The Housing Bubble Will Probably Burst
John Mauldin's Outside the Box

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This week's letter comes to us from Dr. A. Gary Shilling, president of A. Gary Shilling & Co., Inc. Gary is a long time friend and one of my favorite economic analysts. He also contributed a Chapter to my latest book, Just One Thing, which can be purchased at

In Friday's Thoughts from the Frontline, I mentioned that Gary is less optimistic on the housing market than I am. Gary's January letter looks at 10 nonconsensus investment themes and he spent nearly half the letter on housing and makes a case for why the housing bubble may be headed for trouble. This is a topic that has received a lot of attention over the last couple of years and poses one of the largest threats to the US economy.

This letter may seem longer than most, but that is due to the numerous charts Gary uses to back up his argument. You will find this very interesting food for thought in this week's Outside the Box.

- John Mauldin

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The Housing Bubble Will Probably Burst

Most observers look for slower but still positive growth in house prices this year. The 20% or greater fall in average median prices on a national basis we foresee is decidedly nonconsensus. And it will have substantial effects at home and abroad. Indeed, even a flattening of house prices will be meaningful. The Fed estimates that through refinancing and home equity loans, homeowners extracted $600 billion from their homes in 2004, up from $439 billion in 2003, and spent half of it on goods and services. That $300 billion accounted for 40% of GDP growth in 2004, and the zeal for home equity borrowing in 2005 (Chart 5) suggested that it was even more important to economic advance last year.

Flat house prices this year would curtail vastly this withdrawal of money to finance consumer spending. It also would make many much less willing to borrow more on credit cards and save less because their house appreciation piggy banks would no longer seem as likely to keep filling themselves. Falling house prices will magnify these effects greatly.

Furthermore, those many who recently bought second homes and homes for investment (Chart 25) will get quite nervous if house prices stop rising. They've flooded the market with rentals, depressing rents (Chart 26), so even with interest only mortgages, many have negative carrying costs with taxes, interest, maintenance and other costs exceeding rental income. Once their confidence in rapid appreciation fades, their zeal to dump their properties onto the market leaps.

The resulting jump in supply will depress prices, probably substantially because of the rapid rise in the number of houses owned by speculators in recent years (Chart 25). And note that many second home purchases are in part spurred by visions of rapid appreciation. Earlier, Alan Greenspan said that a housing bubble wasn't likely because people needed to live somewhere. Selling a house out from under one's family could strain domestic bliss. But widespread multiple homeownership eliminated that restraint, fueled the bubble, and makes a big price break more likely than a flattening of house prices.

Bust or Flat?

Sure, in the past, most housing booms did not result in busts. The FDIC studies data by metropolitan areas and defines a boom as a 30% or greater rise in inflation-adjusted prices in a three-year period, and a bust as at least a 15% decline in nominal prices over five years. From 1978 until the current bubble commenced in 2000, the FDIC identified 50 booms but only 21 busts. Housing bulls hope that, as often in the past, the current booms in many cities will be replaced by more muted appreciation or, at worst, by flatness as the rest of the economy and prices catch up.

But this time, the housing bubble is quite different than in the past, at least since the 1920s. It's national in scope, driven by three national forces. First is low mortgage rates (Chart 27). Second, loose lending practices such as interest-only and option ARMs, high loan-to-value mortgages, heavy use of home equity loans and extensive subprime loans. Note that despite jumping house prices, low end borrowers are already in trouble as shown by the leaping delinquency rates for the usually subprime FHA insured mortgages (Chart 28). Third, after the big stock bear market of 2000-2002, many investors want an alternative to equities.

A bubble driven by national forces seems more likely to break and spawn national repercussions than past regional booms that were driven by regional economic cycles. In the 1970s, oil patch real estate leaped with energy prices but then collapsed along with the price of crude in 1986. Similarly, the Cold War aerospace spending surge in the 1980s hyped southern California real estate, which then collapsed with the demise of the Soviet Union in the early 1990s. New tech ups and downs have been reflected in house prices in Silicon Valley and the Route 128 corridor in the Boston area.

