Irrational Exuberance

Despite the fact that you can’t turn on the television, open a newspaper, or surf the web without being bombarded with talk of real estate, there seems to be little public concern over rising home prices and a growing bubble. John Mauldin explores…

Looking at a recent magazine covers one is left with the impression that the whole world is concerned about U.S. real estate prices. This is borne out by the fact that if you go to Google and type in sex you get 78,000,000 hits. If you type in real estate you get 110,000,000 hits, which makes housing about 40% more interesting than sex. Is there a greater sign of a bubble? But if you type in housing bubble you get "only" 1,120,000, so there is not much worrying going on

In doing my research, I rounded up an amazing list of facts and figures. Let’s first start with good friend Gary Shilling, who always manages to come up with an assortment of data and charts. This is from his July 2005 letter, which came in just in time for this week’s letter on housing.

No surprise, Gary is worried about there being a bubble and the possibility it could damage his prediction of a rather benign, if not in fact good, deflation. He starts out:

"The housing bubble is not local, but national-not surprising since it’s driven by economy-wide forces: investor zeal for high returns but skepticism over stocks, ample cheap mortgage money, and lax lending standards. Indeed, these forces and the housing boom are global. Earlier U.S. housing booms-busts were driven by local business cycles such as the rise and fall of the oil patch along with oil prices in the 1970s and 1980s. Since houses are much more widely owned than stocks, the bubble’s likely demise will shake the economy more than the early 2000s bear market. It could change the good deflation of excess supply we foresee to the bad deflation of deficient demand. The most likely bubble-pricking pin is massive speculation itself, and as prospective buyers stand aside, mounting inventories will precipitate a downward price spiral."

"…The national scope of the housing bubble is no surprise given its driving forces. They aren’t local economic booms. Indeed, there’s nothing anywhere in the country today to rival the oil patch boom in the 1970s, the Cold War aerospace spending jump in the late 1980s or the dot com bubble of the late 1990s. Instead, the driving forces, discussed earlier, are national – the appeal of real estate as an alternative to stocks and low interest rates. And lax lending standards. The leap in subprime loans from 9% of total mortgage originations in 2003 to 20% last year, according to the FDIC, is telling. So are the high loan-to-value, interest-only and option ARMs mortgages mentioned earlier."

The Housing Bubble: That’s Why It’s Called "Irrational Exuberance"

The National Association of Realtors estimates that 23 percent of U.S. homes purchased last year were for investment. Another 13 percent were second homes. About 23 percent of homebuyers nationwide are using interest-only loans, according to Loan Performance, a company that tracks loan originations. Interest-only and other types of adjustable-rate mortgage loans allow borrowers to pay no principal and sometimes little interest for an extended time while gambling that home prices will keep rising.

But investors are nothing if not optimistic. The LA Times, in a recent survey, reports that local homeowners expect to see housing prices rise by 22% annually for the next ten years. Now this is a group, while admirably optimistic, that clearly didn’t pay attention in math class. Compounding at 22% a year for ten years is an 800% appreciation, doubling every 3.27 years. 22% doesn’t sound like much. Let’s just project today into the long-term future. Not doing the math, they do not realize that means homes would have to go up in value 8 times! But such is the nature of bubbles. That is why it is called "irrational exuberance."

A UBS/Gallup poll shows that only 13% foresee a decline in housing prices over the next 6 months. 67% of investors see real estate investments as more profitable, and 77% see such investments as safer than the stock market.

There are clearly bubbles in some areas of the country. That being said, the average home is still affordable by the average person, according to the housing affordability index. But not in the bubble areas. Only 17% of the U.S. can qualify for a mortgage on a median priced home in California. In certain areas it is much worse. This is not surprising for certain wealthy enclaves, but this is for an entire state!

But if much of the growth in housing values has been in a few select areas, and data suggests that is the case, then it also means that much of the ability of homeowners to use their homes for refinancing is also in those areas. So much of the U.S. economic growth that was created by the asset bubble in housing is coming from a small (yet significant) number of areas in the country. Various estimates are that this adds as much as 2% to overall GDP. Further, economists at the Fed estimate that the economy would slow by 0.2% for every 1% drop in housing values. A softening in housing values in those bubble areas would significantly affect the whole country in a negative way just as their growth influenced a positive growth.

The Housing Bubble: Homes Bought for Investment

Last year, we built 2 million new homes. Yet we added only 1.2 million new households. That means we absorbed about 800,000 homes either as second homes or for investments. Given various studies, it is probable that around 500,000 homes were bought for investment over and above the number of new households.

That is a major part of the bubble. If new homes were rising in line with the growth in households, there would not be the potential for supply to outstrip demand. When, not if, we enter a recession with a significant overlap of excess supply while unemployment is rising, that could cause a sharp break in housing values in certain areas.

We live in a cash flow society. We look at our income and then judge how much we can afford to spend. Rents are actually falling while prices rise. When home prices fail to rise every year, when investor confidence breaks, households will look at their cash flow and realize that they might be better off renting.

