In order to achieve the greatest risk/reward asymmetry from the 2014 single-family housing stimulus “hangover”, or “reset”, happening right now you must change the way you think about this asset class. When doing so, clarity emerges (at least to me).
Things come into mind, such as;
When other asset classes go through periods of excessive price appreciation or returns, most reasonable people worry that a “consolidation” or “correction” could happen at any time. In large part, this fear can keep asset class prices higher for longer than anybody ever thought possible. However, with respect to housing, when prices are moving higher, not a soul will ever forecast a “consolidation” or “contraction”, rather periods of “less appreciation”. I think that in the “new-era” housing market this is odd, misguided, and will lead to many more periods of unprecedented volatility in housing (down and up) like we have seen from 2007 to 2013.
Or, when “greater fool” trades consisting of highly populated cohorts blow up there are serious consequences like we saw when housing crashed in 2008-09. But, at least, because the demand base is so wide (everybody individual in America participated or wanted to be part of “Housing Bubble 1.0”) you have ‘some’ heads to hit the bid all the way down. However, when greater fool trade demand cohorts are razor thin like in “Housing Bubble 2.0” — local area private investors and a hand-full of giant PE firms — extreme volatility is almost certain, as the “trade” wanes or reverses completely.
In this short note, I outline where my research is going at the first of the year supporting ideas about why a “strong economy” is negative for this housing market; houses are far “more expensive” today then from 2003-2007 (i.e., “affordability” much worse); and how everybody has been “fooled by stimulus” and unprecedented monetary policy, yet again.
This report — which I am in the process of turning into a ppt presentation — establishes what US housing has really become over the past 12-years and in my opinion makes it far easier to time its unprecedented volatility and forecast the outcomes that since 2002 have fooled most of the people most of the time.
This housing market is “resetting” right now; for the third time in six years. It might look and feel a little different, but as I detail in this note, it’s not really different this time around.
1) Overview, Housing Bubble 1.0 vs. Bubble 2.0; Same flicker, different actors
We can all agree that extraordinary monetary policy and excessive speculation can cause price distortions and potential bubbles in almost any asset class. I think we can also agree that in 2006 housing was in a legitimate “bubble”. I contend that this housing market is in a bubble, right here and now.
Most have completely forgotten — or are too young to remember — what the 2003 to 2007 housing and finance era was all about. It’s so wild to me, for instance, when I constantly hear economists or the media rattle off “affordability” comparisons between then and now; with such confidence that houses have not been as affordable as they are today in decades. Of course, invariably, they assume everybody always used 30-year fixed rate loans when on the contrary, from 2003 to 2007, these were the “minority” of originations. Not acknowledging, or normalizing “affordability” to account for this, radically changes everything.
At the superficial level, the misguided belief about today’s superior “affordability” makes sense because during Bubble 1.0 — when the economy and labor markets were doing great — ‘rates were higher’ than today. Hey, just look at a chart of Fannie Mae rates or 10-year UST, right? Yes, they are right, technically; “rates were higher” then, than now. And house prices went through the roof. That’s the correlation everybody is sticking too…strong economy + higher rates = higher house prices. But, this would be incorrect.
In reality, on Main Street — to tens of millions of homeowners — from 2003 to 07 mortgages were much cheaper on a monthly payment basis than ever before in history and ever have been since. This statement is true, even when factoring in the much higher nominal house prices back then, and the recent Fed-induced sub-3.5% that lasted from 2011 through May 2013. This was because the incremental — in fact, the “primary” in many regions around the nation — buyer, refinancer, and HELOC user used “other than” 30-year fixed rate money.
In contrast to the revisionist history being peddled today, the 2003-2007 era was all about introducing extreme leverage-in-finance — incrementally increasing each year — through exotic lending. This made it so people could keep buying more expensive houses and refinancing at higher loan amounts on income that didn’t support it.
The advent and increasingly exotic nature of mortgage loans from 2003 to 2007 enabled the greatest “greater fool” trade of all time. Despite “rates being higher” from 2003 to 2007, everybody always earned the amount necessary to qualify for a loan; it turned virtually every homeowner in America into a Real Estate speculator driving the market with reckless abandon. Then, in 2008, when all the high-leverage loans went away at the same time, housing “reset” to what the fundamental, “organic” demand cohort could really “afford” using 30-year fixed rate, fully-amortizing financing and when made to prove their income and assets.
