Because they are wrong. The rumblings that are now becoming apparent are only the precursors of a much larger disaster. I've seen the narrative on the housing market change steadily in the last three years, and never more so than in the last few weeks. All the changes have been in one direction: towards agreement with the contrarian economic voices that I have been following for the last four years. These sources were warning about the problems of the housing market three years ago. The mainstream economic and financial authorities pooh-poohed the nay-sayers at first, but at this point they have come around to about 90% agreement with the doomsayers. The last points of contention seem to be over how wide the impact of the housing bubble pop will be. So far my sources have been pretty good, and they are saying that it's going to wipe out a lot of money (in the form of depreciating home prices) and cut the legs out from under the economy. If that has piqued your interest, then read the rest for the grim details. Otherwise, here's the essential point:
Many loans were made to people who should never have been allowed to borrow, using exotic variable rate loans whose monthly payments can (and will) increase dramatically over time. The viability of these was predicated on quickly rising real estate prices. Those increases were achieved, in part, because of the generationally low interest rates we have had. The (predictable) resulting bubble generated a tremendous amount of wealth, which found it's way into the economy in a variety of ways: withdrawing money via HELOC's, construction (jobs and materials), and production of all the stuff required to fill those homes with stuff. As our economy has been living by the mortgage markets' sword, so it will die by it. When the market crashes construction will slow (meaning job losses), there will be less extraction of money from houses which will cause people to spend less across the board. The economy retracts, potentially resulting in a recession (never mind being stuck with a house that's worth less than you bought it for).
So, the real question is, will there be a crash? IANAE (I Am Not An Economist) but here goes...
What is the problem, right now?
Sub-prime lenders (institutions that primarily write loans to people who have a higher chance of defaulting on their loan) are starting to fail. In the last few weeks I have watched the number of lenders that have either ceased any new lending or gone bankrupt outright, grow from two dozen to three dozen to over forty. That may not sound like a lot, but one of them is the second largest sub-prime lender in the country, New Century Financial. The lender's share value has plummeted over 90% in the last few weeks, it has ceased lending, and is likely to go bankrupt under the weight of its financial woes along with possible criminal inquiries. The drop in the market last week breached a psychological barrier and the sub-prime market moved from being an uncertain source of concern to being associated with terms like carnage and bloodbath. You never want to hear a Federal Reserve Governor use the term tsunami in relation to future mortgage defaults...
But what's really going on?
Lenders are having to buy back their loans. 'Til now lenders would make loans then bundle those loans up and sell them to other financial institutions. This allowed the lenders to move them off their books and free up the money to lend to new consumers. The sales came with an important clause though. If the bundled loans 'performed poorly', the lender would be forced to buy the loans back. Loans have been doing precisely that. (As an aside, it's important to unpack the term 'perform poorly'. This means the homeowner has defaulted on the loan. It represents a very real, very personal tragedy for some poor soul every time this happens. Some of them gambled knowingly, and I have little pity for them, but some really didn't know what they were getting into)
The macroeconomic problem is that the failures have been occurring at a higher rate, and more quickly, than was expected. So the financial institutions that bought the loans have exercised their right and demanded the lender buy back the bad loans. Essentially the lenders gambled that the rate and speed at which these loans would go bad wouldn't exceed a certain level. Presumably they kept cash reserves to cover that theoretical estimation (although who knows). In any event, they are losing the gamble and don't have the money to meet their actual financial obligations. Here's a map (click on the image in the article) that visually demonstrates the potential breadth and range of the risk due to bad loans.
Ok, Why is this happening?
A variety of things contributed to this mess. For starters, the Federal Reserve lowered interest rates to 40 year lows (around 1.0% as I recall). Doing this was guaranteed to spur a real estate boom. You would have to be mad not to try to get a mortgage at those rates. A few percentage points can really make a difference on a large, long term loan. The extreme attractiveness of real estate led to speculation. This is the spark that started the positive feedback loop that allowed the bubble to be blown. Once it got going, the incentive to get in to the market increased, which led to the relaxation of lending standards and riskier loan vehicles. A much higher percentage of loans originated in the last 5 years are to sub-prime (riskier) borrowers. In addition, a large percentage of the recent loans have been non-traditional in their structure: ARMs, interest-only (principle is flat), negative amortization (the principle GROWS - yikes!) and so on. This is a brief list of a variety of loan vehicles that are new, or under greater utilization, and which are bad ideas.
