As of December 2011, housing prices have fallen 38% nationally, 7% more than during the Great Depression. While pricing has already dipped below the trend line that housing might have followed had the housing bubble not occurred, the outlook is for prices to continue freefalling another 4% during 2012. Some experts predict prices could drop nationally below 50 % of peak levels or more. Yet others suggest that economic fundamentals should be supporting a leveling of prices, and they wonder if normal economics of supply and demand have abandoned the housing market altogether.
Even though they may not appear so, the rules of economics actually still do apply to the housing market, and unfortunately they point ominously to even more alarming conditions in the years ahead. While many believe that Congress makes things worse every time they fiddle with the economy, Congress really has no choice but to intervene in this housing market if we are to save a cornerstone of America’s economic future. This post describes why housing prices rose and fell, and why they will continue to fall in the absence of intervention. It suggests why half the home mortgages in America could end up underwater and disrupt our economy for decades to come if Congress fails to act.
1995: Total housing units (in millions) 112.6 Renter Occupied 35.2 Vacant 12.7
In the five decades leading up to the 2000s building frenzy, housing prices rose predictably according to the principles of supply and demand. Housing pricing surged and slumped in response to peaks and troughs of business cycles, increases and decreases in interest rates, and growing or obsolescing local market commerce. Yet, nationally, averages followed historical patterns of a gradually rising nominal price market. Adjusted for home square footage that increased with each decade, new home prices tracked inflation nationally. Housing starts followed population growth, and as a major 14 % component of America’s GDP, housing generally has led the nation out of recessions.
Beginning in the mid 1990s however, housing economics began a dramatic divergence from historical trends. For the next decade, a sustained building spree added 6.6 million more housing units than was needed to support the rise in U.S. population, as many as one million units per year. In a rationally functioning market, this excessive addition of new homes would have quickly precipitated a business cycle slump and prices would have dropped to encourage a slowdown of new housing starts. But America got caught up in a housing frenzy and added enough demand to absorb this excessive supply while bidding prices up 225% above their historical trend line, a speculation that Fed Chairman Alan Greenspan as early as 1997 called an “irrational exuberance”.
COMPONENTS OF INCREASED DEMAND:
2006: Total housing units (in millions) 126.6 Renter Occupied 34.1 Vacant 16.7
LOW INCOME BUYERS: Some blame the excessive demand that pushed pricing well above its historical trend line on low income buyers who benefited from government regulations that forced lenders to ease requirements for lending. By passing the Community Reinvestment Act (CRA) and substantially revising regulations in 1995, Congress pulled these non-traditional buyers and their higher risk into the housing market. In doing so, Congress did nudge the beginning of the feeding frenzy, but the immediate effect of adding these buyers was not a large component of demand but merely a catalyst of future demand.
More importantly to the housing bubble than the numbers of low income CRA buyers was their impact on creative financing. Being forced into accepting additional risk, banks responded by creating risk spreading financial tools to mitigate high-risk, subprime loans. These tools would later be used to set the housing industry ablaze. Without them, the Housing Ponzi could not have developed.
BABY BOOMERS: Others blame the added demand of the bubble on Baby Boomers whose retirement accounts had been consumed by the bursting of the Dot Com bubble. In need of a quick fix for their fast approaching retirements, some Baby Boomers took advantage of “exotic” loans to buy too much home at too high prices hoping for substantial returns. As more Boomers entered the market, they pushed up home prices and acquired excessive debt in the process. At the beginning of the bubble, the median home price was $120,000 and the median income was $73,000, a ratio of 1.65. At the peak, the median home price had soared to $215,000 but incomes remained the same increasing the loan to income ratio to 2.94, an unsustainable level.
To cover the shortfall of income needed to make their new debt payments, consumers relied on home equity loans and credit card debt. Between 2000 and 2006, home equity debt increased $1.2 trillion and credit card debt rose $900 billion, again to unsustainable levels. By the peak of the Ponzi, home ownership had surged from a historical 65.1 percent to a 69.9 percent of the population and home ownership debt load had increased from 65% of GDP to an unsustainable 110%.
