Are We In A Housing Bubble?

Includes: ITB, PKB, XHB
by: Acting Man

There is no official definition of a housing bubble. For this post, I offer the following definition:

A housing bubble is an unsustainable market condition that will end with a pop.

There are plenty of unsustainable market conditions, but not all will end with a pop. For example, Silicon Valley has been appreciating at an unsustainable pace, but it likely won't pop, because home owners in the region have good jobs and sufficient equity, either via large down payments or built up over time. Even if property values decline, it is unlikely to trigger massive defaults, just a lot of grumbling at cocktail parties.

On the other hand, the sub-prime bubble was an unsustainable market condition that relied on unsound lending practices. It also had to pop, because the loans at the time typically had a two-year teaser period. Rolling over the loans required substantial price appreciation to cover all expenses, plus an imaginary profit to keep the scheme going. We knew that ended with a loud pop.

So, are we in a housing bubble today?

Let us first address sustainability. Six years of relentless Fed accommodation and government intervention resulted in double-digit appreciation for the last couple of years. This is clearly unsustainable, but the question is, will it pop?

During the twelve months ending May 2014, Southern California had 230,744 sales, out of which 65,231 (28.0%) were cash transactions and 61,923 (26.8%) were sold to investors. This data is from DQNews, a very reliable source using actual recordings. We know Southern California is not alone. Many metro areas have even higher numbers of cash buyers and investor prevalence. Regardless of how bubbling prices may appear, this is a significant group that provides a buffer against another sub-prime style pop.

Entry Troubles

The picture is not as rosy on the entry side. For evidence, look no further than the battle over the DTI (debt-to-income ratio) benchmark as a prudent underwriting standard. In one corner is the CFPB (Consumer Finance Protection Bureau), the total-waste-of-taxpayer-dollars agency, which is currently under investigation itself. CFPB somehow decided that 43% is the magic number for DTI. In the other corner is also the government, acting as conservator for Freddie and Fannie. Mel Watt, the director of FHFA, has clearly stated the agencies will continue to purchase loans with >43% DTI. Word on the street is that "more often than not", loans are underwritten with higher than 43% DTI these days, especially low down FHA loans.

Try to imagine yourself in a household with, say, $100,000 combined income, which is about double the median income, per the census bureau. If your debt-to-income ratio is 43% or higher, chances are not only will you have little savings, you may have a household budget deficit if long-term expenses such as college tuition for kids, prudent retirement contributions and rainy-day funds are taken into account. Digging a little deeper, real estate practitioners can tell you that if a borrower has to struggle to meet DTI ratios, it will usually involve paying down a few credit card accounts, or a car loan, or some form of "sacrifice", albeit of a temporary nature. As soon as the loan closes, it will be time to run up credit again for that fancy granite counter top that one cannot live without. In other words, a 43% DTI at closing is likely to be higher within a few payments.

Don't forget renters. The rent-to-income ratio is even worse. Case Shiller just reported another double-digit appreciation month for the top 20 cities. Average income is lagging behind by a margin that is impossible for most renters to overcome. This is a long-term negative phenomenon for society and community building, since renters do not have the same sense of belonging or pride of ownership.

The indispensable McMansion addition

Bubble not Big Enough?

However, regardless of how high real estate prices continue to rise and how unsound lending practices are, it is unlikely that the real estate market will pop. On the one hand, there is the support of cash buyers and investors. On the other hand, is there any doubt that if defaults edge up this time, Mel Watt's FHFA will be reducing principal amounts? After all, the CFPB has predetermined that it will never be the fault of borrowers if they cannot make payments. In the middle, there is Ms. Yellen. In her recent Economic Outlook presentation to both the Congress and Senate, she made this statement:

"One cautionary note, though, is that readings on housing activity-a sector that has been recovering since 2011-have remained disappointing so far this year and will bear watching."

I have no idea what is disappointing her. Double-digit appreciation in a supposedly sub-2% inflation world is not enough? It does not matter what she sees, all we need to know is she won't let the real estate market crash on her watch.

In conclusion, I believe future real estate will be separated into two classes. For those who can afford it, a home is a luxury, an enjoyment. For others, housing will simply be shelter, a roof overhead. More and more people won't be able to fulfill the American Dream of home ownership, especially that dream home. If we can isolate real estate, I opine that we do not have a housing bubble that will pop.

The market is more like a balloon that will deflate as the quality of housing continues to deteriorate for the masses. Housing bears may have to look for extraneous forces that may drag the housing sector down, and there are plenty. Children of the millennials should not be expecting media rooms or game rooms. They may have to adjust to just a bedroom, one that they have to share with a sibling or two.


Janet Yellen: Worried that housing isn't bubbly enough