http://biz.yahoo.com/prnews/050602/phth010.html?.v=13

scl23

Good article. I invest in real estate for a living and I've done well for the last few years. My personal wealth is probably 95% in real estate which many people will say is not prudent. My view is that there are two types of people who bitch about the real estate market bubble. The type that doesn't own a home yet and is "waiting the the time is right" to buy a home. The second type is... err, there's no second type. If a home owner really thought that their home value was going to go down, they should sell, rent while prices drop, then buy again. But you will rarely see that. I've heard of people doing that but typically, you'll hear horror stories about how they couldn't afford to buy something or had to buy something much smaller than what they had because prices went up.

What people also forget is that when prices go down, it's typically because interest rates have gone up (all other things being equal such as desireability of the area and no massive resession). When interest rates go up, the monthly payments go up. And most real estate professionals know that the bottom half of the real estate buyers out there make their decision to purchase based upon the best home they can find at a certain monthly payment level. While prices may have dropped, the higher financing cost means that you will not be able to afford any bigger or nicer house than when prices were high.

There's 2 main reasons why the US government gives tax incentives to homeowners. It provides forced savings and a stabilizing effect to neighborhoods and lives. People who own don't move around as much, they have savings they build up, and they have piece of mind that comes from owning your own home.

I do agree that the housing "bubble" has kept the economy afloat. I don't understand why that's a bad thing. An economy is nothing more than the collective economic activities. The best economies are the ones that are highly motivated to produce, consume, and R&D, over and over again. That fury of activity is furthered by increasing the "speed" of money. That is how often it trades hands. The goal of the U.S. and the housing industry should be to sustain this as long as it can without making itself off balance by over-producing. The banks and the lenders actually have the most say in all of this and as long as they slow down their lending to developers in the next few years, the demand should more than meet supply.

I actually went to Yale and studied under Shiller. He's a really smart guy obviously but one thing I learned about academics is that it's easy to talk in broad generalizations, but it's hard to make money off of it. I'm 27 and I probably made more money than he did this year. Am I worried about the bottom falling out? I'm keeping an eye out for signs that the market will decline in SD. I suspect it will happen when the economy cools, interest rates go up, and the population growth here slows. But I don't see that happening at all in the next few years. I think I'm in a good position to make some more money here in SD for the forseeable future. While ppl predict a bubble, I will be making money.

scl23

Here's the number 1 driver of real estate and people rarely talk about it. Ready??? POPULATION GROWTH. The simple math is that population growth is exponential. Housing starts and growth is linear. You do the math. Population growth will always keep the demand for housing there.

The only difference going forward will be how difficult it will be for the first time home buyer. In pretty much every city, the cost to develop housing is going up. Developers maximize what they can make by building the two types of homes that make the most money, downtown condos and large single family homes. Typically, that leaves dilapidated older condos and crappy little houses for the first time homebuyer. And it's getting harder and harder for the first time home buyer to buy something they like. I think the only thing to worry about is what the distribution of the home prices are and how that correlates to the us population. We are building more and more higher end homes, and the older neighborhoods are getting demoed for high density condos. The separation between home owners and renters will grow alongside income spread between the poor and rich.

My prediction is that the poor will truly be priced out of the market for any desireable neighborhood in the future much worse than they are now. Instead of worrying about real estate bubbles, we should be freaking out about the lack of housing stock which is driving up home prices so much.

SpeedyV6

Are you sure about this?

fdl

I hate it when I hear this bs explanation(no offense). So let me get this straight, was population growth not a factor 10 years ago? How about 5 years ago? How about 2 years ago? It doesnt justify the HUGE jump in prices in certain markets. If a house costs 20% more than it did 2 years ago, how you that be a result of population growth?

BigPimp

scl23, you post is very reminiscent of the things people said when the stock market was a bubble. I still believe this is the middle of the end of this particular cycle, even the third quarter in 4 quarter game.

BadBadNeil

I think perhaps certain areas will cool off but speculators will move to other "hot" areas. Initially California was the big rage but since specs have moved to Las Vegas, Phoenix, Florida, and even Texas.

