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Tilting at Windmills

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February 13, 2008
By: Kevin Drum

WAS THERE A HOUSING BUBBLE?....Alex Tabarrok takes a look at housing prices today and makes a seemingly odd argument about whether we're really in the midst of a housing bubble:

The clear implication of the chart is that normal prices are around an index value of 110, the value that reigned for nearly fifty years (circa 1950-1997). So if the massive run-up in house prices since 1997 was a bubble and if the bubble has now been popped we should see a massive drop in prices.

But what has actually happened? House prices have certainly stopped increasing and they have dropped but they have not dropped to anywhere near the historic average....If we don't see the massive drop back to "normal" levels then the run up in prices should be described as a shift to a new equilibrium — much as happened during World War II — see the chart. (It's an important question to ask what changed and why?). In the shift to the new equilibrium there was some mild overshooting, especially due to the subprime over expansion, but fundamentally there was no housing bubble.

But doesn't this depend on whether the overshoot really does turn out to be "mild"? I too don't expect to see home prices go down to their historical levels, but if the housing index goes from 110 to 200 and then crashes back to 160, what would you call that? I'd call it both a new equilibrium and a bubble.

As for what changed to produce this new equilibrium, I don't know. But here's my guess: it's mostly a delayed reaction to growing real incomes. In the past, lenders and buyers both believed that families couldn't afford to spend more than about 20-25% of their income on housing. And maybe that used to be true. Today it's not, and I think that in the late 90s everyone finally internalized the fact that the average family can, in fact, afford to spend more like 30% of their income on housing. Maybe even a bit more. Unfortunately, a few years later everyone started internalizing numbers more like 40% or 45%, and then the trouble started.

Result: a bubble that took the housing index up to 200, followed by a pop that will take us down to a new equilibrium around 160 or so. That's my hunch, anyway. Housing prices may be sticky downward, but eventually they'll unstick. We're nowhere near done with the housing bubble yet.

UPDATE: A reader points out that falling interest rates were obviously one of the drivers of the bubble too. That's true. More efficient credit markets helped as well (though those markets turned out not to be quite as efficient as everyone thought). But even if interest rates eventually go back up to historical levels, I suspect that housing prices won't go down to theirs. We're probably still going to end up at a higher equilibrium than in the past.

Kevin Drum 2:44 PM Permalink | Trackbacks | Comments (59)

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I think Tabarrok is absolutely correct. Coincidentally, I have a house in his neighborhood I am thinking of selling.... Alex, can I give you a call?

Posted by: jerry on February 13, 2008 at 2:57 PM | PERMALINK

I'm not the most historically knowledgable guy in the world, but it seems to me the post WWII "new equilibrium" was due to structural economic changes. First there was a growing and persistent middle class with high income levels. Second there was (i think) a large growth in urban population where zoning regulations and space limitations lead to inevitably higher housing costs. The current boom in prices seems to be based on non-structural, short lived variations. Mainly, low interest rates, unregulated lending practices and often seen bubble hysteria. None of these things will lead to a new equilibrium.

Posted by: kahner on February 13, 2008 at 3:05 PM | PERMALINK

Nope, big crash in prices coming, Kevin. The square footage of a "standard house" has exploded over the last decade. IIRC, it was about 1600 sq. feet average and now it is over 2300 sq. feet. When money got so damn cheap people spent about the same % of income or more (depending on location) and bought or built a MUCH larger house. Now the money isn't cheap we can't afford these humongous boxes. Not to mention trying to heat and cool them on stagnant incomes. In short, we're making about the same wages as we were ten years ago (the bottom 40% less), but cheap money made our houses huge. Now we can't afford a huge home anymore and most of the homes are huge that are on the market.

Posted by: Doc at the Radar Station on February 13, 2008 at 3:06 PM | PERMALINK

Oh, and to add a little more... The reason house prices haven't tumbled that much thus far is because most homeowners aren't aware that the prices on houses that ARE selling have dropped as much as they have. People often list a property for quite a few months before they relinquish and reduce the price.

Posted by: Doc at the Radar Station on February 13, 2008 at 3:09 PM | PERMALINK

Of course there's a bubble - maybe not everywhere, but certainly in a lot of places.

How else does one describe a situation where until a few months ago, there was a market for what has abruptly turned out to be a few years' worth of oversupply of housing?

