Housing: Speculation is the Key posted April, 2005 by Caculated Risk
I mentioned I would be going into the archives to re-post some of Angry Bear’s explanatory writing in the 2004/05 time period. The first was written by Kash in early 2005 on the coming dilemma in paying for health care and how to use measures to think it through.
Here is a post by CR describing early thinking on the housing bubble, and not from hindsight:
Housing: Speculation is the Key
Posted by CalculatedRisk | 4/04/2005 on Angry Bear
Re-posted with permission of the author
I have taken to calling the housing market a “bubble”. But how do I define a bubble?
A bubble requires both overvaluation based on fundamentals and speculation. It is natural to focus on an asset’s fundamental value, but the real key for detecting a bubble is speculation – the topic of this post. Speculation tends to chase appreciating assets, and then speculation begets more speculation, until finally, for some reason that will become obvious to all in hindsight, the “bubble” bursts.
Speculation is the key.
A recent report by the National Association of Realtors (NAR) reported that 23% of all homes nationwide were bought by investors. Another 13% of homes were purchased as second homes. In Miami, it was reported that 85% of “all condominium sales in the downtown Miami market are accounted for by investors and speculators”. This is clear evidence of speculation.
The following supply demand diagrams illustrate this type of speculation.
Click on diagram for larger image.
The above diagram shows the motive for the speculator. If he buys today, at price P0, he believes he can sell in the future at price Pf0 (price future zero), because of higher future demand. The speculation would return: Profit = Pf0-P0-storage costs (the storage costs are mortgage, property tax, maintenance, and other expenses minus any rents). For more information on tax deductions related to property expenses, especially for manufactured homes, you can visit https://cishomeloans.com/blog/tax-deductions-for-manufactured-homes/.
In this model, speculation is viewed as storage; it removes the asset from the supply. The following diagram shows the impact on price due to the speculation:
Since speculation removes the asset from the supply, the Present supply curve shifts to the left (light blue) and the price increases from P0 to P1. In the second diagram, when the speculator sells, such as on sites like https://www.ibuypueblohouses.com/sell-my-house-fast-colorado-springs/, the supply increases (shifts to the right). The future price will fall from PF0 to PF1. As long as (PF1 – storage costs) is greater than P1, the speculator makes a profit.
However, if the price does not rise, the speculator must either hold onto the asset or sell for a loss. If the speculator chooses to sell, this will add to the supply and put additional downward pressure on the price. For expert advice on navigating these market fluctuations and making sound investment decisions, go to https://jwacompanies.com/.
This type of speculation appears to be rampant only in certain regions, mostly the coastal areas. However, something akin to speculation is more widespread – homeowners using substantial leverage with escalating financing such as ARMs or interest only loans.
Leverage as Speculation.
In this LA Times article “They’re In — but Not Home Free”, the writer describes a woman that is “able to afford, barely, her first home”. She has taken out “an adjustable-rate mortgage that won’t require her to pay any principal for three years”. She is already strapped, working overtime to pay her bills, and doesn’t know what she will do in three years. She is a gambling that either her income will increase or that the value of her home will rise enough to sell at a profit.
Californians are adopting a “buy now, pay later” strategy on a massive scale. The boom in interest-only loans — nearly half the state’s home buyers used them last year, up from virtually none in 2001— is the engine behind California’s surging home prices.
See article for graphic on “Risky Debt”. Here is a similar article in the Sunday Washington Post, “Homeowners in Harm’s Way” and a summary of financing options from the WSJ Online: “Buy Now, Pay Later”
This type of leveraged activity pulls demand from future periods. Starting with the first diagram above, these leveraged financing programs shift the demand curve to the right (light red) and increase the price from P0 to P1. In the future, the demand will be shifted to the left and the future price will be Pf1. If Pf1 is less than P1 (the LA Times buyer’s price), then her house might be foreclosed, increasing the supply too!
One way to prolong the bubble is to offer ever more leveraged financing. And here it is – a 35 year loan, interest only for the first 5 years, with no money down and 103% Loan To Value (to cover closing costs). Amazing.
How many people are on the ragged edge? From the LA Times article:
The number of buyers falling into this category in any given month is unclear. But a California home builder recently got a sense when he sought to answer this question: How many of the potential buyers of his houses could still afford them if interest rates went up even a little?
To find out, the builder conducted a little experiment.
His firm’s preferred lender had pre-qualified 90 potential buyers for a group of new houses. Since the houses wouldn’t be ready for another six months, the builder tightened the loan criteria. He didn’t want buyers to sign up for a house and then get frightened into canceling by rising rates.
He raised the threshold from a fully variable loan, the easiest to get since it immediately moves upward when rates increase, to a mortgage that was fixed for the first three years. That would shield buyers from rate jumps for at least a little while, but it’s also more expensive.
Under the higher threshold, only about 15 of the buyers still qualified.
Only one in six buyers qualified for a slightly higher financing package. I believe that means we are close to the end of the housing cycle. Both types of activities are increasing prices: speculation is reducing supply and leverage is increasing demand.
