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EScroogeJr (< 20)

Why housing bears are wrong (Part 3)



September 24, 2007 – Comments (8)

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.

8 Comments – Post Your Own

#1) On September 24, 2007 at 4:49 AM, fransgeraedts (99.73) wrote:

dear Escrooge,

what you call funny money other people call capital.

Yes indeed there is money left over in the economy when consumption goods are payed! Its used to finance capital goods! There is nothing funny about that! Its called capitalism for a reason.

(By the way there is also something fundamentally wrong with the way you define consumption..many of the services you somehow see as superfluous are of course real consumption too.)

What you correctly sense (but wrongly explain) is that for a long time now we have produced to much capital. There is more capital around then can be profitably invested. The result of that is that the prices of investmentopportunities rise. That is also called assetinflation.

Cheap credit is itself one of the effects of the overproduction of capital. Because of the leverage it makes possible, it also contributes as an extra cause to the assetinflation.

Under these conditions assetbubbles will form. We have had five until now (; housing; creditrisk; commodities; china) One of those has burst; two are in the proces of bursting; two are still growing.

The overproduction of capital has not yet stopped. That is something i think you sense correctly as well. But you seem to conclude from that, that as long as the overproduction of capital continues bubbles cannot burst...or that the bursting will always result in the reforming of the (same) bubble all over again.

That conclusion is wrong. Capital is mobile. And riskperception is what gives it direction.

Lets look at the tech/internet bubble. The nasdaq reached 5000 in 2000. It lost most of that and now slowly is recovering. It still has not reached 3000 again. And that does not tell the whole story. Many techfirms have simply gone bankrupt. Think the  the sector. Others are still looking at shareprices that are a mere fragment of their former highs.

Bubbles burst because "free"capital moves away if the riskperception changes..and usually it takes a very long time for it to return.

And then of course there is also capital destruction going on if a bubble bursts.

Now lets look at housing. The riskperception in housing has very definitely changed. It has become visible that to much houses have been build. It has also become visible that a large group of  existing homeowners cannot pay their mortgages. Capital has begun to move away. That began at the most mobile level. Housing related stocks began to lose value. Then the Reits followed, then the Mortgage bank stocks. Then the credit itself dried up. Homeowners are the group who's capital is the least mobile: they live in it. So they are the most reluctant to move their capital out. And that of course means that they will lose the most.

How will this play out? The bubble will burst in slow motion. The housing market will continue to be a buyers market. They will expect prices to come down even further..and will wait for it. sellers will have to take losses. That will mean they cannot afford to pay as much for their next house...etc..etc.

Bubbles will form and burst. Then a new bubble will form ..but it will form elsewhere.

That only stops if the overproduction of capital stops. But that is something for another discussion.

Frans Geraedts

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#2) On September 24, 2007 at 11:54 AM, renegade49 (81.99) wrote:

The battle between you and floridabuilder is most interesting and good for the 'ol noggin.  My take so far is that you two guys are not really talking about the same thing.  You seem to be taking a more philosophical/historical view, while floridabuilder is addressing the near (next couple of years) term.  You are right, I think, that the goverment will do everything in it's power to not let housing tank for any prolonged period of time, but individual companies or even the whole industry, can and will tank in the near term.  As for your conclusions about the winners and losers, I think everyone must agree, but it's nothing new.  Capital will prosper, wages will suffer.  What else is new?  It's called capitalism, not waggeism.  Stocks and real estate will beat out bank savings and money in the matress?  Who'd've thunk it!

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#3) On September 24, 2007 at 1:20 PM, glenvar (67.31) wrote:

Escrooge-interesting take.  I am more in Builder's camp though.  My problem with your argument was that it seemed to me to center on an inflationary environment.  I know that most people are concerned, rightly so, with inflation.  I have been in investment banking since 1983 and during my entire career people have been concerned with inflation.  But if you look closely at that time frame, we have been in a disinflationary environment almost the entire 24 years.  In each interest rate cycle the peaks of interest rates was lower than the previous high, and the lows in rates were lower than the previous lows.  This has led to disinflation, which is ever decreasing inflation, as opposed to deflation which is actually having prices fall.  When I first started in the business we had double digit inflation, now it is in the low single digits.  Thus is certain asset classes we have experienced asset inflation of which housing is a wonderful example, but overall in the economy inflation has been mild.  So the runups in the "bubble" classes are like a frenzy within that class and does not extend to the economy as a whole.  Thus my problem with the argument that we have experienced housing inflation and not a bubble.  It is clear to me that this is very much like gold in the early 80's, and tech stocks in the late 90's.  It is a bubble and the only way out is to work through it which is going to take quite a while. 