I think California is the likeliest place for a cool down because right now with average home prices hovering around $500K how much higher can prices realistically go without wages increasing at an equal level to meet the 20%+ gains? It is getting to the point where a couple earning $100K a year (which is pretty good in other areas of the country) can't afford the $4000/month mortgages.

jlukja

I think the catalyst will be interest rates. A lot of the purchases and refinancings are now using non traditional loans. Interest only and adjustible loans are very popular nowdays and are the only way to qualify for a big loan. The problem is that sooner or later the rate will adjust upwards and at that point the monthly payments can become too much. If rates go up in the meantime the owner will not be able to refinance to a lower rate. If appreciation doesn't continue then there won't be appreciated equity to pull out to make the payments. I think that will be the catalyst.

Maximized

That's my opinion as well. We might very well see a platuea soon, but not a catastophic burst in the market. Real Estate is a commidity that will always be in demand and they aren't making more of it.

Silver™

And in many areas here in CA there is less and less land available due in large part to strict environmental regulations and large land conservation.

In San Diego for example they build one new house for every 4 new jobs created.

BigPimp

Yes, because a large majority of people are affording homes using the interest only products and can ONLY afford the house using that method. Prices stop going up, rates continue to raise, people can not afford the payment once the interest only portion ends and are forced to sell. Timeframe is 3-5 years, that is the reason I am calling this the 'middle of the end.'

SpeedyV6

Is that true? I also wonder how many people are using variable rate mortgages?

BigPimp

Depends on that area. In San Diego 2/3 or 67% of all mortgages are adjustable interest only. I think about 50% of new mortages in Cali are interest only. All the hot markets have a very high concentration of interest only and adjustable products. People just can not afford housing otherwise.

SpeedyV6

That's a lot. If there is a collapse in prices I would expect it to hit hardest in low-end real estate then.

zamo

http://www.freep.com/realestate/rene...e_20050605.htm

Fibonacci

How to Avoid Losses in the U.S. Home-Price Bubble: John Wasik
2005-06-06 00:07 (New York)


(Commentary. John F. Wasik, author of ``The Bear-Proof
Investor,'' is a columnist for Bloomberg News. The opinions
expressed are his own.)

By John F. Wasik
June 6 (Bloomberg) -- While it's folly to predict exactly
when local housing bubbles will burst, there are ways to ensure
that your real-estate holdings don't explode.
With U.S. Federal Reserve Chairman Alan Greenspan finally
weighing in with the observation on May 20 that he's seeing ``an
unsustainable underlying pattern'' and ``froth'' in U.S. housing
markets, it makes sense to monitor local economic signs to guide
when -- and when not to -- buy.
There may be a gradual slowdown as mortgage rates ascend in
line with the Fed's policy to curb inflation by raising short-
term borrowing costs, provided it stays that course. So paying
attention to types of financing used in the most active markets
is critical.
It's unlikely that the housing market will crash soon. Fixed
mortgage rates continue to hover below 6 percent with adjustable
rates about 2 percentage points lower. The 77 million-strong baby
boomer generation is also in the throes of buying, upgrading and
investing in second and third homes.
Single-family, existing-home sales rose 4.5 percent in
April, setting a record, according to the National Association of
Realtors, the industry's trade association.
In the first quarter, U.S. home prices increased by an
average of 12.5 percent compared with a year earlier and by 2.2
percent compared with the previous three months, according to the
Office of Federal Housing Enterprise Oversight in Washington.

Coastal Growth

With the exception of Nevada, most of the growth is
concentrated on the coasts. Ventura, California, for example,
rose 24 percent compared with a year earlier. Oakland,
California, increased 21 percent. And advances of more than 15
percent were recorded by Newark, New Jersey; Norwich,
Connecticut; Nassau-Suffolk, New York; and New York City.
As everyone, from neighborhood investment-club members to
newly minted college graduates, increasingly speculates in real
estate, there are ample reasons to be skeptical.
Negative economic forces will certainly slow or prick the
bubbles on a local basis, though there's no clear storm front on
the horizon.
``We have not seen any evidence of economic weakness in the
33 bubble markets that would signal a correction,'' says Michael
Youngblood, managing director of asset-backed securities research
at Friedman, Billings, Ramsey Group Inc. in Washington.
``The flat U.S. Treasury yield curve is keeping mortgage
rates artificially low,'' Youngblood says. ``The curve must
either steepen dramatically, or the entire level of the curve
must rise dramatically to dampen house prices.''

