Fear

We have nothing to fear but fear itself, but
fear itself can be pretty scary.

…Fear is ruling the
financial markets. Billions of dollars have been lost in mortgage-related
investments. The Federal Reserve worked madly over the weekend to
engineer a takeover of Bear Stearns and avert a systemic meltdown. But
the big fear remains. How low will house prices go?

If prices continue to fall, mortgage defaults will move well beyond the
subprime sector. Trillions of dollars in losses for investors are not
impossible. But that doesn’t mean they are inevitable.

That’s me in today’s New York Times.  Believe it or not, my piece is one of the more optimistic pieces you are likely to read on the housing crisis.

I think that housing prices went beyond the fundamentals sometime around 2004 (and I said so in 2005, see here and also note my warning that prices could fall dramatically here).   But 2004 levels are still well above long run trend.  Thus my optimism stems from thinking that unlike Japan, our housing prices need not fall back to long run trend (see my piece for graphs).

But the problem is that we can overshoot the fundamentals going down as well as going up and the United States now faces two potentially
self-fulfilling prophecies.


If the financial markets can predict where and when house prices will
stabilize, then credit conditions can quickly return to normal, the
economy can expand and house prices will indeed stabilize.


But if the financial markets remain uncertain about when the decline in
house prices will end, then fear will tighten credit even further, which
would strangle the housing market and generate even more fear.

Unfortunately, I do not know what will push us into the right prophecy (but read my piece, that will help!)  Thus, I am more optimistic than Paul Krugman, who thinks that we may have slipped into the state where no prophecy can bring us back to a good equilibrium, but I’m not that much more optimistic.

Comments

Alex-

I especially enjoyed the commenters on the Times' site. You really buzzed them up.

Odograph, you resisted the temptation! Well, done! :) Here it is anyway. The credit snobs had a point.

As a non-economist, undergrad student, and renter, I wonder what the appropriate comparison is here. We all seem to be looking at where housing prices were in 06 and comparing them to where they are heading. But I imagine that, for a homeowner, the appropriate comparison is whatever their house is worth now and what their situation would have been had they not bought a house and, instead, continued renting.

My naive impression is that the basic comparison goes like this: when you rent, you "lose" all of your housing costs. But when you buy, even if the nominal price of your house goes down 10%, you still have some equity in that house (a really tiny bit of equity at first, when your mortgage payments are mostly interest, but equity nonetheless).

Instead of thinking of the house as a good on which there can be a loss, think of "housing" as a cost that people pay. I would guess that, if we hold actual monthly costs constant (rent v. mortgage+maintenance+insurance, etc.), then those buying houses are "making" more on housing than are those that rented, even in this sort of housing market. Right?

I have been sitting on cash watching my friends make lots of money on realestate since 2002. I am hoping for a big fall in price. If there are enough people like the fall will end when we start to buy. Young people who do not own a home cannot afford a home.

TWM, I think the greatest tragedy is the influence of the mortgage interest deduction. It was a one-time benefit for home buyers (at least in my market), long lost as prices incorporated the deduction into "buying power."

Unfortunately it skews buyer psychology, and unduly penalizes those renters.

(The same goes for the capital gains tax "not charged" on homes sold in trading up. Again the tax not charged goes into buying power and drives prices up further. The man on the sidelines, and the first time buyer, again loses.)

More and more people want to live on the coasts, but land is hard to come by in places like Manhattan and San Francisco. Cities and regions built on ideas — like Boston, Los Angeles, New York and the San Francisco Bay Area — have grown even as areas built on manufacturing, like Detroit and the Rust Belt, have declined.

This strikes me as a common mistake -- thinking of certain regions as permanently desirable. Certainly, there is no geographical limit to 'regions built on ideas'. Detroit, Chicago, Cleveland, and Milwaukee have similar Great Lakes locations. Chicago is a 'hot' city like Boston and San Fransisco, while the other are not. There is no reason from climate or geography that Boston or Chicago might not head the way of Cleveland and Detroit. Or vice versa. And that's considering only the only core cities not the areas (Oakland county outside Detroit, for example, claims to be the 4th wealthiest county in the U.S.)

On the other hand, the cities of Minneapolis and Indianapolis in the midwestern 'rust belt' have done well recently despite not being 'coastal' (nor located near the mountains, nor having balmy climates).

