Asymmetrical Information

Dear Economy,

Please let the NYC housing market do the "moderate" thing instead of the "nasty surprise" thing.

Sincerely,

In Contract

That prices rise and fall is not a sign of a bubble. There was only one line in there that indicated a classic sign of a bubble (people purchasing on the expectation that prices would rise) and it gave no indication of the size of the phenomenon.

I sold my NJ home last year. After the closing I said jokingly that I'll return to NJ in a few years after the market collapses and buy my house back at half price.
This was met with extremely nervous laughter, and the realtor looked like she wanted to kill me.

I just hope it last until I cash out. If the market just levels I could sell my house in NVa, move to Texas, buy a bigger house with larger lot, and drop my mortgage debt by 85%. So it needs to hold on for a few more months!

I figure I can take almost a $20K/year salery cut and still improve my standard of living! This is crazy!

Well, I'm no expert, but I was surprised that an article like that didn't mention the higher rates of home ownership that we have now, versus a decade ago. Home ownership rates were steady at about 65% all through the 70's, 80's and up to late 90's. Now they're at nearly 69%.

Four percent isn't much, until you realize that's four percent of about 100 million families in the US, which translates to a demand for three or four million more homes than earlier. And, of course, population increase no doubt has added additional demand. Also, there are the increasingly affluent Americans - like the guy who bought the house across the street from ours to use on weekends to go to UT games - who own multiple homes.

Supply and demand is supposed to be the bread and butter of an economist, so why didn't the article even mention it? Jane, is there something I'm missing here?

I sold my NJ home last year. After the closing I said jokingly that I'll return to NJ in a few years after the market collapses and buy my house back at half price.
This was met with extremely nervous laughter, and the realtor looked like she wanted to kill me.

Considering she was probably set to make a nice killing from the sale, I'm both unsurprised and unsympathetic. Good for you :)

A few years ago, the house across the street was up for sale, and a realtor was showing the place to a pair of prospective buyers and their young offspring. They started by looking at the lot, and just as they had come around from the side yard to the front entrance, the then-neighbors next door to us arrived home. Now, they were actually a pretty mild, harmless couple, but they did have an indulgence for loud, chrome-and-black Harleys and black leather riding gear.

What I wouldn't do to go back to the moment where the realtor turned in response to the sound of poorly muffled four-stroke and saw that sight parading down the street -- except this time, I would have a camera ready.

You know, it's the articles in the newspaper (NYT) and NPR about people buying houses for speculation that freak me out. Seeing as how they're usually late on picking up the trend, doesn't this mean the peak was some time ago and we're all just headed downhill?

This has been your daily dose of paranoia.

OAKLAND — Rachael Herron's new condo will ensure her financial salvation — unless it provokes her ruin.
Herron put no money down for her tidy one-bedroom, borrowing the entire purchase price of $211,000. To keep her monthly payments as low as possible, she got an adjustable-rate mortgage that won't require her to pay any principal for three years.

Thanks to her "interest-only" loan, the 911 police dispatcher was able to afford, barely, her first home. She now has a stake in California's sizzling real estate market. As her home increases in value, she plans to use some of that equity to pay down her credit cards.

But Herron is also setting herself up for a day of reckoning: Nov. 1, 2007.

That's when she has to start paying off her loan principal. If interest rates are higher than when she bought her home last fall — something many economists consider probable if not inevitable — her monthly payment will increase by as much as a third.

"I don't know what I'll do," said Herron, 32. "I'm already working overtime to pay my bills."

Confronted with soaring home prices, Californians are adopting a "buy now, pay later" strategy on a massive scale. The boom in interest-only loans — nearly half the state's home buyers used them last year, up from virtually none in 2001— is the engine behind California's surging home prices.

But all that borrowed money might be living on borrowed time. When higher bills start coming due, Herron and hundreds of thousands of other homeowners in the state will have to find ways to cope — or will have to sell.

In the most dire scenario, if they owe more on the home than it's worth, they'll simply walk away. Abundant foreclosures could spark a downturn in the entire housing market, leading to the long-feared bursting of what some call a housing bubble.

