How Ivory Tower Economists Created the Housing Bubble

This is Econ101 folks. Seems the professionals are so wrapped up in super complex, esoteric theories that they have forgotten that particular part of their education. To understand when our house prices will stop falling, one must first know what the price of a house should be. To know what house prices should be, you have to understand what the house prices look like to the people who actually buy or sell houses.

Two kinds of people buy houses. People who consume them as a dwelling and people who invest in them. Most home buyers are both at once. They may be buying one house or many, big or small, fancy or plain. It really doesn't matter, but here's the underlying critical factor. Each person as consumer is willing to purchase at a price which will expend only a certain fraction of his/her total available resources for their dwelling. This is the rent part of the equation. When many investor/buyers are aggregated together what emerges is that people as a group want to expend a relatively stable, almost fixed fraction, of their total consumable income on housing. The old common rules of thumb such as "housing should take 30% of a person's gross income" are a reflection of this fraction.

The investor part of each buyer is only willing to purchase at a price that will turn a reasonable profit when compared with alternatives - things like saving accounts, collector cars, foreign currencies, stocks, gold, art, bonds, commodities, etc. If the house price are too high compared to alternatives, the investor will not invest in the house. He will prefer rent and invest his resources elsewhere. As investor, the buyer has an ideal tenant - himself. Much (not all) of the investment return normally comes from the rent the property investment will generate. Obviously the consumer/investor has a choice here.

Rent or Buy?

Put many of these decisions from many people together, and it means there is a rent/price ratio at which the house prices will be stable. To state the obvious, the aggregated rent/buy decision is an equal tradeoff at the price which makes the cost to own a house equal to the cost to rent a house.OK, this is all very obvious.

Now let's ask the question. What does it cost to own a house? There are several factors. The major ones are interest on the capital invested, property taxes, insurance, and physical depreciation/upkeep. But what does it really cost to own a house? Interest on the capital invested + property taxes + insurance + physical depreciation/upkeep + PRICE inflation/deflation.

Obviously the last item spiraled out of control in the years leading up to the peak of home prices in 2006. How could this happen? What could possibly cause people to suddenly bid up prices for houses with such reckless abandon? Virtually everyone and everything involved in providing housing has been blamed. Greedy builders, unqualified subprime buyers, incompetent appraisers, Wall Street financiers, real estate agents, zero down mortgages, the Federal Reserve, speculators involved in house "flipping", banks, loan brokers, even derivative financial instruments, lack of regulations, and CDOs have been targeted for blame by one or another of the various pontificating "experts" in this situation. Well, everyone involved behaved very rationally and sensibly. No-one sets out to purposely bankrupt themselves or damage the economy. There are some highly qualified economists who assert "bubbles like this just happen." (You know who he is.) This is all baloney.

The cause of the housing bubble lies with the government economists that determine the reported inflation figures. You see, these geniuses decided that the cost of housing is the stated nominal rent and ignored the REAL cost of owning a house. This is where the government economists went astray. Apparently they could see no relation between the cost of housing as indicated by rent levels and the actual cost of owning a house! Many serious professional economists literally believe "there is no right or wrong relationship between rents and the cost of owning a house."

Folks, this is UNBELIEVABLE BALONEY. Oh, they have reasons for asserting this, mostly laziness. You see, it is pretty difficult to determine the real prices of houses. For an example, consider the latest ill-conceived effort, the Standard & Poor's/Case-Shiller national home price index. It's incorrect because it does not allow that all houses change (depreciate, are remodeled, etc.) with time, and because it does not consider the difference between retail and wholesale (foreclosure) house prices to name just two of the problems. Because it's very difficult to determine the market price for houses, government economists decided just to use stated market rents as the cost of housing. This they could find by simple surveys. Much too lazy and too simple-minded.

