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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.

Source: How Ivory Tower Economists Created the Housing Bubble