Interest-only loans, and other forms of so-called creative financing that are far riskier than the traditional 30-year fixed-rate mortgages, have allowed more people to afford homes in California even as prices have skyrocketed.

When the price of houses in California soared 17% in 2003 and 22% in 2004, a curious thing happened: Instead of home ownership decreasing because fewer people could afford houses, it rose to record levels.

During the last two years, according to U.S. Census Bureau data, home ownership in the state rose to 59.7% from 57.7%. The previous record was 58.4%, measured during the 1960 Census.

Although homeownership in California traditionally lags behind that in the rest of the nation — the U.S. rate in 2004 was 69% — the 2-percentage-point increase during the last two years was greater than in all but about a dozen states.

Rather than closing the door, lenders have apparently been opening it wider, inviting in people like Herron who would not have qualified for a mortgage under the more rigorous standards of an earlier generation.

"If you can fog a mirror, you can get a home loan," said mortgage analyst Ralph DeFranco.

An interest-only loan offers the ability to defer for three, five or seven years any payment for the house itself. That allows a potential buyer to stretch to afford a place that otherwise would be out of reach.

Of course, everyone else using an interest-only loan can stretch too. The result is that prices keep rising. That, in turn, encourages still more people to use interest-only mortgages, which fuels still more appreciation.

In 2001, as the current housing boom got underway, fewer than 2% of California homes were bought with interest-only loans, according to an analysis done for The Times by LoanPerformance, a San Francisco mortgage research firm.

By last year, the level had risen to 48%. Nationally, LoanPerformance says, interest-only loans were used in about a third of all purchases.

What's propelled the market up in California, some experts worry, could just as easily speed its descent.

"In the last few years, rates went down and values went up. It's like you were paid to live in California," said analyst DeFranco, who works for LoanPerformance. "People got so used to refinancing. They'd think, 'No problem. My house will be worth twice what I paid, and I'll refinance my way out of trouble.' That's not going to be a good approach going forward."

Here's how he thinks a collapse could occur: Rising interest rates put a brake on price appreciation and refinancings. People realize their interest-only period is coming to an end, raising their monthly payments substantially. Since they have no equity in the house, they choose to default.

"If housing prices go down or even are flat, heaven help us," said DeFranco. http://www.latimes.com

I tend to agree strongly with Rob and Norman. There is little said about the lack of supply in SoCal, Bay Area, and NYC housing markets. Perhaps the most valid concern is the financing with ARMS leading to a great deal of supply due to foreclosures, but I have recently been told by someone in the mortgage business that historical home interest rates are not necessarily out of line with todays rates (dont have any links and havent researched this to verify).

The problem with the idea that short supply is driving prices is that rents aren't rising at the same rate, which they should if the problem is short housing supply and strong demand. When the ratio of rents to prices gets as far above its historical level as it currently is, it's a pretty sure sign that we're in a bubble.

Dylan, real rates aren't particularly low right now, and although nominal rates are attractive, people who think that this makes their house a fantastic deal are suffering from money illusion, since the reason for low interest rates is low inflation, which means that the real value of the mortgage is going to shrink much less quickly than it would in a high-inflation environment. You pay less up front, but more a couple of years down the road.

House prices are also getting increasingly out of whack to income, particularly median incomes, which are a better guide to ability to pay, since the super-rich who can't really own more than a few homes skew the averages. No matter how attractive your area is, housing prices cannot continue to grow faster than incomes for a sustained period. Where are these millionaires who will by tract homes in LA to keep the prices going up going to come from? Remember, if housing is expensive enough, for long enough, companies will move, thus relieving the demographic pressure on the area.

In short, we have not stumbled into some magic wonderland of cheap money and ever-expanding house prices.

"Simply walk away." IIRC, it isn't that simple. If the property sells at auction for less than the current mortgage balance, the former owner will still owe the difference to the bank. The only way out from under that is bankruptcy.

Of course, I've never seen a banker eager to explain about that possibility up front.

