Housing Boom, Bubble and Bust

Posted by PITHOCRATES - April 15th, 2013

Economics 101

Building and Furnishing Houses creates Great Economic Activity

Central to any booming economy are healthy home sales.  For home sales unleash great economic activity.  From the first surveys of a new subdivision.  To the new sewers and water systems.  Gas and telephone.  Cable television and broadband Internet.  Concrete for basements, driveways and sidewalks.  Structural steel (that beam in the basement and steel poles holding up the house).  Rough carpentry.  Electrical work and plumbing.  Drywall, windows and roofing.  Painting, flooring, doors and hardware.  Heating and air conditioning.  Lighting and plumbing fixtures.  Brick, siding and landscaping.  Etc.

All of this takes manufacturing to make these construction products.  All these manufacturers need raw materials.  And raw material extraction needs heavy equipment and energy.  At all of these stages of production are jobs.  Extracting raw materials.  Processing raw materials.  Manufacturing products out of these raw materials.  Building this production equipment.  Interconnecting these stages of production is every form of transportation.  Rail, Great Lake freighter, river barge and truck.  Requiring even more jobs to build locomotives, rolling stock, ships and trucks.  And jobs to operate and maintain them.  And build their infrastructure.  Filling all of these jobs are people.  Earning a paycheck that will let them buy a house one day.

Then even more economic activity follows.  As people buy these homes and furnish them.  Washers and dryers.  Refrigerators, stoves, microwaves, food processors and coffee makers.  Furniture and beds.  Light fixtures and ceiling fans.  Rugs, carpeting and vacuum cleaners.  Telephones, televisions, music systems, modems and computers.  Curtains, drapes, blinds and shades.  Shower curtains, bath mats, towels and clothes hampers.  Mops, buckets, cleaning supplies and waste baskets.  Lawnmowers, fertilizers, hoses and sprinklers.  Snow shovels and snow blowers.  Cribs, highchairs, diapers and baby food.  Etc.  All of these require manufacturers.  And all of these manufacturers require raw materials.  As well as transportation to move material and product between the stages of production.  And to our wholesalers and retailers.  More jobs.  More people earning a paycheck.  Who will one day buy their own home.  And create even more economic activity.

Bill Clinton pressured Lenders to Lower their Requirements and Subprime Lending took Off

This is why governments love housing.  And try to do everything within their power to increase home ownership.  Which is why they changed the path to home ownership.  After World War II when the building of subdivisions took off there was the 3-6-3 savings and loan.  Where savings and loan paid 3% interest on savings accounts.  Loaned money to home buyers at 6%.  And were on the golf course by 3 PM.  And the mortgage was the 30-year conventional mortgage with a 20% down payment.

The conventional mortgage was the mortgage of our parents.  Who had no problem putting off their wants to save money for that 20% down payment.  They prioritized.  And planned for the future.  But the conventional mortgage has an obvious drawback.  It limits home ownership to those who can save up a 20% down payment.  Pushing home ownership further out for some.  Or just taking that option away from a large percentage of the population.  So the government stepped in.  To help those who couldn’t save 20% of the house’s price.

Mortgage Qualification Decreasing Down Payment

As we lowered the down payment amount it allowed lower-income people the opportunity of home ownership.  But it didn’t get them a lot of house.  That is, those who could afford a 20% down payment could buy more house for the same monthly payment than those who couldn’t afford it.  And a house in a better neighborhood.  Which some said was unfair.  Some in government even called it discriminatory.  As Bill Clinton did.  Who pressured lenders to lower their lending requirements to qualify the unqualified.  His Policy Statement on Discrimination in Lending helped to fix that alleged problem.  And kicked off subprime lending in earnest.  Leading to the subprime mortgage crisis.  And the Great Recession.

Conventional Wisdom was to Pay the Most you could Possibly Afford when Buying a House

But lowering the down payment wasn’t enough.  Even eliminating it all together.  The people needed something else to help them into home ownership. And to generate all of that economic activity.  And this was something the government could fix, too.  By printing a lot of money.  So banks had a lot of it to lend.  Thus keeping interest rates artificially low.  And we can see the effect this had on home ownership combined with a zero down payment.  It allowed people to buy more house for the same given monthly payment.  Even more than those buying with the 3-6-3 conventional mortgage.