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#4) On September 24, 2007 at 6:45 PM, QualityPicks (35.94) wrote:

Thanks EscroogeJr :) I value your opinion, especially because it is different than mine, so I gain a lot from listening to what you are saying.

While you didn't (specifically) say I was a perma-bear, I just want to let you know that I'm far from it. I saw a bunch of excesses build up during the housing boom. The market finally turned and it is taking care of those excesses, just like it did during the tech bust.

If prices were not really excessive, then we wouldn't be having these issues with record foreclosures that are expected to get much worse. I just really think that demand is weak right now, and prices haven't dropped to a point where solid demand is. I take my guesses to where that demand would be. And my guess is based on comparing the cost of owning a home against rents and incomes. I think prices are a far reach from incomes and rents. I don't think the average family must afford a house nor do I think buying must be the same as renting. But I know that the closer we get to those parameters, the closer we will be to what I consider "solid demand" and a bottom for housing.

But I monitor the inventory in my area almost daily to see if houses are selling and how prices are behaving. Right now, I haven't seen anything that says that demand is picking up. I keep seeing "weak demand", and for every 2 or 3 houses sold I see 4 or 5 new listings. And yes, prices are coming down too.

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#5) On September 24, 2007 at 9:56 PM, EScroogeJr (< 20) wrote:

I used the term "funny money" rather than "capital" because in the classical economics, capital used to mean the money with which you buy "the means of production" -  factories, equipment, agricultural land. Also, it was implied that this money is real - secured by gold or literally made from gold. Now it's mostly strings of ones and zeros. Besides, a "capitalist" was someone who earned his capital by running a factory or a grocery store; today, you go to a bank, show how much equity you have, and "capital" is immediately created for you on request in the Federal Reserve's computer. But it's just a matter of terminology.

As to housing being a bubble like dot-coms, I must respectfully disagree. Just one simple question: by how much do expect prices to retreat? By 10%, as floridabuilder does? Normally, an asset would be called a bubble when it's overvalued 300% or more. On the stock market, a 10% correction is nothing. For example, if JNJ is selling for $65, and you feel you'll have a good chance to grab it for $60 a year from now, what will you call it - "slightly overvalued" or "fairly valued"?

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#6) On September 25, 2007 at 9:15 AM, glenvar (67.31) wrote:

If you have looked at our coastal area-especially Florida, then a 10% correction is a pipe dream.  There are condo buildings and more condo buildings totally empty.  There are others with only 4 to 5 year round residents, and condo fees are not being paid by a lot of "investors".  Thus no upkeep.  If those prices only decline 10% I would be stunned.  I think we are looking at 30%-40% in the most heavily developed markets, especially condos, 10%-15% in the interior of the country where the prices didn't get as crazy.  A price is determined by what someone will pay-not by what the seller is asking.  If you look at disposable income--it has not been growing.  The prices being asked in a lot of markets are unsupportable by the level of income in those same areas.

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#7) On September 27, 2007 at 5:37 AM, fransgeraedts (99.73) wrote:

dear EScroogeJr,


you ask after the evidence of a bubble bursting in housing. And you challenge me to guestimate how much housing prices will drop. Fair enough.

If i may i want to first point out that you have not yet in earnest answered the main thrust of my earlier post. To summarize: what you call funny money in reality is capital. And yes, what we do with capital is buy "means of production". We produce to much capital at the moment. Therefore the price of investment opportunities inflates. Cheap credit leverages that. The result of that are bubbles. Those bubbles burst if the riscperception changes. New bubbles will form - but elsewhere.

Your comments about capital formation somehow suggests that only direct ownership of a factory or store counts. That seems hopelessly naive -and never was true. Not even in the italian and dutch cities of the 15th and 16th century where capital was first invented.

You have not yet answered my suggestion that you draw out of your correct (but wronlgy explained) intuitions (that there is overproduction of capital and that it is still going on) the wrong conclusion. You seem to suggest that when overproduction continues bubbles will continue to expand or if they burst will quickly reflate. The truth is more subtle. As long as overproduction continues bubbles will form. But as they inevitably burst they will not reflate. Bubbles will form elsewhere. I believe the historical evidence (even that of the last 10 years) suggests strongly that that is the case.

Now lets turn to housing. 

First a remark in advance. The market of actual fysical houses is a special and in some ways strange market. To call it inefficient is actualy something of an understatement. As you yourself correctly pointed out, that is the case because a house in not just an investment. People live in it. More strongly put: a house is a home. It is not just a large financial investement, but als a  practical and emotional one. 