Posted by: low-tech cyclist on February 13, 2008 at 3:09 PM | PERMALINK

The problem with the 40-45% ratios is that they were used to qualify people on ARMS or Option ARMS but the ratio after the resets was not taken into consideration. 40-45% may be marginally feasible for some people, it's the 75-100% ratios post-reset that could never be feasible that contributed to all this.

Posted by: david in norcal on February 13, 2008 at 3:10 PM | PERMALINK

The house next to mine is for sale for $360K, and it is a 1920s vintage house with no appliance or fixtures more recent than the 1960s. Only one full bathroom. It is near the bottom of the market in this town in central CT with good schools. Its price was appropriate for summer 2007, before the credit crunch; there are plenty of $450-500K homes in the general neighborhood. At the open house last weekend the visitors drove some mighty nice vehicles, in one case a Range Rover. If the tony real-estate clientele are cluster-browsing the bottom of the market, there will soon be much downward pressure on the more-expensive properties.

Tabarrok's conclusion could be supported if the real-estate market were still active, with buying and selling at the new peak valuation. That isnt happening right now.

Posted by: troglodyte on February 13, 2008 at 3:19 PM | PERMALINK

160? Very very optimistic.

130 or 140 is more like it.

Posted by: Crab Nebula on February 13, 2008 at 3:24 PM | PERMALINK

Inflation. Price drops alone may take us to an index of 150 or so, but increasing inflation over the next five years will push the index a good deal lower.

Since we can not get honest inflation numbers out of the government, it is sheer guesswork as to what the index should properly be today.

Posted by: Xenos on February 13, 2008 at 3:32 PM | PERMALINK

Agreed, troglodyte; we're nowhere near the point where prices reflect an equilibrium. Only when sales volume has recovered and we've worked through surplus inventory can we say that an equilibrium has been reached. That won't be for another couple of years at the earliest.

Posted by: idlemind on February 13, 2008 at 3:35 PM | PERMALINK

It astonishes me that anyone would attempt to describe the bursting of the housing bubble yet. We're just about a year or two from the peak! Look at the distance between peak and trough historically... about 20 years from the mid-sixties peak, six from the 1980 peak, eight from the 1990 peak... and Tabarrok wants to describe the extent of this, the greatest build-up ever on the basis of a few months? It's a fool's errand.

Posted by: Wagster on February 13, 2008 at 3:41 PM | PERMALINK

It seems to me that housing prices will sink lower for another reason. One reason people could afford to put a higher percentage of their income toward housing were the relativity low costs of food and energy. These costs are both going up. It stands to reason that we'll have less money to spend on housing in the future.

Posted by: cowalker on February 13, 2008 at 3:43 PM | PERMALINK

The chart is only refers to house prices. It has no relationship to incomes (nominal or real). The return to the mean for house prices will be in relationship to real incomes, and we all know what has happened to them in the past 27 years.

I do like to note that we bought both our first and second houses at the low points on the chart in the 80s and 90s. (sits back, smugly hits "post")

Posted by: Peter VE on February 13, 2008 at 3:45 PM | PERMALINK

Not all housing is created equal. The massive tracts of massive homes in places like Stockton, CA have almost negative intrinsic value (expensive to heat and cool and not near any meaningful source of income).

But flats in the outer boroughs of NYC, for example, have a tremendous amount of intrinsic value, and while possibly overvalued in recent years, will not see anything coming close to a "collapse" in prices.

Posted by: Zac on February 13, 2008 at 3:48 PM | PERMALINK

Tabarrok's reasoning is specious. Comparing the present to the 1940s is not valid because in that instance housing prices increased up to the norm after cratering, whereas this time they shot up first; the situation is reversed. His argument can easily be refuted by noting that it's much easier for the housing market as a whole to go up quickly (because people like it and want it and it has good economic effects) than it is to drop precipitously (because people's lives are ruined by it and will fight it tooth and nail and it has painful economic effects). So it will take a lot longer for the market to drop 70-80% than it did for it to rise 50%. Most economic forces will fight that decline.

Am I missing something here? Several times I have seen the observation made that prices may drop by X percent, or they might stay flat until inflation erodes X percent value, or some combination thereof. The reason given is that many factors are resistant to depreciating home values and people don't want to sell houses at a loss.

Posted by: blah2 on February 13, 2008 at 3:49 PM | PERMALINK

"> post WWII "new equilibrium" was due to structural economic changes. "

Demographics is also about to be a massive player in the slide of the housing market.