CONGRESS: More blame the actions of Congress for the housing bubble than the addition of non-traditional buyers and overreaching Baby Boomers. Certainly the Community Reinvestment Act and its subsequent regulatory revisions in 1995, including HUD’s direction that Fannie Mae and Freddy Mac set aside 50% of guaranty funds for low income earners, increased subprime loans tenfold and increased demand. But the repeal of Glass-Steagall, through the Financial Services Modernization Act of 1999 that allowed commercial-banking, Wall Street banks, and the insurance industry to merge, created banking products that swelled demand much more. And the Commodities Futures Modernization Act of 2000, that excluded certain financial commodities from oversight by the Commodity Futures Trading Commission, the Securities and Exchange Commission, the Federal Reserve, and state insurance regulators, allowed bankers to flood the world with lucrative credit-default swaps and to push exotic retail products into a growing speculative housing market to feed the swap market. Without the collusion of Congress, the irrational exuberance of consumers needed to fuel housing’s excessive demand could not have been enticed by the resulting banking products.
INVESTMENT BANKING: Most place the blame for the Housing Ponzi squarely on the shoulders of investment bankers. To allow non-traditional buyers into the market in the mid 1990s, banks initiated low doc and low down payment introductory loans to the primary market and combined these loans with others to form securities called Collateralized Debt Obligations (CDOs) which were then sold into the secondary market to transfer bank risk off their books. While 52% of low income loans were securitized by Fannie Mae and Freddie Mac in the early years, securitization quickly became a lucrative international commodity product of investment bankers and the market topped $2 trillion at its peak in 2006.
Yet as big a profit maker as CDOs were, an even greater profit was made in the issuance of Credit Default Swaps (CDSs), a form of unregulated insurance that allowed banks to take the risk of loans off their books, to increase their loan-to-collateral values four fold, and to profit from insuring events that they thought could never occur. At the peak of the Ponzi, the CDS outstanding market topped $60 trillion and had made $4 trillion in profits for participants in just three short years, much more than the $2.7 billion paid for lobbying Congress or the $1 billion paid in campaign contributions by the financial industry (peanuts in comparison) to persuade Congress’s votes allowing this free-for-all in the decade prior to the financial crisis.
To feed this frenetic pace of profiteering, international banking required the pace of loan origination to increase even though housing prices were accelerating upward beyond traditional affordability, and thus they began what became their final phase to lure additional demand. To bring the last customers into the Ponzi before its collapse, banks introduced a myriad of “exotic” loan products. After low doc and low down payment loans came no down payment and no doc loans. Later, interest only and negative amortization loans were offered. Banks then created piggy back loans with first and second mortgages that eliminated PMI and even offered to finance closing costs. From 2003 until the peak of the Ponzi, fully 25% of mortgage loans included teaser introductory rates. And in the final two years of the housing spree, banks allowed consumers to acquire pay-option mortgages that gave them the choice each month of paying fully amortized, interest only, or even very small monthly minimum payments. All of these risky products fed the secondary CDO and CDS market with mortgage securities by targeting the U.S. market for excess demand and exuberant prices.
RISING HOME PRICES: By 2003, all semblances of historical housing pricing metrics were gone. Brokers, agents, and bankers all explained that the new measurement of housing value was not bound by either the historical rental rate of housing or the constraint of trailing American incomes, but was instead measured by a new metric, combining these traditional valuations with the rate of return of increasing home prices themselves, thus spurring a real estate bubble with the fallacies of hope and greed. Half of all home buyers responded to this new flawed ideal by purchasing beyond their means, and in the process, pushing up the price of housing.
FEDERAL RESERVE: The Federal Reserve, flush with investment from China and concerned about recession because of the bursting of the Dot Com bubble and the economic shock of 9/11, consciously chose to support the housing surge through lowering of interest rates from 2001 through 2005. As a result, average mortgage rates reduced through the period from 7.9 percent to 5.6 percent, increasing demand and supporting higher home prices.
SECURITIES AND EXCHANGE COMMISION: The SEC inexplicably allowed five of the nation’s largest brokers to waive their capital-to-debt requirements that had historically been held to a 12 to 1 ratio. The brokers responded by leveraging their capital as high as 40 to 1, adding liquidity to debt financing, fueling housing demand, and pushing up pricing. Three of the five qualifying brokers later went bankrupt or were absorbed by other firms.
In the aftermath of the financial crisis, when many are demanding prosecutions of what seems to have been criminal actions by some in the financing industry, the SEC has been loath to act. Data suggests that the SEC had significant knowledge of financial firms’ negligence in following regulations for several years prior to the financial crisis and yet the SEC chose not to act on its knowledge. If the SEC were to take action now, the resulting trials would focus as much on the SEC’s foreknowledge and complicity as they would on the potential criminality of bankers and would shine an ugly light on the revolving door between government and industry, two reasons why the SEC might conspicuously choose to continue its inaction.
