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How a Housing Bubble is Created and the Oncoming Housing Bust

|Includes: FMCC, iShares U.S. Home Construction ETF (ITB)

 

The financial crisis in 2008-2009 had many malicious consequences.  Yet, in searching for how the financial meltdown occurred, the scope and logical causalities have generally been overlooked.  I believe that an unnatural disruption of the causal relationships within the housing market culminated with a housing boom that went bust, thus impacting the financial world.  How and why housing is on the ropes can be explained through simple, logical reasoning (i.e. the science of economics).

For an economy to exist, consumers demand basic needs of food, shelter, and clothing (this also includes other safety elements like defense and medical needs).  These basic demands, along with ancillary consumer demands, drive a need for production of goods and services.  Thus, goods and services are supplied by a producer because they are demanded by the consumer.  The economy must have some element of production before it can consume.

The typical Mr. American satisfies his needs by providing labor to a company that pays him wages.  The company that Mr. American works for can only employ him if the company itself can profit from his labor.  Both the worker and company benefit.



In this very basic economy, the Mr. American produces something, earns wages, and then uses his wages to consume.

If Mr. American chooses to save some of his wages, he can position himself to pursue “the American Dream.”  The American Dream, as it’s been told, is the goal that every American family should have a house with a white picket fence, 2.2 kids, and a dog.  The fallacy that every American should purchase a house is the underlying factor in the housing boom (and bust). 

Since Mr. American has wages (from producing other goods and services), and managed to save some of those wages, he can choose to demand a nicer shelter in the form of a house.  The house is produced (supplied) by a homebuilder; the homebuilder earns a profit from constructing and selling the house (product).

However, since houses are an incredibly pricey (relative to the wages that Mr. American earns), Mr. American desires financing concurrently with his demand for a house.

A bank can supply financing to Mr. American with a loan; in return, Mr. American agrees to repay the loan plus interest to the bank.  The bank is compensated for risking its capital (providing the loan to Mr. American) by earning interest.

Here we have a great economy!  Mr. American provides labor and earns wages.  The company that employs Mr. American pays wages to enable subsequent profit.  The need for financing and a house are met by a bank that risks capital and a homebuilder that supplies the home; both the bank and homebuilder profit from their actions.  Every entity (Mr. American, his company, homebuilder, and bank) produce something that is desired.  This is an efficient economy and maximizes consumer value.

In this ideal economy, every entity that participates, including Mr. American, has bettered itself through a free exchange of goods—each participant gave something (produced) so that it could better itself (consume).  However, there is one entity that does not contribute a desired product to the economy, yet consumes from it.  That entity is the U.S. Federal Government.

The government interferes with economic markets in a handful of ways, almost always to the detriment of consumers.  The consumption of government is not limited to elected officials, but signifies all entities that benefit at the expense of the producing consumer (Mr. American).  This includes recipients of government subsidies/domestic spending, unions, stakeholders of bailed out companies, and other special interest groups, including homeowners.

With regard to the housing market, the government interjects itself to enable as many Mr. Americans as possible to purchase houses.  Even if Mr. American did not provide labor to earn wages, had enough wages saved, or was worthy of bank financing, government filled the void.

First, through the actions of the Federal Reserve, interest rates were/are set at an abnormally low rate.   If Mr. American couldn’t pay a normal rate, but could pay a lower rate (with the government subsidizing the difference), then more Mr. Americans would purchase homes, and more homes could be built.

Second, with public/private entities Fannie Mae and Freddie Mac, the federal government guaranteed mortgage loans on homeowners.  With a government guarantee on the mortgage loan, banks were able (and encouraged) to make scores of additional housing loans, which unnaturally fueled the housing market.  With a government guarantee and bank financing, more homes could be built.

Third, politicians and lobbyists concocted an idea to further reward home buyers (at the expense of current homeowners and non-homeowners) with a homebuyer tax credit.  Their misguided philosophy was to satisfy the need to stabilize the housing market.  However, this policy does not create any meaningful stability since it pulls demand forward and temporarily increases housing prices (or perhaps just slows their decline).

The “benefits” that the government “produces” must come from somewhere.  Indeed, the government cannot give things away without taking them from somewhere else (though it is trying via currency devaluation).  So, government must take from the productive engines of the economy—consumers and producers—via personal and corporate income taxes.  However, the government appetite is larger than the tax base provides.  So, government must continue funding its advance by borrowing from foreigners, mainly China and Japan.

Once these external factors are considered–both government interjection and extraction–a housing boom is born.

 

I present four arguments for how the current housing boom will falter.

First, low interest rates cannot exist indefinitely.  Homeowners who chose Alt-A and Option ARM loan products are seeing their rates begin to reset at higher levels.  Rising delinquencies reflect the pressures of increased rates and an inability to pay mortgages.  When delinquencies turn into foreclosures, there will be a decreased demand for houses AND an increased supply of houses.

 

Second, the cessation of the extended first time homebuyer tax credit will siphon off the political game of artificially creating demand.  Decreased buyers will be a challenging for homebuilders to manage.

Third, continued unemployment, and underemployment, may cut right at the heart of the economy.  Recession or not, there are many variables that are involved with economic downturns; I believe the current tax structure and labor laws are clearly contributors (even though labor rigidity is much worse in Europe).  Regardless, continued weakness in an economy will decrease demand for homes.

Fourth, decreased funding from abroad (less demand for US Treasuries) would either raise US interest rates or force America to become fiscally astute (or devalue the currency).  I am more than willing to bet on an increase in rates (in combination with currency devaluation).  Even recently, we’ve seen modest declines in amount of Treasury Securities that China holds.  A rise in rates would strangle consumers’ desire for financing large purchases, thus decreasing demand for homes.

 

All of these factors ultimately put black eyes on current beneficiaries:  homeowners and homebuilders.  Both parties, having enjoyed a multiyear run, will experience negative consequences down the road.



Disclosure: The author provides labor to a bank, which compensates the author with wages, which are then used to consume rent. The author has investment positions that are short ITB and FRE. The author also has family members short ITB.