Why housing bears are wrong (Part 3)
I have received several comments in response to Part 2. Apparently, my conclusions were so out of touch with what people want to hear that readers feel the need to find a mistake in my arguments. QualityPicks comments: "Your affordability rational is just focusing on inflation and totally ignoring current incomes, which I believe is way more important." If he read my post more attentively, he would have realized that, far from ignoring incomes, I was looking at the effect of income-driven inflation (because interest rates were not a part of the model) on asset prices, and my whole point was that as long as some percentage of income is paid in fiat money, asset prices must grow faster than incomes. In another comment, QualityPicks illustrates what he thinks is an affordability problem by pointing out that in his area (Irvine, CA), the average household makes $97K and has to pay $450K for a 800 ft studio. The numbers look believable (in my part of the world, an 800 ft studio is referred to as a "large 1-bedroom" apartment; other than that, prices are the same or higher); however, I wish he chose a more radical example because his case implies a "merely" $30K of mortgage interest payments, pointing to a home that is still affordable for his "average family" (even though it will bleed them white for sure). If anything, QualityPicks's example illustrates the role of housing as the gutter draining away the extra "fiat" liquidity from that average hard-working American family, which is exactly my point. Imperial1964 argues that inflation has no bearing on the situation: "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." There is no doubt that easy credit was one of the culprits, but that doesn't mean we should ignore the other factors at play, especially when the numbers suggest that monetary inflation alone is sufficient to account for 10%-15% price growth for many years in a row, which is precisely what happened in reality. I argued in Part 1 that the Fed will be easing the credit again whenever necessary, ergo, the first component of the bubble is permanent rather than transient. So in Part 2, I deal with the second component, and conclude that it is permanent too. In order for a bubble to burst, the underlying reasons that cause the bubble in the first place must disappear, which we don't see here.
Part 3. High tide rises all boats
In this short write-up, I was going to take another look at inflation, but it looks like before going farther, I'll have to say a few more words about affordability. The trouble with my opponents' affordability argument is that they are still thinking in terms of the 1950s: housing as a product for the masses, everyone can have his piece of the American dream, and so on. This is an old-fashioned world where debts have to be payed back and jobs are the main source of income. In that world, in order to gauge a person's net worth, you simply ask what he does for a living. Fast-forward to 2007. Today, to gauge a person's net worth, you ask if he owns his house, what year he bought it, and what he knows about the stock market. Median, and even average, incomes are misleading.
Currently, first-time buyers account for roughly 40% of the sales, according to the NAR. In other words, 60% of all transactions are essentially exchanges where the buyer relies on equity in his previous house(s). For the buyers who are trading down, rising prices only improve affordability. For the buyers who are trading up, rising prices is still bad news, but not nearly as bad as for the first-time buyers. If you're trading up, and your new house costs 50% more than the old one, the old house covers half of the affordability gap. If the new house is only 33% more expensive, the old house takes you 2/3 of the way. Thus, the majority of repeat buyers is well-equipped to handle any affordability issues.
What about the other 40% - the first-time buyers who don't have any home equity to give them a jump-start? While the going certainly gets tougher for this category, I'm afraid the official income statistics exaggerates the gloom. First, many first-time buyers are still getting an indirect boost from the housing bubble: according to the NAR, 23% of them receive a gift from "a friend or relative" (translation: someone in the family owns his house free and clear and now feels sufficiently rich ). OK, so now we have the wealth effect percolating to some of the dispossessed households with a measly $97K of annual income. Don't forget to count the immigrants who have sold their home in their native country; the NAR of course would still classify them as first-time buyers. And don't forget to count the first-time home buyers who have equity in stocks. Remember, the bubble is lifting every asset, not just houses. The truth is, if you invested in DJIA in 2003, you would have done every bit as well as the homeowners. Not every first-time buyer is a hoarder collecting greenbacks for the down payment under his mattress. Some of these folks can be very financially savvy. Finally, keep in mind that the average first-time buyer pays about 1/3 less than the average repeat buyer. This means the segment of cheap housing, so when QualityPicks is wondering how a first-time buyer will afford that 800 ft studio, he should really be looking at manufactured homes that he wouldn't touch with a 10-foot pole. (It also means that first-time buyers are making less of an impact than one might assume from the number of transactions).
Last but not least, if you look at the upper decile of homebuyers, you will notice an important phenomenon: just as the households with no assets living on $97K salary are being increasingly left in the dust, the wealthiest buyers buoyed by strong corporate earnings and bonuses are gaining more than enough to offset any losses in the purchasing power of the lower segments. And ever-ready to pick the slack is the growing class of professional real estate investors who use equity in their first 57 houses to buy the 58th, then use the equity in the 58 houses to buy the 59th, and so on. These people own a good part of those extra 10 trillion dollars of equity that has materialized during the bubble years, they have accumulated enormous purchasing power, and they are not going to stop here. Of course, before they get back to the market, they will need to believe that housing still remains a good investment, so they will move with caution, but they will move nonetheless.
In a stark contrast with the picture of unaffordable housing painted by the permabears, the real picture is that of a market two thirds of which is largely immune to price changes, the lower third possesses more resilience than the bears are ready to admit, and the upper decile concentrates enough wealth to buy up all the houses that the lower deciles consider unaffordable. This is not the stuff market crashes are made of.
There is but one segment of the population for whom housing truly remains unaffordable: people with less-than-average incomes and no assets. This is a sorry state of affairs, I really wish the market would stop to pick everyone aboard. However, this is impossible for the reasons I'm going to discuss later. These people have missed their chance. The housing train has left them behind and it will not look back. For a while, they were running together with the train, helping to push it. Some jumped in at the last moment, some fell off the train, a few others will be pushed out the window by resetting ARMs, and the rest will keep running, falling farther and farther behind. For a second the train slowed down, having lost that incremental pushing power, but the train has a steam engine of its own, this engine is powerful enough to accelerate the train without outside support, and the stoker Ben is busy feeding new buckets of coal into the furnace. The middle and the front of the train are already functioning as a market of the homeowners, by the homeowners, and for the homeowners; the last car is still accessible to average income earners who are prepared to surrender their last cent for a ticket. Good enough. Could be worse.
Reason #3. In an inflationary environment, people generally ride an asset to preserve their purchasing power with which to buy more of the asset. This is how the asset remains affordable to those who own it while the savers/hoarders are getting wiped out. Bears are wrong about affordability because they presume the market exists to cater to savers.