1945-1960... How do you spell 'baby boom'? (Buy)
2005-2020... Boomers retire and/or die. (Sell)

Posted by: Buford on February 13, 2008 at 3:51 PM | PERMALINK

There was certainly an overshoot but there are good reasons to expect that house prices will not return to pre-runup levels.

The fact is that today people have a lot more disposable income and dump a lot more of it into their houses. As a result the cost of building houses has been going up. Granite counter tops are now automatic in most new construction, so is central air, a garage is essential and its no longer a master bedroom, its a suite and the guest bedroom will likely be en-suite to boot.

Well what else are people going to spend their money on?

The prices of Victorians in particular have gone up as the stock has been extensively and aggressively renovated. My house is now in the best condition its been in for sixty years, new windows, roof, central air and electrics. Twenty years ago people were still 'modernizing' Victorians. Nobody talks about that today, its 'restore'.

The prices round here were going up because the Boston big dig has made this whole area a premium commuting suburb of Boston. They have slid somewhat but will recover.

The prices on the West coast have an entirely different dynamic. Prices in the valley are unlikely to burst completely, there will always be people with the cash to spare who are willing to invest it in a house to avoid their hour plus commute. But the overbuilt suburbs are totally toast.

If you look at the price of the same four bedroom house in different parts of the country you will see an order of magnitude difference in price. There are many different dynamics in different parts of the country. At the moment everything is going to be falling but in a couple of years time we will be seeing some parts of the country returning to boom, others continuing to crash and yet more that are entirely stagnant.

If you want to know what is going to happen look at the local rental prices. If there is a significant rental sector and rental prices drop significantly below the cost of maintaining a mortgage on the property you should expect to see a crash as the over-leveraged landlords go under.

Posted by: PHB on February 13, 2008 at 3:52 PM | PERMALINK

I think the dramatic increase in double-income families is the main factor in setting the new equilibrium.

Posted by: Bob on February 13, 2008 at 3:52 PM | PERMALINK

... And maybe that used to be true. Today it's not, and I think that in the late 90s everyone finally internalized the fact that the average family can, in fact, afford to spend more like 30% of their income on housing.

I'm bothered by this idea we decided it was perfectly reasonable to spend more of our income on housing. Clearly, we found the extra cash, but were we actually able to afford it? It seems that the rise in housing spending coincides with the rise of debt and decline of savings. Just because we decided we could (or had to, depending on location) spend more on housing doesn't mean we should have simply accepted that as appropriate or wise.

Posted by: filosofickle on February 13, 2008 at 3:58 PM | PERMALINK

a couple of things

real incomes are doubling ever 35 years or so

longer term mortgages and ARMs have lowered monthly payments relative to principle amounts

Posted by: ed_finnertyhly on February 13, 2008 at 4:17 PM | PERMALINK

I am not sure we can trust his opinion of the housing market considering the fact that he has had a house sitting on the market for 83 days, despite dropping the price 9K.


Posted by: Rory on February 13, 2008 at 4:30 PM | PERMALINK

"No bubble because prices are holding steady." I've been hearing this line of reasoning for 18 months now. Before that it was "No bubble because prices are going up." This is the kind anti-analysis that can be safely ignored regardless of your opinion of the market. As always, Calculated Risk has the in-depth scoop.

Posted by: House Whisperer on February 13, 2008 at 4:37 PM | PERMALINK

A couple of potential explanations:

Houses have a LOT more square footage than ever before. Are we comparing apples and oranges?

The prices of land has gone up and will continue to increase with increasing incomes and populations.

One obvious question would be, Why now?

I dont have a good immediate answer, but it may be connected to their usually being less elasticity in home prices but once that that was overcome, the prices surged.

Of course this probably unduely optimistic post rationalization.

I found this link from 2005: http://www.msnbc.msn.com/id/8544466/

"But in 1980, the average home was 1,740 square feet, had three bedrooms or less, and two bathrooms or less, according to U.S. Census figures. About a quarter of the new houses you looked at in 1980 would have had no garage; a third would lack air conditioning.

Last year, the average new home buyer bought 2,349 square feet of living space, with at least three bedrooms and two-and-a-half bathrooms, with a garage that held at least two cars. Some 90 percent included air conditioning.

Not only are today’s new houses packing more square footage, they have more volume -- nine-foot ceilings are becoming the norm."

