The following appeared today in my free weekly e-mail newsletter, A-Clue.Com, now into its 9th year of publication.
You can get it free any time.
The next U.S. recession will result from a real estate crash. (The picture is actually from the inspiring story of an English school, but you don't want your home portrayee as rundown, do you?)
U.S. residential real estate is overvalued because its purchase is subsidized. It is the only good consumers can buy while writing off the interest. Builders also have a host of tax incentives to build. Most have been in place for generations. While there has been enormous abuse of these tax loopholes over the years they will have nothing to do with what is to come.
The whole idea of a home as an investment needs to be questioned. An empty home does not get more valuable. It falls apart. We have one on my street and, even in today's white hot market, it's falling apart. It won't bring back the investment of the idiot who owns it.
What assets naturally rise in value? Those assets which produce valuable products, and can continue producing them, rise naturally in value. (Not all do, of course. You have to account for the Fiorina Effect, for Barbarians at the Gate, and Cluelessness.) Those assets which are naturally limited in quantity, like land itself, will rise in value over time.
But not homes. And the myth that homes always rise in value needs to die. It will die, sooner than you think.
If you like, call the next crash Clinton's Revenge. (And don't call this a bank any more. It's now the Louisville Actor's Theater.) It was under President Clinton that the reins were loosed on the Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae). These are quasi-private entities created decades ago with a good purpose, namely to let more people buy homes.
But during the Clinton years both agencies morphed into scams. What they do is buy mortgage paper, turn that into a bond, and sell it back to the market. In their zeal to create more paper, and make more money, both have let lending standards lapse. This has caused mortgage lending standards to lapse as well. Even bad loans can be turned into government bonds, so who needs to check to see if the loan is good?
By that I mean you can now borrow 100% of the value of any home. You can borrow money even if the monthly payment is a huge proportion of your take-home pay. You can borrow even if your credit is bad. You can borrow even when you can't afford it.
This fact has bid up the price of real estate around the country, and created a building boom that has sustained the economy over the last four years. It was likely the biggest cause for the Bush re-election. The real estate boom kept the economy afloat when it should have collapsed under the weight of debt and deficits.
There are several facts now baked-into the U.S. economy that make a crash inevitable. Interest rates are rising. Inflation is rising. This means those mortgages on adjustable rates are going to see higher payments, and tip some buyers into bankruptcy. Rising oil prices are also making long commutes increasingly difficult to afford.
When too much inventory comes into any market, either on a local or regional basis, prices decline. And it's these price declines that are the real disaster. Many people in the last few years have bought houses for speculative reasons. Other people have leveraged themselves with second mortgages that will go bad once the value of the underlying asset falls.
The result will be a crack, then a crash. Bonds sold with an assumed government guarantee will go bad, at which point there's no bottom. Add to this new bankruptcy laws that will keep people out of the market for years after they hit the financial rocks and you have the ingredients for a long-term economic collapse.
Something like this happened before, in the 1970s. That was the last real estate recession. Thus most investors, and most homebuyers, have never see one. This loss of memory also exacerbated the 2000 stock market collapse. Prices were driven to unsustainable extremes, and once everyone was in the market there were no new buyers to sustain prices.
The stock market crash did little lasting damage to the U.S. economy because the real estate boom was waiting to replace it. Many people made up for losses in their portfolios by "investing in their homes." Home renovation has been an integral part of the recent boom.
But all booms bust. There is ample evidence that home prices are at unsustainable levels in many markets. Monthly mortgage payments in some markets are higher than market rents. The percentage of income being set aside for mortgage payments in other markets is another sign of excess.
The dot-bust of the last few years was actually fairly localized. High tech centers like California got the worst of it. Some markets will even be spared in the coming crash. The Oilpatch - cities like Houston, Denver Tulsa and Dallas - will ride out most of the storm because houses are easy to build there and employment will keep rising. The same thing happened in the 1970s.
But the amount of speculative overhang here is so vast that even these cities are likely to be touched. And once the bubble bursts all the other debts and deficits plaguing the U.S. - imports and government borrowing and all the rest - all those problems will hit at once.
