A Family’s House Is Its Castle—Without a Moat

The real-estate market seems to have become so unreal that we asked a clear-sighted interpreter of the economy, Perry L. Weed, to explain what’s happening. Weed is a retired Washington economist and lawyer whose 30 years in the nation’s capital included Senate and House staff assignments and a position at the U.S. Commerce Department. His last report for us, in our March 15, 2004, issue, was on the troubled election-year economy.

Housing prices in the United States have soared to unsustainable heights. We are in the midst of an unprecedented housing bubble, the biggest in U.S. history.

A bubble exists when prices are bid up beyond what is consistent with underlying market fundamentals and buyers are buying with exaggerated expectations of future price increases. The alarm bells of stratospheric prices, speculation and accelerating, risky mortgage debt are going unheeded. We are ignoring the simple math. Like the expectations of perpetual increase attendant to the 1990s stock market bubble, the exorbitantly high valuations of U.S. homes are gleefully celebrated without regard to underlying worth.

Recognizing the possibility of a collapse in home prices and examining its impact are critical to our economic stability and security. We cannot discuss an “ownership society” without including housing and it affordability. Not only is home ownership the essence of the American dream; to most families it represents their largest investment, their biggest monetary obligation, their major asset and the primary means by which many accumulate wealth.

Over 74 million Americans are homeowners and now hold about $16 trillion in real-estate value, a figure that has mushroomed from $8.7 trillion since 1997. The average mortgage has tripled in the last decade, and households have, on average, twice as much of their wealth tied up in housing as in stocks and bonds. Over the last four years the housing market has driven the national economy.

In spite of the fact that the housing market is primarily a regional not a national market, this bubble has become a national phenomenon. The most overpriced areas—the East and West Coasts and the largest metropolitan areas—represent more than half of the nation’s housing wealth. In the fourth quarter of 2004, 62 metropolitan areas experienced double-digit price growth and, nationally, home-price appreciation skyrocketed—an 8.8 percent increase, to a median price, for a home, of $187,500.

The average price of a single-family home in the nation increased 9.36 percent in the one-year period ending in the second quarter of 2004—this, despite rising interest rates, an inflation rate of 2 percent, puny job growth and flat real wages. Adjusted for inflation, that home has grown in value by 43.59 percent over the last five years.

The last four years were record-setting ones for home sales, home ownership and mortgage finance. In 2004, new-home sales rose 14 percent. Home resales rose 9.4 percent to an all-time high, while the median price of those homes rose at the fastest clip in 24 years. Since 2000 the Dow Jones U.S. Homes Construction Index has risen 588 percent.

Fear of rising prices, rising interest rates and “getting left behind” feeds the frenzy. Outstanding home mortgage debt looms at $7.6 trillion, and the amount of disposable personal income devoted to paying mortgage debt is at record high levels. Despite soaring prices, borrowing debt has grown faster than home values. Home mortgages have degenerated from a means of saving to a means of spending.

THE BOOM IN PRICES—Historically, home prices rise approximately in step with the rate of inflation. But in the last eight years, housing prices nationwide have vaulted past the overall inflation rate by more than 40 percent, according to the government’s house price index.

These gains are twice as large as those realized in the property booms of the late 1970s and 1980s. In 2003 housing inflation nationwide was eight times the consumer price index, the national measure of inflation. Except that a bubble exists, there is no sound explanation for the increase in home prices so far in excess of increases in the price of other goods, in rise of population and of household income.

Other indications of a speculative bubble abound: from the current high turnover of the housing stock and the nearly half-million second homes purchased in 2003.
A growing TV genre has developed around homes. Mortgage-lending ads dominate TV advertising. Buyers increasingly invest for profits rather than shelter. But a Fortune magazine cover story predicts that “the bubble is going to pop.” The historically strong price increases during the 2001 recession and the sluggish recovery through mid-2003 are also reliable indicators of disjunction, since home prices typically fall, not rise, during weak economic periods.

