THE HOUSING BUBBLE

 One of the biggest considerations overhanging the economy at this point is: Is there a housing bubble?

You can find opinions on both sides of this question, but there is no doubt that housing prices have been on a tear. Whereas from 1950 to 1995, housing inflation for the nation as a whole was virtually identical to the overall inflation rate, in the past ten years the divergence has been startling, with home values rising nearly 60%. Nationally, the median price of a new home has been hovering around $200,000, a double since 1993, and a figure that is over 4.5 times median family income, a very high multiple.

The level of appreciation has not been evenly spread around the country, of course. New England, the Pacific coast, the Southwest and the Southeast have all witnessed significantly greater jumps, while the Rust Belt has experienced far more modest increases, if any. Prices in general have risen faster in cities than in rural areas, although much of small-town America is caught up in the boom, too, as affluent but disgruntled suburbanites relocate in search of safer, cleaner environments.

Supply has been working overtime in an attempt to keep up with demand; new home construction topped the one-million mark in 2003, and bettered that by another 10% in '04.

This surge has continued through a stock market crash and the recession of the early years of the 21st century. What has fueled it? Analysts who believe that there is no bubble, that the market is driven simply by demand fundamentals, cite such factors as immigration, limited supplies of urban land, environmental restrictions on builders, and income growth.

We find these arguments unpersuasive. For one thing, these elements are not new to this period of history. For another, if we were in a strictly high-demand situation, then we would expect rental prices to parallel those of ownership, as they historically always have. That is not the case now; in fact, it's just the opposite. Rental prices have lagged inflation (a mere 8% increase since 1995), and in the past two years have actually fallen, leaving the market with its highest vacancy rate ever.

We believe the impact of three key ingredients is paramount: Interest rates kept artificially low by the Fed, aggressive government loan plans to encourage buying, and a flood of refinancing (a stunning $2.5 trillion in re-fi in just the past two years, much of it financed by risky adjustable-rate mortgages).

Whether or not you agree with our position that government meddling in the marketplace is virtually always a bad idea, it's hard to deny that all of the above tend to stimulate the formation of a speculative bubble, rather than a stable market that is reflective of actual conditions.

The sad truth is that people increasingly have come to see their homes as either profit-making growth vehicles, or as ATM machines to be visited when they need cash for other purposes. That this drift may be reaching absurd levels is indicated by reports from Philadelphia-area banks that a number of Eagles fans were willing to re-mortgage their homes in order to finance Super Bowl trips. Some of the banks refused; others happily helped customers further increase their debt load.

Another disturbing trend is that more and more people who cannot really afford to buy a second home do so in order to "flip it", as our notoriously skeptical friends of the
Daily Reckoning call it. "One out of 14 houses sold in Las Vegas has been owned less than six months," they stated in one of last week's newsletters. "Nationwide, one of seven is an 'investment' property or a second home. People buy a house, say, for $300,000... They do a few cosmetic upgrades. And then they sell for $400,000. Assuming they put down just $30,000, and paid less than $40,000 for the repairs, they've doubled their money... in only six months."

Alas, no asset category continues on an uptrend forever, and homes are an asset category, notwithstanding that a roof over one's head is more important than a stock certificate. So how dangerous is the situation? Pretty dangerous, we think, and largely for the same reason we don't like the broad equity market or the federal budget. All are built on a mountain of debt.

Here are some disturbing numbers: Total household debt is now $8.2 trillion (71% of that in home loans), which is over $29,000 for every man, woman and child in the country. At the same time, people's equity in their homes, net of debt, has fallen sharply, from 85% in the 1950s to 57% today. Delinquencies, especially on government loans to the less creditworthy, are way up (11.8% of FHA loans, for example). Most frightening of all, though, is the relationship between debt and GDP. Gross debt in the U.S. (including household, business, and all governmental) is presently $31 trillion (vs. $4 trillion in 1980). That's 305% of GDP, a figure that far eclipses the previous record of 265%, set in--you guessed it--1929.

Here is what legendary investor Sir John Templeton has to say on the subject: "Every previous major bear market [in equities] has been accompanied by a bear market in home prices... This time, home prices have [instead] gone up 20%, and this represents a very dangerous situation. When home prices do start down, they will fall remarkably far. In Japan, home prices are down to less than half what they were at the stock market peak... A home price decline of as little as 20% would put a lot of people in bankruptcy."

We're not much on scare articles simply for their shock value, but we think that real caution is advised. You don't need to rush out and sell the home you plan on living in for the next 7 years or so... but seriously consider getting out of speculative real estate investing entirely.

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Posted 03-21-2005 5:16 PM by Doug Casey