Is There a Housing Bubble?

No.

I do not believe there is a bubble in U.S. housing prices. However, there are substantial risks to housing prices and they may fall substantially.

If housing prices could decline a lot, why is this not a bubble? In a true bubble, prices become so far out of line that it would be impossible for them not to fall. In the tulip mania, for example, it was possible to buy a house for the price of a single tulip bulb. 10 Because tulip bulbs can be pro­ duced in massive quantities with a bit of sunshine and water, it is impos­ sible for bulbs to continue to sell for the price of a house.

Similarly, U.S. tech stocks in the late 1990s reached impossible levels. Cisco, for example, had a P/E in excess of 100, a figure that could not be justified by fundamentals of futures market. While irrationality can last a long time, Cisco's stock simply had to fall. I went on record with, "if Cisco's stock price does not decline, I will tear up my Harvard Ph.D. in business eco­nomics, because a continued high stock price would disprove everything I have learned." (Many other people went on record as well.)

So a bubble is such a degree of irrational pricing that only one out­ come is possible. There are warning signs in U.S. housing prices: It is true that housing prices cannot grow faster than rents indefinitely, and it is also true that the long-run growth in housing cannot exceed the growth in population. Thus, the boom times in housing will end. The valuation levels, however, do not justify the label of a bubble. It is possible, there­ fore, that a decline in housing prices may be avoided.

U.S. housing is expensive but not so high as to ensure a collapse. In addition to the unsustainable trends and the bullish psychology already covered, however, there are additional risks to the housing market. Real Estate 211

In June 2003, the interest rate on the 10-year Treasury was 3.11%. One year later, in June 2004, it was 4.82%. This stunning increase of more than 50% in just one year shows how rapidly rates can rise. How far will interest rates rise? What will the effect be on housing prices?

First, how far will interest rates rise? We learned two key facts in the discussion on bonds that are worth repeating. First, as compared to the last 20 years, interest rates are extremely low. Second, this is especially true when interest rates are adjusted for inflation. Figure 9.5 shows the real—inflation-adjusted—interest rate on 10-year Treasury bonds. This is calculated by subtracting the inflation rate from the interest rate.

Unless the economic world has changed completely, real interest rates will rise. This can occur via a decrease in inflation or an increase in inter­ est rates. If inflation does not fall from current levels, how far will inter­ est rates rise? Over the previous 10 years, the real interest rate (the premium over the inflation rate) has averaged 3.3%. Consumer price

inflation is heating up a bit. The annualized rise so far in 2004 is 3.3%. A different trading system of estimating inflation that looks at year over year changes in prices registers a slightly more benign 3.1%.

Thus, if the real interest rate returns to the average of the previous decade, the interest rate on the 10-year Treasury will rise from 4.8% to somewhere between 6.4% and 6.6%.

The interest rate on the 10-year Treasury bond could therefore easily rise to above 6%. In fact, such a rise could be said to restore interest rates to normal levels. The 3.11% rate of June 2003 looks like an irrationally low interest rate, and the subsequent rise a return to a level with more appropriate compensation for inflation.

What would the effect of a 6% interest rate rise be on home values? The exact answer is difficult because it relies on so many factors. How­ ever, a simple approximation is made by assuming that home buyers will make a mortgage payment that is a fixed percentage of their paycheck. This assumes, for example, that a buyer who can afford a $ 1,000 monthly Real Estate 213

mortgage payment today would be willing to make the same payment in a higher interest rate environment. Let's see the effect of interest rates with this assumption and then adjust the answer.

The analysis looks at the amount a person can borrow with a 30-year, fixed-rate mortgage and a monthly payment of $1,000. At the low mort­ gage rates of 2003, this hypothetical buyer could have borrowed $179,000. At the current rate, the figure drops to $162,000, and if real rates return to "normal," our buyer could only borrow $143,000 (see Fig­ ure 9.6). Thus, for a buyer who allocates a fixed percentage of her or his income to a mortgage payment, a return to historical real interest rates would decrease the feasible home purchase price by 20%.

This view suggests that a return to a more "normal" real interest rate could push home prices down as much as 20%. Of course, the decline could be far less as sellers are reluctant to cut prices even in soft markets, and buyers might be willing to stretch budgets. On the other hand, inter­est rates could swing from their 2003 irrational low to rates significantly above 6%.

Two conclusions seem obvious: Interest rates are historically low by almost any measure, and so rising interest rates are likely; and, they will put downward pressure on housing prices.