Today, those looking at 2006 house prices as a benchmark for where house prices are headed — or assuming house prices are ‘safe’ or not back in a ‘bubble’ because they haven’t regained those prices — are looking at the wrong thing. That’s because house prices never can get back there unless employment surges and incomes rise double-digit percentage points with a respectable number in front. Or, unless all the exotic, high-leverage, no documentation loans come back.
In other words, for house prices to get back where they once were, something has to be introduced that brings back the leverage-in-finance lost when exotic loans went away and everybody suddenly went from earning $20k a month to their real incomes when qualify for a mortgage loan.
Certainly, if we are staring a multi-year economic recovery in the face that brings higher rates, the accompanying job and income growth over the next several years won’t hold a candle to the historical “affordability” from 2003 to 2007 using a “Pay Option ARM” or “stated income” loan.
2) 2003-2007 vs 2011-2013…a stark comparison
There is little difference between between 2003 – 2007, when housing went through “Ma and Pa America speculation-fever” and 2011 – 2013, when private and institutional “investors” caught speculation-fever. Of course, other than the actors being different; the primary monetary policy recipient and speculator cohort changed from Ma and Pa shelter speculator to Dick & Son’s Property Flippers and Blackstone.
This is obvious through a dozen different datasets, and especially in the sales volume divergence between “new” and “resale” houses. Even “resale” volume on an absolute basis highlights the lack of true “organic” demand when normalized for “distressed” and investors reselling flips and rentals, which can look like “organic” sales to most everybody when using surface level data.
The stimulus-induced housing market pumps and subsequent “reset” periods 2003-2013:
a) Housing didn’t peak in 2006. Rather, they peaked with respect to “affordability” in 2002. That’s when the average house became “unaffordable” to the average household on a monthly payment basis using a 30-year fixed mortgage. To makes matters worse, rates surged in 2003
b) Voila’! Enter, high-leverage, exotic loans in 2003. Exotic loans removed the “fundamentals” and mortgage loan guidelines “governor” on house prices.
c) Using high-leverage, exotic loans from 2003-07 Ma and Pa America were able to circumvent the fundamental laws of supply, demand, and affordability and became speculators. Suddenly, everybody in America got a substantial pay raise through the new found leverage-in-finance; they earned enough money per month to buy whatever house they wanted using interest only, Pay Option ARMs, HELOC’s, or SISA’s and NINJA’s.
Bottom Line on 2003 – 07: “Bubble 1.0” — the 2003 to 2007 parabolic period — was mostly due to exotic loan leverage-in-finance (easy credit) being introduced, which — because house prices follow the most readily available mortgage financing terms and guidelines — drove the incremental and primary buyer / refinancer speculator demand cohort, Ma and PA America. In fact, in 2005-06 in CA 70% of all loans were “other than” 30-year fixed rates loans.
d) Then in 2008 the housing market “reset” — when all the exotic, high-leverage loans went away at the same time — to fundamentals (what somebody could buy or qualify for using a 30-year fixed rate mortgage and guidelines looking at real employment, income, assets, DTI, appraisal etc.)
e) Vo1la’! Enter, the 2009-10 “Homebuyer Tax-Credit, $8k nationally and $18k in CA. In 38 states the credit could be monetized for the purposes of an FHA downpayment making it the first, best, and last chance hundreds of thousands of “first-time” buyers had to buy a house. In fact, first-time buyer volume has never been as high since. During the tax credit period there were “lines of buyers around the corner”, “multiple-offers”, and the Case-Shiller index went “vertical”. Everybody was convinced housing was in a “durable” recovery with “escape velocity”. Huge bets were made by well-known investors on ‘this’ recovery.
f) Then in 2010 the housing market “reset” — on the sunset of the Tax-Credit — to fundamentals (what somebody could buy or qualify for without the free downpayment, using a 30-year fixed rate mortgage and guidelines looking at real employment, income, assets, DTI, appraisal etc.). Housing went into a technical “double-dip” in 2011.
g) Voila’! Enter, the summer of 2011 “Operation Twist” speculation that drove down mortgage rates and UST to historically low levels. Cheap cash starving for yield on the back of years of ZIRP and on QE was mobilized. Just like Ma and Pa did in item b) and c) above, “all-cash” buyers, using flawed cap-rate models as a guide, removed the “fundamentals” and mortgage loan guidelines “governor” on house prices.
