Dec

8

The boom/bubble/froth in the U.S. housing market that started in 2001 and 2002 has led to an “excess supply” of 750,000 unsold homes, about twenty five percent larger than the average inventory of four to five months sales. (The data that have led to this conclusion are at the end of this abstract.) These homes were produced in response to the demands of investors who anticipated large speculative profits from “flipping” these properties-and until recently they attained these profits. These speculative purchases directly and indirectly (through the purchase of furniture and appliances, real estate brokerage services, title insurance, etc.) added three or four tenths of one percent to the rate of growth of U.S. GDP between 2002 and 2006. Moreover the U.S. GDP growth rate was boosted by a comparable amount from the increase in household spending financed with the cash obtained through equity withdrawals with re-financings and home equity loans.

The U.S. home price bubble has burst in many metropolitan markets, especially those that have had the most rapid price increases. Excess supply in housing-as in all markets–places downward pressure on prices. Housing starts have declined sharply, perhaps by thirty percent; nevertheless starts still remain higher than the average in the previous several decades. Moreover the excess supply will increase for perhaps six to nine months or more as home developers complete construction on units that were started from three to twelve to twenty months ago, before the surge in the inventory. Moreover many would-be buyers are “on strike” and delaying their purchases until prices decline further. Finally the excess supply will increase in response to the surge in foreclosures, the increase in unemployment as the implosion of the housing bubble leads to a significant economic slowdown, and as individuals who purchased second homes for their own use encounter financial hardship.

The excess supply will begin to shrink only after housing starts declines sharply relative to sales of new homes. The decline in housing starts is the primary cause of the slowdown in the rate of economic growth of about one percent that became strikingly evident in the third quarter of 2006. The rate of economic growth in 2007 and 2008 will depend on how rapidly the excess supply of houses declines; as long as there is an excess supply, prices will trend downward, and housing starts will decline below their average rate in the years before the froth developed in the housing market. The more rapid the decline in starts, the more rapid the decline in the excess supply, the more rapid the decline in the GDP growth, and the greater the likelihood of a recession in 2007. The non-recession scenario involves a slower decline in housing starts and a more prolonged economic slowdown.

The sharpness and the duration of this economic slowdown will have significant “knock off” impacts on the other sectors of the economy that in turn will impact housing. Corporate profits will decline and stock prices will be negatively affected. Monetary history suggests the shock will be sufficiently severe to have major impacts on firms in the financial sector– even though there is no ability to foresee the industries that will be hit, except for the firms that sell and hold sub-prime mortgages.

Now for the background: Analysts of financial behavior have been elaborating models of asset price bubbles for more than two hundred years. Some good news perhaps a reduction in interest rates or an easing of credit restrictions leads to an increase in the price of an asset usually residential real estate. Real estate is the largest component of wealth for most households and the increase in price of real estate leads to a surge in the household wealth that in turn leads to greater willingness to spend. Individuals become more optimistic. The lenders relax their credit standards, often to dampen the decline in their market share to more aggressive lenders. Asset prices increase further. An increasingly large number of investors begin to buy assets to profit from capital gains, the anticipated rates of return on their invested cash are phenomenally high because the down payments are so modest, especially when they buy real estate. The economy booms as real estate construction surges; growth accelerates.

The dominant explanation for the recent surge in U.S. house prices is the unprecedented expansive monetary policy that Chairman Greenspan’s Federal Reserve adopted in 2001to dampen the impacts of the sharp decline in stock prices. Real estate prices had increased by x percent between 1993 and 2000; between 2001 and 2006 they have increased by x percent. Moreover in the last few years U.S. real estate lenders have become both more imaginative and more aggressive in developing new types of mortgages that reduced the home buyers’ monthly debt service payments-and thus enabled them to purchase buy more expensive homes relative to their incomes.

The remarkable phenomenon of the last five years has been the sharp increase in the prices of residential real estate in Great Britain, Australia, New Zealand, and South Africa as well as in Spain and several other European countries. (Canada is the only Anglo-Saxon country that has not experienced a significant increase in the price of residential real estate.)

One possible explanation for the increase in home prices in these different countries is that the Fed’s monetary policy inflated real estate prices abroad. A competing view is that the flow of Asian money into the U.S. and foreign security markets has contributed to asset price inflation; virtually all of the countries that have experienced sharp increases in the prices of residential real estate also have large trade and current account deficits. The two views may be complementary.

The changes in the prices and new construction in the U.S. housing market in the last five years seem part of a pattern that is almost biologic in its regularity and predictability (if not in the timing.) Between 2001 and 2006 real estate prices increased four or five times more rapidly than household incomes, in part in the last two or three years because an increasingly larger number of buyers were purchasing homes and condos in anticipation of short-term speculative gains. In the “hot markets” in Arizona and Florida, annual price increases were six or eight times the interest rate on the money borrowed to finance purchases. The increase in home prices relative to construction costs led to a boom in number of units produced; Toll Brothers and KB Homes and the other large developers were in financial heaven.

Now each day’s news seems to have a story about the decline in housing starts, year-on-year fall in home prices, changes in the size of the inventory of unsold homes, and the increase in home foreclosures. The inventory of unsold homes is larger than at any time since the early 1990s. Home prices peaked one or two quarters ago, although there are significant differences among regions in the price changes. The price declines in the Red states generally have been larger than in the Blue states-but the price increases in the previous several years were larger in the Red states. (For this purpose, Southern California is a Red state.)

Dow Jones Real-Estate Index
Town Zip Code Year-To-Date % Price Change
Stamford, CT (06903) 6.9
Mountain Lakes, NJ (07046) -5.8
Manhasset, NY (11030) 16.1
Old Westbury, NY (11568) -0.1
Villanova, PA (19085) 0.9
Fairfax, VA (22039) -0.2
Glencoe, IL (60022) -17.9
Lake Forest, IL (60045) 11.5
Los Angeles, CA (90077) -20.6
Menlo Park, CA (94025) -23.8
* Source: Wall Street Journal, November 24, 2006

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Steve Leslie replies:

I wish to thank Prof. Aliber for his most excellent explanation of the housing market, with particular reference to the boom/bust cycle we are currently experiencing in this country and the inevitable fallout from such an event.

This is unquestionably one of the finest essay that I have witnessed on DailySpec since I began investing time in visiting the site.

This shows in irrefutable detail the high quality of writing, the amazing intellect of the contributors and the depth of thought available here. Prof. Aliber displays in thorough and logical progression why DailySpec should be a part of the daily diet of serious speculators.

I almost feel guilty in being exposed to such remarkable writing.

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