Bubble Markets

Youngblood also has been tracking the ratio of median house
price to per-capita income. Bubble markets are those in the top 5
percent of these ratios -- representing 17.6 percent of the U.S.
population.
In areas such as Boston; New York/Nassau-Suffolk; Los
Angeles and Riverside, California; and Miami, home prices are
outpacing personal-income growth by a large margin.
A more closely watched indicator of how much markets may be
inflated is the extent of speculation.
In Las Vegas, for example, rapid turnover by investors, or
``flipping,'' accounts for 11.5 percent of current home sales,
according to the Realtors association. While that doesn't sound
significant, the flipping rate is up fivefold compared with five
years ago.

Eye Speculation

Grace Wong, an assistant professor of real estate at the
Wharton School of the University of Pennsylvania, has found a
correlation between speculative investing and above-average
market turnover in a study of Hong Kong residential housing. Such
a link could be applied to any overheated market.
In Hong Kong, home prices increased 50 percent from 1995 to
1997, followed by a decrease of 57 percent from 1997 to 2002. At
the same time, the transaction volume took a parallel course.
``The bubble grows as speculative activities build up,''
Wong says. ``When there is a frenzy of trading, a red flag should
be raised.''
``I would think carefully what you're going to do with a
house,'' she says. ``If you're going to be staying in a home for
seven-plus years, short-term volatility is less important.''

Financing to Avoid

If you are an investor, there are ways to avoid losses when
the bubble pops.
-- Notice the amount of speculation in the market you are
considering. If investor turnover is at least 10 percent -- 20
percent would probably be excessive -- prices may be inflated.
-- Watch short-term interest-rate movements. Those most
vulnerable have interest-only and adjustable loans. Low-
documentation, negative amortization and loans that carry
temporary ``teaser'' rates should also be treated with care.
-- Don't forget income and job growth. Any local market
beset by negative personal-income or job growth will experience a
decline in home prices and sales.
-- Consider slow- or no-growth markets for investment. Be a
contrarian if you can afford to take some risk. More affordable
markets where prices have declined or slowed include Rochester,
New York (down 0.13 percent in the first quarter); Sioux City,
Iowa (off 0.28 percent); Austin, Texas (down 0.12 percent), and
Mobile, Alabama (down 1.31 percent), according to the Office of
Federal Housing Enterprise Oversight.

Many Factors Important

Since homeowners are likely to be overleveraged in the most
torrid markets, due to lower credit standards and easily
available interest-only loans, it makes sense to watch the
foreclosure and bankruptcy rates where you are investing.
And it's unlikely that housing prices will continue to
outpace personal-income growth and consumer-price inflation (by a
factor of four) indefinitely.
Be careful not to overweight any one factor. What may put
the brakes on housing prices is a combination of rate increases
and a prolonged economic slowdown over several quarters.
Whether you believe U.S. housing prices will go down with a
bang or a whimper doesn't matter. An investment strategy based on
cheap financing and guaranteed rapid equity gain will be more
than just unsustainable. It will be irrationally exuberant.

scl23

Good point. I'm not doubting that speculation is adding fuel to the fire nor am I saying that the recent increases in prices aren't abnormal. Interest rates are low, economy is pretty good, demand for housing is high due to stock market and bond market doing crap. Yes, the obvious point is that the real estate market is priced for perfection. What I am refuting is how and when this "bubble burst" will happen.