The Bust
Housing “bubbles” typically do not “pop”, rather prices deflate slowly in real terms, over several years. Historically real estate prices display strong persistence and are sticky downward. Sellers tend to want a price close to recent sales in their neighborhood, and buyers, sensing prices are declining, will wait for even lower prices.
This means real estate markets do not clear immediately, and what we usually observe is a drop in transaction volumes. That is my expectation for this year: stable prices (maybe declining slightly on the coasts) and declining volumes. Stable or lower prices will halt speculation and increase the supply. And if rates rise further, or lenders become more discerning, demand will also decrease. Either spells bust for the current bubble.
You need to send this to Eugene Fama because he keeps saying he does not think there are any such things as bubbles, that the term is meaningless and that no one can explain it to him “scientifically.”
Rickstersherpa,
Calculatedrisk would look a little better as a forecaster had he not missed the mark by definitly 2 years or arguably 3 1/2 years. One could have made a lot of money speculating in those 2 years.
Rickstersherpa,
The problem with calculatedrisk is that he missed the mark by at least 2 years. You could have made alot of money speculating in those two years. Also, along with the housing bubble there seems to have been an enabling savings bubble outside of the United States.
Bubbles are just a fact of life in a free market economy. They come and go and over savers and over speculators have to learn and re-learn these lessons over and over again. There is no solution to it.
Cantab,
Lighten up. You have no idea if CR was two years late, nor is it relevent…this is my pick from archives as simply informative. Your comment is a throwaway to simply re-direct for some reason…drop it.
Enabling savings bubble is OT and a simple media sound bite, and not a serious economic comment for this blog.
Rdan,
Do you think that sometimes you personally run into a conflict of interest between selling and promoting your blog with the content of the conversations that take place. I think this conflict of interest is what promoted your post to me. Its not the first time.
You don’t need to tell me to lighten up. It’s people like Kharris that think there on a mission from god to control what people say, or Bruce with is over-the-top insistance that social security be a big government only program with no private assets, that need to be told to lighten up. Also, Jack and Run go off the deep end from time to time.
You have to remember that first I know more economics than you do and second that I practice working with forecasts, models, and numbers in general way more than you do. So you may want to lighten up on criticizing me.
On the issue:
Calculated Risk made this post in April 2005. In his post he made the following statement.
This means real estate markets do not clear immediately, and what we usually observe is a drop in transaction volumes. That is my expectation for this year: stable prices (maybe declining slightly on the coasts) and declining volumes. Stable or lower prices will halt speculation and increase the supply. And if rates rise further, or lenders become more discerning, demand will also decrease. Either spells bust for the current bubble.
So calculated Risk was making his prediction the bubble to burst sometime in 2005. But the housing bubble did not burst into well into 2007. So he missed the mark on his forecast by a about two years.
Enabling savings bubble is OT and a simple media sound bite, and not a serious economic comment for this blog
Its not a just a sound bite for serious people that actually think about issues rather than selectively piecing together factoids from other blogs that conform with the goals of the group they happened to fall into (ex. liberal democrat). I have on many instances said that the overall volume of money being made a available was the cause of the housing bubble and its popping with it’s negative wealth effect as the cause to the recession. Moreover I’ve consistently dismissed as know nothing idiots those that blame it on things like securitization and/or derivatives.
Bubbles are a fact of life in a market economy. We don’t know about “free” markets because there are few, if any, in existence. The existence of law and law enforcement – commercial and criminal – means that markets are constrained. And a good thing, too.
Three facts, in combination, argue that we should regulate to lean against bubbles. One is that bubbles exist. Another is that they distort economic activity. The last is that, given that markets are nearly always constrained, imposing a constraint on markets is not evidence of making them worse.
So sorry, but the “bubbles are a fact of life, so just live with it” argument doesn’t hold water unless you can show that efforts to lean against bubbles cause greater distortions than the bubbles themselves, or that bubbles cannot be leaned against in any effective way.
Bubbles make us poorer, so successful regulation to reduce bubbles would make us richer. The burden of the other side is to show that regulation cannot be successful.
Cantab,
I’ll lighten up when you stop trotting out illegitimate arguments. Stick to the truth. Get your logic in order. Stay away from convenient fallacies. Then I’ll move on to the next bad child.
Several comments removed. (rdan)
kharris/rdan,
Thank you for trying to bring some coherence and dignity back to these discussions.
A specualtive market can also be manipulated by professionals within that market, and especially true of real estate. A well organized group of broker, investor (often one in the same) together with mortgage broker/banker can ping-pong the price of a property so that it is sold and resold several times within a brief period, say as little as 24 months. With each turn over the property itself makes a profit and so too does the financing provide an additional bonus at each turn over. Note that the mortgage broker, often the same or a related agent of the realtor, earns one or two points on each new mortgage. On a $200,000
mortgage your looking at a several thousand dollars at each refinance under a new buyer’s name. Each prior mortgage on the property is paid off by the new mortgage. Only a continuous escalating market is needed to churn the product, and until the bubble starts to deflate $20,000-$30,000 per transaction adds up to real money. Tulips for sale!!!