According to the chart housing prices between 1980 and 2005 increased by roughly 50% while the average square footage increased by about 35%.

Posted by: CAtch22 on February 13, 2008 at 4:41 PM | PERMALINK

Ignore my last post... mistake.

Posted by: Rory on February 13, 2008 at 4:43 PM | PERMALINK

I would read what Paul Krugman (http://krugman.blogs.nytimes.com/) has to say regarding this at his blog. I think that he draws a more accurate conclusion that home prices are "sticky" and that there will be a delay in their readjustment.

Posted by: DWN on February 13, 2008 at 4:58 PM | PERMALINK

Another point to remember is that real estate is inherently not an efficient market. One effect of that is that changes in prices do not occur overnight as they do in the other financial markets.

One estimate I saw was that the housing in California and Florida were about 40% above what the incomes of the owners could afford, particularly when compared to rental rates. The housing in the Northeastern U.S. was about 30% high. All of these markets have dropped about 10%, meaning at least 20% and may 30% more to drop.

Why have they not dropped further and faster? a lot of people simply can't afford to lose that much money, and until they put the houses on the market, they haven't lost it. So the houses aren't going on the market at current prices. Sellers are not willing to let prices drop to what the market would expect, and they are doing everything possible to stay out of the market right now.

Unfortunately, there are two more upwards readjustments of the ARMs still coming this year, each of which will put a lot more downward pressure on home prices.

The other thing is that inflation is going to bail out a lot of mortgage holders who are currently upside down. But that, too, will take time, because the wage increases that bring wage earners up to inflated prices are themselves a trailing result of inflation since this is not a wage-push inflation. This is an energy price and import price inflation. It's only just started, but the fed's efforts to stimulate the economy by lowering interest rates will push the inflation up as the lower interest rates cause the dollar value to drop further.

Complicated - but what it really means is that home prices will take a couple of years to work out, and when they do the real price of real estate is going to be a lot lower than it is even now in a number of major markets.

Posted by: Rick B on February 13, 2008 at 5:15 PM | PERMALINK

What blah2 and DWN said. People are used to excess returns from real estate. If the market doesn't give them that, they'll hold. Unless they have to sell, in which case heaven help us all.

With a huge inventory of unsold houses out there, claiming that pricess are going to stabilize at a new equilibrium simply ignores the usual rules of supply and demand. (Now the market can stay irrational longer than any of us can stay solvent, but eventually things do come to sanity.) People keep making -- and then losing -- enormous piles of money by claimed that the usual rules don't apply to their sector.

One thing that may bring supply and demand back in balance is the relatively short lifetime -- especially when ill-maintained -- of newer housing stock. Give some of these houses a few years of vacancy or no maintenance, and there won't be anything left to sell.

Posted by: paul on February 13, 2008 at 5:20 PM | PERMALINK

"Only when sales volume has recovered and we've worked through surplus inventory can we say that an equilibrium has been reached. That won't be for another couple of years at the earliest."

This may take a bit longer. A few weeks ago there was a Bloomberg article stating 2 million housing units "for sale" nationwide. And 18 MILLION units are "unoccupied" (for any reason-under construction,vacant,foreclosed,etc).

Posted by: CTF on February 13, 2008 at 5:24 PM | PERMALINK

Sayeth Kevin: "As for what changed to produce this new equilibrium, I don't know. But here's my guess: it's mostly a delayed reaction to growing real incomes."

What are these growing real incomes of which you speak?

Posted by: Jose Padilla on February 13, 2008 at 6:00 PM | PERMALINK

Don't listen to crabnebula, he's just the corpse of a star that died a thousand years ago.

Doc is right about the vastly increased size of the average house, that should keep the prices above the historic level. I think the main thing (scam) that allowed them to go so high was that we somehow got people to think not about price, but only about monthly payments. That meant if you got a low interest rate, and a very long term loan, you figured the house was cheap. Real estate agents chanting that real estate never goes down in value, was sufficient to get the average dimwit to discount the change of getting caught owing much more than the house was worth.

Posted by: bigTom on February 13, 2008 at 6:01 PM | PERMALINK

And while they were deciding that they could afford 30%...40%...even 45% for housing, they were also deciding that they liked the idea of a savings rate of 0%. They also decided that they could carry $8 to $10 thousand on credit cards, that they could buy a car for what their parents paid for a little ranch house or bungalow.