There's really one of several things that can happen. People calling for a burst bubble are just sourpuss is my point. There is a very small chance that this will build up to a point where a downturn in the economy could spell trouble for real estate. However, there are many good reasons why the economists don't think it'll happen, or at least in the form of a bubble burst like the stock market in 2000-2003. The economy is still growing jobs at a pretty good clip. At least here in San Diego, population growth is faster than housing starts. My point on housing growth being linear vs. pop. growth being exponential is based upon historical data. Look it up. As an area becomes fully developed, the only way to gain housing units is to build higher density through getting rid of single family homes and building condos (2-10) or building big old skyscrapers. This is what is happening in San Diego. The fact that the new builds are pretty much all luxury level and NOT starter houses also add to the increase in home prices.

The 20% increase in "median home prices" is a misleading indicator because of new home builds of luxury condos and expensive homes skewing things. A more telling indicator of real estate would be resale of existing homes. I don't know of anyone keeping this data but I'd guess that it's not as good as people make it out to be.

Yes, when interest rates go up, real estate won't be as attractive. But that will only happen when the stock market becomes the "hot thing" again. With the bond market doing crap and the fed still under control of Greenspan, I would doubt that the interest rate market has any reason to escalate out of control.

zamo

http://www.bloomberg.com/apps/news?p...JdoTw&refer=us

NSXNEXT

iTrader: (2)

Chicken little chicken little.

chef chris

"When I took economics in World War II, and we were studying the Great Depression, one of the reasons given were all the interest-only loans that came due,'' L. William Seidman, who was chairman of the FDIC from 1985 to 1991, said in an interview. "They were an indication of an economy getting into unsound lending. Ever since then it's been a rule that when you go into interest-only loans, you're very substantially increasing the risk of default.''

In the last 10 years of lending, the interest-only deal has just started booming in the last 18 months or so. I agree with the article though...you have to be prudent when you do these types of loans and I just don't see the concern being demonstrated like it should be.

With all the compliance & risk management courses I took, the rule of thumb was interest-only at or under 80% LTV only. So, there was a cushion built in just in case the market took a dive.

Not to mention, these types of loans fuel inflation like a bandit. People get in bidding wars over homes because they can afford more...so houses start selling at a premium instead of what they're worth.

Reddly9007

Burn baby burn! This housing boom has to stop one way or another, prices are increasing at such a rate which buyers can not sustain. There is no way wages and income are increasing on the same level.

Reddly9007

good article by the way Zamo

chef chris

Agreed. 1979 all over again if this keeps up.

scl23

Curious. Of the people who say that the real estate is going to bust, do any of you own homes or real estate?

chef chris

Yes.

zamo

That is correct, and a neighbor just sold his house at 60% increase compared to what I paid on Feb. 2004. For me, thats not good appreciation, thats a good sign of speculation.

Reddly9007

Your damn right thats speculation, how can you argue otherwise. What in the hell could make something go up 60% without anything major changing. I do not own a home but an looking to get into one soon, regardless of the price I am not looking at it as an investment for the short term. I am looking for a home to live in not flip. I just have a hard time buying something when there is so much speculation going.

chef chris

Agreed. Even for new construction, 60% is steep...real steep.

NSXNEXT

iTrader: (2)

Then explain what would cause it to "bust"? Interest rates are being controlled to prevent this from happening. Rate of growth is slowing (except maybe for zamo's geographic region). The Feds are smart, they're looking at a time bomb that has no clock so they are making sure to slowly bring this fanatic growth down to a modest level.

Reddly9007

What do you consider a modest level? Thats the problem. If rates start increasing and people start to default on there loans there will be serious draw backs to the lenders and banks. It will become much harder to borrow money for first time home buyers and other who seek a mortgage.

One possible reason for a "bust" would be the supply and demand issue. Some reports are stating that a majority of buyers are actually second home buyers and people looking for investments. If people can not sustain the payments on these second homes and then try to sell they will fload the market.

I'm not debating that the Fed is smart, but I honestly feel they let this problem get out of hand, and now they are warning about side effects.

chef chris

It's already 'busting' in many cases. The 3% figure is a national average, there are localized bubbles that have way too much appreciation. New homes in my area(New Castle County) are going up at 20-30% over market. Typically, new homes are sold at discounted prices and slowly increase to market...this is the basic trend throughout all of Delaware. Not good. The income isn't anywhere near what it needs to be to justify the home prices/appreciation. Where are the jobs...cause they aren't here.