So, we find ourselves in a situation where there is tremendous incentive to get into a market where the underlying condition, interest rates, are at a level that many buyers, realtors, mortgage brokers, and various financiers have never seen. There's no historical perspective, but there is greed. As a result, it's Off To The Races! Everybody gets a loan! If you find you can't afford a normal loan (at which point the lender should have said, "Good day"), well, they'll come up with one you can afford! The trick with these is that many of them get A LOT more expensive after a few years. In many cases the mortgage brokers were less than scrupulous in explaining the terms of these loans. Other financial institutions got into the act by figuring out a way to get the regulators to sign off on bundling and selling the loans. This gets pretty esoteric, but the idea is to sell the risk to investors. This distributes the risk over a wider area and presumably makes them safer. Since the original institution no longer owns the loans, they are free to loan again. This acts as multiplier on the credit supply. Despite the buy back clauses stipulated, most lenders do not keep cash reserves to cover theses obligations (otherwise what would be the point?)
This all acts as a huge circular pump. People rush into the housing market, credit (money) flows into the economy. People borrow money against their homes and cycle it back into the economy, often in the form of home improvements that raise the value of their house. The increased demand for houses leads to a construction boom, which boosts the economy (a significant percentage of the jobs created in the last few years has been in housing related industries - realtors, financing, construction). Those newly purchased houses often have to be filled with things, so that acts as a boost to the economy as well. Speculators jump in, flipping houses every few years. All the pressure is upward (the very psychology of a boom is self sustaining) as a huge amount of money flows into the housing market (incidentally, this money had to come from somewhere, and the somewhere is China) and from there into the economy.
But it is all predicated on risk. The pump, as in most bubbles, works, until it doesn't. At some point the American consumer is tapped out and can't take on any more debt. Lest there be any doubt about it, the American consumer has gorged on debt, mortgage debt in particular, at unprecedented levels in the last few years. With saving levels negative, he is in fact running beyond capacity. Top heavy, running headlong, and with no cushion to land on, it won't take much to trip him up badly. That's what we are starting to see now. With the housing valuations the result of a bubble, when it pops all that added value can, and will, just disappear.
The fact we had an ahistoric boom should have been no surprise. If the Federal Reserve was caught off guard, after lowering rates so precipitously, then their incompetence borders on malfeasance. It's implausible they didn't see this coming, but that's another story...
Where does this leave us?
Right Now: The Changing Narrative
It's tough to keep up with what the conventional wisdom is. Bloggers I read were warning about housing for the past 3 years. In that time I have seen the conventional wisdom progress as follows:
1) No, there's no bubble
2) Ok, we have some localized bubbles
3) Ok, we have a bubble, but it will land softly rather than pop and crash
4) Erm, well there are some problems with sub-prime, but we still don't think that it will get out of hand
5) Yeah, there were some excesses in the sub-prime market and it's going to be ugly there, but it won't spill over into the rest of the mortgage market, a general credit crunch, or the economy as a whole.
This last shift has occurred in the last two to four weeks I would say. I prefer my sources. They were up front about not knowing when the whole house of cards would collapse, but such things are notoriously difficult to forecast. Still, just because the future is opaque that doesn't invalidate the identification of a bad situation.
This brings us to...
The Future
This isn't going to be contained to sub-prime. The problem isn't just people who shouldn't have gotten loans. It's the way many of the loans themselves are structured. Nouriel Roubini thinks that, rather than the much-touted 6%, garbage loans make up 50% of the recent market. Before the end of 2007 700 million to 1 billion dollars in ARM loans will adjust to higher rates, rates that will likely push many of these into default. We'll have to wait til 2009 most likely before all the ARMs and other funky loans originated in this cycle work their way through the system and reset. Those higher levels will force people into default.