What's missing from this approach is recognition that all houses, EVERY SINGLE HOUSE, is purchased by an investor and occupied by a renter. Every single house has been purchased with the rent/buy equation perceived to be in balance whether the house will be occupied by the owner or a renter. The critical role the investor plays in setting house rents/prices is completely ignored when one accepts the view that nominal rent equals the cost of housing. In this view, an investor is seen as superfluous, more of a speculator, even a dangerous individual, possibly a sociopath deserving of punishment for his greedy ways. The truth is that the majority of the houses in our economy are occupied by individuals who are combined renter/investor/speculators. A lessor number of houses have the investor and renter as separate individuals, but the rent/buy equation remains unchanged. The people making the rent/buy decision on a daily basis set the market for rents and house prices. It's Econ101.

Think about what happens to the rent/buy equation when house prices are increasing. Assuming interest rates are unchanged, the investor will see he can make his return on the price change and will be willing to accept a lower rent. i.e. Rents should go down! And, guess what - When rents go down, the same rent also buys a bigger, nicer house. People can move up. Polished granite and soaring entryways here we come! The apportioned fraction of total income for housing is buying more house. Hey, wait a minute! If rents are going down, that means inflation numbers are abating. The Fed will be able to lower interest rates and keep the economy humming without worrying about inflation. In other words, the government's laziness has the perverse result that inflation in house prices ends up being reported as deflation in the cost of housing. Certainly interest rates would have been lower than they were if the market prices of houses were included in the inflation figures. Maybe you gazed in wonderment as I did at the disconnect between the recent astronomical house prices and the government's reported inflation figures. Basically, the government has diddled the reported inflation numbers to the point that they no longer reflect reality. They are an ivory tower dream.

Actually, if house prices increase fast enough, renting the house is not even a necessary aspect of the investment equation. Rents go to zero. Consequence? Builders build simply for the sake of investors who have no intention of ever bothering to occupy or rent the property. But suppose the government inflation numbers had truly reflected the true cost of housing over the last few years by including the house prices. I suspect the Fed would have set interest rates much, much higher in an effort to control the indicated inflation. The excess liquidity that the housing bubble required would have been greatly reduced or simply would have been unavailable. Speculating on house prices would not have been nearly as profitable, and the overbuilding would not have occurred.

Unfortunately, that did not happen, and we have now created a situation where not only is the rent/buy decision is grossly out of balance, there is a huge overhang of superfluous housing. Recall, that, as a group, our population wishes to expend only a relatively stable, almost fixed fraction, of total national income on housing. Basically, we thought we could get much more housing for our fraction of personal income than was truly the case. Faulty inflation numbers were distorting the equation. Without a projected house price increase of 10% or more per year injected into the rent/buy equation along with the resulting artificially suppressed interest rate, the true cost of housing must be set at a level much greater than the population is willing to support. No question, we are now severely overhoused. Declining house prices will only aggravate the situation. Declining prices artificially tilt the equation in the direction of renting and an even lower demand for houses as investment. Only a really stupid investor/renter would invest believing his investment will be losing money.

OK, what happens next? What will stabilize house prices? Back to Econ101. The rent/buy decision must come into balance. Equilibrium can be restored by either lowering house prices or by raising the prices of everything else. People are looking to government to "do something." Seems to me what government has already done is pretty destructive, but let's look at the factors to see if they can bail us out. Property taxes, insurance, and physical depreciation/upkeep are relatively fixed. Not much can be done with those. No-one is so foolish as to think the government can dictate house prices. So that leaves the only factor the government can effectively manipulate: the interest rate on the capital invested. The Fed is trying valiantly to do just that, but the banks are not cooperating. Home loan rates remain stubbornly high. Banks and other long term lenders understand that you cannot set interest rates in one area of the economy without affecting all areas. Yes, low interest rates could eventually bring the equation back into balance, but only by increasing the price of everything else. Inflation is the guaranteed final outcome. Lenders think, "Why should I tie up capital in decades-long loans if inflation will just eat it away?" Still the Fed owns the money printer, so they can do the job of inflating everything else whether the banks and fixed income investors like it or not.