The level of homeownership is pretty much irrelevant, except as a sign that people who really shouldn't be buying houses are buying them anyway. Homeownership has downsides as well as upsides, particularly liquidity risk; if you lose your job, your landlord will let you leave your expensive apartment you can't afford, while the bank will ruin your credit rating, take your home, and dun you for more if it doesn't sell for enough to cover the mortgage. The general rule about housing in a given area is 1 family=1 house. It doesn't matter if they rent or own. A person who buys a house in that area will either live in it, thus freeing up a rental unit, or rent it out, thus creating a rental unit. Thus price growth of houses should stay roughly in line with growth in rents. When it gets out of whack--unless there's some excellent reason to believe that rents are going up, like a big factory about to be built in a previously backwater town--that's a sign that people are buying with expectations of profits coming from some other idiot who will buy it from them at a higher price, even though (he could rent more cheaply)/(renting it out won't cover the mortgage). Just as in the stock market, extensive buying on the Greater Fool Theory is an excellent sign of a speculative bubble.

Also the quality of available is terrible (atleast in California). Landlords don't even bother to clean up the home they are trying to sell as they know they can easily sell it. Also, lots of old homes are coming up for sale. It is looking more and more like a bubble!

This article by Thomas Sowell says that it IS a case of supply and demand, at least in California:

http://www.townhall.com/columnists/thomassowell/ts20050419.shtml

Apparently, no new houses are being built in large sections of California as a result of environmental laws. So, the existing houses cost more and more.

The MEDIAN cost of a house in San Mateo County has reached $896,000!!!

From the article:

"None of this just happened. Nor is it a result of market forces. What has happened essentially is that those already inside the castle have pulled up the drawbridge, so that outsiders can't get in. Politically, this selfishness poses as idealism."

It is a bubble, but it will probably keep going for several more years. High mortgage rates or high unemployment will eventually burst the bubble.

I like the idea that renters are shorting the housing market, this is a nice way of putting it.

Housing and rental units are not typically 100% interchangable, though. I live in San Francisco, and a lot of the units here are only available for renters. A large percentage of renters are not in the market for homes for other reasons other than house prices: they are not close to having a down payment or enough income to buy, or they only have a short-term housing need.

Rental units in SF also tend to be much less desirable than houses: they are smaller, not as high quality, in less desirable neighborhoods, often multi-unit buildings, etc.

Finally, SF has some rent control provisions that tend to keep average rents down, but not marginal rents (vacant property can rent at market). I suppose you could argue that this rent control increases marginal rents from what they would be in an uncontrolled market, so if the stats are current housing prices to marginal rents, that the ratio will be less than it would be without rent control and so would be a stronger indicator for a bubble.

To really tell whether rents are signalling a housing bubble, it seems like you would need to tease out all of these factors: only compare rents on housing of comparable quality/circumstances to owner-occupied, in comparable neighborhoods, not include short-term rentals, adjust for the distortions of rent control, etc.

Maybe this is what you're looking at, or something along these lines, if so I'd love a link to the data.

Bottom line, I think that the ratio of housing prices to rents is a useful number and is a point in favor of a modest housing bubble in the US, but I'm not sure how strong a case this one data point makes. Low interest rates and lower tax rates seem like the main drive behind the price explosion, plus confidence that the WOT and the economy are both doing well. Of course, I'm sure Bryan Caplan's statement applies, that "...homo economicus always plans ahead -- most notoriously with his unlimited use of backwards induction" :-)

BTW, I love your blog and it has been on my regular list for a long time -- thanks for writing it!

I think that people who write articles (and blog posts!) asserting the incipient popping of the housing bubble with virtually no evidence in support are quite humorous. What - a one MONTH blip in new housing starts? A one WEEK blip in mortgage applications? This "evidence" I'm supposed to take seriously?

One year ago - April 2004 - we had a drop in new home sales that was the "largest monthly drop since January 1994". And it spurred talk of the popping of the housing bubble then. (See, e.g., http://www.washingtonmonthly.com/archives/individual/2004_05/004015.php) Of course, the next month - May 2004 - new home sales set a record high.

So excuse me while I say BULLSH*T!

Jane - you said
The problem with the idea that short supply is driving prices is that rents aren't rising at the same rate, which they should if the problem is short housing supply and strong demand.

The reason for this is that people choose to rent and buy for reasons other than economic/investment bases reasoning. Also, rent in many of the most expensive areas has gone up significantly (though admitedly, not at the same rate).