Another sign of a bubble is that the rise in home prices is substantially exceeding the growth in median household income, which has remained flat in recent years. Earning power, the traditional determinant of housing affordability, is failing to keep pace with the cost of living.

According to the U.S. Census Bureau, median family income in 2004 was $43,318, having declined by $1,535 since 2000. Thus, to buy and maintain a home now requires a much larger share of the net household income. One in four American households now devotes more than 30 percent of its income to housing, the benchmark for unaffordability used by the government and the housing industry. Only one-half of U.S. homes sold in the second half of 2004 were affordable to families earning the median income.

Most analysts credit cheap money and low inflation for the explosive run-up in housing prices. Maintaining historically low interest rates in order to fend off a deep recession at any cost has clearly been the controlling policy of the Federal Reserve Board. This prolonged policy has fueled a massive surge in borrowing in recent years—borrowing that has flooded into bigger home mortgages, larger and costlier homes, and larger home equity loans. Mortgage debt has nearly doubled since 1995.

As rising home prices and mortgage rates drive up the cost of low fixed-rate mortgages, buyers shift to riskier mortgages—interest-only, no-down-payment loans and adjustable-rate mortgages, known as ARMs. ARMs now compose over one-third of new mortgages, while three years ago they represented only 12 percent.

Nationwide, in 2004 interest-only loans composed about one-third of home-purchase mortgages. With the economy more leveraged by household debt than ever before, more Americans are at the mercy of credit and mortgage interest rates than ever before. Many potential first-time buyers—keys to market stability—have been priced out of the market.

Another reason for the excessive home-price expectations, perhaps the most important, is the severe weakening of market disciplines—the traditional obstacles and safeguards to assure that only credit-worthy buyers and refinancers obtain loans.

Lenders now sell mortgages in the secondary market. The share of the nation’s conventional mortgages held or guaranteed by Fannie Mae and Freddie Mac—both government agencies embroiled in regulatory misconduct—has doubled since 1990, swelling to nearly $4 trillion and a 60 percent share of that market. Lenders have learned they can hand off the mortgages they give to these institutions with basically no risk.

Congress has, in effect, created a mortgage-finance duopoly that is basically unaccountable. Its actions and acquiescence are reminiscent of those that fostered savings-and-loan industry excesses and their aftermath.

THE RISKS—The housing and mortgage industries, aided by governments at all levels, enlist aggressive lending tactics, while offering liberal terms and numerous incentives, many of which are relatively new and highly risky.

As lenders devise looser, more exotic ways to qualify marginal borrowers, sub-prime lending is accelerating. It has more than doubled in the last four years, now constituting 25 percent of all mortgages. This has given rise to predatory and fraudulent lending. In fact, in 2004 the FBI launched extensive nationwide investigations into rampant mortgage fraud, claiming that it potentially constituted a “national epidemic.”

Consumers, lenders and governments have profoundly changed their attitudes toward borrowing and debt. With total public and private debt in the U.S. now exceeding $40 trillion, the nation is more debt-dependent than ever before.

We live in a debt-driven economy. Homeowners use their home equity as casually as they use ATMs, withdrawing $431 billion last year for their needs, a 35 percent increase over the previous year. The ratio of mortgage debt to home equity is at record highs, and home equity lending is displacing other forms of consumer debt.

The high-debt economy now comprises federal budget and trade deficits; a federal debt of $ 7.7 trillion; and total household debt approaching $10 trillion. This predicament of the high debt in combination with soaring oil prices, a weak dollar, the waning of both the refinancing boom and tax-cut stimuli, and the slowing of the economic recovery portends an end to cheap money, the exhaustion of stimulative monetary conditions and rising inflation.

This may ease housing prices into stagnation or a slow, grinding downward slide rather than a sudden collapse. But a more likely scenario, given the extremes of the housing inflation, is that rising interest rates, a slowing economy, rising real-estate taxes, higher construction costs, flat family income and massive debt will combine to hit the housing market hard. The steeper the climb, the faster the fall.
Housing prices can be expected to fall by 10 to 20 percent nationally and more in the hottest regional markets. It has happened before. Refinancing is already withering. Bankruptcies are on the rise.