Mortgage Qualification Decreasing Mortgage Rate

Falling interest rates bring in a lot more people into the housing market.  Which is good for sellers.  And good for the economy.  A lot more people than just those who could afford a 20% down payment can now buy your house.  As people bid against each other to buy your house they bid up your price.  Raising home prices everywhere.  Increasing the demand for new housing.  Which builders responded to.  Creating a housing boom.  As builders flood the market with more houses.  At higher prices.  That new homeowners move into.  And max out their credit cards to furnish.  Creating a lot of debt people are servicing at these artificially low interest rates.  But then the economy begins to overheat.  And other prices begin to rise.  Leaving people with less disposable income.  The housing boom turns into a housing bubble.  House prices are overvalued.  Those artificially low interest rates created a lot of artificial demand.  Bringing people into the market who weren’t planning on buying a house.  But decided to buy only to take advantage of those low interest rates.

Conventional wisdom was to pay the most you could possibly afford when buying a house.  For all houses gained value.  You may struggle in the beginning and have to make some sacrifices.  Say cut out steak night each week.  But in time you will earn more money.  That house payment will become more affordable.  And your house will become more valuable.  Which will let you sell it for more at a later date letting you buy an even bigger house in an even nicer neighborhood.  But when it’s cheap interest rates driving all of this activity there is another problem.  For printing money creates inflation.  And inflation raises prices.  Gasoline is more expensive.  Groceries are more expensive.  As prices rise households have less disposable income.  And have to cut out things like vacations.  And any discretionary spending on things they like but don’t need.  Which destroys a lot of economic activity.  The very thing the government was trying to create more of by printing money.  So there is a limit to the good economic times you create by printing money.  And when the bad consequences of printing money start filtering through the rest of economy the government has no choice but to contract the money supply to limit the economic damage.  And steer the economy into what they call a soft landing.  Which means a recession that isn’t that painful or long.

The Price of Artificially Low Interest Rates is Inflationary Booms, Bubbles and Great Recessions

As interest rates rise home buying falls.  Leaving a lot of newly built homes unsold on the market.  And that housing bubble bursts.  Causing home values to fall back down from the stratosphere.  Leaving a lot of people owing more on their mortgage than their houses are now worth.  What we call being ‘underwater’.  And as interest rates rise so do the APRs on their credit cards.  As well as their monthly payments.  And those people who paid the most they could possible afford for a house with an adjustable rate mortgage saw their mortgage interest rates rise.  As well as their monthly payment.  By a lot.  So much that these people could no longer afford to pay their mortgage payment anymore.  As a half-point increase could raise a mortgage payment by about $50.  A full-point could raise it close to $100.  And so on.

Increasing Monthly Payment dur to Increasing Mortgage Rate

With the fall in economic activity unemployment rises.  So a lot of people who have crushing credit card debt and a house payment they can no longer afford lost their job as well.  Causing a rash of mortgage foreclosures.  And the subprime mortgage crisis.  As well as a great many personal bankruptcies.  Causing the banking system to struggle under the weight of all this bad debt.  Add all of this together and you get the Great Recession.

This is the price of artificially low interest rates.  You get inflationary booms.  And bubbles.  That burst into recessions.  That are often deep and long.  Something that didn’t happen during the days of 3-6-3 mortgage lending.  And the primary reason for that was that the U.S. was still on a quasi gold standard.  Which prevented the government from printing money at will.  The inflationary booms and busts that come with printing money.  And Great Recessions.

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Chinese Government fights Asset Bubbles and Speculation, Housing Prices Fall as does Economic Activity

Posted by PITHOCRATES - April 21st, 2012

Week in Review

The Chinese housing market isn’t what it was.  Which can be quite the problem considering the housing boom was 13% of China’s GDP (see China new home prices slide for sixth consecutive month posted 4/18/2012 on BBC News Business).

