EclectEcon

If a politician has a net worth of, say $2 million, does it matter in what form they hold their wealth?

Suppose they have $2 million in Treasury Bills. If the gubmnt provides them with a monthly allowance to cover their rent, people do not seem to object too much.

But suppose instead they have a $2 million home. If the gubmnt provides them with a monthly living allowance to cover the implicit rent on their home (what they could have earned from renting it; or, alternatively, what they could have earned from selling the home and buying other assets such as T-bills), people get so terribly upset.

So a Brit politician sold her house merely to justify to the econo-ignorant receiving a monthly rent cheque.

The Sunday Telegraph has learnt that the Wintertons have decided to move out after being barred from claiming any more in Additional Cost Allowance (ACA) for living there. Instead, they will move into a rented flat in Westminster which will cost the taxpayer thousands of pounds a year in ACA.

Lady Winterton, the MP for Congleton, Cheshire, has written to John
Lyon, the Parliamentary Standards Commissioner, informing him that the
family trust, which owns their previous home on behalf of their
children, would now rent it out to a new tenant "at the current market
rate, as now".

And the ignorantia are upset by this.

Again, I ask, what's the difference? Why should it matter how the politicians hold their wealth? If they are to receive a rent allowance, is there a wealth test? If not, whether they own a flat/house should be irrelevant.

Addendum: The criteria for who should qualify for the ACA do, indeed, seem to open the door for some questionable activities (see this); but given the criteria, the buy-rent decision and the wealth of the MPs should not cloud the issue. Opportunity costs are still important.

It perplexed me when President Bush II enunciated a goal of increased home ownership in the US. It has always perplexed me that the US has mortgage interest deductibility in its income tax code. I can readily imagine that the vested interest group of current house owners would shriek in pain if the US were to reduce or restrict its policies which tend to increase the demand for housing. Despite myself, I cannot help but agree with Paul Krugman,

[H]ere’s a question rarely asked, at least in Washington: Why should ever-increasing homeownership be a policy goal? How many people should own homes, anyway?...

In fact, given the way U.S. policy favors owning over renting, you can make a good case that America already has too many homeowners....

All I’m suggesting is that we drop the obsession with ownership, and try to level the playing field that, at the moment, is hugely tilted against renting.

And while we’re at it, let’s try to open our minds to the possibility that those who choose to rent rather than buy can still share in the American dream — and still have a stake in the nation’s future.

Can you imagine the screams of pain, especially among people who own larger, more expensive homes with large mortgages, if the US were to scrap mortgage-interest deductibility? Can you imagine a politician being elected who promised to inflict such pain on this group? Me neither.

I've been puzzling over what happened during the past few years to lead up to the credit crunch resulting from the housing boom/bust and the subprime crisis. Everyone I knew had been concerned about subprime lending for a couple of years, and many people were worried that there might be a downturn in housing prices. So why did mortgage lenders keep granting the funny mortgages, and why did financial institutions keep buying them?

1. Lenders kept granting the funny mortgages because they could. They could grant the loans, re-package them, and sell them to other investors. They could grant the loans and get their money up front with little-to-no-risk to themselves. Also, those who actually retained the mortgage paper on their books appear to have kept mortgages which had a lower default rate than the ones they sold to other financial institutions as part of the securitized, collateralized debt instruments [CDOs] (surprise!).
2. So why did financial institutions keep buying these debt instruments if the risk of default was both systematic and comparatively large? My suspicion is that they convinced themselves these things were really quite low risk because they were insured.
3. But (double surprise!) it turns out the insuring companies appear to have done a pretty poor job of risk assessment. The risks of default for each mortgage were not independent of the risks of default for similar mortgages (duh!) and so the overall risk of the CDOs was much higher than the insurers had estimated it to be. As a result, with the downturn in the housing market, the insurers are teetering on the brink of insolvency. And once an insurer is downgraded, then the insured loan packages full of default risk will also be downgraded, and since many institutional investors are obliged to hold only AAA-rated securities in their bond portfolios, they would be required to dump all their CDOs on the market, causing some serious havoc.

