Housing Bubble Redux


A piece I did for Al Jazeera on the IMF warnings of a potential global housing bubble. Here we go again.

Will real estate bubbles again sink the global economy?


About pilkingtonphil

Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
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4 Responses to Housing Bubble Redux

  1. philippe101 says:

    you should make the images at the top of your blog posts a bit smaller.

  2. Patrick Trombly says:

    2001–Present – a Timeline – My Take on the Housing Bubble and Financial Crisis – Patrick Trombly
    (1) 2001. Jack and Mary are newlyweds with a combined income of $100M. FRMs and ARMs are both priced around 7%. Jack and Mary pre-qualify for a mortgage of $500M (at 40% payment-to-income ratio with payments of $3,325/month). At 80% LTV, their price point is $625M. That is their maximum bid for a house.
    (2) After 9/11, Greenspan cuts short rates. This is achieved through a cut in the Fed’s discount rate and through open market purchases of short term securities with fiat credit. This brings down short rates in the market – in fact this is the planned effect. The policy is maintained and short rates drop by 300-350 bps (a cut of about half) and are held there for years.
    (3) 2003. Joe and Michelle are newlyweds with a combined income of $100K. FRMs have dropped into the 6s. But ARMs are in the low 4s. Joe and Michelle pre-qualify, at the same 40% payment-to-income ratio, for a loan with monthly payments of $3,325/month. But with an ARM at 4.20%, that translates into a loan of $680M. At 80% LTV, their price point is $850M: 36% higher than Jack and Mary’s 2001 price point, based on identical loan payments and debt-to-income and LTV ratios. ARM popularity soars. Millions of “Joe and Michelles” bid house prices up. The asset bubble has formed. The inverse is also true: with no rate cuts, the bubble does not happen – it would be a mathematical impossibility.
    (4) 2002-2004: Builders read the rising prices as a signal of increased demand, and they predictably respond by increasing the pace of building. Builders are also financed at floating rates, typically with interest-carry – the same low rates reduce builders’ cost of capital, and their CAPM equations now way out of whack, inducing overbuilding. This causes an increase in construction wages and employment, as well as use and prices of commodities used in construction (e.g., copper). IRR inputs are distorted via the low rates. It is the classic mal-investment cycle described by Mises and Hayek decades earlier.
    (5) 2002. Long positions in commodities are also financed at margin, at lower rates. Coupled with temporary increased demand from builders, this fuels a commodity boom that will parallel the housing boom.
    (6) 2002-2004. With the low rates, existing mortgage borrowers want to refinance. Refinance applications are evaluated based on payment-to-income and LTV ratios. Payment-to-income improves from the rates and the opportunity to re-amortize. Some homeowners refinance to lower their payment – America starts de-leveraging more slowly, but defaults plummet as payments temporarily decline. However, LTV is determined based upon comparable sales. For every Joe-and-Michelle there are 10 appraisals using Joe-and-Michelle’s purchase as a comp. America leverages up, with no change yet occurring in credit processes or metrics: the standard credit metrics support higher debt levels because of the low rates.
    (7) 2002-2005. Federal policies, with bipartisan support, meant to increase homeownership (the benefit of which is debatable given that it reduces worker mobility) exacerbate the effect of the rates, but this is the frosting – the cake is already baked.
    (8) A cultural shift occurs. We look at homes as hobbies and investments (HGTV ratings, and Home Depot sales soar). We see the values rising and some believe that this results from the culture shift, rather than vice versa.
    (9) 2003-2007. All that printed/borrowed money is spent, temporarily increasing retail employment. This will ultimately raise consumer prices, but this is masked by real price reduction achieved through off-shoring. Those real price reductions temporarily offset the inflation. This, along with a decision to ignore commodity and home prices in CPI, allows the Fed to continue its rate policy yet claim adherence to a “price stability” mandate – itself borne of a baseless fear of deflation.
    (10) 2001-2004. The ECB follows the same rate path as the Fed, and it causes similar housing bubbles in Spain and Ireland – where ARMs are already the norm (actually, with greater impact as the typical loan tenor in Spain and Ireland is 40 years). Construction employment increases, offsetting long-term trends for non-college graduate males, much as it does in the US. Germany is an outlier: it has few ARMs and a strong manufacturing sector.
    (11) 2003-2006. Foreign investors in RMBSs see the same plummeting default rates and spiking collateral values and make the same bets as the banks. Securitization – originally invented to reduce risk by matching long term funds with long term assets and by allowing banks to diversify thus reduce geographic concentration in their local markets – now becomes a channel to globalize the risks inherent in inflating the credit supply. Derivatives follow suit. Low rates increase the amount of debt that a given cash flow stream can service. Lower default rates translate into lower cushion left in the deals, based on VaR models that have worked for decades. Considered with rising collateral values and reduced cost of capital, it is completely logical that derivative investors make the same bets as homeowners, builders and mortgage lenders.
    (12) Before any change in approval thresholds or underwriting models/ratios – any “abuses” – there is a massive asset bubble and a massive increase in debt. The biggest unsustainable boom of all time has been started, and a future “day of reckoning” that will be the main financial event for most people in the US and Euro Zone is already a certainty.

