Housing echo bubble may deflate but not pop
The recent house price rally was financed with stable, fixed-rate mortgages. Stable mortgages make for a stable housing market.
Pundits like to call asset bubbles; it attracts attention and helps make a name for the analyst. Most often they are wrong, but every once in a while, someone calls a bubble just before one pops, and they look like a prescient genius — and sometimes they are: Robert Shiller called both the Internet bubble and the housing bubble right at the peak of each, and he won the Nobel Prize for his efforts.
The pundit sounding the alarm today is Charles Hugh Smith. I like his writing, and he generally displays a great understanding of financial history and the workings of housing markets; however, this time I think he is wrong.
When is a bubble not a bubble?
Is Coastal California housing at the peak of another bubble? My data and analysis says no. Expensive? Yes. Bubble? No. If inflated house prices don’t fall, is it still a bubble? How far must prices decline before it’s considered a bubble?
It probably doesn’t matter much to the underwater borrowers who must wallow in financial pain.
Whether or not it’s considered a bubble, if market pricing fails to find support, I don’t believe prices will fall much. If an economic upheaval causes large numbers of mortgage defaults, lenders will use their “new and improved” loss mitigation procedures, can-kick the loans, and wait out the economic storm. Rather than signal an upcoming decline in prices, mortgage defaults will signal further declines in sales volumes. In fact, if we do see another housing bust, I predict we will see sales volumes fall to lows never before measured, even lower than the worst sales years of the most recent housing bust.
Why will sales volumes fall so low? If sellers are trapped in cloud inventory, unwilling and unable to lower price, and if buyers are abruptly limited by lower borrowing power, financed buyers simply won’t be able to transact, no matter how much they substitute down in quality. If financed buyers can’t buy, sales volumes will crater — prices won’t go down much, which is what lenders are after — but sales volumes will necessarily suffer. That’s how I believe the next housing bust will turn out.
Charles Hugh Smith, September 28, 2015
And here’s the knife in the heart of the Echo Housing bubble: declining household income.
The Federal Reserve-induced Echo Housing Bubble is finally starting to roll over, and the bubble’s pop won’t be pretty. Why is the bubble finally popping now?
His description of the market performance as an “Echo Bubble” has merit, but I’ve characterized it as the reflation of the old bubble because the primary reason the market has been so heavily manipulated to drive prices higher is to restore collateral value to the bad loans underwritten during the previous bubble.
All the factors that inflated the Echo Housing bubble are running dry. These include:
— unprecedented low mortgage rates
Many prospective buyers are unconcerned about the prospect of higher mortgage rates (See: Rising mortgage rates don’t care about homebuyers’ attitudes). Perhaps this is a good sign that buyers aren’t as easily manipulated by realtor fear mongering to create urgency.
— FHA mortgage approvals for anyone who fogs a mirror
Yes. That’s true. (See: FHA insures subprime loans with explicit government backing)
— frantic cash buying by Chinese millionaires desperate to get their money out of China
Yes. They are (See: Are today’s homebuyers counting on continued Chinese home purchases?)
— the Federal Reserve buying up trillions of dollars in mortgages
— lemming-like buying of housing for rentals by everyone from Mom and Pop to huge hedge funds.
I bought all I could get (See: Buy Las Vegas real estate)
The well’s gone dry, folks. There isn’t going to be another push higher or a third housing bubble after this one pops.
Really? This is where he jumps the shark.
Though it’s been slow in coming, the economy is improving, people are getting jobs and forming new households, and wages will start rising more briskly soon. In other words, the fundamentals are finally getting better, and this will spur buying demand as the props from the reflation rally wear off.
Let’s start with the basics: demographic demand for housing and the price of housing. There are plenty of young people who’d like to buy a house and start a family (a.k.a. new household formation), but few have the job or income to buy a house at today’s nosebleed level–a level just slightly less insane than the prices at the top of Bubble #1.
Charts courtesy of Market Daily Briefing)
Posting a chart does not make his point. Job creation, household formation, and wage growth point to increasing demand, irrespective of the price levels. As prices get push to the limit of affordability, appreciation slows dramatically, but it doesn’t signify a bubble waiting to pop.
The petering out of a reflation rally is not without precedent. In Great Britain, they inflated a massive housing bubble in the 1970s, then they stimulated a reflation rally, probably to bail out their banking system like we did. That rally failed to reach the previous peak, and prices drifted back down to fundamental values. It took 15 years to get back to peak pricing (See chart below).
Of special interest is the period from 1980 to 1982 when house prices drifted lower when their reflation rally fizzled. As you may recall, the early 1980s were a period of high and rising interest rates, not just in the US but in Great Britain as well. Their reflation rally died because higher mortgage rates reduced borrowing power, the same effect predicted here in the US.
It’s considered bad form to describe today’s prices as insane. It tends to hurt the feelings of everyone who’s counting on the Echo Bubble to 1) make them even richer or 2) bail them out of the hole they fell into after Housing Bubble #1 popped.