To think that housing prices will stay permanently above long term trends because of limited availability in a fixed pool of desirable locations seems pretty dubious.

I generally liked the Tabarrok article, and if he's right about the market being paralyzed until we know when we've hit bottom, then that underscores my main point in all of this mess: vague government promises to save the day ("maybe we'll suspend ARM resets," "maybe we'll do a 20% loan substitution on mortgages," etc.) only make it in everyone's interest to postpone coming to grips with their losses.

TWM, my quick reading of your post tells me it can't be right. It seems you are saying the rational thing to do is buy instead of rent. But if that were true, wouldn't prices adjust until people were indifferent? (Or rather, until some people were attracted to the legitimate pros/cons of renting, while the others were attracted to the legitimate pros/cons of buying.)

We foolishly bought a house in the fall of 2006, and then when my job changed were stuck with it. Now we are hoping to rent it out for about the mortgage payment, but we are going to use a management company so we won't see all of that (assuming we get a renter). And as for the point about having small equity if you buy a house and it drops 10%--no, you have negative equity in that case! (I'm talking about people who just bought, of course; you are right for people who have owned for a while.)

In short, we would have been much much better if we hadn't bought our house, and instead had invested in Eliot Spitzer trading cards.

I find it difficult to believe that there is only 15-20% down side in home prices. On a national level maybe but it depends on how you weight it. In certain areas of the country home prices hadn't really gone up much beyond inflation over the last 5 years like in rural Wisconsin. But in major metro areas, it certainly has.

In the NYC area wages haven't necessarily gone up much but prices have. For example, in the town I live in over the last 5 years nominal wages were up about 12-13% but home prices were up over 65%. So that means that people had to increase there leverage because equity prices et al certainly didn't drive up net worth. NYC metro is more geared to the financial industry than anywhere else. Once bonuses dry up and banks start to lay people off (I'm already getting desperate calls from friends at Bear Stearns) I don't see any reason home prices can't go back down to a more normalized level of 3-4x income from the current 5-6x. In that case it would mean that, at least for me, my home value could decline 40% from here and it still wouldn't necessarily mean that it would be all that unreasonably priced on a normalized basis.

Structurally there is no reason that home prices should sustain at a new higher level versus income compared to historical norms. Nothing more than the willingness of both lenders and borrowers to take on more credit risk has been driving home price up over the last 5 years. Real estate is local and each area of the country has had different factors driving it but there is no doubt that the national trend has been one of significantly increased leverage with more exposure to interest rate variations on the part of borrows and on the lending side, less willingness to appropriately assess credit quality coupled with more exposure to the negative impact of asset price declines. Given that we are now reversing back to more normal risk premium levels in other asset classes there is no reason that this would not apply to home prices. And it certainly would not be outside the relm of possibilities that the market correction overshoots.

Alex,

Why do you expect the fundamental to remain above long term trends? I see two possible reasons:
that supply restrictions are and will remain much worse than in the past (possibly true in a few
areas) and that interest rates will remain permanently lower (or alternative financing vehicles
will remain available). I do not see these latter holding.

So, looks to me like we could see a long way down in parts of the country, although there are some
parts where the bubble never really took off much and have not experienced the recession much either.

Instead of thinking of the house as a good on which there can be a loss, think of "housing" as a cost that people pay. I would guess that, if we hold actual monthly costs constant (rent v. mortgage+maintenance+insurance, etc.), then those buying houses are "making" more on housing than are those that rented, even in this sort of housing market. Right?

Not exactly. If the value of a house goes down by 10% in less than a year, you'd almost certainly have been much better off renting for that year and then buying at the lower price. Of course, that's using perfect hindsight.

Let's see: proximity to shore and strong zoning makes housing permanently of more value? Maybe New York before Bear, but surely not California or Florida...where is the empirical data to support this? I think we are in new territory here.

Instead, consider correlation of real estate equivalent price with income. If this were to correct, it would more likely be to 1973 values instead of 1997 or 2006--mean incomes haven't risen since then, and real incomes have stagnated. It is not just house-flippers, sub-prime, NINJA, fraudulent contracts, it is the whole market, more in some places than others. The fact is that for a long time (when Nixon took dollar off gold?) Americans have not been saving except to put money into houses. This has been distorted by government intervention in taxes and many other ways, and compounded by extreme leverage by homeowners and financial institutions.

