Arnold Kling  

Housing Bubble?

Sustainability... Economic Attribution Error...

I still contend that we are not in a housing bubble.

The drop in the real interest rate of one percentage point from 3 percent should have raised the intrinsic value on stocks and houses by 33 percent! So, if house prices in your area have gone up 33 percent in the past two years, that may seem dramatic, but it is not out of line with the drop in the real interest rate. Incidentally, the Dow Jones stock average, which was at about 7600 when I wrote the article, is about 33 percent higher today, also.

For Discussion. My essay argues for interest rates rising relative to market expectations. Typically, in an efficient market, the risk of rising long-term rates and falling long-term rates would be fairly symmetric. What are the scenarios under which long term rates would fall?

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COMMENTS (22 to date)
Bernard Yomtov writes:

But the demand for housing as a consumption good is not independent of the interest rate.

Suppose interest rates drop as a result of an economic downturn. This downturn has a negative effect on the demand for housing, so the claim in your first sentence seems incorrect with respect to housing.

I don't think it's necessarily right about the stock market either. Your calculation applies to an asset whose absolute returns are not affected by the level of interest rates. Same cash flow plus lower discount rate equals higher present value. But if the returns are correlated with the interest rate this no longer holds.

Jervis Ninehammer writes:

i.) High productivity produces negative pressures on wages.

ii.) Velocity falls because of poor sentiment.

iii.) Excess capacity appears in an input to production.

Linus writes:

I read your article, but I can't quite put together how the real interest rate could so dramatically effect housing prices. I'm not saying your point isn't sound, I just don't haven't grasped it yet.

Nonetheless, I thought this article was revealing of the current state of home buying.

"But in two years, the house will be worth a lot more and we will have something to show for it."

This guy is buying a house at 6x his income, with 0% down, on an interest only mortgage no less. To me this spells disaster. What's worse is that he is by no means alone.

I could try to make a case for the housing bubble, but this article does it better than I could ever hope to:

Slightly off-topic, but I have noticed that articles proclaiming the lack of a housing bubble are almost always written by someone with a dog in the fight. i.e., National Assocation of Realtors, Realty Times, Harvard's Joint Center for Housing Studies (funded by...). I know you've worked for Fannie Mae, but I wont hold that against you.

Note: I am a recent college grad w/a 20% down-payment in the bank contemplating purchasing my first home.

Jim Glass writes:
I have noticed that articles proclaiming the lack of a housing bubble are almost always written by someone with a dog in the fight. i.e., National Assocation of Realtors ...

Well, The Economist's dog is in the fight all right barking about housing bubbles world-wide -- but it still says there isn't one in the US, where its housing price index says home prices are only 10% above the long-term norm, as I've noted before. That's not much of a bubble.

I mean I hate to go empirical against NY Times anecdotes and all, but ... ;-)

Anecdotes abound. In the part of Manhattan, NYC, where I am prices have gone up 100% in just one year -- but as housing is illiquid and not portable eye-catching local market conditions like this must not be confused with the national norm, which may be far, far different.

This guy is buying a house at 6x his income, with 0% down, on an interest only mortgage no less. To me this spells disaster

Disaster to whom? Not to the home buyer surely, as since he has risked all of his $0 invested in the home he has nothing to lose. If the home price drops to below the loan amount there is nothing keeping him from just walking away from the loan. The risk here is to the lender.

To quote the Times story:

"A lot of these loans are dangerous," said Allen Jackson, manager of Bristol Home Loan in Bellflower, Calif., a mortgage broker... "If you have any dip in values, people can just say the heck with it because they don't have any of their own money in the house."

That's very true -- but the danger is to the lenders, not the buyers, and lenders are supposed to be financially astute enough to be able to take care of themselves and manage these risks through their portfolios ... supposedly.

Bernard Yomtov writes:

The risk here is to the lender.

