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EScroogeJr (< 20)

Why Housing bears are wrong (Part 2)

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4

September 19, 2007 – Comments (13)

Yesterday's action by the Fed could not have illustrated the point I made in the previous post more clearly. I was expecting the Fed to defend homeowner gains with all helicopters in their disposal, but the reality exceeded my expectations. That was too much, too quick. Home prices were on the rise anyway. A smaller cut would be enough to lift prices 5% to 10%. Apparently, Bernanke felt that was insufficient.

Ok, let's continue this series. Imperial1964 is suggesting that housing will come down in real terms but not in dollar terms. I agree with the second half of his statement: housing will not get cheaper in dollar terms. But what about the real terms? This brings us to

Part 2. Real money vs. funny money.

Prices have grown 10% a year for several years in a row when the official inflation was well under 4%. It is not surprising that the bears expect a reversion to the statistical mean.

I did not care to find a link to the graph which showed that in terms of affordability, housing now costs two times the historical norm. Suffice it to say that I'm well aware of it, and I'm sure our permabears - TMFBent, floridabuilder et al could dig up the exact numbers. This and other similar graphs operate with median incomes, ignoring  wealth generation in the upper decile, but otherwise they are accurate.

This affordability problem is a strong bearish indicator, so we should talk about it now. If the spike on the graph that took affordability above 200% (100% being the base level) is only a temporary fluctuation, then we should indeed dump our houses and get into cash, gold, or foreign stocks (becuase not much of economy will be left in the US by the time the market corrects). On the other hand, if the spike had solid underlying reasons, we probably shouldn't worry.

Let us see what causes housing to appreciate faster than the rate of inflation. We start with the assumption that household incomes are always proportional to the GNP. This is not exactly true, but it will do as a rough approximation. When we produce a dollar of GNP, some 70 cents should wind up in the pockets of consumers - from workers to CEOs. The median income figure will not show this becuase the rewards are heavily skewed to the top 10% and even more heavily skewed to the top 1%. Still, a consumer dollar is a consumer dollar, even in the hands of Bill Gates.

Official statistics puts GNP growth somewhere around 4%. By definition, this figure is already adjusted for the CPI, so we must add back inflation to find the nominal growth. To keep our numbers simple, let's also put official inflation at 4%. We are not concerned with minute quantitative details here, only with a bird-eye view. Then the nominal incomes of consumers (wages, government payouts, investment income) should increase 8% every year (sorry, minimum wage earners, you were not invited to the party).

Now, what about the consumer goods that stand behind those dollars? In the good old days (before 1980), the economy was mostly real, so most of that 4% GNP growth meant more Big Macs, more cars, more coffee, etc. Ah, those medieval times! Not any more. Today, we have a more or less constant physical output, and the bulk of growth is concentrated in the "service sector" which produces intangibles, mostly having to do with complex operations that result in changes of ownership of the goods produced in constant amounts by the old-fashioned real sector. In other words, your real consumption grows far less than 4%.

Now, let's talk about affordability. Before you can afford a house, you must buy those necessary items - Big Macs, coffee, cars, and many other things that we now take for granted. There is also the discretionary spending which is not strictly necessary but which you are not going to give up anyway - cigarettes, DVDs, computers, etc. What remains after that is the investment part of your income which you can use to buy gold, coins, houses, stocks, Motley Fool newsletters, and other such things. The problem is that you can't use it to buy more consumer goods because the economy hasn't produced more. This is "funny money". The economy has given it to you under the condition that you invest it somewhere but dont try to spend it, otherwise the economy will develop an indigestion known in the academic circles as hyperinflation. You may have private reservations about it, you may suspect (rightly or wrongly) that some of the assets you're buying are overvalued, but this is the only game in town. The moment you try to divert funny money for consumption, it loses its value.

This is how one should calculate affordability. If in 1980 you could buy a certain fixed amount of assets for all the funny money you've got back then, and now you can buy the same amount of assets for all the funny money you've got today, without having to reduce consumption of your necessary and discretionary items, then affordability hasn't changed even though the asset has appreciated faster than inflation. 

Let us see how your investment spending will change with time when the economy goes off its "real" railtrack and starts churning out flows of funny money. We shall be generous to the Bureu of Economic Statistics and assume that as much as one half of our 4% GNP growth is real, representing an actual increase in the volume of production of consumer staples and "tangible" services. Suppose you received $100 the first year, and after all the necassary expences, you're left with $20 to invest in housing. Fast forward one year. Your nominal income has increased to $108. You are still consuming the same busket of products, which has grown 2% in physical volume and 4% in price, so your nominal consumption is now 80*1.02*1.04=$84.87. The investment part of your income is now $108 - $84.87 = $23.13. That's a 15.6% increase vs. last year. This is what you now can afford to spend on housing. Needless to say, the price responds proportionally to the increased demand. We must, however, subtract approximately 1 percentage point to account for the new construction - yes, the housing stock itself grows about 1% a rear. So it becomes possible for real estate to appreciate 14.6% in one year even as the official inflation is still 4%. To a bear, of course, it seems that housing became 10% more expensive (114.6/104=1.10) in real terms, ergo, affordability has worsened. In fact, nothing has changed. The housing market simply plunders you from all the extra money you have left after paying for the necessary expenses. Has done it in 1980, is doing it today, will continue to do it in the future. The reason people fail to realize it is mostly psychological: they were taught to believe in our government and our currency. They see that they must part with $500,000 for a lousy 1-berdroom condo, and they think it's excessive. They don't understand that these $500,000 were never never real money to begin with. 

