Interview about possible housing bubble

Discussion in 'Economics' started by Cutten, May 26, 2005.

  1. An Interview
    with John P. Calverley,
    Author of
    Bubbles and How to Survive Them


    Q How can you be sure that the rise in house prices is really a bubble?

    A Overall the US seems to be in the early-to-middle stages of a housing bubble. The bubble in other countries, particularly the UK and Australia is much more advanced. The book provides a checklist for identifying bubbles (page 13). Rapid price rises and high valuations are always present, but a good test for a bubble is to look for other typical factors such as a relaxed monetary policy, rapid lending growth, a prolonged economic upswing, falling savings rates and large-scale media and popular interest. The housing bubble qualifies on all these criteria in some regions of the US, though not all are affected. Some of the most bubbly areas are in Massachusetts, New York, New Jersey, Florida and California.

    Q How can you be sure an asset is valued too high?

    A The book proposes broad ranges for stocks and houses, within which valuations can be seen as reasonable. For example a price-earnings ratio of between 10-20 and a house price-rental yield of 6-10% (i.e. the annual rent divided by the house price). If prices take these valuations above the range then we can start to say that it is probably a bubble. The book shows that these ranges are well-grounded both in past history and on an analysis of risk premiums. Realistically, we may not ever be able to identify a bubble with 100% certainty, but the further outside the range market valuations go and the more items ticked on the checklist (see above) the more likely that it is a bubble.

    Q Why are housing bubbles a threat?

    A At present Americans wealth is high in relation to income, despite the collapse of the stock bubble a few years back. This is largely because of the rise in value of housing. If the economy slows down for some reason, perhaps because of a slump in investment, or an outside shock or because monetary policy is tightened to head off inflation, there is a risk of a slump in house prices. This would reduce household wealth, hurt confidence and might severely complicate the downturn.

    Q The collapse of the stock bubble in 2001-2 had only a limited impact. Why should housing be any different?

    A The collapse in stocks only had a limited impact because it was offset by large cuts in interest rates and a huge fiscal stimulus. A new fiscal stimulus is not possible given the deficit levels today. And official interest rates are much lower than in 2000. Between 2000 and 2003 the Fed cut Fed funds rate from 6.5% to 1%. Today rates are only 1.75%. Moreover, the impact of the fall in stock prices was limited precisely because lower interest rates stimulated the housing bubbles, partly offsetting the loss of wealth in stocks and helped to keep consumer spending buoyant. Finally, it should be remembered that the stock bubble has left a legacy of problems for company pension schemes which have not gone away.

    Q Could house prices fall on their own?

    A spontaneous fall in house prices, leading to a slowdown in consumer spending and a weaker economy is certainly possible. The risk is greatest where house prices have reached extremes and where there has been substantial speculative activity, such as in the UK and Australia currently. US valuations are not yet so extreme. In practice, however, a fall in house prices is unlikely to be completely spontaneous. There is usually some sort of trigger, such as a rise in interest rates. But past experience with bubbles suggests that the trigger can often be something quite small.

    Q How much could house prices fall?

    A Based on past averages house prices could easily fall by 15-20% in the US on a nationwide basis but that would imply 20-30% falls in the most bubbly regions of the country. If accompanied by a severe economic downturn, a still-greater fall is possible.

    Q But US house prices have never fallen in the last 40 years. Why should they fall now?

    A The big difference with the past is that underlying consumer price inflation is much lower now. Taking out consumer price inflation, "real" house prices fell by 10% in the last housing downturn from 1990-95, but consumer price inflation of 3.3% pa, meant that nominal house prices moved up slightly. However, with inflation running at lower levels now, and house prices set to reach higher valuations than in 1990, there is a much greater chance of an outright fall in house prices. Moreover, if house prices fell in the context of a weaker economy, there is a risk of deflation (falling consumer prices) which would make the potential for lower house prices even greater.

    Q Why does a fall in house prices matter?

