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Fear
We have nothing to fear but fear itself, but fear itself can be pretty scary.
...Fear is ruling the financial markets. Billions of dollars have been lost in mortgage-related investments. The Federal Reserve worked madly over the weekend to engineer a takeover of Bear Stearns and avert a systemic meltdown. But the big fear remains. How low will house prices go?
If prices continue to fall, mortgage defaults will move well beyond the subprime sector. Trillions of dollars in losses for investors are not impossible. But that doesn't mean they are inevitable.
That's me in today's New York Times. Believe it or not, my piece is one of the more optimistic pieces you are likely to read on the housing crisis.
I think that housing prices went beyond the fundamentals sometime around 2004 (and I said so in 2005, see here and also note my warning that prices could fall dramatically here). But 2004 levels are still well above long run trend. Thus my optimism stems from thinking that unlike Japan, our housing prices need not fall back to long run trend (see my piece for graphs).
But the problem is that we can overshoot the fundamentals going down as well as going up and the United States now faces two potentially self-fulfilling prophecies.
If the financial markets can predict where and when house prices will stabilize, then credit conditions can quickly return to normal, the economy can expand and house prices will indeed stabilize.
But if the financial markets remain uncertain about when the decline in house prices will end, then fear will tighten credit even further, which would strangle the housing market and generate even more fear.
Unfortunately, I do not know what will push us into the right prophecy (but read my piece, that will help!) Thus, I am more optimistic than Paul Krugman, who thinks that we may have slipped into the state where no prophecy can bring us back to a good equilibrium, but I'm not that much more optimistic.
Posted by Alex Tabarrok on March 18, 2008 at 07:44 AM in Economics | Permalink
Comments
Alex-
I especially enjoyed the commenters on the Times' site. You really buzzed them up.
Posted by: Rich Berger at Mar 18, 2008 8:35:06 AM
Should you talked a little about the rise of mortgage equity withdrawals?
If homes were an "investment" they became an aggressively managed one, where paper profits were used as the collateral for increased debt.
(The current 'adjustment' has taken away 20% of my the paper value on my home ... good thing I didn't borrow that 20% out, eh?)
Posted by: odograph at Mar 18, 2008 8:55:21 AM
Odograph, you resisted the temptation! Well, done! :) Here it is anyway. The credit snobs had a point.
Posted by: Alex Tabarrok at Mar 18, 2008 9:09:41 AM
Thank you Alex. It occurred to me after posting that the HELOC cycle was the "greed" fighting with the "fear."
Posted by: odograph at Mar 18, 2008 9:24:26 AM
As a non-economist, undergrad student, and renter, I wonder what the appropriate comparison is here. We all seem to be looking at where housing prices were in 06 and comparing them to where they are heading. But I imagine that, for a homeowner, the appropriate comparison is whatever their house is worth now and what their situation would have been had they not bought a house and, instead, continued renting.
My naive impression is that the basic comparison goes like this: when you rent, you "lose" all of your housing costs. But when you buy, even if the nominal price of your house goes down 10%, you still have some equity in that house (a really tiny bit of equity at first, when your mortgage payments are mostly interest, but equity nonetheless).
Instead of thinking of the house as a good on which there can be a loss, think of "housing" as a cost that people pay. I would guess that, if we hold actual monthly costs constant (rent v. mortgage+maintenance+insurance, etc.), then those buying houses are "making" more on housing than are those that rented, even in this sort of housing market. Right?
Posted by: TWM at Mar 18, 2008 9:29:13 AM
Alex, would you care to revisit your posts on credit snobs? (I see on preview that you have raised the term yourself.)
The Credit Snobs
Credit Snobs II
Tyler might join in too, given his Subprime mortgages post and his recent psych evaluations of pop-economics authors.
In retrospect, do you like your posts? Do you still think them sensible given what you thought you knew at the time? Did you discount the fears expressed at that time because you felt they were from people who'd predicted ten of the last one crises? Or because of your feelings about their motivations? Or your ideology? If you feel the posts were mistaken, how would you change your approach as an economist?
Posted by: Mark Picton at Mar 18, 2008 9:32:52 AM
I have been sitting on cash watching my friends make lots of money on realestate since 2002. I am hoping for a big fall in price. If there are enough people like the fall will end when we start to buy. Young people who do not own a home cannot afford a home.