Because the bubble this time is driven by national forces, it's national in scope and is found in 55 cities, more than twice the previous peak of 24 in 1988 (Chart 32). True, many of these booming metropolitan areas are on the coasts (Chart 33), but that's where the population and wealth are concentrated.

No CPI Bailout

In addition, in the 1980s when oil patch real estate fell, goods and services inflation, gauged by measure such as the CPI, was still significant. So, rises in those prices cushioned the fall in housing prices as they returned to equilibrium. Even so, median house price busts in 10 oil patch cities averaged 28% declines. Likewise, goods and services inflation in the early 1990s mitigated the house price declines in California, which still averaged 18% in the four bust cities, and in New England, where average prices fell 17% in the five cities that suffered price busts.

In contrast, there is little inflation today, especially outside volatile food and energy areas. So, the likelihood of house prices falling substantially to bring them into proper balance is much greater than earlier. It seems, then, that a 20% decline in house prices nationwide is not a wild forecast, and may be optimistic. Indeed, a 29% fall would be needed to get house prices back in line with rents and 35% to restore balance with the CPI (Chart 35). And remember that markets overshoot on the downside just as they do on the upside.

Sure, house prices may appear to simply go flat--at first--and recently, higher priced houses in tony suburbs around the country are just sitting on the market as buyers retreat to the sidelines. It takes time for house price weakness to sink in because the market prices of people's houses are not available daily. Everyone believes that his house is unique, and there is no price quote flashing by on the TV screen or in the newspaper to force homeowners to realize that their homes have declined in value.

So, they can put their heads in the sand, arguing that any price weakness, even of they are trying to sell their houses, is short-lived. The neighborhood is temporarily out of favor, one will argue, even though the family next door just sold at a big discount. Or, I have a lousy real estate broker but I'll get a good one. Or, it's the wrong season of the year, but spring and stronger prices are coming. Still, the housing bubble appears big enough and the speculative overhand so large that sellers won't be able to wait out the weakness, and a major price drop is likely.

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Low Affordability

Price leaps have pushed affordability to the lowest levels since 1991 (Chart 36) despite low mortgage costs. In the third quarter, median house prices rose 12% from a year earlier after a 14% leap in the second quarter. So, many first-time home buyers are frozen out and can't buy the houses of those who want to move up the ladder, ultimately restraining sales all the way to the top McMansions of Reginald van Gleason III.

Mortgage applications recently fell to an 11-week low, with both those for purchases and especially those for refinancings plunging (Chart 37). In 57 of 379 metropolitan areas, houses in the third quarter were so expensive that the family with median income couldn't afford a median priced house with a conventional mortgage. Many have responded, of course, by increasing their financial leverage by 100% financing and interest-only mortgages, which friendly lenders are only too happy to provide.

Some optimists believe that because these financing terms are available, houses are still affordable. Obviously, they aren't concerned with the increased risks and leverage they involve. This is like saying that I have an appointment in a nearby city in one hour and it takes two hours to drive there at a normal average 60 miles per hour. But if I drive at 120, I'll make it on time.

The housing boom is also straining building material suppliers, with resulting price increases that make houses even less affordable. Brass, asphalt, gypsum products, plastic constriction products and concrete have all seen double-digit price rises in the past year, with only lumber and plywood notably lower.

Mounting Evidence

Nevertheless, evidence of the housing bubble's demise is mounting. A recent survey found that 58% of responding real estate agents say inventories of unsold houses are up and 80% believe it takes longer to sell houses. Traffic is down in new home developments, and price cuts and incentives like free carpets and offers to cover closing costs are proliferating.

Due to pressure from regulators, mortgage lenders have slashed option ARMs by 25%, important since they recently accounted for over 30% of jumbo mortgages. These mortgages allow borrowers to make monthly payments that don't even cover interest and, therefore, increase the principal--"negative amortization," as it's called. About 70% of borrowers with option ARMs are making those minimum payments as they strain to own the biggest houses they can manage financially.