That havoc was narrowly staved off for awhile yesterday as AMbac, one of the big insurers sought to increase its financial backing by selling more stock:

Ambac Financial said Wednesday that it plans to raise at least $1.5 billion selling new common stock and equity units as the troubled bond insurer tries to keep its crucial AAA rating.
Ambac shares dropped 13% to $9.27 after the announcement.
The new capital may be enough to secure the company's AAA ratings, Standard & Poor's and Moody's Investors Service, the largest rating agencies, said. Smaller rival Fitch Ratings said that if the insurer successfully raises the new capital, it still won't be enough to secure an AAA rating. The agency is planning to affirm its current AA rating after the offerings are completed.

Query #1. Why did insurers/rating agencies not see this coming? Is it because the rating agencies have a conflict of interest in dealing with the bond insurers?

Query #2: do you think the market has fully discounted the stock of financial institutions to account for the risk that there might soon be a further crash in the CDO market?

Many years ago, Stan Liebowitz analyzed the Boston Fed's study on mortgage discrimination. His finding? It was flawed beyond belief. From the NYPost (via Newmark's Door [still the first blog I read each weekday]),

...[A] "landmark" 1992 study from the Boston Fed concluded that mortgage-lending discrimination was systemic.

That study was tremendously flawed - a colleague and I later showed that the data it had used contained thousands of egregious typos, such as loans with negative interest rates. Our study found no evidence of discrimination.

Nevertheless, political correctness carried the day:

No sooner had the ink dried on its discrimination study than the Boston Fed, clearly speaking for the entire Fed, produced a manual for mortgage lenders stating that: "discrimination may be observed when a lender's underwriting policies contain arbitrary or outdated criteria that effectively disqualify many urban or lower-income minority applicants."

Some of these "outdated" criteria included the size of the mortgage payment relative to income, credit history, savings history and income verification. Instead, the Boston Fed ruled that participation in a credit-counseling program should be taken as evidence of an applicant's ability to manage debt.

Stan warned back then that such policies could lead to bigger problems in the future:

For years, rising house prices hid the default problems since quick refinances were possible. But now that house prices have stopped rising, we can clearly see the damage caused by relaxed lending standards.

This damage was quite predictable: "After the warm and fuzzy glow of 'flexible underwriting standards' has worn off, we may discover that they are nothing more than standards that lead to bad loans . . . these policies will have done a disservice to their putative beneficiaries if . . . they are dispossessed from their homes." I wrote that, with Ted Day, in a 1998 academic article.

Sadly, we were spitting into the wind.

What bothers/puzzles me is that investment bankers bought these collateralized debt instruments. Surely, even three years ago, people could see that these sub-prime mortgage packages were not bundles of independent risks but were bundles of highly correlated risks, all of which would tumble if/when housing prices began to fall. Even if the regulators forced lenders to make crappy loans, and even if the lenders fobbed them off on investors as quickly as they could, who was forcing these investors to buy the packages? Didn't they do their due-diligence and risk-analyisis?

There have been more than 7000 foreclosures during the past two years in Cleveland. Consequently, the Mayor is suing financial institutions for "at least $100m", blaming the lenders for the financial problems of the borrowers and, as a result, the entire city [source: NYTimes].

Cleveland is suing 21 of the nation’s largest banks and financial institutions, accusing them of knowingly plunging the city into a financial crisis by flooding the local housing market with subprime mortgage loans to people who could never repay.

The city is seeking “at least” hundreds of millions of dollars in damages, Cleveland’s law director, Robert J. Triozzi, said Friday. The list of defendants includes some of the most prominent firms on Wall Street, like Citigroup, Bank of America, Wells Fargo, Merrill Lynch and Countrywide Financial.

Mayor Frank G. Jackson said in an interview on Friday that the companies would be “held accountable for what they’ve done.”

“We’re going after them to get the resources we need to rebuild our city,” Mr. Jackson said.

The financial crisis has hit Cleveland especially hard, with more than 7,000 foreclosures in each of the last two years, Mr. Jackson said. Entire city blocks have been abandoned. The city’s budget has been strained by the effort to maintain thousands of boarded-up homes, and by the cost of responding to a rise in violent crime and arson.

... The Cleveland suit, filed Thursday in Cuyahoga County Common Pleas Court under the state’s public nuisance law, asserts that the financial institutions created nuisances across broad swaths of Cleveland because their loans led to widespread abandonment of homes. “We’ve torn down 1,000 abandoned houses, and haven’t even made a dent,” Mr. Jackson said.

