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N.Y. Fed sees no evidence of a housing bubble. Are they blind?

By: 
Peter Schiff
Wednesday, June 23, 2004

Compelling evidence of a potential peak in the housing bubble was recently provided by the New York Federal Reserve, which yesterday released a study concluding that "there is little evidence to support the existence of a national home price bubble," and that a potential regional decline in house prices "would not pose a treat to the overall U.S. economy." They have got to be kidding! However, given the Fed's recent myopia for detecting inflation, it should not be surprising that their vision is similarly impaired when it comes to recognizing clear signs of a housing bubble.

In the late 1990's Alan Greenspan and other Fed officials always responded to questions about the possibility of a stock market bubble by asserting that bubbles could not be identified until after they pop. Apparently Fed officials are so afraid of the housing bubble that they feel compelled to abandon their prior detachment and repeatedly go out of their way to deny its existence. Methinks they protest a bit too much. In fact, the best possible explanation for the Fed's having kept interest rates so low for so long is their fear of pricking the housing bubble.

We have all come to expect that home price studies put out by national real estate brokerage and mortgage associations to make optimistic predictions. However, objective analysts understand that the livelihoods of those organizations depend on the public's belief in an ever-expanding housing market, and their reports are reverse-engineered to support that belief. It appears as if the Fed, which has a similarly vested interest in perpetuating the bubble, is now following the same tactic. This view is supported by the sophomorically crude arguments put forward in the Fed's report and the extent to which it ignores the fact that the American economy is now moving into an environment of rising interest rates.

The study's central assertion is that a bubble can only exist if prices have risen simply because purchasers believe that prices will keep rising, not because there are any "fundamental" factors that have contributed to the increase. Low interest rates, the report says, are the "fundamentals" that justify the run-up in prices. The corollary, that prices will decline when the artificially low rates rise, is not addressed at all in the report! More importantly, such claims overlook other temporary props for the housing bubble, such as sharp reductions in lending standards (low or no down payments, high loans to value, no documentation and stated income loans, and high debt service to income ratios) and the proliferation of interest only and adjustable rate mortgages.

The report stipulates that although there is no evidence for a "national housing bubble" the possibility for regional bubbles, such as in the East and West Coasts do exist. The assumption that a decline in property values in those broad regions, which are in fact the centers of wealth in this country and which contain an extremely high portion of national home value, is patently absurd. It is analogous to a doctor ignoring the threat of heart and lung cancer because it had not spread to the arms or legs, and assuring his patient that heart and lung cancer does not pose a threat to the body in general.

Anyone still believing that there is no housing bubble need only read the following anecdote which recently unfolded in its epicenter, Orange County, California (in which I was a participant). After reading it, anyone remaining unconvinced about the existence of a bubble should consider sending his résumé to the New York Federal Reserve.

An anecdote from the epicenter of the housing bubble

Recently I visited a house which was advertised for rent in the Orange County Register. The house, approximately 15 years old, 2,600 square feet, located on a 10,000 square foot lot in a gated community called Coto De Caza, about 30 -40 minutes inland from the pacific coast, was offered for rent at $3,900 per month. There was nothing particularly special about this house. It had a nice view of the hills, but didn't have a swimming pool, Jacuzzi, upgraded flooring, elaborate stonework or even a built-in barbeque. It was just a typically middle-class residence. When I arrived, I was greeted by a real estate agent who represented the owner, upon whose advice this property was recently purchased as an investment.

Being curious, I asked the agent how much money his client had paid for the house, to which he replied one million dollars. I then inquired as to the annual taxes, homeowner's fees, gardening, insurance, routine maintenance, and other monthly expenses his client might incur as a result of owning this house. He estimated such expenses to be no more than $1,500 per month. I then pointed out that with a monthly rent of only $3,900, and monthly expenses of $1,500, that after interest expenses, $2,400 of net rental income would certainly leave his client in a position of incurring several thousand dollars per month of negative cash-flow. I than asked him why he would recommend making such an "investment?" His reply was that since his client had plenty of income from other sources, that this particular purchase did not put him in a negative cash flow position, and that since his client had plenty of other income, he needed to keep buying more units. In reality, his client needed to "keep buying units" like he needed a hole in his head. What this agent really meant was that since he needed to keep generating sales commissions, he needed to keep dispensing bad investment advice. He also stated that some of his client's other real estate investments, no doubt those made quite awhile ago, produced positive cash flows.

First of all, the fact that his client has income against which to offset investment losses does not mean that his client should actively seek such losses. I reminded this agent that each investment must be evaluated on its own merit, that this particular "investment" reduces his client's income and that his having made some wise real estate investments in the past did not justify making foolish investments now. At this point, not surprisingly, the agent became defensive.

"Do you realize how much this property is going to appreciate?" he foolishly exclaimed. "Why, it's in a community of multi-million dollar homes and will probably be worth at least 1.5 million in just a couple of years!" he boasted.

The debate continued. How can you be so sure about that, I asked? What if the price falls? He responded almost in disbelief: what do you mean, falls? Real estate prices don't fall, not here; they're not making any more land you know (as it happens I drove by miles of undeveloped, flat land, on my way to Coto de Caza). I then posed the question: if this property produces a negative cash flow now, with a million dollar cost, why would anyone buy it for a million five, with an even greater negative cash flow? His reply was that rent had nothing to do with it, and that I obviously did not understand real estate investing. Such a assertion, of course, is absurd on its face, as rent, which represents the return on real estate, is as important to the latter as dividends are to stocks or interest is to bonds. As proof of my "ignorance" he referenced examples of houses his client had bought last year that also produced negative cash flow but which had already appreciated substantially. He also reminded me that the rent could rise. What he failed to understand was that it could also fall, or could be zero if the property were vacant, as it was currently. He was right about one thing, apparently, I just didn't get it.

