Bubble, Bubble, Toil and Trouble

OK, one thing I should point out is that economics is really fucking hard. I thought that chemistry was hard, but economics makes chemistry look like making balloon animals. Then again, I don't know how to make balloon animals either, so perhaps I'm unqualified to make statements comparing those three sciences. Let's just say that they all represent a near infinite level of difficulty, and leave it at that.

So, when I decided that this week's science post would be about bubbles, particularly housing bubbles, I forgot that housing bubbles means economics, which is the section of The Economist that I skip every week. Yes, I realize the irony inherent in my skipping the economics section of The Economist. I'm not particularly proud of my skipping, but I'm taking it one article at a time. That being said, I can't guarantee that this post will be overwhelmingly educational, as I'm still learning myself and I may have to sacrifice providing a wealth of information for clarity. Don't get me wrong, it will still be educational, just not overwhelmingly so. It will be just the right amount of whelming.

Without further ado, here's the question of the week:

What is a housing bubble?

In economic terms, a bubble occurs when speculation in a particular commodity drives the price of said commodity up to unsustainable levels. In real life, bubbles are floating faerie houses made of moonbeams and pixie dust. Let's say you make a candy bar called the Fudgemeister. You go online and talk up Fudgemeister bars and somehow manage to convince the world that Fudgemeister bars are the greatest thing ever, so everyone goes out and starts buying Fudgemeister bars as they see them holding some future value. To capitalize on this success, you make limited edition Fudgemeister bars, and start printing a magazine called Fudgemeister Monthly. As a result, the price of Fudgemeister bars go up, which makes people talk about it more and worry more about them not being around, so they go out and buy more Fudgemeister bars and hoarding them in their basement to sell at a future date. Eventually someone realizes how fucking stupid they're being by thinking they can fund their retirement with candy, and they stop paying inflated prices for Fudgemeister bars. This sets off a panic, people start selling off their bars and soon you can't swing a dead cat without seeing a 3 for 1 sale on Fudgemeister bars at the local drug store. Those still holding massive quantities of bars see their fudgy worth go down the toilet, they come to your house and beat you about the head and neck with King Size Fudgemeisters. This then goes down in history as the Fudgemeister Bubble and the Great Candy Crash of '06.

Sound familiar? Well, it should. It happened with Tulips in the Netherlands in 1636, it happened with dot-com stocks in the US in 2000 and some would say it's happening with real estate, specifically houses, in the US and other countries as we speak. Bubbles are tricky things in that you don't know you're in one until after it pops and whatever you've been speculating on crashes. For this reason, we can't really say if we're in a housing bubble at the moment, although there are plenty of people on both sides to give their opinions.

A housing bubble is just like our Fudgemeister Bubble. People start overvaluing houses, which in turn fuels more overvaluing until the point where house prices reach unsustainable levels. Here's where it gets bad. Unlike in the Great Candy Crash, where speculators are left with a basement full of candy, and not much else to show for it, when a housing bubble bursts, people are left with negative equity on their mortgage. To place this in plainer terms, you owe more on your house than your house is worth. This is a bad thing.

As the economy sputtered along these past few years and the Federal Reserve continued to reduce interest rates, mortgage interest rates fell as a result, making it easier for people to borrow large amounts of cash for buying a house. Mortgage companies then "helped" people some more by offering interest only loans, or loans for 105% of the purchase price, to cover closing costs, and other incentives to get people buying houses. Armed with this cash, folks can now buy more house than they ever could before, only they're not necessarily buying more house, just a more expensive house.

House prices are traditionally set based on what houses in the same neighborhood, with the same features have sold for. Once one sells for a ridiculously high price, others have precedence to be sold for a ridiculously high price. Human nature also pays a part in this, as people don't want to sell their house for less than the next guy, especially if they can get much more than what their house is worth. On the other side, folks don't want to be outbid on a house, so they jack their offer up to match whatever they think the other buyers will be offering. Besides, their interest rate is so low, and they don't have to put any cash down, so why not? After all, in 2 years, the house will be worth double what they paid for it, so they can just refinance then.

You also have all the folks who see houses as an investment, either as a reaction to seeing gains in stocks wiped out after the dot-com crash, or as a reaction to seeing their neighbor make 50k on a house that they owned for only a year. Take a look at the various home and garden tv networks some time and count how many shows are built on the premise of fixing up a house for the purpose of selling it. I can tell you that the number is more than 2. These investments serve to push the prices of houses up and up and up and up to the point where they become overvalued.