The drop in homeownership, and a steep decline in population — to 444,000 residents in 2007 from almost a million in 1950, according to census figures — has drained Cleveland’s budget. In December, Mr. Jackson announced that the city was unable to borrow money and would be forced to postpone or permanently shelve millions of dollars in public works projects.

“The strain on our budget is too much,” Mr. Jackson said. “These companies have knowingly created a public nuisance by exploiting the city of Cleveland.”

Before proceeding with the suit, however, the city of Cleveland might want to worry about whether they will be hit with massive legal fees for having filed a nuisance suit:

• Why are the homes being abandoned? Why are there no buyers, even at repo or distress prices? It is really hard to blame the lenders for the lack of demand for housing.
• The city of Cleveland might want to look into what proportion of the defaults was due to borrower, not lender, fraud. Arnold Kling has been suggesting this possibility for at least a month.

And Tyler Cowen summarizes this view very nicely,

There has been plenty of talk about “predatory lending,” but “predatory borrowing” may have been the bigger problem. As much as 70 percent of recent early payment defaults had fraudulent misrepresentations on their original loan applications, according to one recent study. The research was done by BasePoint Analytics, which helps banks and lenders identify fraudulent transactions; the study looked at more than three million loans from 1997 to 2006, with a majority from 2005 to 2006. Applications with misrepresentations were also five times as likely to go into default.

Many of the frauds were simple rather than ingenious. In some cases, borrowers who were asked to state their incomes just lied, sometimes reporting five times actual income; other borrowers falsified income documents by using computers. Too often, mortgage originators and middlemen looked the other way rather than slowing down the process or insisting on adequate documentation of income and assets. As long as housing prices kept rising, it didn’t seem to matter.

In other words, many of the people now losing their homes committed fraud. And when a mortgage goes into default in its first year, the chance is high that there was fraud in the initial application, especially because unemployment in general has been low during the last two years.

Nouriel Roubini writes about the sub-prime mortgage market meltdown and, with considerable justification, points out that he was warning about this problem long ago.

On my modest side last August, when I started to forecast a recession in the US in 2007 by Q2 that would be triggered by the housing bust, I also argued that this housing bust would soon also lead to serious risks and distress in the financial system. I pointed out that such stress and vulnerabilities would first be noticed in the subprime segment of the mortgage market as many (but not all of) of the excesses of the last few years in mortgage finance were concentrated in this market. I pointed out that the housing bubble and the credit bubble associated with it reckless lending practices and with regulator being asleep at the wheel while this unregulated gambling was taking place. I argued that the result would be financial distress and bankruptcy for many lenders and a systemic banking crisis similar to - or most likely worse than - the S&L crisis.

Here is what I wrote on this topic last August. And a year before that, I linked to a statement by Ed Leamer that a recession would follow the bursting of the housing bubble sometime this year.

And here was my own dismal forecast from last October.

I can readily imagine US GDP growth rates of less than an annualized rate of 1% a year from now, and I just hope the Fed has enough foresight and control to keep them from turning negative.

Update:Dave Altig has much more, with some illuminating graphs, about the mortgage markets.

According to The Economist, housing shortages are causing inflation in Dubai.

Economists agree that a shortage of new homes is the root cause of inflation in Dubai today.

But the Emirates Economist disagrees:

[M]uch of the inflation has come about because Dubai, and the UAE in general, is growing and attracting investment.

In other words, the inflation has been demand-driven, in part because their currency is pegged to US dollars. He also points out that there is a great deal of residential construction going on in Dubai:

I think the number of units coming on line is beyond the needs of the market already.

Overall, the piece in The Economist does a good job of explaining why rent controls are almost always a bad idea. But John Chilton's analysis of the current situtation in Dubai is both better and better-informed.

Menzie Chinn at Econbrowser seems pessimistic about the outlook for the US economy:

Yesterday's dollar plunge unnerved markets. What's the likelihood of a sustained, drastic decline?

... The presumption that there is investor myopia means that median measures of exchange rate expectations might provide very inaccurate indicators of what will happen in the future. Right now, typical forecasts are for gradual dollar depreciation — 8 percent over the next twelve months (in log terms) from November 17th, according to DeutscheBank. The USD/EUR rate is forecasted to depreciate by 5.3 percent. In contrast, the Economist reports JP Morgan forecast of zero USD/EUR depreciation over the next year from November 23rd.

