| |
 September 2005 Homesickness
Most of us aren't leveraging ourselves to the hilt in an effort to buy the biggest house as possible. We don't have any figures on this, but we'd venture to assume that most homeowners in the U.S. aren't betting on hybrid or even adjustable loans, but are rather comfortably paying down the 15 or 30-year fixed variety. Why would it matter to them if interest rates are rising? Regardless, certain economic factors are coming together to possibly make it your concern. Home prices and residential lending are only part of a growing problem that may, in some way, touch us all. Welcome to the global economy. Bubble BehaviorEver since the equity bubble of the 1990s, people have been seeing bubbles everywhere. Anytime a market gets hot, analysts start seeing bubbles. Truth be told, securities markets rarely develop such conditions and most sightings are simply overreactions to what happened in the last decade.Nevertheless, everywhere you turn, you're hearing about the "real estate bubble". There's no doubt that the real estate market has been hot. In fact, it's been sizzling for the past five years. The National Association of Realtors expects 8.2 million houses -- both new and previously owned -- to be sold this year. If that comes to pass, that will mark the fifth year in a row with record sales. Through the second quarter of 2005, the median selling price was $208,500. Over the past five years that median price has jumped by an inflation-adjusted annual rate of 4.9%. That's about three times higher than the average rate since 1968. By themselves, rising sales prices don't constitute a bubble. Prices can rise for any number of reasons such as short supply, increasing demand, or even just as the result of rising inflation. Bubbles, on the other hand, are usually distinguished by irrational investor behavior. In many instances you can't recognize a bubble until after it bursts. Then, with perfect 20-20 hindsight, it's all too obvious. Despite the fact that market analysts often claim to have warned about the 1990s equity bubble, in reality only a few spoke out before it deflated and even then in weasel-word language betraying their uncertainty. Aside from the astronomical median selling prices in some parts of the country, there is evidence that irrational bubble-causing behavior is afoot in the real estate market. Consider the data of Chart 1 which shows median selling prices and average days on the market for five U.S. cities. The cities are listed in descending order based on median selling price.
The frothiest markets are on the East and West Coast as well as the inter-mountain West. Recently the deep South has joined the party but the central part of the country has seen only modest price increases. This is borne out by Chart 1 where homes in Los Angeles and Seattle have substantially higher selling prices. The data becomes even more revealing, however, when you also include the average days on the market -- the time it takes to sell a house in each city. Notice how it increases as the median selling price decreases. This suggests it's much easier (takes less time) to sell a high-priced house in the hottest markets than it is to sell a relatively low-priced house elsewhere. Not only are buyers driving up prices on the coasts, they're doing it with a sense of urgency: Better buy quickly before prices rise even further. That sounds like bubble behavior. The means used by many investors to finance their purchases also fall into this category. Most fixed-rate mortgages are based on the prevailing 10-year Treasury rate while adjustable-rate mortgages (ARMs) are tied to shorter maturities. When the Fed cut the Fed Funds Rate to 1% in June 2004, other rates followed. With the price of borrowing at 40-year lows, investors rushed to refinance existing mortgages or moved up to larger homes with roughly the same monthly payment. Seeing this as a once-in-a-lifetime opportunity, many buyers stretched to buy the largest home they could afford. Some resorted to ARMs or even more complex loans such as option ARMs which allow variable and/or interest only payments akin to the minimum monthly payment on a credit card. But now the Fed is raising rates. In fact, they've been at it for over a year now and there's still no end in sight (more about this in a moment). Instead of staying put or at least considering more modest properties, buyers are resorting to even more arcane -- and potentially dangerous -- financing. There's a certain frenzy in the hottest markets as buyers believe they must act now before prices rise further and money becomes tighter. When such reasoning affects enough people in enough regions of the country, you have a bubble. So is this a bubble? No one knows for sure, but in an important sense it really doesn't matter. Regardless of whether you call it a bubble or not, the present real estate market has the potential to negatively affect the entire U.S. economy and that's why you should be concerned about it. Borrower's RemorseThose with the greatest exposure in a real estate bubble are borrowers who have stretched to buy as much home as possible. Some have borrowed every penny possible while others have resorted to hybrid loans. Rising interest rates pose two perils.