The question we must ask ourselves at this point is, do we really want inflation of everything until it matches the housing price inflation of the last few years, or would we prefer deflation of house prices to match current prices in the larger economy? In other words, Who pays for the government's error, homeowners, lenders or maybe taxpayers? Whatever happens is going to be painful for someone. With the idea in mind that painful adjustment in the rent/buy equation is coming no matter what anyone does, I think it's only fair that there be some pain for both homeowner/investors and lenders. House prices are going to have to come down somewhat, and the general price level including rents must go up somewhat until a stable balance between renting and buying is restored.

Also, the entire infrastructure for producing and financing housing has grown much too large, so many of the companies and individuals involved will have find ways to redeploy themselves to new ends. Homebuilders will have to reduce the size of their operations as the consolidation proceeds. Home builders are used to these ups and downs and seem better prepared than lenders who seem to be suffering an outright depression.

Both homeowners and lenders are paying for the bubble, however, I fail to see why innocent taxpayers should be asked to bear any of the burdens. The government must do what it can to make sure we do not fall into depression in the process of making these painful adjustments, and certainly new, well thought out government regulations are not necessarily a bad thing. Nevertheless, government actions usually make matters worse.

While the stocks of builders and lenders have been badly beaten up, anyone who believes stabilized house prices will return the good times to the housing markets is going to be very disappointed. Stability is going to be dull and recovery will be slow. Still there is money to be made if one is clever enough to pick the bottom and then willing to be patient.

There is however one critically important action government must take to stabilize the housing markets: Make sure that housing inflation numbers convey meaningful information, not the "rents" that are currently reported. Regardless of what else is done, unless the perverted inverse relationship between government reported housing costs and the real cost of housing is corrected, the housing market will remain unstable and prone to boom/bust cycles. For example, the decreasing house prices we are now experiencing will likely result in increasing nominal rents which will end up being reported as increasing inflation which is likely to cause the Fed to keep interest rates higher than they should be thereby driving us solidly into further declines and probably spread real depression to the rest of the economy. This is a positive feedback situation and positive feedback guarantees unstable, usually oscillatory behavior.

Disclosure: I hold long positions in SPF and WB.

Comments

[nickgogerty]

affordability. A capital asset is only worth what someone can pay. nickgogerty.typepad.co...

[76s]

Brilliant.

[keithp]

Well-reasoned relationship between price / rent, but misses the fact that "all real estate is local". In economically depressed areas, as prices fall rents won't rise because people (most particularly renters) will leave the area for the more economically active areas. Putting increased downward pressure on prices, but there you have it - the demand is for housing where the jobs are less than it is for jobs where the houses are.

[dckleins]

I'm really glad you wrote about this topic. My wife and I have been looking to buy in the Chicago area, but we knew we were going to be moving in about 5 years time. I became obsessed with the idea of "renting vs. buying" and build an "all-in" model to compare the breakeven points between buying and renting. What my model basically showed me was that once you've factored in interest, closing costs, tax effects (property tax AND personal deduction), assessments, insurance, appreciation/depreciat... and selling commision, if you compare that to what you could earn by investing your downpayment at a nominal rate, and saving the difference between rental rates and the "all-in" buy rate, you almost always have to live in a house for longer than 15 years with a 30-year mortgage to have it make sense to buy. If you use a 15-year mortgage (does anyone?) you can cut the breakeven point to about 7 years for an average property.

But, what's interesting is to compare this to average homeowner statistics, particularly urban. Anecdotaly, most people I know in Chicago live in a home for 3-5 years, and they all swear they made money when they moved out. That may be...

But, once they remove all of the external costs of buying from the pure nominal appreciation (particularly by removing the closing closing costs and selling commission) their returns are dwarfed by what could have made had they just put their money in a money-market account...and would have had returns with substantially less risk than owning.