Posted by: Floccina at Mar 18, 2008 9:39:07 AM
In contrast to the Internet bubble, the housing bubble was particularly stupid. The 1990s bubble was at least based on the idea that elite Americans would (A) invent lots of great websites (more or less) and (B) make huge profits off them (not so much). In contrast, the housing bubble was based on the idea that run-of-the-mill Americans (especially those marginal renter/homeowners in the second quartile) would go up enough to be able to afford these ridiculous home prices.
But that never made any sense because the wages and human capital of marginal Americans (say at about the 10th to 50th percentiles) hasn't been improving. For example, James Heckman's recent paper shows that the high school dropout rate bottomed out at 20% around 1970 and has since gone up to 25%.
Posted by: Steve Sailer at Mar 18, 2008 9:48:43 AM
TWM, I think the greatest tragedy is the influence of the mortgage interest deduction. It was a one-time benefit for home buyers (at least in my market), long lost as prices incorporated the deduction into "buying power."
Unfortunately it skews buyer psychology, and unduly penalizes those renters.
(The same goes for the capital gains tax "not charged" on homes sold in trading up. Again the tax not charged goes into buying power and drives prices up further. The man on the sidelines, and the first time buyer, again loses.)
Posted by: odograph at Mar 18, 2008 10:17:25 AM
"Instead of thinking of the house as a good on which there can be a loss, think of "housing" as a cost that people pay. I would guess that, if we hold actual monthly costs constant (rent v. mortgage+maintenance+insurance, etc.), then those buying houses are "making" more on housing than are those that rented, even in this sort of housing market. Right?"
Wrong. In most parts of the country, it's not even close. If you compare rents v. mortgage/maintenance/insurance/property taxes, and take into account the carrying costs on the down payment, renting has been much cheaper and much more economically sensible since at least 2006. Because of the massive gap between rents and housing prices, with what it would cost to pay their mortgage/taxes, etc., most people could pay their rent, put sizeable sums into savings, and had money left over to actually enjoy their lives.
Posted by: K. Williams at Mar 18, 2008 10:30:03 AM
More and more people want to live on the coasts, but land is hard to come by in places like Manhattan and San Francisco. Cities and regions built on ideas — like Boston, Los Angeles, New York and the San Francisco Bay Area — have grown even as areas built on manufacturing, like Detroit and the Rust Belt, have declined.
This strikes me as a common mistake -- thinking of certain regions as permanently desirable. Certainly, there is no geographical limit to 'regions built on ideas'. Detroit, Chicago, Cleveland, and Milwaukee have similar Great Lakes locations. Chicago is a 'hot' city like Boston and San Fransisco, while the other are not. There is no reason from climate or geography that Boston or Chicago might not head the way of Cleveland and Detroit. Or vice versa. And that's considering only the only core cities not the areas (Oakland county outside Detroit, for example, claims to be the 4th wealthiest county in the U.S.)
On the other hand, the cities of Minneapolis and Indianapolis in the midwestern 'rust belt' have done well recently despite not being 'coastal' (nor located near the mountains, nor having balmy climates).
To think that housing prices will stay permanently above long term trends because of limited availability in a fixed pool of desirable locations seems pretty dubious.
Posted by: Slocum at Mar 18, 2008 10:51:25 AM
Floccina: "Young people who do not own a home cannot afford a home."
That may be true where you live. But housing is still affordable across much of the nation. Here's 4Q07 median housing median prices in a few cities:
Jacksonville, FL ...$177K
Columbia, SC .......$145K
Atlanta, GA ........$164K
Birmingham, AL .....$156K
Memphis, TN ........$124K
Little Rock, AR ....$127K
Dallas, TX .........$145K
Oklahoma City, OK ..$134K
St Louis, MO .......$133K
Des Moines, IA .....$153K
Omaha, NE ..........$136K
Wichita, KS ........$114K
Who cannot afford those prices? And these are MEDIAN prices. These cities have even lower prices for startere homes.
Posted by: John Dewey at Mar 18, 2008 12:04:00 PM
I generally liked the Tabarrok article, and if he's right about the market being paralyzed until we know when we've hit bottom, then that underscores my main point in all of this mess: vague government promises to save the day ("maybe we'll suspend ARM resets," "maybe we'll do a 20% loan substitution on mortgages," etc.) only make it in everyone's interest to postpone coming to grips with their losses.