Just as the cycle worked as a positive feedback loop to pump the market up, there is a similar loop that will suck it dry. The market slows, houses cease to appreciate, or appreciate enough (this is already happening). Various loans get more expensive for a range of reasons and people default and turn the property over to the bank, or sell at a loss themselves. Banks have to sell repossessed houses at reduced prices to recoup any of their investment. Prices become depressed and the market is flooded with inventory. Lending standards tighten (meaning some people can't get a loan), which reduces demand for housing. The combination of these two factors hits construction (and housing related industries in general), slowing the economy. A slowing economy causes people to tighten their belts, further dropping demand. As this cycle picks up, it puts the pinch on people who were on the cusp of making it. Some of them will cease to make it, reinforcing the cycle. The cycle stops when it has worked the giant bubble of spun money through it's system, leaving little at the other end. It can take a particularly long time, as houses once built, tend to stick around for a while, giving a long lifespan to the depressed real estate market and construction.
How will we know if this is bearing out? Well, housing starts are a leading indicator of problems in the construction industry. That is, the industry could still be doing fine because it is still processing houses started many months ago (houses take between 6 months and a year to complete). If the number of new housing starts drops it indicates a weakening of the market. Some of the luxury home builders have had to restate earnings due to taking losses on canceled starts (sometimes having to write off plots of land purchased at high prices). Employment stats in the industry are also an indicator, but one that lags, as illegal immigrant labor and 'cash' (under the table) workers, who aren't reported in the first place, are laid of first. If there is a problem there it should become apparent in the next few months when the industry typically goes through a hiring boom.
And, of course, there will be the ongoing news of bankruptcies and failures of lenders, spreading through the sub-prime sector and bleeding over into the rest of the mortgage market. Delinquent loans will increase, prices will slide further. It's going to happen, the question is how extensive and deep the effects will be.
Final Thought
As I said at the top, I'm not an economist. I don't like the look of things though, so my personal feeling is that right now is NOT the time to buy a house. I'm certainly not looking to do so myself. If I were thinking of selling in any near timeframe (a few years), I'd try to do it now. If you expect to live for a long time in the house then the pressure to sell or not buy is reduced somewhat. There is a risk, in holding off buying, that interest rates will rise. You'll have to figure out which is more palatable - low rates on larger loans or higher rates on a more realistic loan.
In the event that this all seems terribly unrealistic or overblown, take our situation right now. My wife and I bought our house somewhat less than two years ago. We are fiscally very conservative - we got a fixed rate 30 year loan. We borrowed far less than the banks were willing to loan us and we put down 20 percent. While we expected to own the house for 4 or 5 years with the understanding that we could reasonably expect a modest return in that timeframe, we are in the position of having to sell now. We aren't in any of the trouble that I have been describing, but appreciation in Seattle has slowed. As things stand, after various realtor fees and so forth are factored in, we will be lucky to break even on the house. It's highly possible we will incur a small loss. You can imagine what situation speculators, who were looking to flip their house after a few years in order to crawl out from under a loan that is about to set to a much higher payment, are in.
Credit where Credit is due
I can't take credit for this being original. I've just collated it, really. The following bloggers are excellent resources on this subject, and economics in general. I owe whatever education I have about economics to their writings over the last few years:
Bonddad
Ian Welsh at the Agonist (he blogs on LOTS of topics)
Stirling Newberry, another multi-disciplinarian at the Agonist. Dailykos has an archive of his writings here.
These are resources I found more recently:
Mike Shedlock
Calculated Risk
Nouriel Roubini
P.S. Since I wrote this, a week ago:
1) The number of lenders that have gone bust or stopped lending has climbed from 41 to 44. A month ago it was 25. Three months ago no one was keeping track of this.
2) Mixed messages on housing: starts are up but building permits are plummeting
3) Credit standards are tightening
4) Sub-prime problems seem to be leaking into the next category, Alt-A loans
And so on... A mixed-to-bad bag of news so far.