    A It obviously matters to individuals who have bought recently, since they will lose a large chunk, if not all of their equity. Some could find themselves with negative equity which, as well as being particularly painful, can make it difficult to move house. But it will also be of concern to people who bought some time ago, if they were relying on high and rising house prices to help fund their retirement.

    Q How does a fall in house price affect the economy?

    A the main effect is through a rise in the household savings rate as people save more and borrow less. So-called cash-out financing (or "mortgage equity withdrawal") has played an important role in sustaining consumer spending in recent years. Falling house prices would bring that to an end and the household savings rate would move up. The US household savings rate is currently only about 2%, which makes perfect sense given the strength of balance sheets. But strong balance sheets is reliant on house prices staying high. Higher savings rates mean slower growth of consumer spending, which accounts for around 70% of GDP.
  2. Q Surely the Fed would cut interest rates if house prices fell sharply?

    A Yes, provided they were not concerned that consumer price inflation was too high. The Fed might welcome the combination of lower house prices, lower interest rates and a lower exchange rate. This would help to rebalance the economy and make a start on reducing the current account deficit. Lower interest rates should help to cushion the downward move in house prices, but this cannot be guaranteed since, once bubbles go into reverse, there is a danger that sentiment completely reverses too and prices can undershoot on the downside, as was seen when the stock bubble burst in 2001-2. The Fed needs to get its response just right, or they may be unable to prevent a recession.

    Q What will happen to the US bubble?

    A Nationwide house prices rose 9.36% in the year to Q2, (Source OFHEO) the largest annual rise since the 1970s (when underlying consumer price inflation was much higher). The US bubble is likely to expand further in the near term, which will provide support for economic growth. Mortgage rates will only move up gradually and will remain relatively low for some time, since inflation is still well under control. Meanwhile economic growth will gradually bring down unemployment and raise wage growth. Areas where prices are already very high may slow or even pause, as affordability becomes a barrier, but other areas are likely to become expensive too.

    Q Is there anything the US authorities can do to slow the bubble?

    A Monetary policy could try to "lean against" the bubble by raising interest rates more than otherwise would be the case. But, since two-thirds of mortgages are linked to long-term bond yields, changing Federal Funds rate might not affect mortgage rates. Moreover as Mr Greenspan correctly argues, there is always a danger of precipitating the downturn that we are trying to avoid. More useful would be greater public warnings about the risks of buying property when values are expensive and, possibly, measures to reduce banks' appetites for mortgage lending. Again, this is difficult in the US, since most mortgages are now securitised.

    Q When will the bubble collapse?

    A One of the themes of the book is that bubbles are unpredictable, largely because they are NOT based on rational valuation behavior. Hence they often inflate for longer than seems likely and then crash unexpectedly. The near-term risk of falling house prices is relatively low in the US and is greater in the UK and Australia. But the risk of a combination of a large fall in house prices and a major economic downturn is not great in the near future because general consumer price inflation is still very moderate everywhere and central banks can therefore respond quickly with lower interest rates. But, looking ahead into H2 2005 and 2006, the risks increase, either because a modest fall in house prices suddenly "tips" the housing market over into a downward spiral, or because consumer price inflation re-emerges, reducing the Fed's freedom of manoeuver.

    Q Are there other countries in a housing bubble?

    A The UK and Australia already have major housing bubbles and the central banks there, the Bank of England and the Reserve Bank of Australia are watching very closely. The Governors of both have publicly warned about house prices, in Australia starting in 2003 and in the UK in June 2004. Holland, Spain and Ireland have all had huge increases in house prices, linked to the fall in interest rates caused by the introduction of the euro. These countries too are vulnerable to a major economic downturn. Some other countries have seen fast-rising prices in recent years, including Canada, France and Italy, as well as Hong Kong in the last year, but in these countries prices are rising from depressed levels and it is too early to describe them as in a bubble.

    Policy themes

    Q Can central banks do anything about bubbles?