... [T]he extent to which the rate of return on USD denominated assets is less than those on other assets is too large to be rationalized by standard portfolio balance models.

... a little less optimistic about avoiding a slump if the current strength of the dollar is due to investor myopia, and housing prices exceed those consistent with rationality and the transversality condition (for instance, if there is a bubble). A downward revision in both the relative market-to-book price (i.e., "q") of housing as well as the value of the dollar might induce a slump if the lags in adjustment to the exchange rate are longer than those to housing prices. My own view is that is likely to be the case.

Indeed, the lags to exchange rate changes are more likely to be longer, the harder it is to move capital and labor to the export sector. After the battering taken by the tradable sector over the past decade, I worry. [emphasis added]

I have a strong suspicion that Ed Lazear would have agreed had he not adopted a political stance as Chair of the Council of Economic Advisors.

Addendum: Also see this from Greg Mankiw who presents additional evidence that the probability of a downturn next year is rising.

James Hamilton presents the data at Econbrowser.

Housing starts, which had been up an encouraging 4.9% during the month of September, surrendered those gains and a great deal more with a 14.6% drop in October. That puts them down 27% from October 2005.

... Building permits for privately-owned housing units continued their free fall, down 6.3% for the month and 28% year to year.

It looks as if Ed Leamer's forecast from over a year ago is still on track.

During the housing boom, people were happy to buy high-priced houses with no money down and interest-only mortgages because they expected to gain some equity interest in the houses as house prices appreciated. At the same time, many mortgage lenders seemed to have agreed with them that housing prices would continue to rise. The result was that, in essence, the housing loans were collateralized with the expected capital gains on the house itself: borrowers were expected to be able to pay off their loans as housing prices rose, but even if they defaulted on the mortgage, the lender expected the house to have a repo value, after costs, that would more than cover the amount of the loan.

This massive expansion of credit based on expectations of rising prices is still likely to cause serious problems for the US economy over the next several years.

1. First, there will be a downturn in housing prices. It has already begun, in fact. [Update: see this in NYTimes]
2. Second, there will be mortgage defaults as borrowers simply walk away from houses in which they have negative equity (hint: when this happens, it's boom time for U-Haul; buy now and beat the rush!).
3. Third, consumers will spend less because of their reduced ability to cash in the equity in their homes.
4. Fourth, people employed in the housing industry will have reduced incomes.

All of these effects will have come about because the US Fed let the money supply grow too rapidly, made credit too easy, and indirectly promoted this phenomenal growth in borrowing.

The only thing the Fed can do now is try to ease off. It would be a mistake to crunch the money supply too much, for if the Fed put on a big crunch, aggregate demand would plummet and we would be in for some mighty serious recessionary pressures. Instead, the Fed has to slowly try to ease the inflationary pressures (that were its own doing with past easy-credit policies) while at the same time trying to keep the housing market from crashing too severely.

Dave Altig seems to think that is where the Fed is headed — a slow, soft landing in housing prices and not much of a crunch or crisis. Calculated Risk seems to think otherwise. Nouriel Roubini also seems to think a harder landing is more likely.

My own views are similar to the predictions made over a year ago by Ed Leamer (see here); they seem considerably more pessimistic than Dave Altig's forecast, but perhaps not quite as pessimistic as Calculated Risk. I can readily imagine US GDP growth rates of less than an annualized 1% a year from now, and I just hope the Fed has enough foresight and control to keep them from turning negative.

Also be sure to check out the related material at The Big Picture.

An indirect tip of the hat is due to The Emirates Economist here, who links to an article pointing out the problems of creating an asset-pricing bubble with too-rapid credit expansion in the United Arab Emirates.

Hahn Investments says [h/t to Jack],

As things stands now, we think there is at least
a 50% to 75% probability that a North American
housing downturn will devolve into a grinding
bottom of 2 years or more. It’s true that the onset
of a real estate slump has been quite rapid to
date. That all the more argues for heavy
responses soon.

... Are we witnessing the
first innings of a classical housing bust or not? We
believe the answer is “yes.” However, that said, this
downturn will not go uncontested. Yet, all the same
the excesses are simply monumental. It will not be
easy to re-ignite the housing mania.