But that may not be for some time. I remember writing about how the NASDAQ was overpriced in the 4th quarter of 1998. I watched the stock market take wings after that. Bubbles which are caused by investor expectations and irrational exuberance can last a long time.

This is especially true if interest rates stay low. It goes double if mortgage rates drop from here.

Let me outline a very plausible scenario, and one which will illustrate why the Fed is in such a bind. If the Fed stops raising rates at 3.5% (meaning one more 25 basis point increase in August), what impetus will there be for long rates to rise?

The economy is still growing nicely, up a revised 3.8% in the first quarter. The ISM number rebounded today. Unemployment is down. Inflation ex-energy is benign, and soon we will be at a place where the oil prices from a year ago will not reflect the significant rise that they do now. It is highly likely that we print a lower inflation number in the last half of this year than we did in the first. And with all the good news, long-term rates are still low.

The world is awash in capital, and it seems to want to find a home in U.S. fixed income instruments. The U.S. government deficit is dropping, which means we are making less new government paper for foreign central banks to buy, yet they (and foreign private citizens) are buying more of our debt, putting more downward pressure on interest rates.

Low inflation, excess world savings coming to the U.S. (for whatever reason) and a flat Fed policy is a prescription for lower long-term rates. This means the environment for housing prices could be quite good for some time to come.

But let’s say the Fed is worried about the housing bubble and wants to slow it down, as well as create a more classically normalized interest rate scheme. So they signal they will continue to raise rates. The market fears the Fed will continue until they cause a recession (as they historically have) and in anticipation they begin to buy long bonds, dropping long rates.

Either way, I think the chance of significantly rising long-term rates, which would kill the housing market is less than 20% in today’s environment. By that I mean I do not think the ten-year will rise to over 5.5%, which is what is needed to really slow the housing market, if that is your objective. (This could all change of course if say China and the rest of Asia were to start doing something else with their dollars, but that is not a likely short-term scenario.)

Bill Gross and others speculate about a 3% ten-year note, which would roughly mean a 4% 30-year mortgage. Can you imagine the wave of re-financing? Every mortgage in America would be re-financed. I think that could easily happen in the next recession. It would certainly soften the usual recession cycle again; postponing the ultimate day we hit the debt re-set button. It would trigger what Roach calls another round of Bad Growth (growth based on debt).

The Housing Bubble: Two Recessions

That is just another reason why I think it will probably take two recessions (and thus a long time) to get to the ultimate bottom of the stock market (in terms of valuation) and to hit the re-set button on debt. It is also why I think the Muddle Through Economy will be the paradigm for the rest of this decade, at the least.

And this worries me. Because the above scenario is a prescription for deflation. Staving off deflation, which is evidently part of the programmed DNA transfer that is required when you become a member of the Fed, will not be as easy the next time as it was last time. Ben Bernanke, who is the man I think will be the next Fed chairman, will have his job cut out for him. I fully believe him when he says that the Fed would "move out the yield curve" in a fight against deflation. He will help the market bring down mortgage rates to help stimulate the economy. Simply lowering short term rates may not be enough.

But what would you have them do? Sit to the side and do nothing as the U.S. slides into a steep deflationary recession? You can argue that there should not be a Fed, but that is not reality. There is and they will act to fight deflation. The die was cast when they decided to use housing asset inflation to offset the bursting of the stock market asset inflation bubble. The fact that it became a bubble was not helpful.

In hindsight, Stephen Roach is probably right. They should have raised rates faster and kept a lid on the housing bubble developing in certain parts of the country. But that is water under the bridge. Now, their choices are fewer, and their weapons are less. Get ready to get the lowest mortgage rate of your lifetime in a few years. But it will not be a sign of a healthy economy. While 4% will be good for us as individuals, we will not like the overall economy and the stock market. Can we hear it for Muddle Through?


John Mauldin
for The Daily Reckoning

July 06, 2005

What will happen when interest rates go up, and the subprime homebuyers that are flooding the market right now can’t pay their mortgages? This we can tell you for sure: It will not be good, for the U.S. economy, or the individual investor.

John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly economic e-mail Thoughts from the Frontline. As well as being a frequent contributor to The Daily Reckoning, Mr. Mauldin is the author of Bull’s Eye Investing (John Wiley & Sons), which is currently on The New York Times business best-seller list.

We have been fascinated by the big, big picture.

You’ll recall, dear reader, that we resisted the idea of "empire" for a long time. We denied it. We dragged our feet. We insulted the neocons every opportunity we got. We insisted that America should stick with its old ideals…and mind its own business. Not that the old tattered republic was a perfect country by any means. It was full of bosh and claptrap, but we had gotten used to it. Like watching a favorite old comedy, we knew the punchlines and pratfalls by heart; still we always got a laugh.

But the neoconservatives said we were fools. America was an empire whether we liked it or not. No one chose to turn America into an empire; the role was thrust upon us. We had the last imperial ideology still standing, they said. It was time to stop whining and shoulder our imperial obligations.

Getting to like empire, we found, was a little like eating something new and nasty in a Chinese restaurant. After we got over our initial nausea and revulsion, we found we liked the taste of it. We got used to it. We found it helpful in understanding what was really going on. We found that the neoconservatives were right: looking at the United States as an empire explains a lot.