THE HOUSING BUBBLE POP:
2008: Total housing units (in millions) 130.3 Renter Occupied 35.8 Vacant 18.6
Inwardly, the banking industry knew that it had stretched the bounds of credibility and sustainability as it introduced riskier and riskier loan products to create additional demand. Bankers feared that resulting aggregate loan to income ratios exceeded all historical limits and might eventually collapse. In fact, some industry insiders even began to bet against CDO portfolios of other companies through CDSs, expecting to profit on rising defaults that began as early as 2004.
So when these defaulting subprime loan cracks appeared in the dyke of this elaborate housing Ponzi, a nervous fog settled in over the entire industry and many began to speculate whether highly leveraged firms such as Bear Sterns could cover their liquidity gaps. After some banks refused to cover Bear Stearns with short term loans, confidence waned, Bear’s stock plummeted, and Bear was purchased by J.P. Morgan Chase. By allowing Bear’s leverage to grow to 35 to 1, the SEC allowed just a 1% loss of asset value to increase Bear’s leverage to over 70 to 1. In this maximum consumer debt environment, that extraordinary leverage caused market confidence to collapse. Lehman Brothers followed suit six months later with a delayed total collapse of their 40 to 1 leveraged firm.
In the after shock of Bear Sterns and Lehman Brothers, the U.S. Government stepped in to rescue Freddy Mac and Fannie Mae, made loans to AIG, put in place a $700 billion bailout of teetering banks, forced the sale of Washington Mutual to J.P. Morgan Chase, and implemented a stimulus plan to strengthen Wall Street. The two remaining firms that had taken advantage of the SECs allowance of extreme leveraging, Goldman Sachs and Morgan Stanley, abandoned their status as investment banks. One effect of such sweeping industry changes was to substantially reduce the demand for higher risk mortgage CDOs in the secondary market, thereby dampening exotic retail products which then diminished housing demand and depressed pricing.
THE UNWINDING OF HOUSING SUPPLY AND DEMAND:
2011: Total housing units (in millions) 131.2 Renter Occupied 38.3 Vacant 18.7
EXISTING INVENTORY: At the peak of the housing bubble, housing inventory for sale equaled about 4 months of sales. From that point, listed inventory rose steadily to level off at about 9 months of inventory. Additional shadow inventory being withheld from the market, such as bank REOs, has kept listed supply at about 9 months for the past two years. However, as housing prices continue to decline, more houses will be returned to banks either through walk-aways or foreclosures, adding to bank’s already significant shadow inventory. In addition, job uncertainty and job immobility due to housing illiquidity continues to add to shadow supply. If demand increases, shadow inventory will flow into the market and continue to depress pricing.
NEW INVENTORY: Demand for new construction is now running at about half of the 1.2 million new homes per year required to fill the needs of a growing population. The excess supply of existing housing and the increasing cost of new construction commodity materials have combined to keep existing housing prices well below the cost of new construction. This price differential not only pressures construction labor rates downward and reduces profitability of the new construction industry, but it causes demand to be filled by existing homes rather than new ones. Therefore the vacant inventory of existing homes is being absorbed at a rate of 600,000 units a year. At this rate, the excess 6.6 million homes that were built during the Ponzi will not be fully absorbed until 2020, extending pricing slide and/or excessive gap for years to come.
VACANCY RATE: At 9.8%, vacancy rates are about 40% higher than the 40 year historical norm. Vacancy rates increased to such historical highs for two reasons. First, housing construction lagged the housing crisis and new units were completed even as the crisis unfolded. Vacancy rates surged as these lagging units came online. Second, as the crisis unfolded, foreclosure rates increased fivefold adding to the rental population. Increased vacancy rates have depressed pricing.
RENTAL RATE: Home ownership unwound from its Ponzi peak rate of 69.9% back toward its historical averages of 65.1% as home owners gave their homes back to the banks and entered the rental market. As a result of increased demand for rentals, the percentage of new construction rental units has increased. In addition the monthly rental rate in many U.S. markets now exceeds monthly mortgage rates. The growing gap in rental versus mortgage costs suggests either that home buyers are unable or reluctant to buy and indicates a lax demand that is depressing pricing.