It pains me, but I agree with Jim. Who are these lenders? Are these loans being sold to Fannie Mae?

Jervis Ninehammer writes:

If the home price drops to below the loan amount there is nothing keeping him from just walking away from the loan. The risk here is to the lender.

The IRS would consider the unpaid loan as income, and the buyer would be on the hook for a very large tax payment. The buyer would lose any equity they had in the house, and would have trouble getting any further loan.

DSpears writes:

I read his in the article:

"Interest rates are low today in part because foreign investors have been willing to increase their holdings of U.S. assets. They cannot go on raising the share of U.S. assets in their portfolios forever."

Now, I see this sort of standard thinking presented so often that it is assumed to be fact. The problem I have with it is nobody ever explains the sequence of events that would cause foreign governments to stop buying US assets, and what are the beneficial aspects of such an event (usually ignored)?

It seems to me that the reason foreign governments are buying US assets is that, like China and Japan, they are both desperately trying to hold down the value of their own currencies with respect to the dollar. They are doing this not to drive down interest rates here so that people can buy more house, they are doing it becuase they want to be able to export to the US at favorable exchange rates, because both countries are (or believe they are) dependent on selling to the US. This gives them an abundance of US dollars with only 2 things they can do with them: Buy American goods or invest in American securities.

What course of events would change this and bring about the standard doomsday scenario? Would these countries have to take an unecessary loss to make that happen? Wouldn't that scenario simply result in these countries buying more American goods, bringing down the dreaded "trade deficit"?

What am I missing?

Bernard Yomtov writes:


If the house is worth less than the mortgage due, the "owner" has no equity to lose.

My understanding is that "walking away" often means simply surrendering the house to the bank in lieu of foreclosure. If you do that it doesn't seem that you would have a tax liability, since you are, effectively, selling the house for the balance due on the loan, which is less than you paid.

I don't know how this sort of thing affects future credit.

Lawrance George Lux writes:

I think it would take a very good argument (not herein made) to develop a correlation between Interest rates and Product Prices. The intrinsic argument for Interest rates is a market distribution system to determine how currently-available resources are to be distributed among Producers. Higher Interest rates demand a greater immediate Profit on the economic endeavor, just as in Housing they demand a higher mortgage payment every month. All Economists know, though, that central banks create money; of course, this leads to a fundamentally sound argument that Monetarist policy is basically Inflationary in nature. I see some real flaws in the initial argument, unless it is one stating lower Interest rates can be an ongoing method to inflate the Money supply. lgl

Jervis Ninehammer writes:

It certainly is possible to have negative equity in a house. Alternatively, a borrower could have a small amount of equity and be unable to service the debt.

I found an article titled "The tax trap of forgiven debt" that provides more information on the negative tax implications of loan default. Here's the link.

Defaulting on any loan obligation is likely to damage your credit rating. Lenders like to get their money back and they keep track of people that are bad risks.

Another thing to consider is that forfeiting your collateral may not satisfy a lender's claims. It's usually impractical for lenders to seek to force defaulting borrowers to live up to the terms of their loan agreements, but lenders could theoretically demand specific performance. All in all, I'd say borrowers are taking on risk.

dsquared writes:

If the home price drops to below the loan amount there is nothing keeping him from just walking away from the loan.

Don't get your financial or legal advice from blogs. It is not always a simple matter to "just walk away from" a loan, and you should not rely on the assumption that your lender will accept a deed in lieu of foreclosure, particularly if he was in the business of offering 100% mortgages in the first place.

winterspeak writes:

While your bond analysis is 100% correct, I don't think this is the correct way to think about housing prices.

Buying a house and renting a house are close substitutes. The rents a house can throw off are close to the cash flow you can expect from that asset. The purchase price of a house should therefore be, after factoring in taxes, refurbishment etc., the expected NPV of future rents.