Property prices in China have fallen for a sixth consecutive month amid government efforts to control prices and curb speculation.

New home prices in 46 out of 70 Chinese cities fell between February and March. Meanwhile prices were lower than a year ago in 38 cities.

There have been fears of the formation of asset bubbles in China…

The booming housing industry supported China’s expansion in recent years, with real estate investment making up 13% of the nation’s gross domestic product in 2011…

“The ultimate goal of the property tightening is to drive down prices but maintain growth in construction and investment.”

Hey, this kind of sounds familiar.  Prior to 2008, the U.S. housing market was red hot.  People were being approved for mortgages they didn’t have a chance in hell of being able to repay.  And house flippers were walking in and getting mortgages for zero down.  Fixing them up and putting them back on the market.  The subprime mortgage made both of these possible.  And the government was doing everything within its power to put as many people in houses as possible.  Keeping interest rates artificially low.  And having their GSEs Fannie Mae and Freddie Mac buy up toxic subprime mortgages from banks and unloading them onto unsuspecting investors in the guise of ‘safe’ mortgage-backed securities.   The economy was booming.  Then the housing bubble burst.  As did the economy. 

The lesson here is the same the Japanese learned in the Nineties.  If you put your housing market on government steroids (artificially low interest rates, laws to force lenders t make bad loans, loan guarantees, etc.) it will crash and burn one day.  And if you keep building houses you will lower prices on homes already built.  The houses people are paying mortgages on.  And if you build enough new houses the value of the older houses will be less than the mortgage they’re paying.  Especially after the bubble bursts.  And you see how well that worked out in the U.S.  Suffice it to say President Obama is not running for reelection on his economic record.

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Problems in Chinese Housing Market as Developers file Bankruptcy?

Posted by PITHOCRATES - April 21st, 2012

Week in Review

Looks like the Chinese are having some troubles of their own (see More Chinese developers file for bankruptcy: report by Alex Frew McMillan posted 4/20/2012 on Reuters).

More Chinese property developers have filed for bankruptcy, the South China Morning Post reported on Friday, as some small real-estate companies struggle after more than two years of measures by Beijing to curb home prices in China…

With around 60,000 developers in China, analysts expect more failures among unlisted companies, which would benefit big, geographically-diverse listed developers such as China Vanke 000002.SZ and Evergrande Real Estate (3333.HK)…

Other developers have been selling off assets to pay down debt.

That kind of sounds like a housing bubble.  High home prices that Beijing has tried to curb for two years?  Selling off assets and filing bankruptcy?  Either home prices are too high and people aren’t buying.  Leaving a lot of empty houses on the market that developers can’t sell.  And as a result can’t repay their debt.  Or Beijing has been successful in curbing home prices.  And they’re selling below the amount of debt it took to build these houses.

Whatever the reason it’s bad for the housing market.  Correcting prices in an overvalued market is painful.  As it is always more painful on the down side of irrational exuberance.  And housing bubbles.  Talk to any U.S. homeowner whose house went underwater in 2008.  It ain’t pretty.  The U.S. economy could lose a decade of growth before the correction is over.  Much like the Japanese during their Lost Decade.  Who could also tell you a thing or two about housing bubbles.  And painful corrections.

Is it China’s turn?  Is it time for their economy to crash and burn?  Perhaps.  For they do like to meddle in their economy.  Just as the U.S. and the Japanese liked to meddle in theirs.

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The Great Housing Bubble and The Subprime Mortgage Crisis

Posted by PITHOCRATES - December 27th, 2011

History 101

Putting People into Houses trumped Sound Monetary Policy, a Sound Currency and good Lending Practices

Housing has for a long time been the key to economic prosperity.  Because to build a house you need a lot of economic activity.  Industries produce lumber, concrete, sheetrock, brick, shingles, door frames, doors, windows, glass, flooring, plumbing pipes, plumbing fixtures, sump pumps, furnaces, heating ducts, insulation, air conditioners, electrical wiring and fixtures, carpeting, tile, linoleum, etc.  The bigger the house the more of this stuff there is.  Once built people have to buy them (stimulating the mortgage banking industry) and then furnish them.  This triggers a monsoon of economic activity.  Drapes, shades, blinds, paint, washers, dryers, stoves, refrigerators, freezers, microwave ovens, toasters, blenders, food processers, plates, dishes, knives, silverware, ceiling fans, televisions, home theaters, sound systems, computers, cable and internet services, utilities, shelving, furniture, beds, cribs, art, etc.  And, of course, the exterior of the house creates further economic activity.

