The Imminent Demise of the Great American Housing Boom
Is Your Community Bank Ready for It?
An Interview With Dr. Edmond Seifried, Chief Economist, BNK Advisory Group
BNK Chairman Jay Brew and Chief Economist Edmond J. Seifried are convinced that the housing bubble is on the verge of bursting. Seifried has prepared an article in Q&A form that examines the problem and the fallout from the demise of the great American housing boom.
How Big Is the Bubble?
Do you see a possible burst of the housing bubble? Yes, I do. I firmly believe the bubble will burst very soon. I predict that in the summer of 2006, everyone will be discussing the bubble that had burst in 2005!
I base my view of the housing bubble on my readings of the economic indicators, as well as data from the Economist magazine and studies by the International Monetary Fund.
How big is the housing bubble? The housing bubble represents the largest asset appreciation episode in the history of the United States.
While it is difficult to precisely measure, my current estimate is that the housing appreciation over the past five years represents up to 100 percent of the GDP. The actual calculation is the percentage of appreciation divided by GDP.
How does this bubble rank with previous bubbles?
The third-largest episode of price appreciation was the 1920s stock market boom, which represented 50 percent to 60 percent of GDP. The second largest was the late-1990s stock market bubble, led by the dot-coms, which represented appreciation of 75 percent to 80 percent of GDP. So by comparison, the housing bubble is the biggest in U.S. history.
What areas of the country are at greatest risk?
I agree with the prevailing view that the cities on both the east and west coasts are sitting in residential real estate bubbles. Some areas, such as the east and west coasts of Florida and cities such as San Francisco and Boston, have seen absolutely huge price appreciation in homes.
What is unique about this bubble?
There are some very interesting and unique aspects of this housing bubble. First, it is worldwide, except for Japan and Germany. Most of Europe has experienced double-digit housing inflation.
What has been the U.S. home price appreciation compared to some European countries?
For the 12 months ending March 30, housing price appreciation in the United States was 12.5 percent. It was 15.5 percent in Spain, 15 percent in France, 11.3 percent in Denmark, and 10 percent in Sweden. There is ample evidence that it is worldwide when we see increases of 23.6 percent in South Africa, 19 percent in Hong Kong and 12.5 percent in New Zealand.
Are there other unique aspects to the bubble?
Yes. A good measure of whether home prices are out of balance is the relationship between housing prices and rents. We currently have a situation where housing prices are rising much faster than rents, even after the tax advantages of owning a home are factored into the ratio. In the United States, home price appreciation is 35 percent above the 1975-2000 average. In some countries, it is over 50 percent higher than that 25-year average. That cannot be sustained.
How can that ratio get back to its historical level?
Rents can rise faster than the price of homes, or housing prices can just remain steady while rents rise. But if rents rise just by 2.5 percent a year, which is a pretty good historical average, then the price of houses would have to remain the same for 12 years – no price appreciation in homes.
No price appreciation in homes in the United States for 12 years doesn’t sound good.
Well, consider the alternative – that housing prices actually fall, which I think will occur in certain areas of the United States when the bubble bursts.
You covered some unique aspects of the bubble. Are there any troubling aspects?
Definitely. There are two major aspects that make the situation downright scary – the way homes are being financed and who is buying the property.
Last year, roughly three of 10 homes were financed with interest-only mortgages or negative amortization loans. Those negative amortization loans are really catching on and becoming very popular. Moreover, between 30 percent and 40 percent of homes were purchased without a down payment.
Why are you concerned about some of the people who are buying homes these days?
The latest numbers show that about one in four buyers is an investor. These buyers are betting that home prices continue to rise, so they can make a nice profit on a quick sale. Some investors, of course, just plan to rent out the property. But that may present a problem in some areas of the country because the rents from these properties do not cover the carrying cost – the mortgage and taxes.
Why the Bubble Bursts
What will make the bubble burst?
There are two factors. Prices for homes get so high that people are priced out of the market. Potential first-time homebuyers decide it is cheaper to rent than to buy. People who might have moved decide to continue to stay where they are. Then, those investor owners of homes have a dearth of buyers, which means they either can rent the home at a loss or sell it at a loss. If they don’t have the money to carry the home as a rental unit at a loss, they will be forced to sell – even at a loss.
What is the second factor to prick the housing bubble?
The possibility of rising mortgage rates. The current situation of the small spread between short-term rates and long-term rates continues to be a conundrum, to use the language of Alan Greenspan. Should this spread return to normal – which would mean long-term rates rise more than short-term rates – the demand for housing could be stifled.
Do you see any markets with signs that the bubble is beginning to burst?
Oh, yes. The Washington, D.C., area – including northern Virginia and suburban Maryland – is already showing signs of trouble. The only question is whether prices will stop appreciating or whether they will actually drop or even collapse.
Would you comment about the impact when the housing bubble does burst?
It will impact everyone – but to varying degrees.
What should worry people who are in areas where housing prices have seen little appreciation or even a decline?