[GlobalWarmingExaminer]

The Fed is printing money and the government is going to start pumping large amounts of cash into the economy in May. This and low interest rates will cause an expansion of credit and inflate our economy. Prices for all fixed assets (like houses) will rise and bail out homeowners and the banks.

The question is: Who will the losers be? The simple answer is all the people that own debt like money market funds, bonds, annuities, and people on fixed incomes like retirees. BTW - this includes all of the foreign holders of US debt, who have been keeping their currencies artificially low to promote exports to us. They also hold a lot of the paper backed by mortgages as this was a way they could recirculate their dollars and earn returns higher than the low US government rates.

[GaryD]

(1) If rents start to rise, the government economists will probably re-jig their calculations to show lower inflation. I doubt that they will ever over-report inflation. (2) It is always easier for the government to punish taxpayers than tax consumers because they complain less. My guess is that we are in for a good round of inflation in order to transfer wealth to the borrowers/lenders. They are, after all, the ones who play the game.

[BasicFinance]

Why did everyone ASSUME that house prices would continue to appreciate? If you take that assumption out, the rent/buy equation would have told people to stop buying a long time ago, even if interest rates were not properly adjusted higher to counter higher inflation. So..ultimately it is NOT the economists who are to blame, but those housing speculators who never even bothered to do the rent/buy calculation you describe. Right now I rent an apartment for $3000/month that would cost me $1,000,000 to buy. How low would interest rates need to be to justify that buy decision? The numbers so heavily favor "rent", I'm not sure tinkering with the inflation numbers and its associated rise in interest rates makes any difference (or would have made any difference 3 years ago). All your solution would have done is to change a RATIONAL rent/buy decision from "you are an IDIOT if you buy" to "you are a TOTAL IDIOT if you buy."

[jimmy46]

analyst is only one here who understands the situation.

as for the idea you have to live in a house for 15 years
to break even, that's never been true.

Before Johnson/nixon, the rule was 5 years,
then with inflation it was shorter

[galeth]

The problem with your statement that the economists/federal reserve are stupid and lazy is that they don't actually use the CPI to make their inflation/rate decisions...they use the U.S. core PCE price index which accounts for housing costs differently and, I believe, more accurately. They are perfectly aware of the difficulties you describe regarding the CPI.

[johngonole]

I did a cash flow analysis on purchasig a property to buy and then rent out back in 2003. I'm conservative but I think I assumed 0% price appreciation. The annual return on my investment would be lower than what I could expect from the stock market, bonds, etc.. without any worries or work. In the end I decided to wait for prices to fall before investing in real estate. Bad decision since prices went way up due to the Fed etc... Return on investment could be helped somewhat by increasing the leverage (that is putting less down on the property) but if one analyzed it as I did with the idea of paying down the property quickly the rent/price ratio said it was a bad move or at least a lot of work for little gain.

Your article is right on the spot about the deceptiveness of the inflation numbers and it is what led to the Fed deceiving themselves or self deluding themselves into the idea that ultra low target interest rates were a good idea. They were not. I think of course they knew this all along but at some point the Fed and the government thought risking any recession at all was a bad idea. Mild recessions are good in that it should be part of the natural cycle where consumers and businesses eliminate debt. Of course this reduces the money supply which creates deflation. The Fed has an unhealty fear of deflation. I think this phobia will eventually cause a huge deflationary spiral once people a business borrowing capabilities are simply tapped out or they will simply print the money to zero.

Without the assumption of real estate property appreciation most would have stopped investing in multiple properities to rent out back in 2003 as prices were even getting high back then. The rent was simply paying for the costs. Any profit was locked into the real estate appreciation and it became a self fufilling prophecy backed by easy credit and speculation frenzy. Now that has to unwind and it I personally think it is going to be paid for by the savers and those with assets based on the dollar. The govt and the Fed always screw the responsible class thus creating more irresponsibility.

The article was right on.