Another, IMHO, factor that is overlooked is the number of people who are upgrading to more expensive homes. Many of these people have been able to afford housing seemingly beyond their means by paying a large down payment after taking the market equity from a previous house. Thus a family with an income of 100k can get into a 750k or 1m house with the 250-400k of profit from their previous 500k house while maintaining about the same payment.

I am not quite sure I completely follow your statement about rates and value of the mortgage. My point about about rates is that they may not necessarily be heading back to the 8% range, and if they dont then ARMS will likely have little adverse affect on the market when they enter the fixed rate period or require refi.

Is the Greater Fool Theory: buying something on the assumption that there is always going to be someone dumber than yourself willing to buy it away from you to your profit?

Knowing you're in the midst of a bubble is easy, if you pay attention and keep your head. Knowing when it's going to burst isn't quite so easy. The Greater Fool Theory may be a loser in the long run, but it's seldom wise to gamble on an _imminent_ shortage of Greater Fools...especially when it's one's living arrangements that one is gambling with.

On the other hand, there's comfort in knowing that, since there's no way anyone would give me a mortgage until my student loan troubles roll off the back of my credit report five years from now, the bubble will almost certainly have popped long before _I_ could enter the housing ownership market anyway. :)

Dylan, yes, rents have gone up. But the fact is, if housing demand were driving the market, we should see rents rising at roughly the same rate. Given that they aren't, something emotional is going on. And emotional is a bad state to be in when you're making a major capital investment.

Anecdotally, there are a lot of people in this market who can't afford even a small increase in their monthly payment. Given that rates are expected to rise, yes, at least up *near* 8 percent (particularly if China pulls the financing plug), those people are in big, big trouble. It's theoretically possible that rates won't rise, but given that inflation is starting to accelerate and our current account deficit is enormous, I wouldn't bet on it.

Matt, it's an adage that the market can stay irrational longer than you can stay solvent. Short selling the bubble can be a disaster--I know someone who almost lost his shirt that way--but

...but? But?!?

As I wrote to Tyler Cowen, regarding his recent post on Marginal Revolution, I too may be deluded, having bought a house in Oakland, CA seven months ago. But my thoughts on the possiblity that we're in a housing price bubble are as follows:

1) A lot of this increase is regulation-driven. More so than is accounted for by the studies on the subject, which show a lot of the price in areas like the Bay Area or inside the Beltway is caused by regulation.

2) House prices have something of a ratchet effect. Many sellers have the option of whether or not to sell their house. Increasingly creative methods for capturing one's equity without selling the house add to the ability of people to choose to not sell. Therefore, when prices "should" fall, fewer sellers enter the market, contracting the supply, and maintaining prices.

3) Sellers who enter the market when prices "should" fall will experience a price fall based on their need for a quick sale. Bridge loans and other creative financing reduce the urgency for a quick sale for many sellers; without the pressure, a seller will be willing to hold out for a better price. A seller will also get a lot of pressure from his sales agent to hold out for a better price, not just because of the commission the agent will earn on the particular sale, but on all other sales - if one house sells cheap, it lowers assessments (by lenders) for all other houses in the area. So time on the market will increase in a soft market more than prices will drop.

4) House prices are significantly determined by interest rates, as many buyers are budgeting based on the monthly payment, not the total cost. However, many buyers are existing homeowners, and have significant equity, and are thus bringing more than their ability to make monthly payments to the table. Enough buyers with enough equity will continue to push up prices. So they are not as significantly determined by interest rates as
many people think.

Jane, join with me in prayer for an abyssal collapse of the NYC housing market between 18 and 36 months from now.

Also, Jane, do you have data on the share of houshold income that homeowners are spending on housing? That is, including debt service, taxes, insurance, etc. Has this been increasing a lot?

AT,

Why are you hoping for and abyssal collapse of the NYC housing market. I would just hope for the end of rent control.

Now back to the topic: Specific question - I own a house in the extremely overheated Fairfax county (NVa)housing market. It went up in value at least $100K in the year since I bought it (and may be worth $175K as much). If I sell and move to Texas I can buy a better house, better lot, same schools and dump roughly $500K of mortgage debt. I have a great job but can get another great job in Texas (and pay will not drop more than 10%). Expected promotions will not increase my pay more than 40% for the next 4-5 years.

