March 11, 2006

The Biggest Fear in Real Estate

The front page of today's Wall Street Journal reads, "Many mortgage borrowers may face financial problems or even foreclosure as adjustable-rate-mortgage payments are reset higher." Why has the WSJ used the prominent upper right-hand corner of it's front page for this message? Perhaps their aims are similar to those of the Federal Reserve, to stop the unhealthy speculative boom in the real estate market. That boom is slowing, but the question remains: Will the boom become a bust? More important, would such a bust spread to the entire economy?

The answer to the first question depends on the local market. Some markets might not see a bust, like Baltimore, Maryland, which will experience housing demand in response to recent military base realignment decisions. Others might be in for a shock, for reasons below.

First-year economics teaches us that prices drop when supply increases. It was with this in mind that David Seiders, cheif economist for the National Association of Home Builders recently said, "the biggest fear I have is investor-owned units coming back on the market in large numbers." [1] He has good reason to fear, because there's a record number of such units available to flood the market.

Second homes now comprise 38 percent of the nation's entire existing housing stock, according to the National Association of Realtors' "2005 National Association of Realtors Profile of Second-Home Buyers" released in March 2006.[2] Add to that the "millions" of borrowers who face foreclosure because they have exotic balloon-rate mortgages, and the "potential" for a downward bust in prices is undeniable.

That potential is a main ingredient for a bust. The other ingredient is self-reenforcing feedback. Lets look at a boom cycle as an example of such feedback. In the earl-1990s the Asian market was getting attention in the business press and many people pondered investing in foreign stocks. Early investors acted and the stocks rose. This rise gave confidence to a few more investors who entered the Asian market driving the stocks and other asset prices up further. This undeniable rise reenforced the justification for others to invest, which in turn drove up the prices. The feedback process continued, word got around to less informed investors who boosted the stocks further. There is often a "testing" period, when wise investors leave the market for fear of a downturn, and the rise slows or even dips, but this is often counter-balanced by late comers to the speculative boom. Eventually, the dip turns back up, fears of a downturn subside, and the self-reenforcing boom continues. This was the case in Asia until 1998 when the bottom fell out. The spread of this crash became known as "the Asian contagion."

What is clear is that this self-reenforcing feedback process works in both directions. Eventually, profit takers start to leave, and the stock price comes down a little. Those who got in late have little profit margin to loose, and they get must get out quickly, causing a clearly evident price decline. This undeniable decline reenforces the rationale for leaving, and others start to fear an actual loss on their investment. The same logic certainly applies in the case of the current real estate market, though the process is slower than for stocks; investor-owners don't want to get stuck holding a property they must maintain, particularly if the rigors of being a land lord is not their strong suit.

A third ingredient of boom-bust mechanics is summed up by the phrase, "the bigger the rise, the bigger the fall." For five years, real estate prices have witnessed dramatic annual rises. The annual percentage assessment increase in Maryland for at the end of 2005 was 20%. The range by county was 13%-26%. [3 Baltimore Sun] This followed five years of similar annual increases. But forget the numbers, who hasn't heard someone say, "I couldn't even afford to buy my own house today if I was in the market to buy." I've heard this statement a half-dozen times from people with well-paying jobs.

But, as convincing as that might be, that's all hypothetical. There is hard evidence of "the biggest fear" coming to pass. The Baltimore Sun article, referenced above, was accompanied by another article entitled, "slowdown poses new reality for buyers, sellers in region." The article includes a graph entitled, "listings soar" in which the number of homes for sale is shown to have more than doubled in a year. This is happening in the Baltimore market, which is supposed to be buffered by pending demand due to military base expansions. The 25% drop in San Diego housing prices from 1990 to 1996 also wasn't hypothetical. [4]

Now, to address the question of a potential spread of real estate woes to the rest of the economy. On August 8, 2005, economist and columnist Paul Krugman had a piece in the New York Times entitled "That Hissing Sound." He notes that the economic recovery since the 2001 stock market crash "wouldn't have happened at all without soaring spending on residential construction, plus a surge in consumer spending largely based on mortgage refinancing."

Will people run back into the stock market if the real estate market deflates? Major US auto manufacturers now make most of their profits on finance fees for car purchases, rather than on the product itself. The average US citizen has a negative savings, implying that the auto industry might have squeezed as much real money out of the public as it can for some time to come.

Then there are our financial institutions. They too have huge exposure to the real estate market. In February 2003, the Office of Federal Housing Enterprise Oversight released a REPORT that lost the OFHEO director his job. The director, Armando Falcon, had the nerve to explain that major commercial banks were heavily invested in risky real estate-based financial instruments crated by Fannie Mae and Freddie Mac. This meant that if the real estate market goes south some major banks will go with it, and with the banks go other parts of the economy in a chain reaction.

For example, the report indicates that major insurers are also at risk. So, imagine you run a business that has no relation to real estate, so you think, say import/export. One morning you read in the business section of the news paper that real estate is taking a beating. The next morning you read some banks are getting shaky, fortunately, not the bank with which you conduct business. The next week, you read that your insurer has gone belly up because it was invested in real estate. Suddenly, you realize that your business is related to real estate, and that the world is a very dangerous place. You pray nothing bad happens to your current import shipment, while you frantically seek another insurance company. Unfortunately, you learn that the four biggest insurers were heavily invested in real estate. Maybe the "biggest fear in real estate" isn't the possibility that gobs of "investor-owned units will come on the market in large numbers," but the fear that real estate is strongly coupled to the rest of the economy.

1. "Housing Slowdown Ripples Through Economy," March 6, 2006, Associated Press, David Koenig.

2. Realty Times, March 10, 2006

3. Baltimore Sun, December 30, 2005 "Home assessments jump over 20 percent statewide."

4. Paul Krugman, "That Hissing Sound," New York Times Opinion section, August 8, 2005.

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