It is said that the snake that bites is rarely the snake that is visible. Almost everyone is aware of the risks that rising interest rates create for housing prices. By contrarian logic, therefore, rising interest rates are unlikely to topple the housing market. If there is to be a big bad wolf in housing it is likely to come in the form of some less discussed risks.

I first learned about leverage during my high school physics class. My teacher got the biggest, strongest football player in the class to compete against a scrawny boy. The battle was to push a door that was half open; the football player was given the task of trying to close the door, while the scrawny nerd tried to force it open even further.

214 Applying Science and Art to Bonds, Stocks, and Real Estate

The twist was that the football player had to push right next to the hinges, while the skinny kid got to push on the edge farthest from the hinge. The scrawny boy won easily! The reason was leverage; being far­ ther from the hinge provided an enormous advantage.

Housing has been the road to riches for two reasons. First, U.S. hous­ ing prices have been rising relentlessly since World War II. Second, because people are able to buy houses with relatively small down pay­ ments they can have tremendous leverage.

Recall Fatima Melo's home purchase that we discussed earlier. The young couple bought a house for $95,000, which they sold for $358,000. So they bought a house that increased in value by 277%. So how much did they earn on their investment? They invested $5,000 and borrowed $90,000. After selling the house and paying off the mortgage this $5,000 had swelled to $268,000! Now that's leverage! Figure 9.7 shows the return on this investment in reality (with leverage) and how it would have performed without leverage.

Financial leverage is great in bull markets. To make the most money the rule is simple: The lower the down payment, the greater the return on investment. Alternatively, for any fixed down payment, the bigger the house, the more profits. The road to riches in the U.S. housing market has been to buy as much property as possible and borrow as much as possi­ ble to leverage profits. It has truly been an astounding way to make money.

There are two risks to leverage. One is individual, and the second is the spillover effect on others.

Groucho Marx learned the individual consequences of leverage in the 1929 stock market crash. 11 Groucho was opposed to gambling but had nevertheless invested his life savings into stocks. And he bought stocks on margin. In the 1920s the customary margin requirement was 10%. This allowed a speculator (or investor) to buy $1,000 worth of stock with $100 of cash. A 10% margin requirement allows for 10 to 1 leverage.

What are the effects of buying stocks on margin? With maximum leverage, any movement in the stock is magnified 10-fold. So a 1% rise in stock would produce a 10% return on investment. Throughout the bub­ bly 1920s people focused on the ability of leverage to increase returns.

Groucho found out that leverage works to dramatically decrease returns in a down market. A 1 % decline in a fully margined account leads to a 10% loss on investment. More important, a mere 10% decline leads to total wipeout—a 100% loss.

As Groucho's stocks declined in 1929 he did what he could to avoid selling into a dropping market. He put up additional cash, and he bor­ rowed money to provide margin for his stocks. In the end, he lost every penny.

Leverage was financial disaster for Groucho Marx (fortunately for him, he was able to recover through making successful movies after he went bankrupt). Groucho's decision to margin stocks also hurt other investors. At the market top, Marx owned a lot of stock. Once he was bankrupted he owned none—he was forced to liquidate his holdings as the market declined.

In a leveraged market, price declines put owners in financial distress as they are forced to liquidate. The liquidation puts further selling pres-

216 Applying Science and Art to Bonds, Stocks, and Real Estate

sure on prices, and the further declines then cause more financial distress and more forced selling.

Margin calls were widely attributed as a major cause of the 1929 crash. The Securities Exchange Act of 1934 was enacted to curb the excesses of the 1920s. Section 7 of the Act addresses margin lending, beginning:

For the purpose of preventing the excessive use of credit for the pur­ chase or carrying of securities, the Board of Governors of the Fed­ eral Reserve System shall. . . prescribe rules and regulations with respect to the amount of credit that may be initially extended and subsequently maintained on any security. 12

Under this law, the Federal Reserve sets stock margin rates. They have maintained the required level at 50% for several decades.

A dollar today can buy two dollars' worth of stock. The same dollar can buy many, many dollars of real estate. It is relatively easy to borrow $20 for every $1 of down payment. Furthermore there are a large number of ways to avoid putting any money down to buy real estate (and these go far beyond "no money down" techniques so common on infomercials). Small down payments create massive leverage. The greater the leverage, the greater the possible gains—and possible losses.