Monthly payments on home equity loans have begun to climb. Declines in housing prices negatively effect not only the housing sector but the entire economy, since decreased household wealth shakes consumer confidence and reduces consumption. The mortgage market suffers foreclosures, losses for lenders and a strained financial system. The resulting social dislocation and economic harm will be severe, costing American families considerable wealth.

All that is required for the bubble to burst is a major change in home buyer sentiment, the simple reversal of expectations that prices will continue to rise. It was precisely this—investor sentiment—that ultimately burst the stock market bubble. Investors simply refused to keep on paying extreme prices while disregarding underlying value.

Housing prices don’t turn on a dime, and, historically, speculative bubbles continue to inflate for a lot longer than analysts expect. Nevertheless, even if interest rates remain relatively low, this bubble is at risk of imploding under the strain of exorbitantly high prices. Other pressures upon the bubble include the economic slowdown, soaring oil prices, the falling dollar and the gradual withdrawal of Chinese and Japanese investors from U.S. securities markets.

One risk that looms large is that U.S. policy-makers would have few tools to cushion the fall if a housing decline were to gain momentum, since interest rates are already very low and fiscal policy so loose that few corrective options remain. We are boxed in.

As Business Week has concluded, “Either the economy’s long-term prospects will get worse or interest rates will rise. In either scenario, housing prices will weaken.”

And the British Economist has warned that inflated housing prices pose an even bigger risk to the world economy than inflated oil prices. In its annual outlook, “The World in 2005,” the publication concludes, “House prices have lost touch with reality. In 2005 they will come down to earth.”

The current housing bubble holds profound implications, not only for the middle class but also for America’s 34 million working poor, elderly, disabled and children. Nearly 15 million families spend more than 50 percent of their income on housing.

Housing affordability is in crisis as Americans in increasing numbers find themselves paying more for housing and forced to live further and further away from where their jobs are located. More and more families simply cannot afford housing at all, let alone decent housing.

The median home price nationally is approaching $200,000 and in California, it is over $460,000. Soaring housing prices, and the housing patterns that result, restrict us further in where and how we live.

Gated communities proliferate, commutes to work lengthen, inner-city schools deteriorate and homelessness increases. Localities struggle to provide affordable, moderate housing for firefighters, teachers, nurses, police and others required to provide a competent local workforce. Communities of great abundance are increasingly segregated from communities of great need.

BUSH-WHACKED—On the housing front, President Bush’s second-term economic agenda, which he calls “America’s Ownership Society: Expanding Opportunities,” offers mere rhetoric and symbolism.

For a perspective on ownership, it is useful to note that 20 percent of the nation’s population owns 83 percent of its wealth. Despite the intensifying squeeze on housing affordability, for fiscal year 2006 the Bush Administration proposes a $3.7 billion budget cut to the Department of Housing and Urban Development (HUD).

Section 8, the Housing Choice Voucher Program, which provides affordable housing in modest apartments in the private market for over 2 million households, will be insufficiently funded to maintain previous levels. Although this program has become the nation’s most basic safety net, more than 80,000 vouchers may be lost this year.

The Administration’s basic goal to reduce all housing subsidies has been unrelentingly pursued. The President’s budget last year cut the Section 8 voucher program by $1.6 billion, 12 percent below what was needed to fund existing vouchers. Congressional appropriators resisted these cuts, but the outlook for 2005 is discouraging.

Unless Congress rejects further cuts for the current year and prevents HUD from using administrative directives to implement them, Section 8 vouchers will be slashed further. A New York Times editorial entitled “Playing Games With Housing” exposes a good cop/bad cop shell game in which Congress allows HUD to undermine Section 8 and each blames the other for the cutbacks and the chaos.

With an annual federal budget of $2.6 trillion and a $12 trillion economy, are we so impoverished that we would abandon this basic program for the most vulnerable among us? What is certain is that we continue to witness a widening divide between the two Americas.