People in areas where little or no appreciation has occurred are very likely not to be immune. If the bubble bursts because of higher interest rates, building and construction would be impacted throughout the nation – not just in the bubble areas. Therefore, there will be some impact even in areas that have not been affected.
Do you have other concerns for bubble and non-bubble areas when the burst occurs?
My worry concerning community banks stems from the negative wealth effect. As asset prices fall, people everywhere feel poorer. They retrench their spending. That is what happened after the collapse of the dot-coms.
How would this impact community banks?
They might make fewer mortgage loans. In turn, homeowners would slow their withdrawals of their home equity via loans because there would be less equity to borrow against.
Is there any good news for community banks in the non-bubble areas?
Yes, in areas where most of the home sales are for owner occupation – not investors – prices probably will not fall, but they will not necessarily appreciate much. Credit problems will probably be minimal or within normal experience.
What will be the impact in the bubble areas?
Where you have a large portion of investors, there is a big chance for big losses. When prices start to fall, you may very well get the snowballing effect – home prices will drop rather rapidly.
The National Impact
What will be the impact on the overall economy when the housing bubble bursts?
I’d like to point to a study by the International Monetary Fund. The study found that there have been 20 episodes of rapid home devaluation in different locales around the world during the last quarter-century. Prices fell 30 percent or more. The study found that in 19 of the 20 countries, a recession followed the burst of the housing bubble.
What were those recessions like?
Bad. The recessions tended to be longer than average and deeper than average.
The best scenario would have a gradual slowing of appreciation in most areas and only minor depreciations in a few areas.
The worst is that the busted bubble will put the whole economy into a recession that is long and deep.
Impact of the Hurricanes
What is the short-term impact of hurricanes Katrina and Rita on the housing bubble situation?
Keep in mind that the city of New Orleans and surrounding area account for $40 billion of the gross domestic product. Most of that contribution can be subtracted from the nation’s overall economy in the short-term. I also expect to see actual job losses over the next couple months in the Labor Department’s monthly employment report and an upsurge in the initial claims for unemployment assistance.
What is the long-term impact? Won’t the rebuilding be a positive factor for the economy? Yes, the rebuilding in the hurricane-ravaged areas will be a good thing, but only for those in the building sector. In fact, the rebuilding may hasten the housing bubble to burst.
Has the overall importance of the construction industry changed in recent years? Yes, it has. In the early 1990s, building and construction accounted for about 3.25 percent of GDP. Today, the impact is much larger, almost 6 percent of GDP!
The timing of this change could not have been better. Just has our production sector was hemorrhaging jobs – due to the offshore globalization of jobs – the construction sector began to boom and reduce the negative impact of offshoring. So you see, there is a lot more at stake if the construction boom ends.
My hope is that the pricing bubble can be deflated without crushing this important sector of the economy. I’d say the folks at the Fed have their work cut out for them!
Why might the rebuilding spur the housing bubble to burst?
The first and largest portion of the rebuilding will be for government infrastructures, such as roads and schools and hospitals, and for large commercial ventures such as shopping malls and office buildings.
The demand for materials and people in the construction business will increase the price of all construction. That means that the price of new home construction will rise. If the new buyers cannot afford to buy a new home, they may decide to rent instead. So, less home-buying demand could create a supply-demand imbalance that pricks the bubble.
Are there other factors associated with Katrina and Rita that will impact the housing market?
Yes, the price of energy and consumer confidence. The damage to oil refineries in the area sent energy prices skyrocketing. Fortunately, energy prices have dipped some, but I do not expect energy prices to return to the pre-hurricane levels. That means consumers will have less to spend and businesses will have higher costs, as well. Both of those factors are inflationary, which could cause the Federal Reserve to raise interest rates to stem inflation. Rate increases, of course, could accelerate the collapse of the housing bubble.
How does consumer confidence impact the housing market? It makes buyers less eager to buy because they worry about their job security and rising costs of necessities such as food and energy. Again, low demand serves to dampen home price appreciation or may even depress prices in some areas.
The Consumer Confidence Index fell to its lowest level in almost two years in the first report that was based on the reactions of consumers after Hurricane Katrina. That September report stated, “Consumers’ outlook for the next six months turned considerably pessimistic” in September.
What actions can community banks take to reduce their exposure to the housing bubble?
First, I am not recommending that community banks should stop making mortgages. All markets are local and, therefore, community banks need to assess their lending standards against local factors. However, I think bankers need to consider a few changes.
If a community bank has been aggressive in its lending practices, such as offering loans with little or no down payment, interest-only loans, and the like, then the bank probably should halt these practices or restrict them significantly. Bankers also may want to sell some of these loans to reduce their exposure.
Another thing community bankers can do is to continue to make loans where there is a good-sized down payment and the borrower has sufficient income to support the loan, regardless of any short- to medium-term changes in the value of the house.
The third action involves loans for second houses or rental properties. These loans should be subject to closer scrutiny and made based on the cash flow of the borrower rather than potential appreciation of the property.