The subprime mortgage market, into which many lenders have rushed as they strain for yields, is also showing strains. The rise in delinquencies is actually worse than it appears. Delinquencies for new subprime ARMs in the first nine months of 2005 were 6.2% compared with 3.7% for the same period in 2004. The more recent borrowers have proved to be the worst re-payers. And since many of these ARMs will adjust up in several years, even a flat house price pattern will spike delinquencies since refinancings won't work without price appreciation for many. Note that among 2003 subprime mortgages with ARMs that reset up after two years, delinquencies leaped from 10.2% right before resets to 16.6% six months later. Note also that there were about $220 billion in two-year ARMS in 2003 but $440 billion in 2005.

Investors are not amused. Credit default swaps on subprime ARM pools, in effect insurance policies against defaults, have almost doubled in price from mid-September to December of 2005. Buyers of these derivatives obviously anticipate more trouble. As delinquencies and defaults mount, mortgage lenders will withdraw, much as they abandoned manufactured home lending when that market collapsed in the late 1990s. Lender exits will only add to the plight of desperate, overleveraged homeowners.

Inventories Are Key

As in many markets, the key place to watch for problems in housing is inventories. Suppliers seldom realize they're producing too much until inventories leap as a result of unexpected demand weakness. Furthermore, inventory-sales ratios, a key indicator in most goods-producing businesses, leap as the numerator--inventories--rises while the denominator--sales--falls.

The housing industry calculates inventory-sales ratios as the months' supply for sale, or inventories divided by monthly sales. For new homes, that ratio has been rising for about two years (Chart 38) because rising inventories outran sales increases. It jumped in November as sales fell by 11% from October while inventories rose 3% (Chart 39). Since sales are volatile, it's too early to know whether the sales drop will persist, but if it does and new home builders keep cranking them out, the months' supply will skyrocket until builders slash output. Existing home sales and inventories are showing similar patterns (Charts 40 and 41), with the months' supply climbing to 5.0 in November for single-family homes, and leaping from 5.4 months in October to 5.9 in November for condos.

Publicly-held house builders, of course, assure their stockholders that inventory problems are ancient history, never to be repeated. Many say they build only to firm orders, while others declare they have small and declining numbers of spec houses in their inventories. Public builders also say that shortages of land on the coasts as well as population growth from immigrants and the children of the postwar babies will keep demand and house prices rising rapidly for decades.

Well, our statistical analysis finds no correlation between housing starts and the change in population in their 20s, 30s or 40s, the prime house-buying ages. Also, the percentage of new buyers who walk away before the houses close is rising. And despite public house builders' rosy forecasts, senior managements in those companies have been selling their own shares with gay abandon in the past year.

Fragmented Industry

Furthermore, homebuilding is a fragmented industry. Sure, the top 10 account for 25% of output, up from 10% five years ago. And maybe they do in fact control their inventories tightly. But many of the rest of the 80,000 homebuilders are small operators. Has human nature changed so much that those guys, whose assets consist of a few pick-ups and lists of subcontractors and lenders, aren't building extra spec houses to take advantage of recent leaps in prices?

A substantial fall in house prices will, of course, wipe out many highly leveraged speculators. They are already on the run in some exuberant markets, and their selling is depressing prices. Even where prices are still rising, the gains aren't fast enough to allow speculators to flip properties quickly and still cover brokerage, closing and other costs. The number of investors buying properties in San Diego has been cut in half, by some estimates. In Phoenix, 30% of the properties for sale are investor-owned, so inventories of houses for sale rose from 8,600 in April to 22,340 in October of 2005.

Speculators are only a small part of homeowners, but given their lack of staying power, their dumping will rule the decline in prices. Prices of houses, like most things, are set on the margin by the most zealous sellers and buyers.