But is there still room for further appreciation as funny money takes up the ever-larger share of our income? Let's rerun the numbers, increasing its share to 40%. So you now receive $100 in year 1, out of which you spend $60 and invest $40. Fast-forward one year. Your new income is again $108. Your new expenses are 60*1.02*1.04=$63.65, and your investment spending goes up to 108-63.65=$44.35, or 10.8%. Subtract 1 percentage point as before. Still a 9.8% increase, well above our 4% inflation! Until all your income is fully redirected to assets, there will still be room for assets to appreciate in "real terms". This is unavoidable as long as your income is largely composed of dollars unsecured by consumer goods.

To which, by the way, houses should belong if you use your common sense. It is very unfortunate that what is by its nature a consumer product ever became an asset in the first place. If the cost of houses were included in the official CPI index, you would realize the full extent of hidden inflation in this country, and the figures would not be pretty. 

So, we conclude with 

Reason #2: Bears are wrong about affordability because they confuse funny money with real incomes.

 

13 Comments – Post Your Own

#1) On September 19, 2007 at 9:02 PM, QualityPicks (24.80) wrote:

Your affordability rational is just focusing on inflation and totally ignoring current incomes, which I believe is way more important. If a house costs the same in "real money", then income has dropped 50% in the last three years in "real money".

Current incomes do not support home prices, not even close. Most people I know have no other assets other than retirements accounts (which you can't really use to buy a house) and their house. And I'm I high income earner and know a lot of high income earners. I always ask my friends, if you had to buy your house today, would you be able to afford it? Everybody says no.

And you just don't understand how much people overextended themselves in the last two years to buy a house, all because they were thinking the same things you are thinking, that house prices can't go down, at least not a lot.

There are so much problems in housing you are just ignoring. We'll see. Are you just trying to provoke people or debate? :-)

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#2) On September 19, 2007 at 9:09 PM, QualityPicks (24.80) wrote:

One last thing, people weren't able to pay more for a house because they were making more money, but because they could temporarily borrow larger amounts of money. How much more could you afford to borrow? almost twice. Think about it, new loans like negative amortization loans allowed people to borrwo twice as much. Until the promotional rate resets that is. And as simple as that, that is why there is potential for prices to drop 40%, if these loans are gone for now, or if people needed to qualify for the full loan not just the promotional period.

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#3) On September 19, 2007 at 9:14 PM, MMCapitalMgmt (99.82) wrote:

QualityPicks...

 Consumers overextend themselves all the time. When people get money they haven't had before, they tend to buy material items. The difference between those times and these are in the economic status of the individuals affected.

 Moreover, these consumers were not just thinking about housing prices, they were thinking about mortgage rates, and ignorant and unintelligence is to blame for the entire subprime mess. The lenders were ignorant to think they would continue to reap those types of returns from individuals who possessed ARMs.

 If these "high-income" earners cannot afford a house, then nobdoy would be able to, but that just isn't the case. Again, it is a case of your friends being overextending themselves or believing they need an unnecessarily large one. You are telling me they couldn't afford a $250K ranch home somewhere? They must not be earning much after all.

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#4) On September 19, 2007 at 9:15 PM, EScroogeJr (< 20) wrote:

"Are you just trying to provoke people or debate? :-)" 

QualityPicks, it's very simple. I'm writing what I think about the issue.

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#5) On September 19, 2007 at 9:31 PM, retailsails (95.55) wrote:

That's all well and good, but irrelevent if:

1) nobody will lend by giving mortgages to consumers, not anytime soon - even if they wanted to buy...standards & availability are going to be tight

2) There is just way too much supply and not enough demand - it will take years to offload the existing inventory plus what will come on the market through foreclosures and "walk aways" - there were something like 44,000 new apartments built in Miami alone this year, and even those that were sold had people walk away from their deposits - and how much of the demand over the last 5 years was due to speculation?

3) Most Americans barely have any savings...how are they going to put 20% down on a house?

I think the only funny money is the endless cheap credit everyone was supplied with - I mean, who wouldn't but a house for nothing up front and a 3% teaser rate...before it resets you're gonna flip it right?

The govt./financial industry marketing scam worked - they achieved 70% homeownership and lined their own pockets for years - now prices will plunge and they will just point fingers...

