Ironman at Political Calculations recently wrote an article titled "The U.S. Housing Bubble Is Back". While I agree that the fundamentals behind housing are weaker than ever, I disagree that this is merely a bubble that will have a modest correction.
The price of homes will face substantial downward price pressure within the next ten years.
The price of new homes has outstripped inflation by roughly 1% per year on average since 2000, even after the correction from the housing bubble. Even such a modest gain will prove to be unsustainable.
I have a myriad of reasons to back up this prediction.
Irrational exuberance applies to more than just stocks
It is tantamount to heresy to claim that the price of homes will decrease. This mantra of the 90s and 2000s has only been slightly muted by the collapse of the housing bubble. Housing market bulls are very loud in their denouncement of housing market bears. We saw this behavior in 2007, when now-wealthy Steve Eisman tried to warn everyone about the coming collapse, while taking as many short positions as he possibly could. Despite the fact that his money was where his mouth was, nobody wanted to hear about how housing prices were going to fall, because "everyone knows they never fall". Now he is widely regarded as a genius, and rightfully so.
Yet, despite the all-too-recent crash, the lesson learned is not one of caution. The impression that remains both on real-estate investors and the general public is this: Housing prices will never, ever go down, even in the worst of crises. The government may intervene, the sky may fall, but housing prices will not drop. Take that, real estate bears!
Current housing market bulls are quick to point out that after the correction resulting from the bubble, housing prices are still much higher than they were in 2000, before the bubble began. This, in their minds, somehow means that price growth will continue for the next 5, 10, 15, 20 years.
Although I am a little too young to remember what the general opinion was before the burst of the dot-com bubble, my impression seems to be that bulls had this same attitude toward tech stocks. Perhaps someone older can tell me if they're getting a sense of deja vu here.
This insurmountable zeitgeist is only a small part of the continuation of elevated home prices.
Lower incomes means less ability to prop up prices
If you look at figure three in the aforementioned article "The U.S. Housing Bubble Is Back", you may notice what I did. Look at the pre-bubble trend (the gray dotted line in the bottom left). Notice that if that trend were extrapolated to current income levels, it falls well below the current household sale price to income ratio.
I'd like to also point out that the trend line occurred during a period of rapid expansion in the U.S. economy. Now, we are in a stagnant economy, and home prices are even above the trend from the high-growth period.
If household income is indeed strongly linked to the price of homes as Ironman at Political Calculations would lead us to believe, then there is a correction still to come, regardless of whether or not he is correct about another bubble forming.
Granted, this correction could take place as an explosive rise in household income, like we saw during the '90s. I think the probability of that happening to be somewhere in "laughable" territory. The only other way this correction can take place is through a drop in housing prices.
Econ 101: Supply, Demand, and substitute goods
Homebuilding has restarted, with housing starts reaching past 900K in February. Who is going to buy all these homes? Some seem to think it will be the millennials, but 16% of people under the age of 25 are unemployed. Let's not even talk about what percentage are underemployed or employed but drowning in debt. It is obvious that there are but a few amongst my so-called "boomerang generation" that can afford to rent a place, let alone save up for a down payment.
It's not just the young who are not going to buy. Gen X and the Boomers are not in the mood or position to buy a vacation home, or a home for their unemployed, indebted children. Many consider themselves lucky to keep up with their current mortgage.
Banks have been very unwilling to loan out money, as well. With interest rates so low, there is no incentive for the banks to make these loans. Why not put the money received from deposits in the stock market for a nice 10% per year, instead of giving it to some random person who could potentially default on their obligation? I can hardly blame the banks for behaving this way, as they are for-profit entities, but this is a considerable headwind to home purchases.
A flood of used homes
There's no rational case for robust demand for homes, but there doesn't need to be robust demand to maintain the current price levels. All that is needed to maintain prices in that low-demand scenario is for available homes to be in short supply. Homebuilders aren't flooding the market, so prices should remain stable, as the logic goes. There is one problem with that: the retiring baby boomers.
With retirement funds taking a beating in 2008, rising healthcare costs, and rampant pension cuts, many retired boomers will need to take drastic measures to continue to make ends meet. Some will resort to selling the house they own in order to downsize into a more modest home, or in more severe cases, to move in with their children. Others will have their homes sold to cover assisted living costs.
Even if only small fraction of families cut the number of homes they own in this manner, this will have a profound effect on the supply of homes, further pushing prices down. One cannot reasonably argue that a used home is not a substitute for a new home. It may be classified as an inferior good in this market, but it is a substitute nonetheless.
A whole lot of downward pressure
Thus, we have the supply of available new and used homes increasing, and decreasing demand. This is happening while homes are still overvalued relative to income as a result of the 2008 bubble never completely "popping" as it should have. Americans love to buy homes, but nobody can or will buy a house if prices continue to rise as wages continue to fall. It is not whether a housing price crash will come to pass, it is a matter of when.
Postscript: The mortgage tax reduction
I believe the mortgage tax reduction will probably not be going anywhere anytime soon, but it is important to consider the possibility.
This deduction drives economists mad, and for good reason. This is the only tax refund so powerful that it can convince certain people to take on debt they can never repay. It raises home prices to artificial highs, which free-market economists are always against.
Proponents argue that the underprivileged get a house, and once they have a house they can be more productive citizens. Unfortunately, this tax rebate no longer assists the lower class the way it used to, and is more used as a way for the more affluent to get richer by buying multiple homes to discount their taxes. The result is now a long way off from the intent.
The politics look good for continuing the mortgage tax reduction despite the current loophole it provides. There is a chance it could be repealed, however.
The U.S. government is desperate for ways to raise revenue and/or cut spending to pay for its tax cuts and wars in Iraq and Afghanistan. Add to this that every time an economist is asked about what cuts to the federal budget they would make, the first recommendation is frequently "eliminating the mortgage tax reduction". Congress may well begin listening if economists continue to recommend removing this tax reduction.
It's not as ludicrous as it sounds. Democrats could potentially get behind such a measure because the affluent have been using it as a tax loophole, and the party has been eager to make the wealthy pay their fair share. Republicans may support it because of their belief that the government should not incentivize certain behaviors; repealing this deduction would make the market more free. Even in today's polarized political climate, it is not difficult to envision bipartisan support for repealing the mortgage tax reduction.
Perhaps politicians will realize that they would be causing yet another crisis by repealing this deduction. A more likely conclusion would have any attempts to repeal the tax deduction stall in congress. However, the more economists push for a repeal, the more likely it will be brought into the limelight of the national political stage. I would classify this risk as a low-tier tail risk, but it is one that needs to be recognized.