    (13) The “abuses” do happen – but they too happen because of the increase in supply, and decrease I price, of credit. Because the credit supply has been expanded through all these open market purchases with newly printed money, there is still money, in 2004, to lend after all the apparently “good loans” have been made. Because default rates have plummeted and values have increased, such loans do not appear to be as high-risk as they turn out to be. The default rate on home mortgages in the US hits an all-time low in Q4 2004, at about 1%. We now know that this is because households that got into trouble could refinance or sell; all we saw then was default rates. It appeared to be as safe, based on default rates, to lend to someone with a 600 credit score in 2004 as it had been to someone with a 700 credit score in 2002. Similarly, with collateral values rising by 15%-20% per year, it made sense to loosen LTV thresholds. Banks had always used 80% LTV as a rule of thumb because that translated into 70% LTV a few years out. In 2004, based on collateral value trends, 70% LTV a few years out translated into 90-95% LTV at origination. With unemployment low, higher debt-to-income ratios seem OK.
    (14) Some structures later deemed “toxic” or “exotic” are used more often – e.g., “interest-only option with teaser rates” – but interest is over 95% of the payment – it’s the rate that is “toxic” – and only because short rates are so much lower than long rates. If short rates and long rates hadn’t diverged, the “teaser rate” would be 50 bps below the long term rate – – few would opt for it and even if they did, it would not change the payment on a given amount of debt, or the amount of debt that a given income could support. “No doc” and “low doc” loans begin to be issued in greater numbers – to borrowers who either have the income but want a faster process, or don’t have the income but want to sell at a 20% gain (100% gain on an investment with 20% down). At first, these bets pay off. Because of the expanded supply of credit, the rates on these loans are not much higher than the rates for conforming loans. There had never been rules against such loans – the only laws preventing them were usury laws – but with expansion of credit, the rates on such loans falls to the single digits.
    (15) Many refinance transactions and HELOCs are used to term-out credit card debt. Consumer default rates plummet, hitting historic lows in Q4 2005. Credit standards and pricing are adjusted for unsecured debt based on the default rate trend and the fact that there is somehow still a bottomless pitcher of credit to pour (even though savings rates are at historic lows).
    (16) By late 2004 the Fed cannot ignore even their version of CPI. It gradually raises rates from late 2004-2007. As a result, a given income can no longer service an ever-increasing level of debt – it services a declining level of debt. Predictably, prices are no longer bid up. At higher rates and without increasing collateral values, the mortgage refinancing boom ends. Default rates start to climb back up; borrowers who get into trouble cannot simply refinance or sell out as quickly.
    (17) The homes started by those builders in 2002-3 are completed and put to market, further dampening prices. As rates continue to climb, builders’ costs climb with them – exacerbating an already tight margin situation produced by the commodity price bubble referenced above. Ironically, construction employment and wages temporarily increase further, as builders race to complete and sell out of projects. But all of the profit on a development, by 2005, comes from the land.
    (18) The rate and valuation spiral is by 2006 heading downward as rapidly as it had headed upward in 2002-3. This is exacerbated by the new buildings coming to market even faster than in 2005. Credit-wise, the situation is made worse in 2007 as ARMs begin to re-price at much higher rates and payment-to-income levels rise from 40% to 60%. Homeowners are already squeezed by commodity prices which have been driven up by the same low rates and have not yet popped. Default rates keep rising. They return to historic norms – and then start to pass them.
    (19) 2007. In an effort to sell off a few more rounds of mortgage securitizations, fraud and abuse, and poor and/or rushed underwriting, become more common. But the collapse will not be limited to just the last few RMBS issuances.
    (20) 2008. The house of cards collapses. Everyone is affected. Not just borrowers and lenders on, or buyers of, “liar loans.” The spiral is simple: inflation squeezes households and producers; with the Fed and ECB unable to ignore inflation, they raise rates back up. The amount of debt that a given income can service falls, and so do purchase prices. It is impossible to simply refinance to get out of trouble. The ARMs re-price. Builders’ cost of capital soars, and once the existing projects are rushed to completion, no new projects are started, and construction employment falls. With no new money printing, less money is spent, and retail employment falls. The increase in unemployment results in even more defaults. All of the various instruments “derivative” of mortgages (leveraged bets on the mortgages themselves) necessarily collapse. Predictably, the commodities bubble simultaneously collapses (this obviously has nothing to do with “mortgage abuses”).
    (21) 2008-2009: the Fed and ECB respond with credit expansion on a larger scale than in 2001-2003, in an attempt to re-inflate asset prices and stimulate “aggregate demand” – to induce people to buy more and save less. They also buy the “toxic assets” – loans that no longer work – most of which were not fraudulent but in fact had worked at origination based on the numbers; they no longer worked because the numbers had reflected credit expansion, not economic fundamentals.
