I have great respect for many in academia. Some of them actually know what they are talking about. However, I am dismayed whenever I read poor reasoning and a faulty interpretation of data by someone passing themselves off as an expert. It tarnishes the image of academics everywhere.
Irvine Home Address … 27 STARVIEW Irvine, CA 92603
Resale Home Price …… $2,999,000
I practice every day to find some clever lines to say
To make the meaning come true
But then I think I'll wait until the evening gets late
And I'm alone with you
The time is right your perfume fills my head, the stars get red
And oh the night's so blue
And then I go and spoil it all, by saying something stupid
Frank Sinatra — Something Stupid
When economists who have no idea what they are talking about get published, it diminishes the entire profession. The gentleman I am picking on today simply has no concept of the underlying causes and motivations of real estate market participants. To start, I want to show one example of his lack of understanding with a paper he wrote about commercial real estate.
A few economists have likened the commercial real estate market of the last 10 years to the housing cycle. In fact, the commercial and housing markets were fundamentally different.
As recently as last week (see also here), Paul Krugman claimed that the commercial real estate market followed a bubble much like that of the housing market, and thereby concluded that the housing bubble could not be blamed on anything unique to the housing sector.
Mr. Krugman observed that real estate prices went up, and then came down, in both the residential and nonresidential sectors. For example, he has presented the chart below comparing the Case-Shiller index for housing prices with a commercial real estate price index from Moody’s.
In Mr. Krugman’s view, both “bubbles” had some of the same determinants. For example, lenders were hungry for risk, and they fed their appetites by investing in a variety of assets, like houses and office buildings. Thus, he takes comfort in his observations that the two sectors had real estate prices that moved roughly together.
For the record, Paul Krugman is correct. The commercial real estate bubble was caused by the same stupid lending as the residential real estate bubble. There are differences between the two markets which is why their correlation is not perfect, but the severity of the price declines in both markets were a direct result of stupid lending.
I have long disagreed with his interpretation, arguing instead that the housing and commercial real estate cycles had very different determinants. Housing boomed for residential-specific reasons, such as technical change biased toward homes, home-buyer optimism or lax home-mortgage standards.
The housing price boom led to a jump in home construction, which pulled resources (workers, materials and land) away from the commercial sector. Commercial real estate construction was low during the housing boom and began to recover only after 2005, once housing busted and construction workers and other resources were free to work on commercial projects. (The commercial recovery in 2009, however, was limited by conditions in the wider economy, like the fact that fewer businesses were hiring and therefore in less need of space in which their employees could work).
Here is an example of the author not knowing what he is talking about. Commercial and residential construction workers are not interchangeable. In fact, very few commercial construction personnel at any skill level go back and forth between the two. The skills required to build commercial construction differ from those required in residential. The office work is also very different. A developer of commercial projects is not going to hire a residential specialist to analyze the deal, supervise the construction, or perform other tasks related to the project.
If Mr. Krugman were right, construction activity should have boomed (and then busted) at more or less the same time in housing as in commercial real estate.
Why? He is making a bad, straw-man argument here, and simultaneously displaying his lack of understanding of the relationship between commercial and residential development. Commercial spending always lags behind residential spending. Look at retail for example; if developers want to build a shopping center, they wait until there are sufficient customers living in an area before proceeding. Commercial developers will tell you that rooftops drive demand. Residential development must come first and commercial follows. What is the first type of construction you see in the hinterlands? Housing. Once there is enough housing, retail and office follow. That is how development works.
Thus, one way to distinguish my hypothesis from Mr. Krugman’s is to look at construction activity separately by sector. The chart below displays monthly private residential and nonresidential construction spending from January 2000 to October 2009.
Of course, housing construction spending increased dramatically during the housing boom (2002 through 2006), and collapsed during the bust.
The charts he calls evidence of his hypothesis are actually evidence of his ignorance. The lag between residential and commercial can be traced back through many cycles. Any good economist would know that.
Apparently, Mr. Mulligan is trying to position himself as an outsider. From his writing, it appears he believes in the efficient markets hypothesis. That may explain much of his ignorant drivel.
Casey B. Mulligan is an economics professor at the University of Chicago.