Those lower prices in turn will depress the sentiment and spending of many of the 69% of American households that own their abodes (Chart 42). Note that many of the 31% that don't are already strained. They are low-income folks with little income cushion to cover increased energy costs. The weak sales of low-end retailers like Wal-Mart and Family Dollar Stores reveal their plight. Sure, the 61% of homeowners with mortgages won't be forced to sell as long as they have jobs and can meet their monthly mortgage payments. But their convictions that their houses are automatically filling savings accounts will be shattered and their zeal for spending in general will plummet.

The overall effect will be much greater than was caused by the 2000-2002 stock bear market. While 69% of households own their homes, about 50% own stocks or mutual funds. More important, the stock ownership is much more skewed toward higher income people, so the average American is decidedly more influenced by house than stock market prices.

Skewed Ownership

Notice (Chart 43) that in 2001, the latest data, the stock holdings of those in the top 10% income bracket were 36 times the $6,800 owned by the lowest 20%. But in ownership of primary residences (Chart 44), the top 10% on average had houses worth only 4.6 times those in the lowest 20% by income.

Because of these different distributions for equities and homes, most American homeowners have made more money in the recent housing boom than they lost in the earlier stock collapse. They are better off even though total individual net worth in relation to disposable personal (after-tax) income remains well below its 2000 peak (Chart 45).

Not surprisingly, research shows that a 10% rise in house prices leads to a 0.62% increase in consumer spending, about twice the rise from a 10% jump in stock prices. So, the $2 trillion rise in house values in the last several years just about offset, in terms of consumer spending effects, the earlier $4 trillion drop in equities. Obviously, this effect will work in reverse as house prices fall.

Beyond the depressing effects of lower house prices on consumer sentiment and spending, the related drying up of housing activity will cause sizable layoffs and income loss. Moody's estimates that 1.1 million of the 2 million net jobs created in the five years ending last October were real estate-sired, including real estate brokers, mortgage bankers and lenders, builders and building material producers. UCLA's Anderson Forecast sees most of those gains disappearing over the next several years with a housing bust--500,000 jobs lost in construction and 300,000 in financial services.

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A severe housing bust will be detrimental to the earnings and, no doubt, stock prices of homebuilders, building materials producers, mortgage and subprime lenders and related entities like Fannie Mae and Freddie Mac. On the other side, real estate weakness severe enough to convince many that an abode and a great investment are no longer tied up in the same package--a house--will benefit cost-effective housing.

Rental apartments are an interesting example of this as younger families no longer see any advantage in jumping into single-family homeownership early on, and instead stay in rentals until their kids are big enough to necessitate separate houses. At a later stage, empty-nesters who hate home maintenance may sell their houses a few years earlier than now and move into rental apartments, not condos. Rental apartments, many owned by REITs, have been recovering in the last 18 months as vacancies have fallen and rents have started to rise, in part due to conversions to condos that reduce supply.

Still, condo speculators, many of whom bought them even before the buildings were started, will probably rent them as condo prices plummet and the resale market dries up. That, as well as the overbuilding of condos, may depress rental rates in future years. Since 2002, the number of existing condos and co-ops has risen 37% and median prices were up 15% in October 2005 from a year earlier. Note that oversupply fears are now inducing lenders to require developers to put more of their own money into condo projects and have cut lending in exuberant markets.

Manufactured and modular homes, which often are much cheaper than site-built housing, should also benefit when houses are no longer seen as great investments. In addition, they will appeal to postwar babies for vacation and retirement homes and are clearly benefiting from hurricane related rebuilding on the Gulf Coast and in Florida. (Note: Dr. Shilling is a Director of Palm Harbor Homes, a publicly-traded factory-built housing company.)


I hope you enjoyed the insights of A. Gary Shilling. You can find out more about his company at

Your still leasing his home analyst,

John F. Mauldin


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.


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Posted 01-09-2006 10:02 PM by John Mauldin