Saturday, February 28, 2004

The housing bubble is going to burst: take your profits while you can

by John Rubino
For Virginia Business
February 2004

A lot of Virginians are feeling very smart these days. You know who you are. You were farsighted enough to buy a home in Alexandria or Charlottesville or Richmond’s West End, and since then you’ve happily watched your net worth grow by five or ten or fifteen thousand dollars each year. Many of you are up $100,000 on your homes in the past decade, and some of you have made much, much, more. You are, in short, highly successful real estate investors, with every right to a little self-congratulation.

But now you face an interesting problem: How do you hold onto those big, juicy capital gains when home prices go back down? Because they are going back down, further and faster than might seem possible in the warm glow of today’s recovering economy. Why? It’s simple: home prices are too high and we owe way too much money.

So let’s begin with the common sense notion that when you borrow too much, your lifestyle changes in disturbing ways. This is as true for a country as it is for a family and, by any reasonable measure, Americans have clearly borrowed too much. For the past decade, we’ve taken on about $5 of debt for every $1 of new wealth we’ve created (as measured by gross domestic product or GDP), and instead of pulling back, in 2003 we stepped up the pace, borrowing more in a single year than any other society ever. Add up all our outstanding debts — mortgages, credit cards, business loans, government bonds, etc. — and the total comes to about $34 trillion, or $450,000 per family of four.

Meanwhile, home prices (as a result of our nonstop borrowing) have soared to record levels just about everywhere. In hot markets like California and Boston, the average home now costs about $400,000, which is about twice what the average family can afford. In Virginia, the average sales price was $192,537 in November, a 9 percent increase over the previous year. Nationwide, the ratio of home prices to our take-home pay is the highest it has ever been. Housing, in short, is a classic financial bubble, propelled by excessive borrowing to unsustainable price levels and destined, like all bubbles, to burst.

Now, I’ll grant you that in theory the housing bubble could have some life left in it, since most bubbles last far longer than their early critics expect. But this bubble won’t, and the reason it won’t is, in two words, the dollar. For the past decade, Americans have been buying a lot more stuff from abroad than we’ve been selling to our trading partners. We make up the difference (known as the trade deficit) by giving them dollars, and right now we’re flooding the world with about half a trillion dollars each year. This was fine as long as our trading partners were willing to, in effect, loan those dollars back to us by buying U.S. bonds and other financial assets. But lately they’ve lost interest in lending us money and, instead of buying our bonds, they’re converting their dollars to yen, euros and gold. The dollar, with more sellers than buyers, is becoming less valuable day by day and soon, perhaps very soon, its orderly decline will turn into a rout.

At that point, a panicked Federal Reserve will be forced to raise interest rates to make U.S. bonds more attractive to foreign investors. Mortgage rates will jump to 8 percent to 10 percent, effectively pricing most buyers out of overheated housing markets. Hard times in Boston, California, New York and Florida will quickly spread to the rest of the country, including Virginia. And those capital gains that were going to make your retirement so cushy will evaporate like fog on an August morning.

So what should you do? The obvious answer is to take your profit now. Sell that expensive place and rent for a few years. If that’s not an option, shift your capital into investments that will benefit from a collapsing dollar and bursting housing bubble. Gold is one clear winner, since, as the only form of money that governments can’t simply create at will, it tends to do well when the dollar is falling. Global bond funds, since euro and yen-denominated bonds pay interest in currencies that are rising against the dollar, will also benefit. And if you can tolerate a little risk, consider betting against the housing bubble by “shorting” the stocks of the companies which now benefit from it. As a major financial center, Virginia is a target-rich environment for short sellers. Do some of these things, and a few years hence you’ll have a whole new set of reasons to feel smart.

John Rubino is a former Virginia Business contributing editor. He is the author of “How to Profit From the Coming Real Estate Bust” (Rodale Press) and is now at work on a book about the dollar’s coming collapse.