Bottom Line on 2011 – 13: “Bubble 2.0” — the 2011 to May 2013 parabolic period — was mostly due to easy and cheap capital in search for yield turning private and institutional investors into the incremental buyer / speculator demand cohort. Like Ma and Pa from 2003 to 2007 (items b) and c)) above, they have been able to circumvent the fundamental laws of supply, demand, and affordability but through “all-cash” using flawed cap-rate models as a guide. The parallels are many. For example, in Bubble 1.0 hot spots, over half of all mortgage loans were “exotic” in nature. In Bubble 2.0 hot spots, over half of the buyers paid in cash.
3) Housing responds well to “stimulus”; contracts when stimulus is removed. The next “Reset”
The point of items a – g above is clear; housing responds well to “stimulus” and “resets” when the stimulus dries up.
From 2011-13 the “stimulus” was most utilized — not by end-users like from 2003 to 2007 and again from 2009-10 — but by ‘yield starved” investors. Which is exactly the “catalyst” for the next “reset”. That is, a move from “distressed”, which has ruled the market for years, back to an “organic”, or a “fundamental” based housing market — as the private and institutional investors leave — in which people use mortgage loans to buy will once again be “governed” by 30-year fixed rate mortgages, fundamentals, guidelines looking at real employment, income, assets, DTI, appraisal etc.
And as in 2008, and again in 2010, when the “governor” is put back on, prices will “reset”. Right now, under house prices, there is an air-pocket equal to half the past 2 year gains.
4) My Favorite Datasets…Bubble 2.0 in Pictures
These following data show how “cheap” houses really were from 2003 to 2007 (affordability high) relative to today, for those using a mortgage loan to buy relative to today.
a) California Mega-Bubble 2.0
House prices are down 26% from peak 2006. But it costs 12% MORE on a monthly payment basis to buy today’s median priced house. Say what!?!?
Or, put another way if house prices were the same as 2006 today, using today’s 4.625% 30 year fixed rate mortgage it would cost 34% more per month to buy; one would have to earn 48% more to qualify. Astounding!
That’s because back then the primary buyer/refinancer/price pusher used “other than” fixed rate loans. In fact, in 2005 to 2007 over 60% of all mortgages were “other than” 30-year fixed-rate fully documented loans.
Masking the “unaffordability” of today’s housing market is “all-cash” buyers who are not “governed” by end-user fundamentals (what somebody could buy or qualify for using a 30-year fixed rate mortgage and guidelines looking at real employment, income, assets, DTI, appraisal etc.)
Bottom line: If 2003 to 2007 was a bubble then why isn’t today a bubble with it so much more expensive to own on a monthly payment basis? I believe it is, and as investors slow or shut down the buying and the market turns more “organic” — or normal — in nature, significant price pressure will present again.
For those with questions on “Column 4)” above, what this says in a nutshell is “don’t look at 2006 prices and think there’s a shot in hell for prices to get back there. Especially, if the market returns to more historical end-user demand percentages because to buy the 2006 priced house today using a 30-year fixed at a 45% DTI, the population has to earn 44% more per year.”
b) The Smoking Gun
The red line in the chart represents the mortgage payment needed for the median priced CA house (black bar) from 2000 to 2013. This chart assumes that from 2003 to 2007 the primary purchase/refi/price pusher cohort used the popular loan programs of the time, “other than” 30-year fixed-rate fully-documented loans.
Bottom line: Houses first became “unaffordable” in 2002. Then, exotic loans were introduced in 2003 allowing people to keep buying more house without income following suit. When the exotic loans all went away at the same time in 2008 house prices “reset” to the real “affordability” using a 30-year fixed rate mortgages requiring proof of income and assets. The market ticked higher slightly in 2010 on the Homebuyer Tax-Credit then “double-dipped” as the stimulus was removed. Of course, the third major stimulus aimed at housing in the last 10 years came in Q4 2011, exactly when housing caught it’s most recent bid. The past two-year move was so fast and large that the subsequent “reset” should be ‘another’ one for the record books.
c) The Smoking Gun 2
Like the chart above, this shows the monthly payment for the median CA house from 2001 to 2013 using the popular loan programs of each period.
Bottom line: Houses have not been MORE EXPENSIVE” on a monthly payment basis in 11 years, right before when exotic loans were introduced to promote affordability.
Question is, what will be introduced to promote affordability after years of ZIRP and QE?
Or, will a massive economic recovery complete with a full labor market recovery and surging incomes take the place of artificial affordability tactics?
Those betting on a “durable” housing market recovery are betting 100% on the latter.
If 2003 to 2007 was a bubble then why isn’t today a bubble with it so much more expensive to own on a monthly payment basis? I believe it is, and as investors slow or shut down the buying and the market turns more “organic” — or normal — in nature, significant price pressure will present again.