It's going to be the Perfect Economic Storm. In the movie, the boat sank and they all died.
Dana Blankenhorn has been a business journalist for over 25 years and has covered the online world professionally since 1985. He founded the "Interactive Age Daily" for CMP Media, and has written for the Chicago Tribune, Advertising Age, and dozens of other publications over the years.
1. Dimitar Vesselinov on April 8, 2005 11:10 AM writes...
Bubble Blog
http://bubblegroup.blogspot.com/
Real Estate Bubble
Permalink to Commenthttp://realestatebubblegroup.blogspot.com/
2. BK on April 8, 2005 12:28 PM writes...
I own a mortgage company. Everything you say is true. 10 years ago....NO....was a possible outcome when someone applied for a mortgage. Not anymore. Its YES....regardless of the circumstances. Its gotten worse each year.....with underwriting standards really falling in the last few years. Its a time bomb. Its scary.
Permalink to CommentAll the knuckelheads driving around in cars they really cant afford...living in houses they cant afford....will go from the feeling like "kings and queens of the world"....to "losers" with even a mild pullback in values. The economic impact will be devastating.....but I think the psychological impact of people being able to feel like they are "winners" (on paper with their false equity) and then becoming losers in a matter of months....will be really scary to watch. Suicides, shootings, rampages, robberies, are all VERY posssible on a large degree. There will be a lot of DESPERATE people out there.
3. Ben on April 8, 2005 01:11 PM writes...
Good points Mr. Blankenhorn,
Permalink to CommentI have a blog on the matter that may interest you.
Ben
4. Jim A. on April 8, 2005 02:35 PM writes...
The answer to the question "Is the US real estate market overvalued" is an incredibly complex one. Fortunes have been made and lost by people guessing this was and was not the case. And this question certainly can not be answered by saying "it is because it is subsidized". This is just one small factor in the picture. Ten years ago the mortgage interest deduction was the same as it is now (no, actually it was more significant since AMT was not a significant factor back then and presently the interest deduction is negated by AMT for over an estimated quarter of home owners.
First, arguing that the subsidy is bad is an uphill challenge. Second, from an economic standpoint, the subsidy itself would not cause an economic displacement unless it was altered or eliminated. And then there are arguments that greater dis-incentives in our country's tax structure for home ownership because of how heavily many states rely on real estate taxes to fund municipal services. Does the $1 million dollar home typically require four times the municipal services of the $250K home next door? Rarely, if ever. Should that be the case, perhaps, but that is another issue, but unquestionably this is a case of an economic dis-incentive for moving up in homes, additions, and real estate improvements. Does this mean that the real estate market is undervalued and going to take off? Only if you think that this artificial dis-incentive was going to be removed.
Hey, go ahead have your opinion that real estate market is going to collapse. But don't blame it on a deduction that has been around for 60 years of housing boom. And the statement that the next recession will result from a real estate crash is pretty extereme. Wouldn't the real danger be what would happen to the real estate market during the next recession, instead of thinking that real estate would turn down first and be the catalyst?
Permalink to Comment5. Brad Hutchings on April 8, 2005 04:19 PM writes...
So save your money. If Dana is right, you'll be able to pick up a mansion on the beach in SoCal for a few hundred grand. Meanwhile, I'll keep renovating my home in hopes of selling for a premium and moving up.
Permalink to Comment6. Paul on April 8, 2005 05:35 PM writes...
"An empty home does not get more valuable."
But, the land underneath it does, due to growth in population and GDP. However, I agree that the current housing market in parts of the country is highly speculative.
Robert Shiller has it right. (As if he needs my approval.) Home prices can't continue to go up at double-digit rates. Eventually, they have to level off. When they do, all the speculators will sell off, which will cause prices to turn down. The downturn will accelerate, because homeowners will be averse to losing the paper profits they have "earned" from their home investment.
Permalink to Comment7. Bob R on April 8, 2005 08:47 PM writes...