And, what the hell, why not pop $50 grand for a wedding for one of the kids (do it for one, you've gotta do it for all) that can be financed on the equity in our our non-bubble house.

Can't consider the housing bubble without factoring in all the other bubblicious stuff that was served as appetizer and fabulous entree, then dessert followed by expensive cigars and "What do you say? How 'bout we buy a nice condo at Gulf Shores?"

It's not a bubble. It's a fookin' nightmare.

Posted by: Jimboman on February 13, 2008 at 6:11 PM | PERMALINK
But what has actually happened? House prices have certainly stopped increasing and they have dropped but they have not dropped to anywhere near the historic average

Well, duh. If you look at the charts, after a decade-long runup, we've maybe just barely peaked and started downward. Most of the recent past boom-and-bust cycles are (see the 1970s and 1980s ones on the chart) are roughly symmetrical, taking about as long to collapse as to initially climb to the peak.

It is certainly ludicrous to conclude that we are at a new equilibrium since we haven't yet fallen to pre-boom prices. Sure, its possible, but there isn't any particular indication. All that you can say now is that it looks like the boom has stalled and given back ground; whether are going to see a "bust" the whole way back to the average of the last half-century or a smaller correction is less clear.

Posted by: cmdicely on February 13, 2008 at 6:18 PM | PERMALINK

We're only in the first inning of the housing crash. Wait a year and tell me that we have a new, higher equilibrium price.

Houses are not like stocks, even if they are investments. The psychology of selling a house that was supposed to be your nest egg is completely different. Prices come down slowly but they eventually come down. The rate of foreclosures and short sales in every state has also increased dramatically and is picking up speed.

I predict Alex Tabarrok will be revising his conclusions before long.

Posted by: DevilDog on February 13, 2008 at 6:36 PM | PERMALINK

Whenever I hear someone talking about a new paradigm, I want to reach for my gun.

The only places that will not see housing prices reset to local median household income are those where there are significant constraints on expanding the supply on housing units and a good supply of rich people to purchase thoses units. This includes a fairly small number of communities not unlike Manhattan and SanFrancisco.

Posted by: Ray on February 13, 2008 at 6:52 PM | PERMALINK

Rent is a huge factor in CPI, and the Schiller graph is implicitly a ratio of rent to house prices. If we do not revert to at least 120 then it will never make financial sense to ever buy a house again. You will make more money renting and investing the difference in something that barely beats inflation. It is that simple.

You can wish that prices will stay up, but that won't keep them up.

Posted by: Walker on February 13, 2008 at 6:58 PM | PERMALINK

Maybe one way to predict how low house prices will drop is to correlate that with Inkblot's weight.

Then Kevin can solve this pesky housing crisis simply by feeding Inkblot more nibblies and treats.

Posted by: optical weenie on February 13, 2008 at 7:00 PM | PERMALINK

One question:

Then why are rents still on the old formula?

Posted by: Crissa on February 13, 2008 at 7:12 PM | PERMALINK

Most of the posts are spot on - of course it was a housing bubble. That article reminds me of some of the articles in the 90s that postulates whether the "new economy" has managed to beat the economic cycle, which is patently absurd, of course.

Posted by: Andy on February 13, 2008 at 7:16 PM | PERMALINK

You are engaging in wishful thinking. There are fundamental differences between too much cheap money and play-now-pay-later mortgage and re-financing schemes driving an asset bubble and broad demographic changes and government policies supporting expansion of home ownership.

The latter was then and the former is now. There will no no "new equilibrium." Housing prices are poised to fall like the proverbial stone.

Posted by: Bob Hall on February 13, 2008 at 7:30 PM | PERMALINK

By the way, for people who are arguing that we will just spend more of our income on housing in order to support this graph... That is a completely orthogonal issue. We can spend 40% on housing, but if rents rise significantly to meet them, then the curve in that graph will still revert to historical levels. What has happened in that case is that inflation has eroded your real wages so that you are poorer. And that is what people who want prices to stay high are really advocating -- hyperinflation that will erode the value of the dollar so that house prices are stable but people become poorer supporting these assets.

Whether we are going to experience deflation (house prices go down) or inflation (rent prices go higher) is a matter of great debate. But the fact remains that either way, the curve will revert to historical levels.