... Housing Bubble Has Started its Decline. We
anticipate that there will be a strong response
from the Fed as this development gains
momentum … at some point likely no later than
early 2007, and very possibly much sooner.
Undoubtedly, the North American housing bubble
has begun to deflate. This sets a key backdrop to
the economic and financial outlook over the next
18 months to several years.

(I posted this a year ago this coming weekend):

That [headline is] the prognostication of economist Ed Leamer:

In Leamer’s view, the housing market appears to have peaked “in California and elsewhere. It will take more than a year for this weakness to turn into job losses and to affect the economy in general.” [emphasis added]

And, yes, he’s using the “R” word. As in “recession.”

Leamer lays the blame squarely on the Federal Reserve for leaving interest rates too low for too long. Now, he says, we’re not only heading for trouble in the housing sector, but in the auto industry — another market that got drunk on historically low rates.

Low borrowing costs accelerated future sales by enticing consumers to trade up to bigger homes and new vehicles sooner than they might have done otherwise. Instead of waiting to buy a new family car in a couple of years, folks said, “Oh, what the heck. Financing is so cheap we might as well get it today.” As a result, car dealers lose the sale they would have gotten two years from now.

As rates creep higher, consumers happily driving their new cars or living in their larger homes have no motivation to purchase additional ones. Since consumer spending drives two-thirds of our economy, when consumers close their wallets, the impact is far-reaching.

---

Update in 2006: With growing doubts and concerns about what will happen in the US economy over the next year or so, it looks as if Leamer may have called it pretty well.

For more on the housing slowdown and possible recession, see the postings at Calculated Risk and Econbrowser.

And for a really bleak outlook, see the charts reproduced at The Big Picture, where Barry Ritholtz contrasts what most people think of as a "housing bubble" with what he and Lon Witter call a lending bubble. Interestingly, these concerns were being raised a year and a half ago (and brought to my attention by MA and Sean), but only now are the predictions being realized. Ed Leamer seemed to have the timing right, too.

On one of my walks here in Southern England, I stopped to peruse the listings in the window of a real estate agent. The very cheapest listing I could find was for £105,000, roughly the equivalent of over $210K (Cdn). It was a two-room [not two bedroom, two room] flat. Maybe that does not seem like very much to those of you who live in big cities, but your salaries tend to be commensurately higher, too. I don't think that's the case to the same extent here. Most standard (but small) homes in the area where I am living would go for maybe £300,000, with prices up in the range of £600,000 (over a million dollars) for a nice, but not too luxurious, suburban type home, at least in this area.

I started wondering (and asking about) how housing prices can be so high in this part of England. I'm an economist, and so my attention turned to supply and demand, of course.

Supply

On the supply side, zoning-type restrictions are clearly important. There are many pastures and fields that the local councils will not free up for housing development. This explanation sounds remarkably like the one that Tom Sowell makes often, when lamenting the high housing prices in the San Fancisco area. I gather prices are lower up north.

Demand

Who can afford these places? I would have said nobody, but clearly many people can afford them — otherwise the demand curve would not be out where it is. If there is a nearly vertical supply curve, the prices are mostly demand-determined, and that demand must be coming from somewhere.

Part of the demand is driven by expectations of capital gains. Everyone I asked about the housing prices said something to the effect of "You just have to get in. Once you're in, then you can start trading up." This kind of expectation, of course, can turn housing prices into a bubble phenomenon.

Part of the demand is financed by parents and grandparents. Older people sell or re-mortgage their homes and lend/give the money to their younger progeny so the young ones will be able to get in on the ground floor.

[an international tax lawyer teaching here was unable to confirm this next bit for me]: One person told me that in the UK if parents bestow gifts on their children more than seven years before the parents die, then there is no inheritance tax on the gift. I'm sure it is more complicated than that, but it made me chuckle to think of the gaming and planning involved:

• Should we give the kids thd money this year, or do you think we can hold on for another eight years instead of seven?
• Or imagine this conversation: "I don't know....Dad's barely a vegetable on a ventilator but in just four months it'll be seven years since he gave us that money, so let's keep him hooked up at least four more months. After all, the NHS will end up paying for it anyway."

If you don't think people respond to these types of incentives, recall this .