Those ineffeiciencies have many effects. One of them of course is that the (fysical) housing market is slow. Extremely slow.

Lets look at the history of the bull market (and bubble) in the pricing of houses that is now over. That bull began somewhere in the eighties after the Fed had raised interest rates to historic heights. Interest rates have fallen from those heights more or less continious. That has been the driver behind the rise in the price of houses. There was a dip in the early nineties, but that was all. The bubble fase that marks the end of that bull market, ended in 2004/5. Depending on the markets you look at that bubble fase started either in the late nineties or after 2001.

Now to the question of the evidence of a bubble bursting. First ofall, you have to widen your perspective. You must not stare only at the prices of homes. (Dont worry i'll come to those too.) Would you call the price action in home builders in the last two years the bursting of a bubble? And how about the action in the shareprices of mortgage lenders? or in the housing related industries (furniture etc)? Like i said in my last post, how more mobile forms of capital are, how quicker they will move. That  bursting of the bubble in housing related stocks is what has put your CAPS-portfolio under water! You have ignored that at your peril!

If we look at the actual house prices the picture is exactly the one to expect from the most inefficient part of this market. The bubble will burst here in slow motion! It will go on for years. Slowly but surely prices will erode.

What i see as your mistake is that you have been staring at the slow-motion part of the bursting and have wrongly concluded from that slowness that there was no bubble (1), there is therefore no bursting(2) and that surely the bear market of housing related stocks in the markets was wrong(3) and would turn around any minute now (4).

How far can house prices fall? To answer that question we need to discuss a second effect of the inefficiency of the market in homes. Its regionality. Location, location, location. So my first answer to your question would be, it will differ locally. The largest declines will be in those places where the run up in prices has been large up to 2004/5 ánd there has been an overproduction of houses. Think Florida for example, or parts of California. I would not be surprised to see declines in the region of 50% in the most vulnerable communities.

Will there be an overall decline? Yes, i think so. Lets guestimate it at somewhere between 10 and 15%. 

In your answer to my earlier comment you seem to suggest that a 15% decline cannot represent a bursting of a bubble. But here you again make the mistake to compare this market to the much more efficient markets where capital is mobile. For a market that has not seen any significant downturn for ages a loss of 15% in say three (?) years will be the equivalent of a stock market crash. 

Just one last remark. You should resist the temptation of selectively quoting facts. The median prize increase (?) you quote is a prime example. Did you see the shiller index news, published on the same day?


sincerely yours,






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#8) On September 27, 2007 at 8:32 AM, EScroogeJr (< 20) wrote:

A well-balanced bearish opinion. Several comments.

As I said, I don't care about terminology. So let us call funny money capital (even though it still appears to me that a large part of it is "produced" in Bernanke's computer).  

I didn't quite understand your comment about overproduction of capital. How much capital would be "too much"? Are we back to normative economics, to guessing what things should be like, or do we just observe that every corporation produces as much capital as it can? And in that case, can we call something a bubble when the capital that inflates it seems to be just commensurate with the bubble's volume?

Inefficiencies of the market. I would submit that the housing market is one of the most efficient. Whereas a stock can go up 300% in just one year for noapparent reason, the fair price of a house is usually known with the margin of error of 20% at most.

Now, points 1), 2), 3), and 4). I am guilty as charged with 1), 2), and 3). But I never said that housing stocks will turn around any moment. Markets can remain irrational for years. Investors could wait a year, two year, even three years before they return to the market. But I can guarantee that in 5 years all of these stocks will be much higher than they are now. A couple of years ago I would have closed a position at 70% loss, but today, I would do such a thing only if convinced that the stock has never been anything but a sinking ship. Otherwise, I will just hold on, and eventually my Caps score will recover.

Bubble burst in slow motion? I wouldn't over-exaggerate the market inertia. When it was going up 20% a year, the market demonstrated an amazing agility and a very, very rapid adjustment to changing demand. When demand drops, a seller does not have to wait 3 years to realize what is going on. Then the seller makes a decision: is he going to go ahead with the transaction, or is he going to wait as long as needed until prices return to his minimum treshold. Usually after the first 3 months it becomes clear what the sellers decided to do. For the last 50 years, during every housing correction, sellers have always chosen to wait and they have always prevailed. This is what's going to happen this time as well.

Finally, I'm not being selective with my data. I do mension the Case-Shiller in the same post, and the thrust of my argument is precisely against those people who would quote the median only as long as it's going down. I was not afraid to address the issue of the falling median price  when it was going down, so I felt justified bringing up that issue when the price has gone up.

Respectfully yours,


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