Posted by: Walker on February 13, 2008 at 7:35 PM | PERMALINK

I was amazed to see how far this thread progressed before rents were finally mentioned. Comparing sale prices from different eras is interesting to a point, but comparing prices to what people with cash are willing to pay to live somewhere yields a clearer picture, since monthly rent can't be financed or deferred by shifting risk onto hapless foreign investors. In the fizzier coastal real estate markets, one can still rent comparable houses for about half of the monthly ownership cost. To put it another way, experts used to say that price/annual rent ratios of 16 or so signified a lot of froth in a real estate market. I'm writing this from a rental house about 2 miles from a very large corporate campus in a Seattle suburb, with a price/annual rent ratio of about 28. Although both the prices and rents in my neighborhood are higher than the county average, that ratio holds fairly consistent as one moves further out.

It seems to me that the largest housing glut in then nation's history combined with an economic downturn will not raise rents any large amount. That puts my local market on a collision course with a 35%-50% reduction in values before renting isn't obviously a better deal. This will be probably be spread over several years, though.

Posted by: Jim on February 13, 2008 at 7:47 PM | PERMALINK

What I find really fascinating about the chart is the steep drop (35%) in home prices well before (like 9 years before) the stock market crash of '29 (presaging the Great Depression). What's up with that? And does anyone feel like we're tempting fate on that score again?

Posted by: CB on February 13, 2008 at 7:59 PM | PERMALINK

CB, Check out this link where the fine print is legible:

"Prices dropped as mass production techniques appeared early in the 20th century. Prices spiked with post-war housing demand."

Posted by: Doc at the Radar Station on February 13, 2008 at 8:18 PM | PERMALINK

Whether we are going to experience deflation (house prices go down) or inflation (rent prices go higher) is a matter of great debate.

Based on the ever-dropping Fed rates in the face of a weak dollar and energy & food inflation, it appears that those in power have chosen for us to get the inflation option.

Let the war on savers begin!

Posted by: Xenos on February 13, 2008 at 9:52 PM | PERMALINK

The problem with housing prices at the current level is that normal people can't buy at existing prices without exotic loans (which are no longer available.) A couple looking to buy their first home in Southern California has to have a combined income of at least 90k to be able to afford a $350k home. Even starter homes in dodgy neighborhoods like mine haven't dropped down to that level yet. I bought my tiny little bungalow (one bath, no granite counter tops) for $170k back in 2002. Listings of similar size houses are still hovering around $380-$400 for this area (down from a peak of $475 at the top.) I would have to be pulling down $100k a year to be able to buy my own house now. Prices have to drop to levels that people can afford to buy at.

Posted by: arteclectic on February 13, 2008 at 9:58 PM | PERMALINK

The problem with housing prices at the current level is that normal people can't buy at existing prices without exotic loans (which are no longer available.)

It is more than that. It is that it makes absolutely no sense to buy right now.

Where I am, prices seem comparatively low. I can get a 3/2 with a small lawn for around $225k. Local property-school tax is 3%. With a 20% down payment at 6.25%, I calculate a little over $1800 a month. Yes, some of that can be deducted from income tax, but the tax savings are less than $400 a month. With a monthly principal payment of under $200, I am looking at a monthly "rent" (e.g. money that is being thrown away and cannot be recovered from a sale) of around $1200.

Alternatively, I can rent a 3/2 farmhouse on 10 acres with a small apple orchard for $900/month.

Anyone buying a home right now has no idea how to manage money.

Posted by: Walker on February 13, 2008 at 11:05 PM | PERMALINK

So many good answers above. Can I proffer a bad answer?

Where did I read that during an election year where the economy sucks, the political party in power is more or less fired on election day?

Could it be that Bush and Republicans are artificially keeping the crash in a holding pattern?

Impossible, couldn’t happen some say.

Gas for 2 dollars a gallon in October of 06 (just before the midterm elections) couldn’t happen either.

Posted by: Testing on February 13, 2008 at 11:14 PM | PERMALINK

Testing, good point about the gas prices in late '06, it does get one to wondering there... It wouldn't surprise me a bit if there has been some accounting shenanigans regarding the Strategic Petroleum Reserve and domestic refineries. As far as the crash holding pattern goes, I think of it more like someone catching expensive and highly fragile vases thrown off shelves by an earthquake just before they reach the floor, and the aftershocks keep coming. More of a sad and reactive sort of thing. If the vase makers hadn't made such needlessly fragile and expensive products...