The Japanese collapse may be different, those consumers had savings. Also we now have runaway inflation caused by central bank actions and the collapsing dollar and distorted investment decisions moving into commodities.

A more pertinent question would be, how long will it maybe take for price discovery and mark-to-market transparency to become available so there is the necessary information for market transactions to resume. What are the incentives for creditors/debtors and equity holders to get moving quickly on this (now that the FRB has essentially assumed an equity position)? Right now in the housing market there are huge numbers of people who are sitting and waiting and asking these same questions. It will take a long time to find that point, the actual bottom of the market will be somewhat later.

What are the wider implications of what house price the market eventually sets? Will the resulting rate of inflation create another bubble? Who loses in this transfer of wealth from one generation and geographical area to another? Does concern for solvency abolish any concern for moral hazard?

I rent a house on the water in Florida, house for sale for a year, nobody is looking at it, I expect value to drop 30% but it will take another year or two to sell. It would be much more rational for there to be a policy that encourages people not to build where hurricanes can destroy property and much gasoline necessary to drive to work and shop, but instead to build high-density where people can walk to work, shop, and study. Flipping houses or financial derivatives are obviously not wealth creators, what we need are not more service jobs but instead work to create capital, invest in infrastructure, education, health, alternative energy. Our American lifestyle is irrational and it may be a collapse would be welcomed by most people in the world. After all, the Islamic banking system doesn't have interest, but equity, which is better?

<>
There is nothing like macroeconomics to get economists preaching to the market!

John2: "It would be much more rational for there to be a policy that encourages people not to build where hurricanes can destroy property and much gasoline necessary to drive to work and shop, but instead to build high-density where people can walk to work, shop, and study."

Consider this solution for avoiding hurricane zone building: force those in hurricane areas to pay market rates for flood insurance and eliminate federal disaster protection. That doesn't require a government policy, just the elimination of one.

Consider this solution: let people have the freedom to spend whatever they wish to for gasoline and live as dense or as spread out as they wish. That would require neither government policy nor government bureaucracy to enforce the policy. Oh, yeah, it also lets people live where they wish to live instead of where collectivists think they should be living.

Let us address this issue of supply restrictions more generally.
If supply is restricted, then this should show up in higher rents,
not just higher prices. Shiller showed that the price to rent ratio
was at an all time high in 2005. Those defending those prices had to
do so on the basis of interest rates, which are not going to stay down.

Of course, Alex realizes there was a bubble. But the price to rent ratio
will have to get back down to its longer term averages, and in many parts
of the country that still has a substantial ways to go (and, yes, John
Dewey is right that there are some major parts of the country that never
got bubbly and probably will do all right on this, although that may not
help the financial markets with their subprime messes unraveling).

Guys grow up. The problem is not what the house prices are or what they are going to be. To me who lives in Europe your average house prices as posted above are laughably low and someone complains about not being able to afford that. Well there is your problem. Your money is worthless in the world and getting so more everyday. You're headed for dark times i'm afraid, that is why house prices will fall. It may take a month a year but it is going down. As will the prices in the UK.

I would have hoped the basic problems in the Housing market would have been much better understood by now -- and certainly taken more seriously. The cavalier attitude of many -- first denying the problems of housing, now glibly declaring them to be less than a function of fundamental market factors -- serves no one.

This is not merely a problem of fear: There are very significant issues of prices, inventory, and income.

The problem in Housing comes down to basic economics: Too much supply, not enough demand.

Add to the mix too little available credit, and you quickly realize the psychology is secondary the ability to find a qualified buyer who can afford to put a down payment on your house AND obtain financing.

Hence, the drop form an annual rate of sales from 7.5M in 2005 to to 4.5M today.

Emotion is always potentially a factor in markets. To say its the dominant driver in US real estate today misses too many other fundamental elements.

At this monment anything is unstability. so it is not strange. But we always live our lives

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The Japanese collapse may be different, those consumers had savings. Also we now have runaway inflation caused by central bank actions and the collapsing dollar and distorted investment decisions moving into commodities.

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