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#6) On September 19, 2007 at 9:46 PM, Imperial1964 (97.81) wrote:

It is true we don't produce more consumer goods.  We import them, though, as evidenced by our hugely increasing trade defecit with Asia.

Most everyone I know now has more toys and unnecessary crap than ever before--mostly financed with debt.

Which leads me to provoking some debate:

What primarily enabled the runups in housing prices was easy credit and low monthly payments, rather than an increase in leftover dollars in their bank account.  That's why no-money-down, Alt-A, and jumbo loans increased so much in the last few years.  People didn't have the cash to make a down-payment, but could somehow borrow all the money they needed.

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#7) On September 19, 2007 at 10:08 PM, EScroogeJr (< 20) wrote:

Wow! What a heated discussion :) That's more concerns than I could address in a single post. I'll try to provide the answers, in their due order. Yes, this is indeed promising to become an interesting matchup. Bulls vs. Bears, the Lincoln-Duglas debate. The series will continue. Several more entries should leave the battlefield clear, ordered, and covered with neatly trimmed grass. Real incomes, overstretched consumers, the drying-up of loans, marketing scams, homeownership rates, the origin of easy money - this and what needful else we shall address in measure, time and space :-)

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#8) On September 19, 2007 at 11:22 PM, MMCapitalMgmt (99.82) wrote:

QualityPicks...

 Consumers overextend themselves all the time. When people get money they haven't had before, they tend to buy material items. The difference between those times and these are in the economic status of the individuals affected.

 Moreover, these consumers were not just thinking about housing prices, they were thinking about mortgage rates, and ignorant and unintelligence is to blame for the entire subprime mess. The lenders were ignorant to think they would continue to reap those types of returns from individuals who possessed ARMs.

 If these "high-income" earners cannot afford a house, then nobdoy would be able to, but that just isn't the case. Again, it is a case of your friends being overextending themselves or believing they need an unnecessarily large one. You are telling me they couldn't afford a $250K ranch home somewhere? They must not be earning much after all.

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#9) On September 20, 2007 at 1:41 AM, QualityPicks (24.80) wrote:

Hirshey, there is nothing that costs $250K around here. Not even one 800 sq ft studio. Those are $450K. :)

I used "high-income" earners when I really meant "more than average", sorry about that. The average family in my zipcode according to census information makes $97K (and this is high for the average US family income). So I was really talking about people making $120K or $130K.

I realize people overextend themselves all the time. This will never change.

I just heard in a financial radio show a caller that said he works with one of the biggest mortgage companies. He said they are receiving about 100 notices of default a day and this is only for San Diego, CA.

And the biggest number of loan resets is about to happen in the next few months.

So, I just have a hard time thinking that things are close to a bottom. But hey, who knows, maybe I'm wrong and most people are making $160K a year, and they will be comforted by the 50 bps cut, and people will start buying like crazy and absorb all this inventory.

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#10) On September 20, 2007 at 2:26 PM, TMFKopp (97.88) wrote:

Am I the only one that took note of Quality's assertion that prices could fall 40%? Anyone want to take a stab at what that would do to the economy? If prices are going to fall 40% we shouldn't be wasting our time debating in CAPS, we should be out buying water and canned foods.

I think there are two things to consider here: 1) the inborn desire of every American to own a home -- maybe this changes over time, but for now how many people do you know that don't have owning a home as at least a long term goal? I think there will be more demand out there over the next few years than we're giving the market credit for.

2) The history of the mortgage industry. There seems to be a lot of focus on the idea that loans greater than 80% LTV, subprime loans, Alt-A loans, and anything outside of the historic norm will disappear completely. I think this is far from the case. While the past few years have been a big debacle in all of those areas, there will continue to be big demand for all of those products, and if they are priced appropriately there is good money to be made for those who offer them. 

I don't see the housing market shoring up quickly, but I'm just trying to point to a moderate scenario for the next few years -- somewhere between continued 10% growth in housing prices and a 40% delince in prices...

kopp 

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#11) On September 20, 2007 at 3:43 PM, devoish (96.56) wrote:

I have read the testimony of one blogger (billdrummer) on this website who says his home is currently worth 190,000 and 18 months ago appraised for 295,000. How close to 40% is that?

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#12) On September 20, 2007 at 6:56 PM, TMFKopp (97.88) wrote:

You're talking about an extreme example of a forced sale in a formerly hot market. It's kinda tough to say that a 35% loss there suggests that housing prices broadly could drop 40%.

On that note, my heart does go out to bill... man what a tough story.

kopp 

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#13) On September 24, 2007 at 4:46 PM, floridabuilder2 (99.33) wrote:

As far as home prices dropping 40% that is extreme... however, i think you will find the average drop across the top 100 markets to be 10%, which isn't that bad considering the run up and 5-10 markets dropping 15% or more...  at the end of the day, you don't lose any money unless you sell... just like the builders, a home owner that can weather a 3-5 year storm will see his price appreciate at 4% a year again

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