First, those with hybrid or variable rate loans may find themselves pushed beyond their limits if their payments reset above current levels. Most people don't expect to live in their homes long enough for the initial low rates to reset, but those who are one or two years into their loans may be in for a rude surprise. Refinancing to a fixed rate mortgage is always an option, but should rates rise, they may be out of reach for the overextended borrower. A higher rate environment will also make it more difficult to sell one's home. The current buying frenzy has been driven by demand, but higher borrowing costs could quickly dry that up, especially in markets where prices have risen the most. In such an environment, sellers may actually need to cut their price in order to sell their home. And that's the second trap for overextended borrowers: Falling home values. Investors, whether it be in stocks or real estate often mistakenly assume the trend -- whatever it is -- will continue well into the future. In this case, the trend is rising home prices, but like all investments, the real estate market is cyclical. At some point the trend will reverse and home prices will stop rising if not actually fall. By damping demand, higher interest rates can lead to declining property prices. If this were to occur, those who have put their last dime into their homes could easily find themselves "upside down", owing more on their home than its current market value. Homeowners in this situation would find it extremely difficult if not impossible to get out from under their current loan as they would lack the equity to move into a fixed rate mortgage. This impacts lenders, too. Banks, hard-pressed by the flattening yield curve, have done everything possible to accommodate borrowers. That's why they've come up with the hybrid loan products. But if rising interest rates drive borrowers to default, many of these institutions will be left holding the bag. This may be more of a problem now than in the past since many lenders that had specialized in originating mortgages may have a harder time selling them given that Congress is busy placing limits on the number of mortgages Fannie Mae and Freddie Mac can hold in their portfolios. This is especially problematic since many banks are managing their loan-loss reserves to enhance quarterly profits. As the flattening yield curve has reduced the spread between loans and deposits, banks have boosted profits by setting less aside to cover potentially bad loans. In its report covering the second quarter of 2005, the FDIC reported that loan-loss reserves were at the lowest levels in 19 years. That's OK as long as the economy keeps moving forward and housing prices continue to rise, but for those able to recall the real estate induced S&L crisis of the late 1980s this is definitely a red flag. So even if you're dutifully paying off your fixed rate mortgage, all this this affects you, too. Although you probably have built up substantial equity in your property, any decrease in home prices will reduce it. You may not be out there speculating, but your home equity is still at risk.
So what's the likelihood that interest rates will continue rising? It's pretty good if you listen to the Fed. After pushing short-term rates up 2½% over the past fourteen months, many had speculated we were nearing the end of the current tightening cycle. The Fed however, continues to speak hawkishly, implying more increases are still in the offing. When the Fed Funds rate was at a 45-year low of 1%, the Fed feared that an improving economy and a continued easy-money policy would lead to inflation. "Our baseline outlook for the U.S. economy is one of sustained growth and contained inflation pressures," said Fed Chairman Alan Greenspan in his July testimony before Congress. Still, "in our view, realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation." Even the devastation of Hurricane Katrina hasn't altered this outlook. Speaking on August 31st, just two days after the hurricane tore through New Orleans, Philadelphia Fed President Anthony Santomero was still optimistic. "These developments may slow the rate at which the economy will grow for a time, but the expansion is strong enough to withstand them," he said. "If the economy evolves as I expect, then my sense is that the policy path upon which we embarked just over a year ago -- a movement toward neutrality at a measured pace -- will continue to be appropriate." Stunted GrowthSoaring real estate prices aren't the only culprit, there are other inflationary concerns, too. According to the statement following the Fed's August meeting, "Core inflation has been relatively low in recent months and longer-term inflation expectations remain well contained, but pressures on inflation have stayed elevated."Although the Fed chooses to focus on "core inflation" which excludes volatile food and energy prices, it's hard to ignore this year's jump in crude oil, natural gas, and gasoline. It's often pointed out that since the U.S. economy is more service-oriented than it was during the oil embargo back in the 1970s, a similar spike in energy prices won't have the same effect. That's true, but when they're up 50% so far this year, they certainly act as a tax on the consumer. By Mr. Greenspan's reckoning, the jump in energy costs has lopped ¾% off this year's GDP. The Department of Energy is a little more conservative, estimating it would take a 100% increase in oil prices over a 12-month period to reduce GDP by 1%. Regardless whose numbers you follow, moves like those experienced this year will certainly impact economic growth