There used to be(up until 18 months ago or so) a noticeable property value difference in this state. North DE had the higher prices, lower DE had the best prices, except within 10 miles of the beach areas or shore property. Now, a home in Smyrna(mid-DE with no jobs whatsoever) is going for more money than my home in New Castle County ~ same builder, same lot size, same exact home. My home is worth about $330K with a finished basement and a few extras(.17 acres, small)...they are selling new construction for about $330-340K with no extras and .15 acre lots.

There's only so many people who are dumb enough to come in from philly and commute over an hour each way for a 'deal'. When that market dries up, as it has been(average sale times are increasing) these prices will come down and bring comparable property values with them. Afterall, your home is only worth what someone is willing to pay and what others have paid recently as far as a bank is concerned. This is where all those interest-only mortgages will come into a world of problems.

chef chris

1. That is a possibility, albeit not too probable. More like how about the thousands of new homes builders have under contract or are about to build...and where are the buyers? Statistics in DE show over 15K new homes are planned to be built in the next year or two...where are the buyers coming from? Another concern...DE has a ton of soon-to-retirees...and the vast majority of homes being built are 2 story multiple bedrooms, no ranchers being built as far as the eye can see. These people may consider moving to a home they can better move around in/smaller homes out of state.

2. Problem with the FED, on a banking compliance level, is they can only react to trend information they gather from their annual audits/exceptions. So, by the time they gather intel on risk of certain types of loans, demographics, etc...the horse has somewhat already left the barn.

SpeedyV6

GreenMonster

I'm glad I'm not the only one who remembers that... People actually had negative equity on houses around here...

I was reading an article in Forture magazine about the "bubble" a couple months back, and they cited 5 cites where the properties were over valued. I was amazed to see my homecity listed as an overvalued market (Providence-Fall River, Mass. +25%).
I'm in the suburbs of Fall River, so I've see it in housing prices in the neighborhood.

Forture requires a login, so I can't link, but if you're really interested in the article, google for "Home prices have gone up for so long that people think they'll never come down. But the fundamentals tell a different story—a scary one."

chef chris

Negative equity...people will soon be learning what that's all about. I'm not saying every market is in danger, but there will be plenty of markets affected.

Another thing I noticed in this thread...people have stated that interest rates were so much higher in the 70-80's and that it's better now with the lower rates. But, having a 15% loan isn't a big deal when the homes were so cheap(er). I think my pop paid $17K for our house in 1975, sold it for $30K two years later.

zamo

Speculative prices will adjust, that I forsee.

In my country of origin, as I already stated before, we have suffered a real state depreciation of around 20% ~ 30% in the last 10 years. That because the population DOES NOT have/qualify for loans and thus cannot afford buying property. Having that as a factor, property prices declined and unfortunately the market became a buyer's market from a seller's market.

Just think about that.

GreenMonster

There seems to have been alot of refinancing going on in my (overvalued) neighbor hood. We the intrerest rate tumbled, it seemed like every other house had major renovations going on (new additions, new garages, etc, etc).

With all the "equity" gains (on paper at least) it appears that alot of people are overleveraging themselves. Lots of money being throw around. I've noticed it in a lot of different markets too (not just housing). The early 911 prices have risen. Where a early 70's T that was worth 10-14K three years ago, is now selling for 20K. Longtime porsche experts (guys that have dealt with 356's) are saving that this has happened before, and that the prices will readjust. They even use the same term. Waiting for the "bubble" to burst.

It might be time to stockpile some cash. When the bubble does burst, and people are struggling to get out of a bad equity situation, deals on luxury cars, and speculative real estate properties (summer homes, etc) might be up for sale at bargain prices

SpeedyV6

The Fed only exerts control over short term interest rates.

chef chris

Really Greenie...funny you use those terms, "over-leveraging". I've read countless papers on this from the Fed and just about every other financial regulatory agency. You're 100% right...these gains are on paper only...market adjustments that will re-adjust...and yes, alot of those people who went 100% LTV are going to have issues, not to mention the banks that gave them the loans(interest-only can only be 10x worse in that scenario).