This is why one of the most important economic indicators is new housing starts.  For each new house we build we create a whirlwind of economic activity.  So much that it boggles the mind trying to think about it.  That’s why governments do whatever they can to stimulate this particular economic activity.  They encourage borrowing by allowing us to deduct the interest we pay on our mortgages.  They use monetary policy to keep interest rates as low as possible.  They’ve created federal programs to help veterans.  To help low income people.  And to remove risk from lenders to encourage more risky lending (as in Fannie Mae and Freddie Mac).  They’ve even used the power of government to force mortgage lenders to qualify the unqualified (Policy Statement on Discrimination in Lending).

You see, putting people into houses trumped everything else.  Sound monetary policy.  A sound currency.  Good lending practices.  Everything.  Because that was the key to a healthy economy.  A happy constituent.  And healthy tax revenue.  Not to mention you can score a lot of points with the poor and minorities by helping them into houses they can’t afford.  So this coordinated effort to put people into houses did two things.  Made money cheap and easy to borrow.  And created a boom in new housing starts.  Which resulted in a third thing.  A housing bubble.

Subprime Mortgages were for those who didn’t have Good Credit or Stable Employment with Reliable Income

Builders couldn’t build enough houses.  People were buying them faster than they built them.  And the houses they bought were getting bigger and bigger.  As they qualified for ever larger mortgages.  Poor people and people with bad credit could walk into a bank and get approved without documenting income.  House flippers could walk in day after day and get loans to buy houses.  Fix them up.  And put them back on the market.  Without using any of their own money. The market was soon flooded with new McMansions.  And refurbished smaller homes that people were moving out of.  Demand for homes was high.  And interest rates were low.  So the supply of homes swelled.  As did home prices.

Interest rates were low.  But they didn’t stay low.  All this coordinated effort to put as many people into homes as possible created a lot of artificial demand.  Heating up the economy.  Increasing prices higher than they had been.  Leading to inflationary worries.  So the Federal Reserve began to raise interest rates.  To temper that inflation.  Which didn’t sit well with those low income house owners.  Who got into their homes with the help of the Policy Statement on Discrimination in Lending.  Which forced lenders to get creative in qualifying the unqualified.  To avoid undo federal attention.  And legal actions against them.  So a lot of poor people had subprime mortgages.  As did all of those house flippers.  People who used little of their own money.  Who put little down.  And had little to lose.

What is a subprime mortgage?  In a word, risky.  It isn’t a 30-year fixed-rate mortgage at a good interest rate.  No, for those you need a good credit score and years of stable employment with reliable income.  And enough money saved up to put close to 20% down.  Subprime mortgages were for those who didn’t have a good credit score.  Years of stable employment with reliable income.  Or any savings.  These people didn’t get the ‘prime’ mortgages.  They got the expensive ones.  The ones with the higher interest rates.  And the higher monthly payments.  Why?  Because risk determined the interest rate.  And the higher the risk the higher the interest rate.

In their Effort to sustain Economic Activity the Government caused the Worst Recession since the Great Depression

But this posed a problem.  Because of the Policy Statement on Discrimination in Lending.  Making loans available to the unqualified was no good if the unqualified couldn’t afford them.  Enter the adjustable rate mortgage (ARM).  These mortgages had lower interest rates.  And lower monthly payments.  How you ask?  By making them adjustable.  A fixed-rate mortgage has to account for inflation.  And adjustable-rate mortgage doesn’t.  Because if there is inflation and the interest rates go up the ARM resets to a higher value.  Which is what happened right about the time housing prices peaked.