TWM, my quick reading of your post tells me it can't be right. It seems you are saying the rational thing to do is buy instead of rent. But if that were true, wouldn't prices adjust until people were indifferent? (Or rather, until some people were attracted to the legitimate pros/cons of renting, while the others were attracted to the legitimate pros/cons of buying.)
We foolishly bought a house in the fall of 2006, and then when my job changed were stuck with it. Now we are hoping to rent it out for about the mortgage payment, but we are going to use a management company so we won't see all of that (assuming we get a renter). And as for the point about having small equity if you buy a house and it drops 10%--no, you have negative equity in that case! (I'm talking about people who just bought, of course; you are right for people who have owned for a while.)
In short, we would have been much much better if we hadn't bought our house, and instead had invested in Eliot Spitzer trading cards.
Posted by: Bob Murphy at Mar 18, 2008 12:05:22 PM
Alex-
The comments at the NYT site just get frothier and frothier. I think you may be banned from writing opeds because you upset the readers so much.
Posted by: Rich Berger at Mar 18, 2008 12:18:31 PM
I find it difficult to believe that there is only 15-20% down side in home prices. On a national level maybe but it depends on how you weight it. In certain areas of the country home prices hadn't really gone up much beyond inflation over the last 5 years like in rural Wisconsin. But in major metro areas, it certainly has.
In the NYC area wages haven't necessarily gone up much but prices have. For example, in the town I live in over the last 5 years nominal wages were up about 12-13% but home prices were up over 65%. So that means that people had to increase there leverage because equity prices et al certainly didn't drive up net worth. NYC metro is more geared to the financial industry than anywhere else. Once bonuses dry up and banks start to lay people off (I'm already getting desperate calls from friends at Bear Stearns) I don't see any reason home prices can't go back down to a more normalized level of 3-4x income from the current 5-6x. In that case it would mean that, at least for me, my home value could decline 40% from here and it still wouldn't necessarily mean that it would be all that unreasonably priced on a normalized basis.
Structurally there is no reason that home prices should sustain at a new higher level versus income compared to historical norms. Nothing more than the willingness of both lenders and borrowers to take on more credit risk has been driving home price up over the last 5 years. Real estate is local and each area of the country has had different factors driving it but there is no doubt that the national trend has been one of significantly increased leverage with more exposure to interest rate variations on the part of borrows and on the lending side, less willingness to appropriately assess credit quality coupled with more exposure to the negative impact of asset price declines. Given that we are now reversing back to more normal risk premium levels in other asset classes there is no reason that this would not apply to home prices. And it certainly would not be outside the relm of possibilities that the market correction overshoots.
Posted by: asiequana at Mar 18, 2008 12:39:31 PM
Instead of thinking of the house as a good on which there can be a loss, think of "housing" as a cost that people pay. I would guess that, if we hold actual monthly costs constant (rent v. mortgage+maintenance+insurance, etc.), then those buying houses are "making" more on housing than are those that rented, even in this sort of housing market. Right?
I don't know how your proposed calculation comes out, but I think your view of housing has a lot of merit. The advantge of buying is that you hedge future housing costs. Yes, taxes and insurance and maintenance can and do go up over time, but generally less than rents. (Of course there are other tradeoffs as well. In many US cities you almost have to buy if you want to live in an upscale neighborhood.)
Posted by: Bernard Yomtov at Mar 18, 2008 1:06:02 PM
Alex,
Why do you expect the fundamental to remain above long term trends? I see two possible reasons:
that supply restrictions are and will remain much worse than in the past (possibly true in a few
areas) and that interest rates will remain permanently lower (or alternative financing vehicles
will remain available). I do not see these latter holding.
So, looks to me like we could see a long way down in parts of the country, although there are some
parts where the bubble never really took off much and have not experienced the recession much either.
Posted by: Barkley Rosser at Mar 18, 2008 1:48:08 PM
At least where I am, renting a house that is big enough for a family in an area that is safe and quiet leaves you with very few choices, especially if you insist upon amenities like wiring that meets modern codes, central air, and more than one bathroom.