You didn't mention the single biggest tax subsidy given to housing - the ability to shield up to $500,000 in capital gains profit from federal taxes. No other investment gets that kind of preferential treatment. This tax break came into existence in 1997 and has played a big role in the inflation of housing prices since then.
Permalink to Comment8. Home Bubble on April 8, 2005 10:16 PM writes...
Great post.
You're exactly right. Rising interest rates, inflation, higher monthly payments on adjustable rate loans, and rising oil prices are the perfect storm that will pull the rug out from under the housing market.
But there is one more element that you missed - psychology.
As Robert Shiller says, "In a bubble, high prices are sustained only by the expectation of more high prices."
One of the main reasons that home prices are so expensive is that the price tag already takes into account the expected appreciation. You have to pay alot because you'll make alot. It's an "appreciation premium".
When this logic starts to fail, and the expectation of quick profit diminishes, prices will make a steady retreat until the price of home is once again in line with it's actual value and not with it's psychological one.
More information about the real estate bubble can be found at my blog www.homebubble.com
Permalink to Comment9. Tony on April 9, 2005 01:32 AM writes...
Housing Bubble Blog
Permalink to Comment10. Patrick on April 9, 2005 06:27 PM writes...
One little correction - you can borrow MORE than 100% of a house's price now. You can borrow 103%, with the extra to cover closing costs.
So literally any fool without as much as a penny can dig a very deep hole for himself.
Patrick
Permalink to Comment11. johnny on April 9, 2005 06:48 PM writes...
in the early 1970's i owned and operated a small produce
Permalink to Commentwholesale company in south carolina prices
and interest rates got so out of hand that a
base price law was passed the highest price that
a item sold for when the law passed was the most you could charge for that item example for instance if lettuce had sold for 20.00 and the
market price was 22.00 they would be a sign at
the state market stating that we are out of lettuce because the the price of lettuce excedes
the base price i am 59 years old now but if you want to research this out i don't remember if this was a state or federal law
johnny in south carolina
12. NO FOOL on April 9, 2005 09:51 PM writes...
BRAVO! what needs be said? a fool and his money are soon parted. p.t. barnum had it right! simply BRAVO on this article. this piece lays it out clearer than any other i have read. and i have been on top of this for years now. knowledge is power. this knowledge of what is going to happen is pure horror.
Permalink to Comment13. NO FOOL on April 9, 2005 09:53 PM writes...
what needs be said? a fool and his money are soon parted. p.t. barnum had it right! this piece lays it out clearer than any other i have read. and i have been on top of this for years now.
Permalink to Comment14. leonard on April 10, 2005 12:59 AM writes...
I read what you had to say and I come across a web page
call
http://www.themoneymasters.com
thay sell a DVD called The Money Masters.
I seen it and it gave me a new outlook on what is going on.
Your on the right track.
your onto the banks big move.
but i think you mist on thing its called "debt free money".
I think America could be saved if this DVD is seen by the rigth people so I Think you should see it.
study it.
because it shows the one idea that I Think can get rid of the fed debt.
It also can my social security and american jobs.
Take note: this is not my websit its just were you can get the dvd.
get this dvd
Permalink to Commentstudy it then push the idea.
its a good one .
15. Randy Nethery on April 10, 2005 04:15 AM writes...
Mr. Blankenhorn:
Outstanding article! Very well written and directly to the point. It never ceases to amaze me when I speak with others regarding the housing bubble issue. I'm a police officer in California, and at least 95% of my fellow officers not only think I'm crazy when I relate my views on the coming disaster, but they actually get angry.
The only other time I've seen this particular type of behavior was in the fall of 1999...and we all know what happened soon thereafter!
There is one young officer who recently purchased a 1500 square foot home for 435K, and he truly believes it will double in price within the next two years. Apparently, they need to start requiring all college students to attend a business related course that focuses on real estate economics.
Unfortunately, for most of the younger folks (30 and under), they have never lived through a real estate bubble. I have some really bad news for them -- they are about to live through the WORST real estate decline in history.
Of course knowing the "New Millenium American", five years from now, they will have already forgotten, and the sheep will once again be led to another "speculative" slaughter!