When the ARMs reset a lot of people couldn’t make their monthly payments anymore.  Having put little down and having made few monthly payments, these homeowners had little to lose by walking away from their homes.  And a lot of them did.  Including those house flippers.  And that was just the beginning.  With higher interest rates the new home market contracted.  Those artificially high house prices began to fall.  And when the ARMs reset they caused an avalanche of defaults and foreclosures.  The market was correcting.  There were far more houses for sale than there were buyers looking to buy.  Home values began to fall to reflect this real demand.  People who bought the biggest house they could afford because they thought real estate prices always went up soon discovered that wasn’t true.  People were making monthly payments on a mortgage that was greater than the value of their house.  Some walked away.  Some got out with short sales.  Where the lender agreed to eat the loss equity.

The housing market was imploding.  Thanks to a great real estate bubble created by the government.  In their quest to put as many people into houses as possible.  By making mortgages cheap and easy to get.  Relaxing lending standards.  And encouraging risky lending.  None of which would have happened had they left the housing market to market forces.  Where the market sets interest rates.  And housing prices.  The irony of the subprime mortgage crisis is that in their effort to sustain economic activity the government caused the worst recession since the Great Depression.  The Great Recession.

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Economic Recovery Requires less Keynesian Spending and more Cutting the Cost of Employment

Posted by PITHOCRATES - September 26th, 2011

The Structural Defect in Keynesian Economics is that Sustained Inflation Creates Asset Bubbles that Must Burst

More bad news for the housing market.  And the American economy (see New-home sales fell in August for 4th month by Derek Kravitz posted 9/26/2011 on the Associated Press).

Sales of new homes fell to a six-month low in August. The fourth straight monthly decline during the peak buying season suggests the housing market is years away from a recovery…

New-homes sales are on pace for the worst year since the government began keeping records a half century ago…

Last year was also the fifth straight year that sales have fallen. It followed five straight years of record highs, when housing was booming.

The housing market is bad.  There’s no denying that.  And this affects everyone.  Not just homeowners.  Because where the housing market goes the economy follows.

While new homes represent less than one-fifth of the housing market, they have an outsize impact on the economy. Each home built creates an average of three jobs for a year and generates about $90,000 in taxes, according to the National Association of Home Builders.

Jobs and taxes.  Both of which the government is having trouble generating these days.  That’s why they are desperately trying to stimulate the housing market with all that easy monetary policy.  Getting interest rates to their lowest in years.  If not of all time.  Because new houses equals jobs.  And tax revenue.  Especially when housing values increase over time.

Home prices have dropped more since the recession started, on a percentage basis, than during the Great Depression of the 1930s. It took 19 years for prices to fully recover after the Depression.

But not so much when they don’t.

Worse than the Great Depression.  Now there’s something you don’t hear every day.

One of the missions of the Federal Reserve was to prevent another Great Depression.  In particular, preventing a devastating deflationary spiral.  Such as we’re seeing in home prices now.  Looks like they’ve failed.  Or rather, Keynesian Economics has failed.

The problem is the dependence on Keynesian Economics.  Which uses monetary policy to maintain economic growth.  By having permanent but ‘sustainable’ inflation.  But the structural defect in this model is that sustained inflation creates asset bubbles.  As people bid up the prices of these assets.  Like houses prior to the subprime mortgage crisis.  And when these bubbles burst these asset prices have to fall back to market levels.  Like house prices are doing right now.  And apparently will do for another 19 years.  Give or take.

It is the High Cost of Labor that is Hurting the Advanced Economies

Manufacturing has been better than the housing market.  But it’s not looking too promising right now (see U.S. manufacturing slowdown: 4 cities at most risk posted 9/26/2011 on CNN Money).

U.S. manufacturing has been one of the rare bright spots in an otherwise annoyingly slow economic recovery…

But expectations of slower growth could threaten the rebound and cities that have gained from it. The ongoing European debt crisis and efforts to curb worries over inflation in China have analysts predicting lower demand for everything from American-made electronics to machinery.