In the most recent issue of The Economists' Voice, Robert Shiller argues persuasively that housing prices will decline in real terms sometime in the near future:

• "The news is not good for homeowners. According to our data, homeowners face substantial risk of much lower prices that could stay low for a long time after. It’s notable that until the recent explosion in home prices, real home prices in the United States were virtually unchanged from 1890 to the late 1990s."
• Real house prices are higher now than they have ever been over the past 120 years.
• The ratio of real house prices to real rental rates is also higher than it has been over the same time period.
• "Interest rates are not the explanation, as some have suggested (notably Himmelberg, Mayer and Sinai 2005). The rent-to-price-ratio downtrend is not matched by a downtrend in real long-term interest rates, here measured as a long-term U.S. government bond yield minus the previous year’s CPI inflation rate (see Shiller 2005). Also, real rates today, while much lower than in 1980, do not appear low by historical standards."
• "[T]here is substantial evidence that there is a strong psychological element to the current housing boom. While the boom may continue for some time, the psychological element is likely to die away as thinking changes and current folk expectations for further price increases are lost. ...[T]he current home price boom is best thought of as a social epidemic: a fad of sorts. And yet social epidemics are not even mentioned by most of those who say reassuringly that there is no reason to worry about home prices. Social epidemics can unwind sharply as psychology changes, suggesting the worrisome possibility of a rather hard landing."

In the same issue of The Economists' Voice, Dean Baker argues,

An unprecedented run-up in the stock market propelled the U.S. economy in the late nineties and now an unprecedented run-up in house prices is propelling the current recovery. According to Dean Baker, like the stock bubble, the housing bubble will burst. Eventually, it must. When it does, the economy will be thrown into a severe recession, and tens of millions of homeowners, who never imagined that house prices could fall, likely will face serious hardships.

In response the risk, Shiller is working on proving a futures market for housing in ten major housing markets.

A futures market will generate price discovery for this: market expectations. If the futures market in effect concludes that real estate price declines are likely, then we might see backwardation in the futures market: futures prices lower than today’s cash market prices and futures prices declining with horizon. In this case, speculators who expect prices to fall less than the market expects will tend to be long the futures market. Speculators who expect prices to fall more than the market expects will tend to be short the futures market. Hedgers will take sides depending on their preexisting exposure to the real estate market.

There is a contrary view, however. The Smiths find that most major markets are not over-valued. But in his review of their piece, Michael Shedlock points out,

I find it interesting the number of complete fools hopping on the "no bubble bandwagon". The 2% maintenance figure is of course questionable, but I am very surprised that no one questioned the key assumption that house prices will rising 6% a year from now until eternity.

It simply does not wash. Here is something that does. Long term prices of houses simply can not rise above people's means to pay for them. That is a simple economic fact. Here is another simple economic fact: Family incomes are falling. The negative savings rate and rising foreclosures are more proof of stress in the system. Real wages have fallen for 4 consecutive years and that includes some pretty fat bonuses of the Wall Street fat cats at the top end.

The fact is that home prices are several standard deviations above norm in terms of affordability in many locations. Gary and Margaret Smith are simply making the classic mistake of projecting into the future what has happened over the last 10-20 years as if it that period is the norm. That is the same type of mentality used to justify the Nasdaq bubble in Spring of 2000.

At 6% appreciation a year home prices would double again in 12 years. That nifty 3 bedroom shack in California now priced at $800,000 would supposedly go for $1.6 million in 12 short years. That $750,000 condo in Florida supposedly would be going for $1.5 million 12 years from now. Sorry, I do not think so. Who could afford to buy them? Buyers are already stretched.

Read his entire piece for more exquisitely worded criticism.

And for yet another perspective, check out Kip Esquire's post.

Of course they do. It is impossible to construct welfare programmes that do not reward some type of behaviour, and, because people respond to incentives, poor people often or sometimes [I didn't say always!] become trapped by the system.

Tom Hanna provides further evidence. He cites the great old-time liberal interventionist State of Minnesota, explaining why that state has among the lowest rates of housing ownership among people of colour:

I’d argue that the results are not “despite” Minnesota’s progressivism, but in fact because of it. From trapping poor minority families in public housing to trapping poor minority children in failing schools (and a dozen other examples of the soft bigotry of low expectations), lower outcomes for minorities are the predictable result of government programs which entice people to accept the status quo under the assumption that they are incapable of helping themselves.

Is the housing market slowing down yet? Should we expect a crash?

I had written earlier that I expected the bubble to deflate slowly, but not burst. Lee Adler, of the Wall Street Examiner thinks it will be worse.