PURCHASE RATE: At a rate of 4.9 million purchases annually, housing purchases are occurring at approximately the rate that would be expected had the bubble not occurred and had the trend of purchases extended with population growth from the early 1990s until now. The current rate of housing purchases is slightly below historical standards, but only appears depressed when compared to the excessive standard of the housing bubble. No indicators point to any trends that will materially increase purchase rates for the foreseeable future. Therefore, an extended period of excess housing supply will continue to support a long term downward drift in pricing.
Buyers have left home ownership in droves since the beginning of the housing crisis by either selling, short selling, walking away from mortgages or being forced out through foreclosures and have shifted to either rentals, sharing quarters with others, or becoming homeless. Home ownership has unwound from its Ponzi peak rate of 69.9% back toward its historical averages of 65.1%. Nonetheless, there are no indicators to suggest in this high unemployment and uncertain business environment that home ownership will level off at its historical average of 65.1%. It will likely continue to decrease, depressing demand and pricing further as a result.
REDUCED DEMAND OF SECONDARY MARKET: While the market for credit default swaps still exists and continues to destabilize the world’s economy, demand for CDSs has dropped to half of its peak of $60 trillion at the height of the housing bubble. Demand for underlying CDOs has been hampered by the scandal of claims to title that has rocked the CDO market. During the frenzy of the housing bubble, short cuts were taken that left the chain of title to millions of individual notes in question, threatening legal entanglement for years to come. At the same time, housing value deteriorated, reducing the value of their packaged CDOs and in some cases triggering repayment from their corresponding CDSs. The resulting title debacle collapsed the secondary market for CDOs, squashed the exotic loan supply, lessened demand for housing, and dampened housing pricing.
REDUCED ACCESS TO CREDIT: Banks, that had received bailouts from the Federal Government in its attempt to preserve lending liquidity, instead chose to reserve funds to enhance balance sheets. In addition, without being able to pass risky loans to the secondary market, banks tightened credit criteria and withdrew to more standard loan products, requiring PMI insurance, higher down payments, higher credit ratings, more solid work histories, and historical income to debt ratios. Tighter credit requirements diminished demand for housing and depressed pricing.
Banks also substantially retracted from the credit card market, eliminating 25% of $5 trillion available credit. In addition, banks increased average rates on credit cards from 10.9 percent to 16.2 percent. Buyers had counted on consumer credit to support their short fall between income and housing debt during the bubble, and without it, home buyers lost the ability to carry higher priced homes. Even though the financial crisis eliminated the motive to flip houses for profit and thus removed a primary reason for excessive use of credit card credit, the loss of credit as a cash management tool for existing housing dampened demand and depressed pricing.
SAVING TREND: After the housing bubble burst, consumers prudently used excess funds to pay down loans, eliminating more than a trillion in housing debt, and more than $100 billion of the peak credit card debt. Another $4 trillion is needed to reduce housing debt overhang and close to $800 billion in credit card debt still remains. If the economy and housing prices continue to drift downward, these numbers will grow. The trend toward repayment has subsided somewhat but continues to remove funds from the purchase market and to depress pricing.
INFLATION: While median salaries essentially remained stagnant throughout the housing bubble and beyond, prices for commodities have increased. As food, energy, clothing and other essential commodity prices continue to increase against a back drop of stagnant wages, less income will be available for housing which will dampen demand and depress pricing.
The Fed has signaled that interest rates will be held at essentially zero for the next two years but the Fed may be forced to change its position as external events overtake it. Housing ARM interest rates are threatened not only by creeping inflation but by rating agency threats over continued Congressional inaction, the Fed’s stuffing of long term treasuries with the its Operation Twist, and by potential overflow reaction as the Euro Zone worsens. The mere uncertainty of interest rate increases that would cause more funds to be used to pay interest instead of higher home prices dampens demand and depresses pricing.
POPULATION DEMOGRAPHICS HAVE SHIFTED: The housing bubble was driven in large part by Baby Boomers who controlled 80 percent of America’s wealth. During the bubble, they aggressively added 12 million housing units to the existing inventory of 112 million units, influencing the size and style of new inventory. Boomers reached beyond their means to buy more square footage than they needed or could afford. From the post war 1950s, the average home gradually increased from 258 square feet per person, but during the bubble, size increases swelled to over 960 square feet per person. To fill the square footage void, boomers added immediately obsolescing features such as gargantuan walk in closets, media rooms, sitting areas, and home offices that would not be valued by the following green generations.