Permalink to Comment16. jim on April 10, 2005 08:58 AM writes...
i've been investing in real estate since 1986 and believe me i am selling before the crash hits. One observation i have made recently. is the auctions that are out there every day. they say that at the end of every cycle only the fools are participating. well at the last auction that i saw, only idiots were bidding on this shack. who ever bought it got stuck with a pile of wood not even worth it weight in scrap.any way if you want some kicks and giggles go to one of those mortgage calculators on the net and put in 400,000 then slowly keep increasing the interest watch how the payments go threw the roof and remember how 60 percent of the recent mortgages are all adjustable rate . you will see the problem.
Permalink to Comment17. Jim A. on April 11, 2005 10:56 AM writes...
My only comment to Randy is I do not know which one is more out of touch with reality....the person who recently purchased a 1500 square foot home for 435K, and truly believes it will double in price within the next two years, or the person who sees the market collapsing because the only other time they saw this type of behavior was in the fall of 1999.
Both are pretty extreme. If an investment has a chance to double in 2 years, then the market is telling you there is a large amount of risk in it.
And if the only other time you saw this type of behavior was in 1999, then you are delusional as well. There was differences between the fall of 1999 and the fall of 1998, or the real estate market 4 years ago and the one today? Prices of many items go nuts all the time. And sometimes they blow-up, and sometimes they don't. There are cases where the manias continue on for a decade or more before imploding. The economic classic "Memoirs of Extraordinary Popular Delusions and the Madness of Crowds" goes over many of these, some back to the middle ages.
I have no problem with someone saying the market is way overpriced. But when people start thinking that the market can't continue to go up they are just as delusional. History has clearly shown that pricing anomalies can last a very long time, and can continue to get worse/more extreme before correcting.
Permalink to Comment18. Brandon on April 11, 2005 05:38 PM writes...
I agree with this article.
Last week on MSNBC.COM there was an article: Home foreclosure listings surged in March 2005.
Data seen showing housing market may be coolingThe Associated Press
Updated: 12:38 p.m. ET April 7, 2005
NEW YORK - In what could be a crack in the housing market's sturdy foundation, the number of foreclosed homes put up for sale rose 50 percent between February and March, according to a new study by Foreclosure.com.
Go to this link to read the rest...
http://www.msnbc.msn.com/id/7419149/
- Good luck to all those people that have purchased homes in the last 12 months with adjustable mortgage rates :-|
Permalink to Comment19. Gary Harlan on April 12, 2005 08:19 AM writes...
John Templeton's father was an attorney during the Great Depression. His office was perched above the town square and he had a clear view of the couthouse steps where real estate auctions of the day were held. Seems that he would only attend when there were no bidders, which allowed him to purchase an 80 acre farm for 2 bucks. The cureent real estate market is far more leveraged than the folks in the 1930s could even imagine. Margin debt is margin debt and it insures a much faster and more devastating decline in real estate (land and home) prices. Just waiting for the trigger. Gary
Permalink to Comment20. John Granville on April 12, 2005 10:22 AM writes...
As can be seen from the Japan experience real estate bubbles deflate at a much slower rate than stock & bond bubbles. Lenders who forclose properties liquidate them slowly & methodically. In the Seattle bust in the early 1970's many houses were foreclosed, local unemployment reached 20% even after many people left the area. Houses quit selling, but prices didn't drop appreciably. By the early 1980's house prices were almost double the early 1970's prices. The market & bubble characteristics are different and so also is bubble deflation. And the surrounding overall economic environment, for example high inflation in the mid 1970's through the early 1980's, has a major influence on how things play out. It's hard to be certain about amplitude and interval! JG
Permalink to Comment21. A. Greeen on April 13, 2005 04:38 PM writes...
RE: fraud & appraisals
Permalink to Commentsearch for 'real estate appraisal fraud'.
22. M.Jacobs on April 14, 2005 08:35 PM writes...
The snears and insults one receives when when describing the bear market side of the real estate market to a house flipper is just like the reaction you get when you bet on the wrong side, or house side, on a craps table.
Permalink to Comment