Adjusted for inflation, residential property values were still higher at the end of 2009 than 10 years ago. This fact raises the possibility that at least part of the housing boom was an efficient response to market fundamentals.
Whoa. Wait a minute. A hidden erroneous assumption is in play here, and it undermines everything that follows. The foundation of this professor's argument is built on a false premise: the housing market has not bottomed. What you are about to read from Mr. Mulligan is based entirely on the assumption that house prices have bottomed, and worse yet, they have bottomed because prices have found support in market fundamentals. Both assumptions are wrong.
Inflation-adjusted housing prices and housing construction boomed from 2000 to 2006 and crashed thereafter. Commentators ranging from President Obama to Federal Reserve Chairman Ben S. Bernanke have described that cycle as a “bubble,” by which they mean that, at least in hindsight, the housing price boom was divorced from market fundamentals.
But maybe there was a good, rational reason for housing prices to increase over the last decade.
Let’s consider first what it means to believe that the spike in prices since the late 1990s was unwarranted — the so-called “bubble theory.”
Do you read a subtle condescension in his statement? I do. Perhaps I should refer to his so-called market bottom and so-called market fundamentals.
According to the bubble theory, for a while the market was overcome with exuberance, meaning that people were paying much more for housing than changes in incomes, demographics, technology and other basic factors would suggest.
Now that the bubble is behind us, people today should be no more willing to pay to own a house than they were in the late 1990s. (It’s true that population has grown since the 1990s, but population growth is nothing new and should not by itself increase real housing prices. Don’t forget that greater population also means more people available to do construction work.)
Eureka! He openly states his false assumption. The bubble is not behind us. Notice how he slipped it in as an unimportant preposition at the beginning of his argument as if the idea were accepted fact.
Bubble theory also implies that the technology for building homes and providing housing is not very different today from what it was in the late 1990s, and so you couldn’t blame the spike in prices on changing building technologies either. In other words, the bubble theory blames rise in prices on animal spirits, and not on any “legitimate” increase in building costs.
Meanwhile, bubble theorists also say that today America is “overbuilt” as a result of the bubble. With too much housing and no additional demand to be supported by market fundamentals, real housing prices should, according to the bubble theory, be lower today than they were in the late 1990s.
Wrong again. Inflation adjusted prices may or may not be lower when we really do reach the bottom, mostly due to financing terms and interest rates. If we had interest rates to match 1997, we would almost certainly bottom at prices at or below inflation adjusted levels of the late 1990s. Further, as someone who writes frequently about bubble theory, I haven't read any prominent bubble theorists make the assertion he says we do. In short, he is setting up the straw man.
A reasonable estimate, based on bubble theory, is that housing inventory is about 3 or 4 percent above what it would have been without the bubble and without the temptation to overbuild. In order to make these excess homes worth buying, prices need to fall further; economists would generally estimate that an extra 1 percentage point of housing inventory requires a matching 1 percentage point decline in price to make those excess homes look like a good deal.
So if we believe we had 3 or 4 percent more homes than we really needed last year, based on market fundamentals, that means that housing prices would eventually be about 3 or 4 percent below what they were before the bubble, to make those extra houses worth purchasing.
What economists have made such a correlation? I haven't read it. Of course, I don't spend my days reading drivel from economists, but I see no reason such a correlation would hold true. Prices need to fall until they are affordable. Once they are affordable, lowering price further would stimulate some additional demand, but it would take prices to drop to cashflow investor levels to really bring in money to mop up the mess. The linear relationship he describes isn't reality. Again, the remainder of his analysis is built on a straw man argument.
I’ve plotted this path out in the blue series in the chart below. It shows the housing price path one might have expected for 2009 and beyond if housing demand had returned to about where it was before the housing boom.
A note: Here housing prices are measured according to the Census Bureau index, which dates back far enough to observe previous cycles, and adjusted for inflation using the Bureau of Economic Analysis’s price index for personal consumption expenditures. The index is normalized so that it is 100 in 1994-97. In other words, a value of “100” for today would mean that inflation-adjusted new home prices were no different today than they were then.