    A Monetary policy cannot be relied upon to prevent bubbles, because policy-makers have only one instrument, interest rates, and their primary target is consumer price inflation. But if the housing bubbles burst, interest rates may need to be cut sharply to deal with the consequences.

    Q What other suggestions do you have to deal with bubbles?

    A The book proposes the establishment of an Asset Valuation Committee, charged with advising investors and the government when assets move out of reasonable ranges e.g. a price-earnings multiple for stocks of 10-20 and a house price rental yield of 6-10%. This could help by discouraging buyers when prices become high. It could also be used to help the authorities decide when to consider other measures such as speed limits for bank lending. Such a committee would need to have some independent standing but could be part of the Federal Reserve.

    Q What are "speed limits" to bank lending?

    A The book suggests that the expansion of bubbles might be limited by measures to link the mandatory capital requirements or the provisioning for bad loans made by banks to the behavior of asset prices. So, for example, if house prices are thought to be in a bubble, the authorities could require higher capital or larger reserves to be held against new mortgage lending.

    Questions for Investors

    Q What should homeowners in the US expect?

    A In the US home prices look set to continue rising for a while, as the combination of a growing economy and only gradual rises in interest rates support the market. Prices are already high in some regions, particularly on the coast, but prices elsewhere look set to keep rising.

    Q Are bubbles an opportunity or a threat to investors?

    A They can be an opportunity if the investor can ride the upswing and get out at the top. This is easier to do with stocks than with houses, but difficult with both in practice since it is always very difficult to know how far a bubble will go and when it will crash. Moreover bubbles often create over-optimism on investment returns, inadequate savings and over-concentration in the bubbling asset class.

    Q How should investors react to bubbles?

    A Investors need to try to diversify away from bubbling asset classes. As always they should hold a balanced portfolio with a range of asset classes including stocks, bonds and property. When a particular asset is bubbling they should reduce the weighting. Right now stocks look a better bet than housing for the medium term.
  3. How can their possibly be a housing "bubble" if every story on CNBC, newspapers, internet it "Watch out for the housing bubble" ????

    just buy
  4. Quite easily - one of the characteristics of a bubble is widespread media coverage. Loads of people in late 99 and early 2000 were talking about a bubble in internet stocks.

    Keep buying by all means, just remember it is hard to use a stop loss on a real estate portfolio.
  5. Well, you have to mark when you first heard the word "bubble" and then wait a couple of years while the early bubblers get their asses kicked. The best trading period is during this interim.

    Second mouse gets the cheese...

  6. stop loss on real esate = oops.... sorry Mr Insurance agent.. but my house just caught on fire.... i dont know why
  7. THE HOUSING MARKET HAS shown Herculean strength in the past few years. New home sales increased 0.2% in October, to the third-highest level ever, according to a recent Commerce Department report. That same month saw new home construction rise 6.4%, to the highest level of the year. But the furious rise in property prices during the past few years leaves some experts scratching their heads in befuddlement and others dropping the "b" word.

    In his new book, "Bubbles and How to Survive Them," John Calverley analyzes some of the major market bubbles of the 20th century, and says that the U.S. is now in the early to middle stages of a housing bubble. Calverley, chief economist and strategist at American Express Bank, writes that there are clear signs of an already inflated housing bubble in the U.K., Australia and Spain. Modern economies, he argues, are increasingly dominated by bubbles in asset prices, be they tech shares circa 1999 or single-family homes today.

    So what's driving home prices ever higher? On the demand side, it's low interest rates, relatively low unemployment, rising incomes and increased migration; on the supply side, new building is constrained by planning and zoning restrictions. Calverley also cites a crucial factor that plays into all bubbles — an expectation of future price increases. "In any asset market, whenever price appreciation becomes the main reason for people buying, the market is in danger of becoming a bubble," he writes. "We must suspect a bubble if homeowners are regarding housing primarily as an investment, rather than as a place to live." recently talked about bubbles with Calverley and asked him why he thinks that, just as with stocks in 1999, now is the time to reduce exposure to the housing market. According to your book, the U.S. is looking at the early to middle stages of a housing bubble. Have people not learned from the tech bubble of a few years ago?