U.S. manufacturing grew 6% during the economic recovery after declining 13% following the financial crisis in 2007. IHS Global Insight economist Tom Runiewicz says the industry has grown 4.5% so far this year. While that’s still robust growth, he expects manufacturing growth to slow to 2.9% next year.

The American consumer may not have been buying but consumers in other countries were.  A good example of American exports is the delivery of the first Boeing 787 to ANA.  And Boeing’s 747-8, too.   Though the largest U.S. exporter, Boeing won’t be able to fix the economy alone.  Especially when they’re competing against Airbus.

It is the high cost of labor that is hurting the advanced economies.  The Europeans subsidize some of their industries to make up for this economic disadvantage.  Boeing charges Airbus with getting subsidies that lets them compete unfairly.  And Airbus, of course, accuses Boeing of the same.   To help gain a competitive edge over Airbus, Boeing wanted to expand production in South Carolina.  A right to work state.  Which the Obama administration has opposed.  In support of their union donors.

The lesson of the Boeing-Airbus rivalry is this.  They’d be able to sell more planes if they could cut their labor costs.

Listening to the Private Sector turned around the German Economy and is why they can Bail Out the Euro

Germany’s high cost of labor was crippling her economy.  BMW and Mercedes-Benz built plants in America to escape their high cost of labor.  But things are different in Germany these days.  In fact, the country is so rich that the hopes of saving the Euro common currency falls on the German economy.  The only European economy rich enough to save the Euro.  So how did they make this turnaround?  Through reforms (see Getting People Back to Work by Matt Mitchell posted 9/26/2011 on Mercatus Center at George Mason University).

Germany’s unemployment rate is only 6.2 percent today. This is pretty remarkable given the severity of the recent recession, the slow growth of Germany’s trade partners (including the U.S.) and the unfolding fiscal crisis in the Eurozone.

NPR’s Caitlin Kenney attributes Germany’s relative success to a number of reforms adopted a decade ago. Kenney reports:

To figure out how Germany got where it is today, you need to go back 10 years. In 2002, Germany looked a lot like the United States does now, they had no economic growth and their unemployment rate was 8.7 percent and climbing. The country needed help, so the top man in Germany at the time, Gerhard Schroder, the German chancellor, made in an emergency call to a trusted friend.

So who did he turn to?  A government bureaucrat?  Or someone from the private sector?

The friend was Peter Hartz, a former HR director whom Schroder knew from his VW days. Schroder put Hartz in charge of a commission, the mission of which was to find a way to make Germany’s labor market more flexible. The Hartz commission made it easier to hire someone for a low-paying, temporary job, a so-called “mini job”:

A mini-job isn’t that great of a deal for workers. In these jobs, they can work as many hours as the employer wants them to, but the maximum they can earn is 400 Euros per month. On the plus side, they get to keep it all. They don’t pay any taxes on the money. And they do still get some government assistance.

He went to the private sector.  To get advice of how to create jobs in the private sector.  And he listened to what they said.  The cost of labor and regulatory costs were crippling job creation.

Generous unemployment insurance and regulations that add to the cost of employment tend to make for a static, unhealthy labor market. Though designed to make life better for workers, these policies may do them more harm than good.

Listening to the private sector turned around the German economy.  Made it the dynamo it is today.  And it is why that the German economy is the only economy that can bail out the Euro.

Economic Recovery Requires New Jobs

The economy still looks like it’s going to get worse before it gets better.  Whereas the Germans are doing so well that they may single-handedly bailout the Eurozone from their sovereign debt crisis.  And a lot of Americans are saying that should be us.  Not the bailing out the Eurozone part.  But having the ability to do that.

And that could have been us.  And should have been.  Like it used to be.  When America led the world in creating jobs.  So what happened?  The same thing that had happened in Germany.  The cost of employment grew.  And as it grew new job creation declined.

Economic recovery requires new jobs.  The Germans understood that.  And they did something about it.  So should we.  And the sooner we do the sooner we will see that economic recovery.

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