Posted by: Doc at the Radar Station on February 14, 2008 at 12:06 AM | PERMALINK

Doc: you are basically on fire on this thread. Made some great points. Hat's off.
I would simply reiterate that it isn't a question of IF there was a bubble, but the unfortunate truth that it was unbelievably, and I mean unbelievably large. Home prices rose like we were all working for Exxon-Mobil. But we weren't. People who bought late in this fantasy cycle are trying very hard not to see their investments lose 100s of percent of value. But they have. The reward for buying a huge and expensive house is very little disposable income from your tenuous job, and a HUGE tax burden that will never go away till everything sinks to where our incomes can sustain their cost. Everyone from banks to school districts is loathe to see the bubble blow up. And they know that the $600 "stimulus" check won't buy one month of utility payments or keep foreclosures away. But there are a lot of over-priced and unsold homes everywhere. The game is over and it takes no chess master to see three or four forced moves away. . .

Posted by: Sparko on February 14, 2008 at 12:22 AM | PERMALINK

Doc is right about the vastly increased size of the average house, that should keep the prices above the historic level.

Posted by: bigTom on February 13, 2008 at 6:01 PM | PERMALINK

Presumably in the same way that America's vast armada of supersize SUVs will keep car prices high.

Posted by: Jassalasca Jape on February 14, 2008 at 1:50 AM | PERMALINK

If the budget is balanced going forward (i.e. tax rates rise) then prices will continue to fall. What was unstainable, will stay unsustainable. There is BIG trouble coming. Kevin, I think you are vastly underestimating the importance of:
1. Peak Oil
2. The balance of payments deficit
3. The Federal Government General Deficit.

Posted by: reason on February 14, 2008 at 2:55 AM | PERMALINK

Has someone an equivalent chart for Japan? That should give you a good idea of what might reasonably happen.

Posted by: reason on February 14, 2008 at 3:06 AM | PERMALINK

I must protest the portion of the post that suggests that the credit markets have become more efficient. The truth is that this statement is a partial truth. As we're learning, the credit markets, and the risk diversification instruments invented to serve this market, have proven to be quite inefficient do to a complete lack of transparency and no real means to price to market. As such, these vehicles which are designed to allow for a more fluid use of capital by banks and other lenders have proven to be the source of many problems most prominently insolvency to the tune of over $125 billion and counting.

Furthermore, the fact that the post's author glosses over the impact of irresponsibly low interest rates for an extended period of years weakens the thrust of an otherwise worthwhile piece.

Lastly, as deceased former Fed Governor Ed Gramlich wrote, the Fed under Greenspan simply refused to act within its legally defined role as regulator thereby abetting the rise of the housing bubble and setting the nation at large and millions of home-owners specifically to serious financial issues.

I'll conclude by saying that a return to the mean for house prices will most likely not happen as a calamitous decline event but will occur over time as a slow, painful stagnation of value that directly impacts the financial well being of US home-owners.

Posted by: wphurley on February 14, 2008 at 4:01 AM | PERMALINK

Tabarrok never heard about pigeons, did he?

It would be well to remember that the shift in house values followed the aptly named Great Depression that lasted ten years until WWII, during which the economy was controlled and millions of young men under arms and overseas. The fact that there is basically one smooth adjustment to the 110 range during the post war housing boom and thereafter speaks volumes for economic management, whether deliberate or not.

Since 1997 the graph indicates an unsustainable rate of change. Do the math. Whether it will ever hit 110 again I somewhat doubt, would indicate serious economic problems, and possibly a buy if the problems are not terminal.

As pointed out, houses built this millenia are huge compared to the post-WWII boxes. Building land, especially convenient land, is limited. Population and demand are (were) higher. The government actively encourages home (and even second home) ownership. All these would add up to a permanent shift.

On the other hand, inappropriate buyers were induced into the market. Or, at least, to inappropriate mortgages. Hopefully, if they come back, it will be at what they can afford. This represented overdemand for a period of time. Some of the sub-prime savior proposals seem to want to gum the market with this overhang rather than to clear it over time.

Outright and real mortgage interest rates have been at or near generational lows, and a bubble, once started, is, by definition, self-sustaining until it bursts. That is, until the reality suspended is realized.

The governments reaction has been to try to soften any blow (huge injections of liquidity here and in Europe, Fed rate cuts, budget stimuli, sub-prime mediation). Confidence in the banking system needed to be maintained. Actually, I think we were all too dumb to panic; that all happened in granddad's or great-grandma's time. However, this may slow or prevent proper market clearing, or, worst, sustain the unsustainable. Despite the interbank overnight rate cut, note that treasury rates are trending up recently, telling you what the market expects down the road. (Also, see Japan in the nineties.)