    John Calverley: The construction of new housing is at a very high level, and has been at a high level for the last few years, which is unusual in a recession. As a percentage of GDP [gross domestic product], residential housing investment is just about at its highest [on record]. Obviously, it's driven by low interest rates and strong demand. The Office for Federal Housing Enterprise and Oversight provides a price index for houses, which came out last Wednesday. It was up 10.3% over the last year... one of the fastest rates in history.

    One of the main drivers is low interest rates. When people look at a house, they see how much they can afford, the biggest mortgage they can afford. What that means is that they end up paying for expensive housing. Interest rates are low in nominal terms. Mortgage rates are 5.8%. But when they rise against rents and [people's] incomes, housing is actually not a good investment.

    SM: In your book you say that bubbles make the economy highly vulnerable to shocks or policy mistakes. With the danger of a housing bubble looming in the U.S., how careful does the Federal Reserve have to be in its attempts to prevent something comparable to the Internet stock bubble of the late 1990s?

    JC: At the moment, the Fed wants to raise interest rates. I think that's correct; it makes sense to raise rates. The danger is if they raise rates to a point where the economy slows. Predicting how the economy will respond is hard. I think it would take a major mistake to cause any real damage.

    SM: Part of your book compares the U.S. bubble of the 1920s with the Japanese bubble of the 1980s. Given similar experiences, why did Japan's bubble not lead to a depression like the U.S.'s did?

    JC: The big mistake the U.S. made was in 1931-32. The U.S. had a normal recession, and the stock market was showing signs of recovery. Because of the gold standard, the Fed raised interest rates to defend that standard; it raised interest rates when the economy was still weak. It was a particular mistake linked to a fixed exchange rate system. Since we don't have the gold standard system anymore, the risk of major depression now is pretty low.

    SM: You suggest that buyers in recent years seem not to appreciate that interest rates have been held at unusually low levels. Are people now overly optimistic? Do they have poor short-term memories?

    JC: It does depend on people having enough confidence... In the U.K., in the early 90s, house prices fell in London. People don't remember the last time interest rates were this low. In the U.S., you have to go back 40 years. The mortgage market has liberalized; it's a lot easier now to get a mortgage.

    With the tech bubble, everybody could see how good this technology was, that it could transform the economy. People thought that any company using that technology would see a rise in profits, and there's no way you could lose money. With housing, people look back at the price index of the nation as a whole, and they see that prices haven't fallen. Which is true. They think the economy is good and house prices are rising. Houses look like a good investment. The problem is that prices didn't fall in the past because the underlying consumer price inflation was rising. The last time house prices fell [in several regions] was around 1990 to 1995. But house prices fell [during other periods] if you adjust for inflation. The worst thing is the view that people have that housing is a no-lose investment. And we were there four years ago with stocks.

    SM: In your book, you talk about the psychological factor in bubbles and how investors sometimes behave irrationally when it comes to assessing risk. You cite "mental framing," the tendency of individuals to organize their world into separate mental accounts. So they might borrow at a high interest rate to finance buying a car while saving at lower rates. What are some other examples?

    JC: Another is called "anchoring," which is believing that the current price is somehow justified and likely to continue. People regard a two-bedroom apartment in New York City costing hundreds of thousands of dollars as justified because that's just the way it's been in Manhattan. Obviously there is demand, genuine underlying demand, but to what extent do people want to live there for all the real reasons — like it's a cultural center, it's close to work — vs. because it's a great investment? People are partly motivated by feeling that it doesn't matter how much I pay for my apartment because it's an investment.

    SM: Real-estate prices in Manhattan are outrageous. Is it a big bubble waiting to burst?

    I wouldn't say it's a big bubble. More people now want to live in cities rather than in the suburbs. There is an underlying demand for Manhattan specifically. I think it's definitely bubbly. It's clear a lot of people are treating property as a great investment.