Then again, perhaps I do. As I recall, such arrogance, unbridled confidence in absurd rationalizations, a complete disregard for logic, history and time-honored, previously widely-accepted investment prudence typified the stock market bubble of the 1990's. Dividends did not matter, earrings did not matter, all that mattered was price, which could only rise. The only mistake was to refrain from buying or, heaven forbid, sell. The higher stock prices climbed, the more arrogant buyers became as the naysayer, the people who just didn't get it, were increasingly proven wrong with each up-tick, until the bubble burst and all that remained were the memories of the paper profits that were never taken.

Let's take a closer look at this property. Assuming this investor had paid cash for the property (which he did not) and was able to rent it at the full asking price of $3,900 per month, his total annual return would be approximately 2.9%. After tax, including an allowance for depredation of the building, the net yield, assuming the investor is in the top federal and state income tax brackets, would be about 2%. Alternatively, he could have purchased general obligation bonds of the state of Californian for an after-tax yield of 5%. Why would a rational investor accept a 2% return for assuming all the risks associated with paying one million dollars for a property that appraised for less than half that value a few years ago, and the other risks and potential aggravations inherent with being a landlord, when he could earn 150% more by simply buying general obligation municipal bonds? The answer is: he wouldn't. Only an investor whose judgment was impaired by the intoxicating effects of a bubble, or in this case by an equally inebriated, overly-zealous real estate broker would take the plunge.

However, this particular "investor" used leverage, with the down payment no doubt having been "extracted" from equity accumulated in previously purchased properties which themselves produced negative cash flows. Therefore, instead of simply producing a low rate of return, this "investment" produced significant monthly losses. For now, the "investor" is able to use his considerable current income to fund these losses, which in effect amounts to a rent subsidy paid to the tenant (similar subsidies nationwide are temporarily suppressing rents, keeping the core CPI artificially low) which the investor feels are justified based on future appreciation. That this property was already vastly overpriced, as evidence by its negative rate of return, and would be even more so were it to appreciate, was irrelevant.

The agent who so cavalierly boasted that this property would soon fetch over 1.5 million dollars did not even stop to think that to justify such a price, given even moderately higher interest rates, the property would have to rent for about $10,000 per month! Could a typical middle class southern California family afford that kind of rent? He couldn't care less, because in his mind rents have nothing to do with real estate values. Even if rents were to rise, how high could they go? If rents increased substantially, imagine the effects on the core CPI, which is 40% rents. Such a sharp increase in the core CPI would certainly mean much higher short-term interest rates, and thus much lower property prices. Ironically, higher rents, the only factor that might legitimately lead to higher property prices, will actually cause lower property prices, do to their immediate effect on the core CPI and their ultimate effect on interest rates.

The fact that this particular property was located among multi-million dollar houses over-looked that such properties, brand new five to ten thousand square foot structures on two to five acre parcels, were themselves vastly over-priced. Ironically, this agent, who had just advised his client to purchase highly appreciated real estate solely on the expectation of higher prices, insisted that he saw no signs of speculation in the current real estate market. As proof he offered the fact that the average mortgage in this area was made with a 20% down payment, as apposed to the the late 1980's, which in his option was a bubble, when average down payments were only 10%. In other words, he was convinced that this time it was different, and relied on distorted statistics to produce his desired conclusion. What he ignored was that the 20% average had been skewed by all the million dollar plus homes for which large down payments were financed by equity accumulated through trading up. The mortgages for the starter homes, which produced the equity funding the trade ups, and which form the base upon which the current real estate pyramid rests, were made with little or nothing down. Plus, the fact that 80% of those making large down payments chose adjustable rate mortgages is the most alarming example of speculation possible.

The reason I have been placing the word "investor" in quotation is that investors buy assets which generate superior current rates of return. By that criteria, the purchaser of this property can hardly be called an investor. In fact, even the term speculator would not be appropriate because speculators purchases assets based on the rational anticipation of price appreciation. In reality, this individual is simply a real estate fool, buying assets solely on the expectation of selling to an even greater one.

The most likely outcome for this fool is that he and his real estate equity will soon part. When interest rates rise and the economy slows, not only will the cost of servicing his adjustable rate mortgages rise, his other income, currently funding the negative cash flows, will most likely fall. To reduce this growing drain on his diminishing income, he, along with many other similarly situated fools, will most likely try to sell properties. However, in a week economy, with rising interest rates and falling property prices, there will be no fools left to buy, only those investors who had the foresight to remain liquid during the mania, and who will only buy properties offering superior rates of rental return. Given low rents and higher interest rates, the sale prices necessary to attract such investors is likely to be less than the outstanding mortgage debts, resulting in bankruptcies, foreclosures, and distressed sales.

While most accept that those who forget the mistakes of history are doomed to relive them, few appreciate just how short people's memories really are. Since even those remembering such mistakes seem to repeat them, it is likely that history's mistakes will repeat indefinitely whether remembered or not.