How do we know they're overvalued? There are a number of factors, but the only one I somewhat understand is the ratio of house prices to rents. To quote The Economist, "...the price of a house should reflect the future benefits of ownership, either as rental income for an investor or the rent saved by an owner-occupier." In other words, if you're paying $600,000 for a house, you should either a) be able to rent that house for an amount that matches the montly mortgage amount or b) be able to pay a monthly mortgage that represents a savings over what you were paying in rent. For the most part, this ain't happening. Again, from The Economist, "America's ratio of prices to rents is 35% above its average level during 1975-2000". This points to overvaluation, because there is no financial savings to owning rather than renting. The housing investors are willing to accept this temporary loss, by renting our their investment property, for the hint of future profits, which is a sure sign that speculation is taking place.

There are counters to this argument, however I barely understand this argument, so forgive me if I don't get into what the counter is, but it has to do with the fact that lower interest rates makes it easier to buy a house, so it costs less than before to buy your McMansion, so it only makes sense that the price of houses is so much larger than rents. I've included opposing arguments in the reference section, so please don't take just my word for it.

I can tell you from personal experience that there are some crazy regional shenanigans going on, that, in my opinion, need to be fixed with some sort of market correction, lest we all plummet into economic despair. We bought our first house in Northern VA., in October of 1999. A little over 5 years later, in Feb of 05, we sold it for roughly 2.25 times what we paid for it. That's a pretty significant appreciation rate. Granted, we painted, added a deck and a fence, finished the basement and did some landscaping, but none of those additions can account for the rise in price. Part of the reason we decided to sell, was that we could no longer afford our own home. Don't get me wrong, we could make our mortgage payments, but if we were to buy our house, for the price we sold it for, our mortgage would have been through the roof, and beyond what we were comfortable paying. Not much of a big deal had we decided to stay put, but what if we decided we wanted something larger, or just something different? In the 5 years of ownership, the area got priced out of our income range. How first time home buyers, like us, could afford such ridiculous prices, is beyond me. See mortgages, 105%.

And the prices are ridiculous. I know what my house was worth, and I feel like I cheated the buyers out of a huge bundle of money because of where we priced it. But, human nature being what it is, had we priced it significantly lower, it would have been avoided because people would have wondered what was wrong with it.

Now, compare that experience with what we have in Atlanta, and you can see the argument for there being small, regional bubbles, rather than a large US wide bubble. Most houses here take several months to sell, and seem to be pretty much on point with what I would expect to pay. I know how much the seller of our current house paid, and I know how much we paid, and I don't feel like we got cheated. They were jerks, but that's another story for another time. Similarly, I don't expect to be able to sell my house for double in 5 years, which is just fine with me. Maybe new houses are ridiculously overpriced. I have no idea.

Regardless of whether or not it's a case of regional bubbles, or a large US bubble, a crash would be bad news for a bunch of people. All the housing investors would now have property that they won't make a profit on. All the people with negative equity will have a hard time getting additional equity should the roof on their $800,000 house spring a leak, because of the negative mortgage equity. If interest rates go up, all those with interest only ARM's will feel the pinch once they go from an interest only 5.25% mortgage to an interest + principal 8% mortgage on a house they could barely afford in the first place. The private sector jobs wrapped up in construction, real estate, mortgage brokering and other aspects of buying, selling and owning a house will dry up. People, who have to move will find themselves selling their house and not taking enough, if anything, from the sale to put towards the next house. Finally, people will spend less in general, because that new 42" plasma TV seems less important when you have a $650k mortgage on a house valued at $300k. The only people who would benefit, would be first time buyers who would be able to finally afford a house that's priced near or at the home's value, and who are willing to stay in it for 5 - 6 years, until the whole stupid process gets going again.

Me, I'm happy with having sold our house when we could benefit from this bubble, and am more than happy to hoard my cash for when it eventually bursts. Besides, I've got an inside tip on these candy bars. Trust me. I have seen the future, and it is Fudgemeisters.

Next week: No Idea, but Man Will It Be Good

Sources:
Wikipedia - Economic Bubble
Wikipedia - US Housing Bubble
Wikipedia - The Housing Bubble
Investor Elite.com - Housing Bubble
Economy.com - U.S. Bubble Trouble - Celia Chen
The Economist - In Come the Waves, June 16th, 2005 (requires subscription)