Hurricane season notwithstanding, it’s hard to watch the news without seeing some report on the housing market. And while real-estate investment never really achieved broad collegiate appeal — unlike keg stands, for instance, or iPods — this housing situation is nonetheless symptomatic of, and contributing to, a debt crisis in America. Therefore, to facilitate discussion on this important issue, I present my brief, high-altitude summary of debt in America, and the three great delusions of the housing fiasco.
First, a little context: On the tail of the dot-com crash, the Fed lowered interest rates, hoping to avert recession with a soft landing. The goal of this rate drop was to spur borrowing, quell saving and inject money into the economy through consumer spending. The 9/11 attacks marked another impetus for economic slowdown, countered immediately with further rate cuts and those bizarre presidential edicts commanding citizens to travel to Disneyland and spend money. This, in short, began a sustained, multi-year period of rock-bottom interest rates, which of course translated to cheaper borrowing costs, low mortgage rates and, among other things, more people eagerly shopping for homes.
A deluge of hungry buyers leads to market unbalance, and is met with increased production where feasible, and increased prices where not. This is exactly what occurred in some coastal markets of California, Florida and the Northeast, with home prices soaring alongside a boom in new development wherever space would permit. In the hottest markets — like Los Angeles, San Diego and Miami — house prices have posted double-digit annual appreciation for several years, with many properties doubling or trebling in value since 2002.
The exact definition of a speculative bubble is the subject of some debate, but, for our purposes, let’s say it constitutes any situation where people feel compelled to invest with urgency in a product whose intrinsic value is less important than the promise of profit. Thus, the nature of the product and the price paid are functionally irrelevant, as long as some buyer exists who is willing to pay even more. This “greater fool” theory powered the recent dot-com boom, just as it once fuelled the Dutch tulip craze.
This brings us to Delusion One: that real estate always rises in value. Any cursory study of history will show this belief is simply untrue; nonetheless, polls show that a disturbing number of people believes real estate values always go up. A significant share of homes is now sold to speculators (or “flippers”), whose only intent is to re-sell the property for profit.
That real estate can only increase in value is a dangerous assumption, one that bears primary responsibility for Delusion Two: that negative-amortization, interest-only mortgages are a good idea. If home prices in your area have outstripped the amount you can afford, you might weigh what Alan Greenspan politely termed an “exotic mortgage”: a debt where, despite hefty monthly payments, you are left after five years owing more on your house than its initial sale price. Without getting mired in detail, such mortgages defer all principal and some interest payments for a set period, usually two to five years, end-loading the unpaid interest onto the principal. In my view, such products are useful in only two instances: first, when a buyer’s income will increase sufficiently to cover the major jump in payments after the five-year introductory period; and second, if the property value will rise sufficiently during those five years to cover the increased principal with a sale. If either of these assumptions proves untrue, the owner is in trouble. Unheard-of as recently as 2001, in some areas such mortgages are now used in upwards of three-quarters of all home purchases.
And here we introduce the important — if obvious — notion that in order to profit from real-estate appreciation, you must actually sell your property. The problem with this is that, unless you rent or move to a different city — or the property in question is a second house — any comparable house you can buy is just as pricey as the one you’re selling. This unfortunate complication has been termed the “golden prison” phenomenon: Homeowners watch helplessly as their houses appreciate, unable to cash in without spending even more to move.
This quandary is nicely sidestepped by a wholehearted immersion in Delusion Three: borrowing against inflated home equity realizes your gains. Overheated markets have produced outlandish home prices, prices that utterly outstrip the ability of the average household to afford modest dwellings with any but the most exotic debt instruments. Borrowing against such inflated appraisals isn’t realizing gains – it’s staking money on those valuations. Nonetheless, home equity loans have injected significant cash into the economy in recent years; much consumer spending is therefore fuelled on borrowed money secured by overvalued assets – hardly the hallmark of a robust financial system.
American indebtedness has reached epidemic proportions. Greenspan deferred a deserved recession with a sustained infusion of cheap money, allowing us to deny reality for a few years. But amid this furor of consumption, warning signs abound: The personal savings rate dropped to zero in June. Foreclosures and bankruptcies are up, the latter at record highs. Check-cashing joints are among the fastest growing businesses in the nation — a glaring beacon of a society living above its means. The housing bubble looks poised to burst: Rents remain low, often falling far short of covering the mortgage costs on rapidly appreciating properties, and in many markets housing may already have peaked — evidenced by a drought of buyers amid a glut of stale listings.
Across the country, millions cling to the belief that housing gains are real, hoping their prime store of wealth won’t suddenly evaporate in a market correction. And who knows? Maybe they’re right. Maybe interest rates will stay at record lows, home prices will continue to appreciate, and an insatiable pack of well-heeled suckers will buy anything that needs to sell. Too many homeowners are staking everything on the best possible scenario, praying that a rainy day will never come. We all hope for the best — but don’t bet the house on it.
Michael Seringhaus is a fifth-year graduate student in molecular biophysics and biochemistry. This is his first regular column.