In certain markets, such as boston, these are *way* out of whack from their historical norms. The rent implied by purchase prices is WAY higher than the actual rent available on the market. This means that either rents have to increase, or that housing prices have to fall (or a little of both).

For a variety of reasons, I think that it is prices that will adjust, not rent. And while a low fixed rate mortgage will keep your monthly payments in line when rates increase, it will not protect your property value -- so expect a large decline in your wealth (although not your income).

Bernard Yomtov writes:

"you should not rely on the assumption that your lender will accept a deed in lieu of foreclosure, particularly if he was in the business of offering 100% mortgages in the first place."

No, you shouldn't rely on it, but it will often happen. There is not much percentage in going through the foreclosure procedure and then seeking and trying to enforce judgments against people who are financially distressed.

Jim Glass writes:
"Another thing to consider is that forfeiting your collateral may not satisfy a lender's claims .... lenders could theoretically demand specific performance"

The typical mortgage is a non-recourse loan -- by law in many states if not most. That means no specific performance. The property is all the lender can collect against.

"Don't get your financial or legal advice from blogs."

Very good advice! Get legal analysis from a lawyer. And send money!

"It is not always a simple matter to 'just walk away from' a loan, and you should not rely on the assumption that your lender will accept a deed in lieu of foreclosure"

Assume nothing. But if one consults with a lawyer one will learn that in the real world (or the US at least) very few of the home mortgages that enter default status ever reach foreclosure. Because the lender loses by pushing things that far.

If the house has fallen in value to below the loan amount the lender can never make that up (unless it wants to become a speculating property owner, which lenders do not want to be). So there is no point in trying.

Meanwhile, the longer the lender goes without receiving payments on the loan the more cash cost it incurs. And should the lender push down the legal road to foreclosure the borrower gets at least two easy shots at bankruptcy (so called "Chapter 20") to stop the foreclosure process, get a court-imposed renegotiation of loan terms, retain possession of the home for at least a couple years more even if he defaults on those, and make the lender incur all kinds of extra costs and delay -- with after all that the lender getting at most no more than the market value of the house which it could have gotten in the beginning. That's what a legal fight produces. What lender wants all that?

So what happens in the great majority of cases is that either the lender renegotiates and the borrower keeps the house on revised terms, or the lender arranges for a third party to step in and buy the house for current market price from the existing borrower. In either case the lender eats the loss of principal on the loan -- and deservedly so, as it stupidly loaned more than the house was worth, simply making a bad investment.

One should remember that the traditional "20% down payment" requirement was imposed by lenders to protect *themselves*, so borrowers would have investments in homes that kept them from walking away from loans in a down housing market -- not as a good will gesture benevolently looking out for the welfare of borrowers.

But in today's market loans are resold so quickly by lenders that what they want are fees and volume, which they get from making more loans on easier terms, with the higher default risk on zero-down-payment loans being spread over the vast secondary market (we hope wisely), instead of being all concentrated in the local Bailey Savings & Loan, as in the old days.

Arnold Kling writes:

A response to some of the earlier comments:

1. I used to work for Freddie Mac, but I no longer have any stock in the company or any relationship to it. My only stake in the housing market is that I own a house.

2. The arithmetic of the effect of an interest rate on a price-earnings ratio is this: With no risk premium (or no margin of safety, as I call it in the article), E/P = r, where E is earnings, P is price, and r is the real interest rate. If r goes from 3 percent to two percent, then r has fallen by 33 percent (3-2 = 1, and 1/3 = 33 percent). If r changes by 33 percent, then the E/P changes by 33 percent. If E is constant, then P changes by 33 percent.

3. If equity turns negative, both the borrower and the lender lose. Typically, the borrower tries not to default. But in reality, borrowers get into trouble all the time. It's when you lose your job or run into some other problem that you start to consider your mortgage payment as a choice rather than an obligation.

If you lose your job and you have a $250,000 mortgage with a $300,000 house, you do not default on the loan. You try to keep up the mortgage payment anyway or, worst case, you sell your house.