According to the blue series, created using the “bubble theory” premises, real housing prices would be 3 or 4 percent lower now than they were before the housing boom (a value of about 97 for the index) if in fact housing demand were no different, because the “overbuilt” inventory of houses is supposedly 3 or 4 percent greater now than it was then.
This path approximates what some bubble theorists were expecting last year. For example, during the first half of 2009 Professor Robert Shiller (the same Shiller from the Case-Shiller housing price index) forecast that housing prices would fall further.
Yes, the path he outlines in blue is what would have happened if we didn't have massive government intervention including a plethora of bailouts, tax incentives, loan modification programs, and direct purchase of mortgage debt by the Federal Reserve. Do those measures strike you as "market fundamentals" that put a durable floor under pricing?
Of course, our population continues to grow, so the housing boom’s excess inventory will not last forever as new households form. But this process takes a while, which is why the blue series in the chart shows real housing prices returning to normal (a value of 100 for the index) only slowly after 2010.
Now let’s turn to the black series in the figure, which shows actual housing prices.
Contrary to the blue “bubble theory” series, actual housing prices have risen slightly over the last four quarters, so far remaining well above what they were before the housing boom. Although real housing prices are sharply off their highs, today they appear high by historical standards.
That is accurate. It is also the best evidence of the fact that the housing bubble has not deflated yet.
Bubble theorists might say that some unfounded optimism lingers in the market place, and that Professor Shiller was just a little early in predicting that real housing prices would soon be significantly below what they are now.
But another interpretation is that a large fraction of the housing price boom was justified by fundamentals (and next week I’ll consider some of the specific fundamentals that may have permanently increased housing demand in the 2000s). If so, we are probably asking too much of the Federal Reserve and other regulators to accurately disentangle bubbles from fundamentals the next time that asset prices rise.
I am eagerly awaiting Mr. Mulligan's next installment. It will be difficult to come up with a worse analysis than the one he provided in this article, but I have faith in his inability to grasp the problem or to correctly identify market funamentals. But since I am a nice guy, I will give him forewarning on what market fundamentals are.
- Income. People make housing payments from their wage income. If prices rise faster or slower than incomes, it is due to the influence of other market fundamentals, but wage income is the basis.
- Debt-to-Income Ratio. When lenders calculate how much they will loan someone based on their income, they apply a debt-to-income ratio to calculate the affordable monthly payment. Experience with lenders has shown that DTIs in excess of 32% are prone to very high default rates. Do you remember the first round of loan modifications done at 38%? All of those people redefaulted. The latest round is down to 31% because lenders know this level to be high but stable.
- Amortization method. Loans must amortize and be paid off over time. Option ARMs were among the first casualties of the credit crunch, and interest-only ARMs were finally discontinued in 2010. These are Ponzi loans, and they are largely responsible for the bubble.
- Interest Rates. Once lenders know a monthly payment, they apply a market interest rate to calculate the maximum loan balance they are willing to loan. As we all know, interest rates are at historic lows, and we are just on the backside of an unprecedented Federal Reserve program to lower mortgage interest rates. Back in the late 90s, interest rates were 7% to 8%. Now they are at 5%. Is that a change based on fundamentals?
I consider the above list to be fundamentals because each of these variables directly impacts the individual borrower, and it is the collective action of individual borrowers that creates a market. Prices rise to the level of aggregate loan balances. I also favor these as fundamentals because they are measurable. This isn't a vague idea about animal spirits that cannot be measured.
Irrational exuberance is certainly real, and as a motivator, it did cause the housing bubble. Fortunately, rather than being an abstract and unmeasurable factor, the results of irrational exuberance show up in debt-to-income ratios and amortization methods. Borrowers are stupid, and they will borrow money under very unfavorable terms. For evidence of that look at pay-day loans. Lenders are supposed to control borrower's animal spirits. When they don't, we inflate massive housing bubbles.
I could see Mr. Mulligan's next installment being full of fancy macroeconomic charts and graphs for what he will call fundamentals. Things like GDP growth, household formation, vacancy rates or any of a number of interesting but completely useless housing market indicators. An argument can be made for nearly any measure of economic activity as being a housing market fundamental because most of this will in some way impact the real fundamentals I outlined above.