    SM: How much does immigration factor into the rise in housing prices?

    JC: Clearly, there is some demand for housing from immigrants. The argument that immigration is driving much of the demand for new housing is more relevant in the U.K. than in the U.S. In London, they're not building as many houses as in the U.S. because they have more planning controls and restrictions there.

    SM: One of the ironic points you make in the book is that, as a response to the bursting of the tech bubble in 2000, Federal Reserve Chairman Alan Greenspan cut interest rates, which led to stronger demand for housing. And now we may be facing overvaluations in housing.

    JC: In the last year or so, we've seen an acceleration in house prices. Now the Fed is trying to raise interest rates, though the most important rates for housing are long-term interest rates, which the Fed doesn't control. Bond yields are so low. Why? Maybe because Asian banks are buying Treasurys... The mortgage rates are linked to the bond yield. The 10-year yield is 4.15% now. If mortgage rates go up a quarter of a percent, that might slow housing prices. I argue in the book that to stop the housing bubble, you probably need the mortgage rate to be 7% or more. (The average rate on a 30-year fixed-rate mortgage was 5.71% this week, according to Freddie Mac.)

    SM: How should investors approach the prospect of a bubble?

    JC: The most important thing is to recognize that it is a bubble, because then you can be careful not to be drawn into it. People see a rise in prices, they see the gains their friends make, they read about it in newspapers, and everybody wants to buy. A late-stage investor should be very cautious, generally, about buying housing. That doesn't mean it isn't going to be a good investment for some people in some places. Where yields are higher, it might be a good income. People should be careful of having massive amounts of property in their portfolio... They can lose a lot of money.

    SM: How do you think Fed officials should deal with it?

    JC: It's quite difficult for monetary policy to do anything about bubbles. The Fed is right to raise interest rates. With other policies, there are not many options. One is to publicly warn about bubbles. Greenspan has warned in specific areas; he hasn't made a general warning. Another way to go is to try to see if there are ways to restrain bank lending.

    Another issue in the U.S. is the role of Freddie [Mac] and Fannie [Mae]. They are the source of a great deal of mortgage lending. Greenspan suggested they be broken up — and instead have a number of private sector institutions. That might help.
  8. cakulev


    Nevertheless, 77% of Americans claim to have heard nothing about a potential housing bubble.
  9. izeickl


    I find the same in the UK, sometimes you assume everyone has heard of X Y or Z because about everyone you talk to has heard about it....BUT, thats because I talk to and mix with people who have similar interests to myself and are more fiscally aware on a personal and national level. I think thats how bubbles can come across too, by people who are not really fiscally sensible throwing themselves into a frenzy that some marketing guy has blown up their ass.
    I sat down with a friend the other day who doesnt know a lot about biz, and she was interested in buying this shop that was fire damaged. The owner said that it made profit over 100 000 USD per year and thats all she heard....When I sat down with her to go over the costs and real potential it worked out a complete lemon. (After all if it was such a great biz why would the owner not just restart the business?)
  10. 14:09 TOL Toll Brothers on Conference Call (91.10 +5.37)

    -Update- Strong visibility for future growth... notes WSJ article of growth of millionaire houses in the U.S.; believes luxury market is the 'sweetest spot' in the industry... lowest backlog dropout rate in the industry (under 5%); thus backlog is a solid forecaster for co...

    14:20 TOL Toll Brothers on Conference Call II (90.99 +5.26)

    -Update- Unit delivery guidance for Y05 is 8100-8400 units; Q3- 2100-2200; Q4- 2500-2700 homes... Avg Price per home: Y05- $645-655K; Q3 655-665K; Q4- $660-670K (all are increazses to previous guidance)... home building gross margins as a percentage of home building revenues in fiscal 2005 are expected to be: Y05- 31.75-32.00%; Q3 32.2-32.5%; Q4- 31.8-32%...
    #10     May 26, 2005