The inventory of existing unsold homes has been rising at an accelerating rate for 13 months.

... Sales volume is declining.

... Prices have begun to decline, down 6% since November overall... . This is consistent with the pattern of past real estate bubbles that I have experienced first hand, with four important differences. This one was bigger, lasted longer, was more widespread, and was the engine of growth for the entire US economy and world financial system.

... What's going on worries me greatly.

... The crash will begin to show up in prices over the next couple of months, but the full effect will not be felt for a year or more. January is the first time since the bubble began that house prices were lower than they were seven months ago.

The worst is yet to come.

Keep in mind that Adler is writing about the U.S. market; things will likely be different in Canada, especially in Alberta. At any rate, The Wall Street Examiner is an interesting, sobering site. It has been on my blogroll since its inception.

I've never seen a bedbug. I do, however, recall a scene from the movie "The L-Shaped Room" in which the hero teaches the heroine that she can catch bedbugs by softening a large bar of soap in water, then slamming the bar onto the scurrying bedbugs as she turns on the light and throws back the covers.

Judging from this article in the New Yorker, I get the feeling that technique might not be very effective.

According to Andy Linares, the proprietor of the Bug Off Pest Control Center, in Washington Heights, which he describes as the largest supplier of pest-control products in the city, New York is witnessing “without a doubt, a dramatic increase in bedbug activity. We hadn’t seen bedbugs in New York in sixty years. Then, all of a sudden, bingo. Who’da thunk it?”...

Whatever satisfaction Alexis [the subject of this article] and her roommates might have derived from having caught the wave of an interesting new trend was offset by the heart-of-darkness horror of it. That’s how they felt, anyway, after the fourth or fifth visit from the exterminator, a redundancy necessitated by the fact that, as Alexis explained the other day, “the bedbugs kept not going away.”

Back in August, I cited an article quoting Ed Leamer as saying the housing bubble will burst, and when it does, the economy will go into a recession. But he also said it wouldn't happen for about a year (so much for rational expectations and instantaneous adjustments!):

In Leamer’s view, the housing market appears to have peaked “in California and elsewhere. It will take more than a year for this weakness to turn into job losses and to affect the economy in general.”

The bubble hasn't burst, yet, although there are some indications of slowdowns in some housing markets. And now The Economist is saying the burst is yet to come, with likely serious impacts on many economies:

A recent report by the Organisation for Economic Co-operation and Development (OECD) indicates that house prices in Britain remain overvalued by more than 30% compared with rents. Britain’s economy, which has grown steadily for over a decade, has been flirting with recession in recent months. In response, the central bank cut interest rates, which may have sparked a temporary recovery in the housing market. But without faster growth, consumers cannot pay ever-higher prices for their homes.

Though the relationship between house prices and rents is less outlandish in America, consumers there are seriously overstretched. According to the Federal Reserve, the ratio of debt-service payments to disposable income was 13.75% in the third quarter, an historical high. Since 2000, the level of outstanding mortgage debt has almost doubled. While lower interest rates have helped consumers to meet these obligations without much additional pain, those rates are now creeping back up.

Not only is the Fed not done tightening, but the flood of cheap capital flowing into America from abroad could reverse itself at any time. This is bound to hurt consumers, especially since soaring house prices have forced many of them into adjustable-rate loans to keep their payments low. Indeed, a lot of desperate homebuyers have turned to interest-only loans, or even negative amortisation loans (where the payments don’t even cover the accrued interest). As interest rates rise, many of these marginal buyers will be forced out of their homes, and the supply of new buyers will fall, which may result in a sharp decline in house prices. The Federal Deposit Insurance Corporation, which regulates America’s banks, indicated on Tuesday that it was considering stiffer guidance for banks that grant these sorts of loans.

If the housing market does turn sour, it would be bad news for the American economy, as it has been for the economy in Britain, where the recent slowdown has been partially attributed to a weak housing market. In both countries, consumers have become dangerously dependent on strong house prices to keep them feeling wealthy enough to spend. Housing markets may be the canaries that signal the fate of the broader economy.

This is no different from what Ed Leamer was saying five months ago. The only question in both cases, is "When is it going to happen?"

But increasingly, it looks as if the housing market might be in for a soft landing, itself, thus mitigating the effects on the rest of the economy.