But the harder we looked, the more we saw that the neocons were even bigger imbeciles than we realized. They have noticed that America really is playing an imperial role. They have encouraged it and expanded it. What they haven’t bothered to notice – because they are too busy gazing at their own glorious reflections – is that it is a mad empire of debt and delusion, one that ruins the imperial race rather than enriches it.

That is what makes history so entertaining. As we mentioned yesterday, people seem to come to believe just what they need to believe – just when they need to believe it, in order to make public spectacles of themselves. That is, they need to believe six impossible things before breakfast so that can do something absurd before lunch. It is the aberrations – the exaggerations, the mass movements way beyond the ordinary mean, the empires, the bubbles – that give us some place from which we can regress. And it is the delusions, vanities, and preposterous flatteries that make it all so amusing.

According to a report in Britain’s Guardian newspaper, Americans now spend $1.08 for every $1 they earn. But American economists, politicians, and media manage to spin the numbers so they seem almost normal – if not favorable. Americans spend more than they earn, say the latest hallucinators, so that people in Asia can continue saving so much money. Get it, dear reader? America’s current account deficit is not America’s fault; it’s the fault of all those Asians who haven’t the wit to spend their own money.

That is the sense of the delusion known as the "glut theory of savings," according to which, America does the world a favor by being willing and able to recycle excess savings from Asia. We have to spend the money for them! Thus, we do the whole world a service…helping to match up savings with borrowings…spendings with makings…and takings with gettings. We do not doubt the math of it; for every debit, we are sure there is a credit somewhere (most likely in Asia). We just don’t see how the imperial arithmetic favors the imperial race. That, of course, if the funny part of America’s empire…a little joke on the neoconservatives themselves, with a punch line that is likely to knock the whole nation on its derriere.

More news, from our team at The Rude Awakening:


Dan Ferris, reporting from Oregon…

"You don’t drop the pounds with magical pills and fads. Classical music will never appeal to the impatient. As for investing…well you already know the secrets there, don’t you?"


Bill Bonner, with more views:

*** Gold dropped below our most recent buying target — $425. Buy.

*** Dan Denning’s new book, The Bull Hunter, has hit number 13 on the New York Time’s best-seller list…

This is, of course, great news for Mr. Denning – but it’s not enough to save him from the infamous "green sarong." He hasn’t yet edged Thomas Friedman off of the Amazon best-seller list, so come August 10; you may see a six-foot man wandering the streets of Vancouver during The Agora Wealth Symposium…

*** "I am just a humble American writer with a weakness for old French ‘pierres,’" we explained to the farmers.

The little speech seemed to need a little joke. The farmers looked at each other. Finally, one of the Pierres got it.

The luncheon was organized by one Pierre in order to introduce another Pierre. The two Pierres are going into business with your editor, raising limousine cattle in on his farm in Normandy. But what the farmers wanted to know was what your editor was doing there. That was where the other "pierre" came in. In addition to the Christian name, Peter in English, the word "pierre" means "rock." Christ told the same little double entendre in the French-language version of the gospels, when he said: "On this Pierre I will build my church." St. Peter did as he was told.

Your editor can’t seem to pass a pile of them without wanting to own it; thus had he become the owner of a vast ruin of stone, stale and wood-munching fungus in the Norman countryside. And thus had he become an expert on French fix-up projects.

MoneyWeek magazine asked us for our views on French chateaux yesterday. We have lived among the frogs for more than a decade. We have learned their ways and the ways of their dwellings.

We recalled when we bought our first chateau during the early years of the Clinton administration. "It never rains in the summertime," said one of the Pierres. "And, no, the roof doesn’t leak." One day in July, we found that he lied twice. But this was the just the beginning of the adventure. Nothing is ever quite as straight in France as we Anglo-Saxons imagine – neither the people, nor the laws, nor the chateaux walls. There is always a little "play" in them.

We began our chateaux counseling by explaining our search for our first chateau. We looked at a dozen of them, many of which were owned by English people. They mostly suffered from the same problem – the owners had begun something but were unable to follow through. A few rooms were done up. Others were left undone. Roofs still leaked. Heating systems creaked. Plaster cracked. And finally, the owners packed up and left, often in different directions.

"When I arrived here," said one older Englishman who had not cut and run, "the chateau was broken down. But I was in good shape, financially as well as physically. Now, the chateau is in good shape…and it is I who is broken down. You can make these things work. But it will cost you."

Chateaux are relatively cheap to buy, but expensive to repair and run. Our experience suggests that buyers should expect to spend twice as much on repairs as they did on the purchase. Compared to English prices, however, they will still get a lot for their money. A place already done up will sell for only a third to one-half as much as a roughly-equivalent place in England.

A buyer must also consider the non-financial costs. Doing up a chateau is a consuming occupation. It breaks down not only pocketbooks, but also nerves and marriages. There are all the Pierres to deal with. And the language. And the government. And the community. And the travel back and forth. And the sense of alienation. Taken together, it breaks down buyers.