While businesses have been building cash hoards, it's consumer spending that's been fueling the current expansion. The moderate inflationary environment has made this possible as relatively stable prices have offset the lack of wage increases. Cash-out mortgage refinancings have also boosted consumer spending. As interest rates fell earlier in the decade, many homeowners withdrew some of their equity from their newly appreciated houses when they refinanced. While some was used to fix-up and remodel, much of this new-found wealth was spent on other items unrelated to the home. Freddie Mac expects there will still be $162 billion in cash-out refinancing in 2005. Rising rates, of course, will tend to curb this. Anything damping spending -- whether it be higher costs of borrowing, energy, or simply in the cost of living or doing business -- will weigh on GDP growth. Any weakening will also impact stock prices. Investors -- at least those who know what they're doing -- don't buy stocks because of previous profits but rather based on their perceptions of future earnings. If it looks like the economy will be slowing, they'll price stocks accordingly. Both the economy and the stock market are cyclical. Over the past 5- and 10-year periods, price performance on the S&P 500 has tended to follow GDP growth by 11-12 months. This suggests investors are looking about a year ahead when making their decisions. If they think GDP may be slowing over that time frame, they won't be buyers. It doesn't take an actual decline in GDP to cause this reaction, only the expectation that it will decline. So if investors fear the real estate bubble is about to burst, or that the value of their homes is set to fall, or even that gasoline will be eating a greater hole in their wallet, they may expect the economy to stall and pull back from stocks. Indeed, that may be why equities have had such a tough go of it this year. It All Matters to EveryoneDr. Ed Leamer, director of the UCLA Anderson Forecast, offers one last reason to be concerned about soaring real estate prices. Writing in the August 19th edition of The Wall Street Journal, Dr. Leamer provided a chart showing the residential investment per civilian worker (including the cost of new homes and sales commissions but not appreciation) from 1948-2005. This is reproduced on Chart 4.Two things jump right out: First, the chart clearly illustrates the cyclical nature of real estate. Spending tends to range from $2,500 per worker at the bottom of the cycle to $4,000 at the top.
The second thing to note is the extreme level of current investment. It was near the cyclical peak in the late 1990s, but instead of falling back within the historical range, took off to today's record level. It's hard to believe that can be sustainable. In the past, when residential investment per civilian worker has peaked, it's moved back down towards cyclical lows -- generally bottoming in a recession. With a workforce of approximately 140 million, Dr. Leamer estimates spending would drop by $140 billion (140 million x $1000) if investment just returned to the normal cyclical peak level. It would be even greater if investment fell further back in to the historical range. With a reduction in spending this great, it's not hard to see why previous downturns have ended in recession and why it easily could again. There were, however, two investment declines and bottoms that didn't end in recession. They occurred in the early-1950s and mid-1960s. Dr. Leamer labels them "false positives" and suggests the country was spared from recession due to an increased spending for the Korean and Vietnam Wars. That's not much of an alternative, is it? Of course one could reasonably argue that the current real estate boom is the result of low inflation and interest rates. These conditions have rarely coexisted in the past forty years. This isn't just saying it's different this time but that it's a result of different economic conditions. Unfortunately, those conditions are changing. Both interest rates and inflation are now on the rise. With gasoline reaching new nominal highs, consumer confidence is starting to slip and corporate profits are cooling. Add to this the potential after-effects of a real estate bubble, and you've got a dangerous scenario. It's this combination rather than any one individual factor that's so worrisome. The demise of the real estate bubble -- if there is one -- could be just the catalyst to tilt the economy into recession. It doesn't matter if you're stretching to buy the biggest house possible, flipping condos, or simply staying put, it still affects you. Better pay attention. Search this site! Just enter you key word or words:
Get current quotes or follow your own custom portfolio,
courtesy of E-Line Financials:
|
||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
F YOU DON'T LIVE in a large city or resort community on either the East or West Coast, you may wonder about all this talk warning of a "real estate bubble". If home prices aren't soaring in your neighborhood, it's difficult to see how they can potentially pose and economic problem for anyone except those who are overextended.