[DonPaulOlshove]

For Keithp -

Yes, this article leaves out a great deal and still is too long. Yes, all RE is local, but the total aggregate demand for our nation is pretty fixed. Those people leaving one area simply boost demand (and rents/prices) in the area they move to. In a stable, nationwide RE market, these forces will balance out as capital flows from one area to another. If the gov would track the aggregate national demand and resulting prices properly it would solve many problems.

Another related and very important factor that is not adequately addressed in the above discussion is that all RE is continuously depreciating and must be replaced on a regular basis. I make the rate of actual physical depreciation to be about 2%/year. In other words, about 2% of the housing in any stable area will need to be rebuilt every year. Of course, much of this building is maintenance of existing building. Nevertheless, as a consequence of the ongoing depreciation, even those areas are depressed by jobs and people that have left the area will eventually recover to the cost of construction for housing in that particular area. - If you can wait that long. In a truly stable housing market, the cost of construction is the dominate controlling factor. You can't get too much above this or builders simply build more houses. You can't get too much below this because existing houses are continuously evaporating and the supply of houses eventually falls to meet the demand.

For dckleins -

I am not familiar with the Chicago area RE market, but I would guess that the details of RE returns/losses for the next couple years are going to be dominated by market swings, and you should probably not base your decision on a calculation that begins by assuming stability. The immediate future may turn out be a grand opportunity to nail down a big chunk of equity that you can take with you when you leave Chicago depending on what programs the gov offers to home buyers. One things sure, the gov is not going to let the whole economy go down in flames, so easy money (general inflation) seems guaranteed at this point and house prices will not be allowed to decrease dramatically. I hope you allow for a big enough inflation number in your model. Gold prices tell you what others are expecting. A person's personal residence makes a better real asset holding than gold.

That said, I would also suggest that many people come out ahead by owning a house because it is an enforced savings plan so they don't end up spending the money they could have invested elsewhere.

In any case, this is a complex investment that is unique to each buyer and each property. Any local property market will contain many houses distributed on a bell curve of pricing. This is not like a stock where every share is exactly the same as every other share. You can't slap a coat of paint on your GE shares and get a higher price for them. It is entirely possible to buy a particular house low and sell it high even though the nominal prices are unchanged simply by mowing the lawn and cleaning the kitchen and bathrooms. This can be greatly amplified by serious personal efforts put into what is commonly called "sweat equity."

For Analyst -

Yes, the price of everything other than houses will increase until this equation is back in balance. Whether this is at the current level of house prices, the lower 2001 prices, or the much higher 2006 level is yet to be seen. In order to bail out the most extreme cases I see would require a level of money creation that, in itself, would crash the economy. I think the gov is smarter than that, but you never know. Some of us still remember the 70s. Not fun.

[dalefromvail]

Interest rates lower...housing prices higher. The low interest rates caused the problem.

[User 171325]

When one rents an apartment, as I've done for 25 years, and moves, no profit is ever made, and I'm including any amount of the previous total rental paid. When one owns a home, typically, a portion, if not all, and in other than the bubble bursting (now), a profit is made..with the resultant taxes, if above the 250,000 or 599,000 limits. I'd like to know the amount paid to the IRS these past 10 years in taxes by homeowners? That would tell the real story. A renter simply gets nothing back..perhaps a bill for any damages in the property (to carpets) caused occasionally by pets. There is something else to consider. A long time ago, a local real estate broker advised me NOT to purchase a home for investment purchases. It's all about living in the home, and enjoying the privacy, space, furbishing to ndividual tastes, etc. I don't know about Chicago or any other place, but a rental on a 1m dollar home here is much more than 3,000 month., closer to 7,000 to 10,000. One thing about considering other investment assets, they are speculative. Just take a look at the price of Motorola or Ford..this past year. I bought silver during the 80s at 25.00 Morgan Dollar. For years it went down after the Hunt brothers debacle. 30 years later, it's back up to 19.00. Go figure. It's still a loss. The real problem with the bubble was allowing people with the American dream to live beyond their means, or on wishful thinking. It burst, as we know.