That is an uncomfortable truth.
Exhibit B is the insanely low mortgage rate, which has finally reversed course and is notching higher after 30 years of going lower. Why are today’s rates insane? Risk. Mortgages are intrinsically risky. People with high credit scores lose their jobs, experience horrendous medical crises, get divorced, etc., and the net result is a default that is unexpected.
Another uncomfortable truth, and it’s the primary reason I believe appreciation will be well below what occurred over the last 30 years. (See: Housing fundamental value analysis: 6% mortgage rates kill appreciation)
Then there’s all the credit-rating-of-501 crowd that was always one missed paycheck away from defaulting on their FHA/VA mortgage. Once the layoffs begin scything through Corporate America and struggling small businesses, those living paycheck to paycheck buyers of Echo Bubble housing will have no choice but to jingle mail the keys to the bank.
While it’s true that the FHA underwrites loans to unqualified borrowers, they will have plenty of choices other than jingle mail (strategic default). Bankers learned from the housing bust that modifying loans to prevent foreclosures and keep REO off the market is essential to maintain pricing. Bankers allowed many delinquent borrowers to squat, some for eight to ten years now, rather than foreclose and endure the consequences.
Though they may still be drooling from the smack-like high of get-rich-quick fantasies, anyone buying rental housing at these prices is on the cusp of discovering a very painful reality: few can make money buying rental property at these prices, not once rents plummet as the global recession comes home to roost.
I really have no idea what he’s talking about. While the opportunity to buy good cashflow properties is certainly diminished, the likelihood of plummeting rents is near zero. Rents stabilized in 2009 even in the weakest markets in the US after the worst recession of the last 80 years. If rents didn’t plummet under those circumstances, it’s unlikely rents would plummet under whatever doomsday scenario he believes is on its way.
If we look at the ratio of mortgage debt to household income, the current level is still double the pre-financialization level. A slight decline from the insane levels of the bubble mania do not qualify as sane.
The mortgage debt to household income percentage was bound to increase when mortgage rates went from 18% to 3.5%. The whole point of lowering mortgage rates was to increase this ratio to bail out the bad loans from the bubble. Might this revert to the mean? Over time, yes, but it may take a very long time.
The Fed goosed the Echo Bubble by buying up an insane $1.75 trillion in mortgages, almost 20% of the entire mortgage market in the U.S. The Fed has kept buying mortgages to maintain this level, but the Fed is no longer expanding their mortgage holdings. That well has run dry.
Unless or until the federal reserve starts selling those mortgages, the impact is zero. Further, it’s very unlikely the federal reserve would sell these mortgages if the result was higher mortgage rates and more problems for the banks.
And here’s the knife in the heart of the Echo Housing bubble: household income– stagnating for decades for 90% of households–has declined since the Bubble Top when adjusted for inflation. Please explain how declining real income can support nosebleed home prices now that mortgage rates have bottomed and started their inevitable rise from absurdly low levels.
Now he is conflating real wages with nominal wages. People borrow money and repay debt with nominal wages, and nominal wages have gone up. In fact, the whole point of generating inflation is to raise nominal wages to make the excessive debts affordable. If this doesn’t translate to a real gain, that isn’t the federal reserve’s problem.
If you want to believe the Echo Bubble can continue inflating, by all means take another hit of happy-housing-talk smack. But let me warn you–the high wears off.
Now that house prices rest at the equilibrium of current wage affordability, future appreciation will be limited by wage growth (and rising mortgage rates). Future slow wage growth will limit home price appreciation, and it’s one of the reasons I believe the federal reserve will keep the pedal to the metal and not raise interest rates in 2015.
Should prospective buyers fear a bubble?
Nobody wants to be a peak buyer, so fear of a housing bubble stops some people from buying homes, but are these fears well founded? Are we inflating housing bubble 2.0 (actually 4.0 in California)?
Because houses seem so expensive and prices rose so rapidly, particularly in California where kool aid intoxication is a cultural addiction, many people are wondering if we are inflating another housing bubble. My answer to that question is no.
We are not inflating a new housing bubble — we are reflating the old one, but the interest rate stimulus used to reflate the bubble is applied to stable loan terms; stable loan terms make for stable house prices.
The last housing bubble inflated prices well above the stable equilibrium of cost of ownership relative to rents based on a foundation of toxic mortgage products, most notably the Option ARM. The current rapid rise in prices is caused by different circumstances, and it’s being built on a foundation of stable 30-year fixed-rate mortgages.
When the federal reserve lowered interest rates from the bubble-era 6.5% to the current 3.6%, they imbued the market with tremendous affordability. This lowered the cost of ownership well below the historic relative valuation with rents. This provided buyers with the ability and the incentive to bid up prices and buy homes with stable loan products.
While there is no question we are reflating the old bubble, we are doing so with affordable payments and stable loan products; it’s a difference that makes all the difference.