Why should I stay in the greater Washington DC area?

I ask this for two reasons. one for me. But secondly, I find lots of people complaining about the high cost of living in DC, NYC, SF etc across the net. Why don't they move? There are plentiful jobs available in much cheaper areas, so why do they stay? And worse insist that something be done to offset the high cost of living in high cost area (Both Drum and Yglesias have mentioned that people living in high cost area should get a tax cut).

What do you all think? I am ex-military and moved about 10 times in 20 years.

I noticed this thread is focusing on the US housing market. I thought I'd bring in the European. Namely with this observation.

As populations decline the supply of housing will increase, thus depressing housing prices. Any thoughts on what that would do to European economies?

Jane, please don't listen to AT.

buffpilot - we complain because, well, in the case of new york -- because it's new york. that's what we do here. it passes the time, and keeps us from getting too cheerful. as everyone knows, cheerfulness leads to californianism, which is Bad.

but whining aside, why don't we leave? because it's new york. all the goodness that comes with living in new york outweighs the costs. that doesn't mean we're not going to whine about the costs though.

Matt,

That made me laugh! You sound like a crewdog - give them steak and they ask,"Where's the lobster?"!

-There may not be a bubble nationwide but housing prices in some metro areas seem overdone. Any correction will probably most affect the properties that have appreciated the most.

-The DC area may be a special case to the extent that its housing boom is fueled indirectly by growth of the federal government. IOW local housing may remain pricey as long as government keeps growing.

-The weak dollar has stimulated buying by foreigners in some markets, e.g., Miami. The dollar probably won't remain weak forever.

-There really isn't a good way to short the housing market. There are ways for an individual who expects a price correction to hedge himself, e.g. by renting, but there's no easy way to take a leveraged position favoring a price decline.

-There is, however, plenty of leverage available for people who want to buy, and that's part of the problem. There are probably lots of marginal loans out there. What happens when rates go up? Do marginal lenders fail and dump the problem on Fannie and Freddie? Maybe there will be a soft landing, but maybe not.

I'm renting a nice-enough late-'40s 3-bedroom in Costa Mesa, California, a perfectly ordinary Orange County suburb, for $2,300/mo., which is at the low end of the rent-market range for a comparable property. If I were to buy the same house with a conventional, fully-amortized 80% LTV mortgage at 6%, I'd be paying $4,000 a month. No bubble, my adz.

A block away, a similar house, slightly renovated, is being marketed by its delusional speculator/owners for $1.2 million -- this in a neighborhood where comparable houses were priced in the $300,000s as recently as 2000.

The only possible explanation for the massive premium ownership is now commanding above rental value is the expectation of rapid future appreciation. When appreciation levels off enough to drive out some of the get-rich-quick speculators (and my totally unscientific observation is that those scum-sucking pigs constitute about half the buyers in my area), IF the market acts rationally, then prices ought to return to a level consistent with the market value of a house's basic function, to wit, keeping the rain off your head.

Until last spring, Southern California residential real estate was appreciating at 20%+ per year; as a result, houses were priced appropriately for their function as magical money trees rather than as their function as rain-keeper-offers. I look forward with interest to see the reaction to it becoming broadly published and known in June that house prices have not appreciated much, and may even have decreased a little, since a year ago.

Oh, and residential real estate speculators should have their heads stuck on their own "For Sale" signs in their front yards. I'm as economically conservative as they come, but speculation in necessities, when the supply is not increased thereby, is a classic zero-sum case of the haves oppressing the have-nots. Nothing brings out my inner Marxist like having missed the real estate boat and having to be a shaftee instead of a shaft-or.

For all those who believe that price increases are a result of more restrictive zoning:
Why are we seeing similar increases in places outside of the U.S. east/west metro areas? Like London, Paris, Singapore, etc? Are zoning laws becoming more restrictive there as well? This strange symmetry does not seem likely to me.

Techy789 - London and Paris don't have anything approaching a free market in housing; I don't know about Singapore, but I'd expect it's the same.

While the market in transfer of existing houses may be relatively free, how easy is it to buy a piece of land, demolish what's on it, and build new houses or apartments?