Posted by: MH at Mar 18, 2008 2:27:09 PM
Instead of thinking of the house as a good on which there can be a loss, think of "housing" as a cost that people pay. I would guess that, if we hold actual monthly costs constant (rent v. mortgage+maintenance+insurance, etc.), then those buying houses are "making" more on housing than are those that rented, even in this sort of housing market. Right?
Not exactly. If the value of a house goes down by 10% in less than a year, you'd almost certainly have been much better off renting for that year and then buying at the lower price. Of course, that's using perfect hindsight.
Posted by: Anthony at Mar 18, 2008 2:34:43 PM
asiequana: "In certain areas of the country home prices hadn't really gone up much beyond inflation over the last 5 years like in rural Wisconsin. But in major metro areas, it certainly has."
Not sure what you consider "major metro areas". Dallas, Houston, and Atlanta are among the largest in the nation. Housing is not overpriced in those markets. Nashville, Memphis, San Antonio, Oklahoma City, St Louis, Kansas City, Cleveland, Cincinatti, Detroit, Pittsburgh, and Syracuse haven't seen huge housing price increases.
Posted by: John Dewey at Mar 18, 2008 3:06:44 PM
Let's see: proximity to shore and strong zoning makes housing permanently of more value? Maybe New York before Bear, but surely not California or Florida...where is the empirical data to support this? I think we are in new territory here.
Instead, consider correlation of real estate equivalent price with income. If this were to correct, it would more likely be to 1973 values instead of 1997 or 2006--mean incomes haven't risen since then, and real incomes have stagnated. It is not just house-flippers, sub-prime, NINJA, fraudulent contracts, it is the whole market, more in some places than others. The fact is that for a long time (when Nixon took dollar off gold?) Americans have not been saving except to put money into houses. This has been distorted by government intervention in taxes and many other ways, and compounded by extreme leverage by homeowners and financial institutions.
The Japanese collapse may be different, those consumers had savings. Also we now have runaway inflation caused by central bank actions and the collapsing dollar and distorted investment decisions moving into commodities.
A more pertinent question would be, how long will it maybe take for price discovery and mark-to-market transparency to become available so there is the necessary information for market transactions to resume. What are the incentives for creditors/debtors and equity holders to get moving quickly on this (now that the FRB has essentially assumed an equity position)? Right now in the housing market there are huge numbers of people who are sitting and waiting and asking these same questions. It will take a long time to find that point, the actual bottom of the market will be somewhat later.
What are the wider implications of what house price the market eventually sets? Will the resulting rate of inflation create another bubble? Who loses in this transfer of wealth from one generation and geographical area to another? Does concern for solvency abolish any concern for moral hazard?
I rent a house on the water in Florida, house for sale for a year, nobody is looking at it, I expect value to drop 30% but it will take another year or two to sell. It would be much more rational for there to be a policy that encourages people not to build where hurricanes can destroy property and much gasoline necessary to drive to work and shop, but instead to build high-density where people can walk to work, shop, and study. Flipping houses or financial derivatives are obviously not wealth creators, what we need are not more service jobs but instead work to create capital, invest in infrastructure, education, health, alternative energy. Our American lifestyle is irrational and it may be a collapse would be welcomed by most people in the world. After all, the Islamic banking system doesn't have interest, but equity, which is better?
Posted by: John2 at Mar 18, 2008 3:13:15 PM
Anthony: "If the value of a house goes down by 10% in less than a year, you'd almost certainly have been much better off renting for that year and then buying at the lower price."
Perhaps from a strictly cash standpoint. My guess is that homeowners see much more value in owning a home, living beside other homeowners, living in highly desired school districts, than we can calculate from a simple rent vs buy financial comparison.
For me, homeownership is all about control. I do not need permission to plant a tree or replace a patio. I'm not dependent on a landlord to replace my air conditioner. It matters not whether one dog or three inhabits my backyard, the choice is mine. It's all about freedom.
Posted by: John Dewey at Mar 18, 2008 3:14:30 PM
Barry Ritholtz has described your column as "merde."
Posted by: Dave at Mar 18, 2008 3:21:43 PM
<>
Ther is nothing like macroeconomics to get economists preaching to the market!
Posted by: Mario Rizzo at Mar 18, 2008 3:23:40 PM
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There is nothing like macroeconomics to get economists preaching to the market!
Posted by: Mario Rizzo at Mar 18, 2008 3:25:41 PM