Mr. Mulligan needs to take a mulligan, this study is a complete do over.
Pretending in style
Sometimes I wonder what borrowers had to do to induce lenders to give them so much money. It must be a convincing story when lenders shell out a couple of million dollars.
Based on the HELOC abuse, anyone could have temporarily made the payments from the borrowed money. It wasn't very difficult to live like a Ponzi in these high-end properties. It didn't require any wage income.
- Today's featured property was purchased on 11/22/2005 for $2,514,000. The owners used a $1,500,000 first mortgage and a $762,207 HELOC, and a $251,793 down payment.
- On 8/23/2006, the owners refinanced with a $2,240,000 first mortgage and obtained a $250,000 HELOC. At that point, they had withdrawn all but $24,000 of their down payment.
- On 2/13/2007, Countrywide gave them a $500,000 HELOC.
- Total property debt is $2,740,000.
- Total mortgage equity withdrawal is $477,793.
- Total squatting time is at least 8 months.
Recording Date: 04/13/2010
Document Type: Notice of Sale
Recording Date: 01/08/2010
Document Type: Notice of Default
It will be very tempting to buy a really high-end property with liar loan next time around. Once your in a property like this one, they won't throw you out because lenders are loathe to take a loss. Plus, when a high-end property appreciates, a 10% gain is much larger in absolute dollars than a normal property. Therefore, the more you extend yourself, the more HELOC money you get to spend.
The extra spending money and squatting in luxury are powerful inducements to do something totally financially irresponsible.
We are all learning the lessons of the Great Housing Bubble.
Irvine Home Address … 27 STARVIEW Irvine, CA 92603
Resale Home Price … $2,999,000
Home Purchase Price … $2,514,000
Home Purchase Date …. 11/22/2005
Net Gain (Loss) ………. $305,060
Percent Change ………. 19.3%
Annual Appreciation … 3.9%
Cost of Ownership
$2,999,000 ………. Asking Price
$599,800 ………. 20% Down Conventional
5.07% …………… Mortgage Interest Rate
$2,399,200 ………. 30-Year Mortgage
$625,930 ………. Income Requirement
$12,982 ………. Monthly Mortgage Payment
$2599 ………. Property Tax
$567 ………. Special Taxes and Levies (Mello Roos)
$250 ………. Homeowners Insurance
$420 ………. Homeowners Association Fees
$16,818 ………. Monthly Cash Outlays
-$1911 ………. Tax Savings (% of Interest and Property Tax)
-$2846 ………. Equity Hidden in Payment
$1190 ………. Lost Income to Down Payment (net of taxes)
$375 ………. Maintenance and Replacement Reserves
$13,626 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$29,990 ………. Furnishing and Move In @1%
$29,990 ………. Closing Costs @1%
$23,992 ………… Interest Points @1% of Loan
$599,800 ………. Down Payment
$683,772 ………. Total Cash Costs
$208,800 ………… Emergency Cash Reserves
$892,572 ………. Total Savings Needed
Baths: 5 full 1 part baths
Home size: 6,070 sq ft
($494 / sq ft)
Lot Size: 13,429 sq ft
Year Built: 2005
Days on Market: 262
MLS Number: S586104
Property Type: Single Family, Residential
Community: Turtle Ridge
According to the listing agent, this listing may be a pre-foreclosure or short sale.
This property is in backup or contingent offer status.
PRICE FOR QUICK SALE!!!!!!Spectacular home!!! gorgeous and functional floorplan on grand scale, oversized living room and dinnig room bring back the grace of entertaining, luxurious executive home upgraded with wood floor through-out first floor, granite counters, marble baths,lots of built-ins,wrought iron staircase, 3 indoor fireplaces, exotic outdoor living with cooking island, beautiful garden, fireplace, patio,gazebo,foutains and much more!!!
This asking price is WTF too high, but we are to believe it is priced for quick sale? Give me a break. The agent is very excited as evidenced by the numerous exclamation points.
I hope you have enjoyed this week, and thank you for reading the Irvine Housing Blog: astutely observing the Irvine home market and combating California Kool-Aid since 2006.
Have a great weekend,