But if you lose your job and you have a $300,000 mortgage on a house that is now worth $250,000 you pretty much have to go into default. So you lose (your credit rating tanks) and the lender loses (typically, the lender would lose a lot more than $50,000 because the costs of processing a default are astronomical).

4. Concerning winterspeak's point that P/E's are out of line with historical norms, I think that's absolutely true. I think that there are two reasons for that. One is that historical norms are ridiculously low. That is, historically, the risk premium or margin of safety on residential real estate was very high. The second reason that P/E's are higher than they have been in the past is that the real interest rate is so low today. What DeLong and I are saying is that if you believe that interest rates are going to stay this low, then you can make a case for high P/E ratios.

Jervis Ninehammer writes:

I had difficulty verifying the statements concerning the status of most mortgages as nonrecourse loans. One article I found said, "It's rare when these types of loans are available to residential borrowers, however, they are frequently available in commercial deals - often with strings attached." Reverse mortgages appear to typically be nonrecourse loans, but I don't remember any of the mortgages I've taken out as being nonrecourse loans. I'd be curious which states allow only nonrecourse mortgages. The link to the article referenced is below.

Bernard Yomtov writes:


Like Jervis, I am surprised that mortgages are nonrecourse in some states. Are you sure of this? Is it possible you are confusing banruptcy exemptions with nonrecourse loans?

Linus writes:

Look what topic made the cover of newsweek:

It's only a matter of time, folks.

Mark Harrison writes:

Surely if the interest rate falls from 3 percent to 2 percent we would expect house prices to rise by 50 percent, not 33 percent. To take your formula Arnold, P = E/r and E/0.02 is 50 percent bigger than E/0.03. So the housing bubble is even less plausible.

Peter writes:

The existence relationship between real estate values and (real) interest rates is not as simple. Many of you eluded to this fact. However, there are two additional points to consider due to institutional differences.

First, since the the real estate market is segmented, each market needs to be analyzed in separation. For simplicity, there is a private commercial (office space) and private non-commercial real estate market (housing).

The real value of private commercial real estate is influenced by the required cost of its capital. With very low real interest rates, the leverage adjusted required cost of capital is lower and the real estate values would increase even if the real expected cash yields (net cash rents) stay the same. When demand for private commercial real estate increases because the rapid economic growth demands more office or other commerical space or when the supply of real estate declines because of limited or limiting supply, the ensuing value appreciation is only indirectly influenced by changes in the real interest rates.

Second, the real value of private non-commercial real estate is not influenced by the required cost of its capital, but the real after-tax disposable income. In geographic areas where the real after-tax disposable incomes are higher, real estate bubbles are more likely to occur. Case(s) in point are geographic areas where there as a large proportion of individuals and families with high real after-tax disposable income, i.e., NY, Boston, SF, and DC.

simon writes:

check out the reasons provided in the url below.

justthefacts writes:

Interests rates are lower worldwide than historical norms because there is an unusually large supply of savings relative to demand for borrowing.

This is because Asians traditionally save a large proportion of their incomes while Americans consume more than they earn, funding the difference by borrowing the money that the Asians have saved.

The long-run trend is for Asian incomes to grow much faster than American incomes and this trend has been accelerating in recent years - causing the Asian savings pool to grow much faster than even American consumers desire to borrow - which has put downward pressure on interest rates.

However, Asian consumers are becoming increasingly Westernized. For example, in India, the 300m+ middle class (more than entire US population) are now starting to buy homes using mortgages and to finance large purchases such as autos - unheard of a decade or so ago. Similar developments are happening in the leading coastal cities and provinces of China. Soon, demand for credit in Asia will be sufficient to absorb all their traditional savings, leaving the US short of foreign sources of funds to borrow.

This will force up interest rates in the US including mortgage rates - leading to deflation of leveraged assets such as real estate.

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