Debt is getting huge in direct and indirect ways. Not just those who paid too much for their home or "investment", or those who borrowed against the equity, but individual debt of those below the monied minority. The miniscule savings and, often, dissaving. The nation's infrastructure that has been hugely underinvested in for the sake of delusional accounting. State incomes are probably about to contract; let's see what happens this time around after all the creative accounting 2001-03. Social Security adjustment needed; worse the longer we leave it. On top of it all: Federal debt; set to go well over $10 trillion. Thank you Reagan, GHWB and GWB. "Conservative" arseholes all.

That'll be well over $30,000 for every man, woman and child. Take out the children, the poor, the retired and the unemployed and that will be well over $100,000 for every productive taxpayer. That's $4,500 interest per annum at today's preferential US bond rate out of your wallet with nothing to show. A little less than 10% of median household (pre-tax) income. Not just to Uncle Sam, but out the window to China, Singapore, whoever.

You might be hoping for the corporations and the rich to help out. Perhaps that supremely bloated military budget could be cut? Don't hold your breath.

Depending how it's handled depends how unpretty it's going to be, but pigeons just have to come home to roost sometime.

Posted by: notthere on February 14, 2008 at 4:07 AM | PERMALINK

Only response to this is, "You ain't seen nothin' yet."

Posted by: Nancy Irving on February 14, 2008 at 4:59 AM | PERMALINK

There is little mention of the tax exemption on the gain from the sale of personal residence that was granted in the 90s or so. Sortly after many people treated their homes as speculative ventures. I know people who, on paper, live in a house long enough to qualify for tax emption on the gain. (at least did)

Posted by: nonheroicvet on February 14, 2008 at 7:56 AM | PERMALINK

I also don't buy the theory that larger houses are going to keep the market above the mean. In most of the major boom cities those large houses were built on the outskirts as the area expanded because that was where the available land was. Here in SoCal the areas with the most (and largest sq ft) new home construction also come with painful commutes. The price tag for that 2300 sq ft house includes an extra hour each way of lost time someone could have spent with their families.

Posted by: arteclectic on February 14, 2008 at 10:41 AM | PERMALINK

Reading Kevin's update reinforces my appreciation the blog and the contributors' openness.

Considering the additional statement posted by Kevin, may I direct him and others here to a commentary made by PIMCO Chief Bill Gross about 2 years ago (or less). In one of his monthly letters to investors, he suggested that globalization and growing efficiencies in capital markets had changed the historic mean regarding stimulative/restrictive interest rates. Its his assertion that a 6% Fed rate is the equivalent to 8% of years past. This observation is interesting in light of today's issues since the Fed's rate hikes had little direct impact on mortgage prime rates, which are generally marked to the 10 year bond's market price.

As for house price's absolute rise or decline, allow me to suggest that price stagnation over a decade equates to a major, real dollar decline when inflation is running at ~4% a year.

Lastly, allow me to point to the matter of new and existing home inventories. It is via this measure that one can conclude that the massive over-supply will necessarily force house prices down - in nominal or absolute terms. According to Calculated Risk, there's over a year of inventory on the market - far exceeding historical norms of 4 months of stock. Add to this the fact that well over a million home owners are "upside-down" or will simply default due to onerous monthly payments, one can only conclude that inventories will continue to rise not fall for the foreseeable future.

As someone her succinctly said, "we've not seen anything yet."

Posted by: wphurley on February 14, 2008 at 1:51 PM | PERMALINK

I think a real reason housing prices aren't going down is that they cant. people cant sell for less then the existing mortgage amount without the permission of the mortgagor (the bank). thats called a short sale. the bank relies on appraisers who look at comparable property sales in the neighborhood. And those prices are going down slowly.
In addition the number of buyers will be substantially lower-potentially forever.
I think prices will stall in the some hot markets- such as Manhattan. maybe parts of Brooklyn. In most markets though I think there will be a long and prolonged downturn, especially considering that we will continue to face a vastly elevated foreclosure rate over the next many years. I'm going to say 5 years minimum, although how the next president does could effect this either way.

Posted by: Aaron on February 14, 2008 at 5:38 PM | PERMALINK



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