The housing bubble burst just as the Baby Boomers began to retire, wanting to shed themselves of large houses. Their 1.7 children were flying from the nest and Boomers now wanted to condo-size. However, the 20 years following the Boomers’ births, 1965 to 1985, produced about one million less babies per year, not enough to absorb Boomer houses. This group of home buyers is now entering their peak earning and peak square footage years at a time of economic slump and increased awareness of energy and space efficiency. Therefore, the demand for large Baby Boomer houses will be diminished as contractors build new houses to meet this group’s desires. Changing demographics will place a downward pressure on Boomer housing pricing that will permeate the entire home market.
PRICE STICKINESS: 28.6 percent of homes with mortgages, or 14.6 million homes, have underwater mortgages. If the cost of selling a home and putting a down payment on a new home is included, then fully 50% of home owners cannot afford to sell their homes now. As pricing drifts downward, this figure will only exacerbate. As a result, would be buyers who cannot take the loss of a sale of their own property are trapped from entering the market, reducing demand, and depressing pricing.
Employers, who used to buy workers’ homes to initiate job transfers have ample local employee choices and can no longer justify the cost, further exacerbating a reduction of demand and thus putting a downward pressure on pricing.
GLOBALIZATION: After WWII, the United States military provided a modicum of economic stability in the world, lessening the risks of businesses transferring operations to overseas locations. As a result, mass transfers of capital and jobs to direct foreign investments increased significantly. With China’s doors opening in 1979, the U.S. flooded China with 40,000 new factories that each took away certainty of America’s future and that accelerated a trend toward wealth disparity and a diminishing middle class. The resulting impact on wage pressures over the past three decades has lowered the expectations of the new generation of home buyers, reducing demand and depressing pricing.
MONETARY IMPLOSION: The artificially stimulated economy of the past two bubble decades hid the underlying sickness of America’s base GDP. When the housing bubble finally popped, our consumer based economy was clogged with both housing and consumer debt that had been diverted from the real economy to feed the housing bubble. After the banks quickly pulled credit to protect themselves from what they knew would be a chaotic implosion, America’s consumer base had no means to continue consuming, the credit engine of small business was stopped even before small business could fulfill its current client requests, and business shortfalls translated to employee layoffs, precipitating a circular implosion of consumers, businesses, and employees wealth and debt capacity.
After the implosion, as the economy lingered without commerce or money creation, debts mounted, credit ratings suffered, and unemployment intensified. The ability of home owners to pay their mortgages decreased which in turn increased mortgage delinquencies and foreclosures and accelerated the deflation of the housing bubble, exposing the housing debt overhang.
The resulting economy now suffers from a trifecta of dilemmas. The greatest bubble America has ever experienced has led to a housing debt overhang that stifles America’s engine of consumption. It has also damaged credit ratings that have pulled American businesses’ and home owners’ access to essential cash management tools and vital growth credit. And it has led to a loss of productive jobs for 25 million Americans who without work cannot help to restore America’s economy. If a simultaneous solution to these dilemmas is not enacted, the economy will spiral lower and will create an environment for a continued downwardly drifting malaise of the housing market.
Since the passage of the National Housing Act of 1949, Home ownership has been heralded as a benefit to American society, supporting stable families and prosperous communities. It has provided the number one source of economic security for the majority of Americans for the past six decades. However, rather than bring hope to millions of Americans that had previously been left out of the American dream, two decades of governmental policies and international banking have led to the gutting of that dream not only for those who could not afford homes previously but for tens of millions more Americans, eroding home ownership benefits in the process.
Rather than the rock of social stability that it could have been, the American home has become the proverbial albatross around the neck of the middle class, draining its limited wealth to keep banks from suffering the consequences of their prior decisions. If Congress is to stop the housing crisis’s deterioration of families and communities across America, and if it is to protect the cornerstone of our economic and national security, Congress must act now to stabilize what, by all indicators, will be another decade of housing pricing decay.
Components of my plan:
Equity for debt swap to remove excess housing debt
Job voucher plan to employ all able Americans immediately
Credit amnesty program to quickly repair business and consumer credit
Modified Republican multinational incentives that entice domestic investment without giving carte blanche tax holiday and that do not entice further foreign domestic investment