We're formerly of CA, then Seattle - then we cashed out at what we THOUGHT would be the top and moved to TX for hubby's B-school. In doing so, we aced ourselves out of living near our families (in CA, north and south) for many, many years - perhaps forever, if hubby's salary doesn't follow the same trends as the real estate market in CA.

At first, he (a CA native, unlike me) was very, very sad about our inability to move back "home." But now, as his mom's 1600-sq.ft. tract home in an older, not-bad-but-not-great neighborhood in Oxnard where you'd never send your kids to public school unless you had no other choice, is "worth" more than our 3x-as-big house on an acre in a beautiful part of the western Philly 'burbs with great schools and easy access to all the East Coast has to offer, he tends to scratch his head and say, "Why again would we want to leave here to move into the equivalent of Mom's house?"

Which is what I've been saying all along, having no sentimental connection to CA.

But it does still bum him out that when we left CA we were too young and poor to buy any real estate there, and thereby missed the big run-up. (We left during one of the rare downturns, back in the early '90s.) Many people he knew in high school are now sitting on a reasonable mortgage that they could cash out of and retire to New Mexico tomorrow, if they chose. The point being, as he argues both sides of, that they wouldn't so choose... As with the New York argument above, people who stay in southern Cal tend to believe it's Shangri-la and can't understand why ANYone would live anywhere else. (We've noted the same thing in New Orleans people, New York people, Paris people, and London people - you know, "When you're tired of London, you're tired of life.") But is the undeniable uniqueness of these places worth the unbelievable premium people pay to live there - as opposed to living within a day-trip or so? Hmmm... Echo answereth not.

In my humble opinion, based upon semi-informed opinion, we are in a bubble. I have witnessed two housing bubbles, in two different States, in my life. Each time, those in the heat of the bubble clamed "it's different here/this time". And, in a sense, they were right: each bubble has unique qualities. Each one has common elements as well.

I have not yet seen a 1-day seminar on "How To Get Rich In Real Estate" at the local Hilton, but am expecting it soon. Property values in areas well away from the coasts, and not just in fashionable areas such as Austin, Texas, have increased far above any possible CPI. More and more ordinary people with zero experience in property management, in real estate investment, or often in any investment at all, are getting into the business of flipping properties. The article posted above on flipping condo properties is another case in point. The notion that "real estate never goes down" is showing up in various places both online and in the popular press.

New instruments for financing are making it possible for literally anyone with a job to buy: Adjustable Rate Mortgages (ARM's) are old had, now there are interest-only mortgages (with balloon payment of the principal due...someday) that are being advertised on dinky AM radio stations during talk shows. Said adverts are often followed by adverts for debt consolidation/credit counsel services, ironically. There are also 40 year mortgages being offered in some parts of Southern California; would anyone like to estimate how much principal is paid in the first 30 years of that note?

In some localities, such as Las Vegas, Nevada, anecdotal evidence tells me that at least 15% and possibly as high as 25% of new single-family homes are being sold to people who have no intention of actually living in them; they are engaged in speculation and intend to flip the property as soon as possible for a profit.

All these are signs to me we are in a bubble. The first bubble I ever witnessed featured many of the above: people buying houses solely to flip them in a few years or even months for profit, people with no experience in real estate buying single family homes & renting them out just long enough to get ready to sell, common 'wisdom' insisting that real estate "never goes down". When I left, the housing market was still insane. Four years later I returned on a visit, and while looking at cameras in a pawnshop, listened to the owner tell his troubles.

He had bought multiple single family houses at the top of the bubble, then it popped. He couldn't sell any of the houses for what he owed on them (negative equity), he couldn't rent them for enought money to cover his monthly note, and taxes were eating him up. Either he took a slow, draining loss in the hopes of the housing market picking back up, or he sold at a loss. Well, it's not easy to feel sorry for a pawnbroker, perhaps, but telling him that the local market would surely pick back up in 3 to 5 years as the over-built stock of housing was worked off didn't do much, I'm afraid, to make him feel any better.

In conclusion I assert there is a housing bubble, it is multi-market, it may be national, and a lot of people are going to get badly hurt as it deflates.

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