    (22) 2009-Present: the central banks and other regulators dramatically increase oversight and lending restrictions, sometimes addressing issues that needed to be addressed but often not, and rarely touching on the root causes of the bubble-bust cycle. As an industry we increase the amount of red tape by tenfold all in the name of “preventing the next 2008.” Asset classes through which the central bank credit expansion of the 2000s flowed, and which were bid up and then collapsed, are mistakenly deemed to be inherently volatile. Banks’ ability to lend against these assets is limited, more tightly regulated, and in some cases (investment R/E at some banks) is forbidden – by the central banks that created the bubble.
    (23) 2009-2011. After the crash, as with many bust phases, banks have minimal capital to lend, and are afraid to lend. And investors and companies are afraid to invest, even if they still have capital to do so. Banks, investors and firms are, frankly, confused. In their view, CAPM has failed on all fronts: projected revenue, projected costs, projected cost of capital. All the ratios have failed – banks that adhered at all times to the old debt-to-income, DSCR and LTV ratios may not be shuttered but have suffered almost as much as banks that threw caution to the wind. There is significant turnover at the top – few managers dig deep enough to ascertain that the ratios did not fail – but were simply the victim of erroneous data that reflected credit expansion rather than economic fundamentals. It is easier to just claim that the prior managers (knowingly) “took on too much risk.” This becomes a catch-word: “risk.” This begs the question: risk of what?
    (24) 2011-2012. The growth mandate returns, and the price distortion continues: prices are not allowed to fall to levels at which they can clear because of “stimulus” policies designed to prop the prices back up. De-leveraging obviously must occur, but governments want to borrow more and want private lending to continue, also as “stimulus” to support a simultaneous growth in both investment and consumption. Rates are cut again, and many banks take the bait, causing local booms in margined, annuity-like assets such as NYC CRE and Midwestern farm land. With NYC CRE, NOIs in most neighborhoods have not changed – they simply support more debt because of the lower rates, and as a result, buyers bid up the asset prices and cap rates come down. With QE, cap rates fall further. It is the housing bubble all over again.
    (25) 2012-Present: the central banks impose new capital requirements and stress tests, including a capital and liquidity test assuming a downside economic scenario resembling “another 2008.” Stress testing is always a good idea but the stress in question is the bursting of another central bank bubble, and it is the central banks that are in charge of the stress testing. This is akin to the South Fork Fishing and Hunting Club rebuilding the South Fork dam and then ordering the residents of Johnstown and Cambria to build concrete dikes 100 feet high and 10 feet thick to protect against the next flood.
    (26) It could be possible to cut the credit stream off downstream of the Fed – but this would prevent bubbles only in the asset classes downstream of those cut offs –it’s a bit like eating a diet of cheeseburgers and beer while wearing a corset 24/7 – you’ll simply end up with fat deposits in areas other than the belly. If we don’t lend the money against the asset class that was inflated in the last decade, then credit expansion would result in leverage and inflated prices in other asset classes – taxi medallions, farmland, equities, commodities…. Historically, Germany, where ARMs are rare, really didn’t participate in the housing bubble and bust in the 2000s other than in its economy’s reliance on exports to the others, even though it is subject to the ECB monetary policy. The “twist” might temporarily inflate some bubbles but with no ARMs, the 2000s housing bubble and bust probably does not play out as it did. However, Germany did suffer through a commodity price bubble and bust, and its export businesses were impacted by other countries’ debt-fueled consumption binges.
    (27) Also one has to wonder why, if we agree that the harm caused by credit expansion is so severe, would we want to expand the credit supply to begin with? And why has there been no admission of the Fed’s undeniable causal role? Without the early 2000s rate cuts, the housing bubble, and thus the crash, are mathematically impossible. And if one goes back to read the financial papers at the time, one soon discovers that the primary reason for the low rates was to boost investment, spending and the “wealth effect” – i.e., they deliberately let the genie out of the bottle and hoped somehow to put it back in. Remove the first domino and the rest of them don’t fall – can’t fall. Let the market set the interest rates and this never happens – it mathematically cannot happen. The initial payment on ARMs and “teaser” structures would be the same as the payments on a FRM – opting for those structures would not enable the borrower to take on more debt using the same income, and buyers would not be armed with a sudden 36% increase in credit thus sudden 36% increase in purchasing power to chase the same assets. Wouldn’t that be better? Also, while it makes sense to require real estate appraisals to be ordered independently, and it doesn’t make sense to process “no doc” loans, it is inaccurate to cite loose appraisal processes or no-doc-loans as causes of the bubble. The cause was a temporary, artificial, increase in the supply, and decrease in the price, of credit, carried out by the Fed and ECB, both of which, incredibly, still blame everyone else. “Avoiding the next 2008” can be achieved not through reform by the central banks, but through reform of the central banks, who have never taken ownership of the disaster that they created, and who seem bent upon a repeat performance.
    (28) Of course some investors’ “liquidity preference” has grown – they’re spooked by what happened last time. They wouldn’t be as spooked if the Fed hadn’t distorted the price signals that guided their decisions.

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