Monday, November 15, 2004

Double, double, toil and trouble

The American Street

One of the reasons George W. won re-election two weeks ago is that John Kerry was unable to convince the voting public – and especially the voting public in belleweather states like Ohio and Missouri – that the economy was as bad as purported. And one of the reasons he was unable to do so was the booming housing market in many parts of the US. If home prices are skyrocketing and interest rates are low, allowing you to refinance at 5.7% while boosting your mortgage-levereged consumption at the same time, who says times are hard?

The National Association of Realtors tells us today that in dozens of housing markets across the US, prices continue to soar into the stratosphere. That being said, incomes are not following in tow, Americans aren’t saving a damned thing, interest rates are finally beginning to rise and foreign capital is showing signs of losing interest in mortgage-backed securities. Is this bubble set to come to a bad end?

No housing markets are more bubbly than those in Florida and the Southwest. Over the past year, these are the bubbliest, tracking a rise of more than 30% in the median sales price on existing single-family homes. Following these numbers is the rise over the past three years.

Metro area 2003:III to 2004:III 2001 to 2004:III
Las Vegas, NV 53.7% 89.9%
Bradenton, FL 40.7% 80.0%
Riverside/San Bernardino, CA 36.2% 98.9%
San Diego, CA 32.5% 93.7%
Sacramento, CA 30.5% 90.4%

In these most frothy markets, “double, double” does indeed describe the process exactly. But what’s underlying these huge price gains? In short, what’s the fuel, and is it sustainable?

It certainly isn’t incomes. Using Freddie Mac median household income data, we find that at the national level the housing price-to-household income ratio is 4.5:1. In bubble-deflating London they’re finding a ratio of 5.5:1 is too high to support current prices. Quick calculations show ratios of 5.1:1 in Sacramento; 5.2:1 in Las Vegas; 5.7:1 in Riverside/San Bernardino; and 9.1:1 in San Diego.

Part of the story is an insuppressable enthusiasm for adjustable-rate mortgages and low downpayments. In Las Vegas the use of ARMs has shot up from 19% of all loans a year ago to 55% in 2004:III. In the Los Angeles/Long Beach/Riverside region, use of ARMs has gone from 27% to 58% of all loans. In Sacramento, the usage went from 28% in 2003:III to 67% today, and in San Diego, from 37% to an unbelievable 72%!

The incredible price gains have completely eliminated the marginal and first-time buyer from the market. Nationally, those buying with downpayments of less than 20% of the sales price – i.e. those putting down so little as to be forced into mortgage insurance – make up around 23% of the market now (a year ago they were 30% of the market). These folks have fallen to just 20% of the market in Las Vegas, 13% in Sacramento, 12% in Los Angeles and a paltry 5% in San Diego.

When first-time buyers were eliminated from the housing markets in Australia and the UK, prices began to slide. In the latest data from the National Association of Realtors, we may be seeing the bloom coming right off the rose in some US markets as well.

California is the place to look. From the second to the third quarters of this year, median home prices actually fell in both Orange County (for the first time since 2002:IV) and in the Bay Area (for the first time since 2003:I). In Orange County, prices changed -1.8% as the mortgage insurance crowd fell to under 13% of the market. In the Bay Area, prices changed -0.2% as the mortgage insurance crowd fell to a mere 8% of the market. In both places, effective interest rates are up around 0.25% over the last six months. The price-to-income ratio in the Bay Area is around 7:1, and in Orange Co. 8.7:1.

According to PMI Mortgage Insurance,

Of the country’s 50 biggest cities, homeowners in San Jose stand the greatest chance of seeing their homes plunge in value . . . San Jose, Oakland, and San Francisco are three of the top five MSAs at the top of the risk index list.

The housing bubble in California may finally be ending. We Americans are spending every dime we come across, so much so that our savings rate this year may be the lowest since the Great Depression. With all these adjustable-rate mortgages, housing costs are going to rise in the coming years. While nominal household incomes in some California markets are up a nice 6-7% over 2003, they’re stagnant (and thus in real terms, they’re falling) in other housing-bubble cities like San Jose, Las Vegas, Phoenix and Washington, DC.

As Nixon’s chief economist Herb Stein (father of Ben Stein) once said, “If something cannot go on forever, it will stop.” These housing prices cannot go on forever, and when they stop, the consumption which they fuel will stop as well. Will there be anything to replace this asset bubble when that day comes?

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