Musings of the Sundarman

The real estate bubble will burst in 2006: where will you be?

When I walked into Borders recently and glanced at the 'Investing' section, a chill ran down my spine. I saw row upon row of books with titles such as 'How to make money in real estate' and 'No-money down real estate strategies'. The moment took me back to 1999 and the same scenario existed, except the titles were something akin to 'How to Day-trade your way to wealth'! The stock market crash of 2000-2001 had a visceral impact on me, economically, and emotionally. So I looked for ANY book in the stack that held the contrarian view.

One of the few books that bucks the prevailing wisdom that real estate investing is the path to sure-fire riches, is 'Irrational Exuberance' by Robert Shiller, who is the Stanley B. Resor Professor of Economics at Yale University. He is also author of The New Financial Order: Risk in the 21st Century (Princeton) and Market Volatility and Macro Markets, which won the 1996 Paul A. Samuelson Award. The book is an engrossing read, in which Shiller amasses impressive evidence to support his argument that the recent housing market boom bears many similarities to the stock market bubble of the late 1990s, and may eventually be followed by declining home prices for years to come. After stocks plummeted when the bubble burst in 2000, investors moved their money into housing. This precipitated the inflated real estate prices not only in America, but around the world, Shiller maintains (think London in 1996, LA, New York and Sydney in 1997, Paris in 1998, Miami, MOscow and Shanghai in 2001 and Vancouver in 2002). Hence, irrational exuberance did not disappear-it merely reappeared in other settings.

I thought about it and sure enough, the evidence was right before me: I learnt that some houses in hot markets in coastal states like California are being bought twice in single day. I know for a fact that there are over 3000 realtors covering just the town of Fremont, CA! The government reported that sales of new homes jumped sharply in Feb 2005 this year, in its biggest monthly increase in four years. I personally know of many buyers who are trying to beat rising mortgage rates. These rising rates themselves could cool the market. Some top real estate analysts are troubled by the evidence that growing ranks of real estate investors are buying houses they never expect to be able to rent at a profit. These investors say they think prices of houses will just keep rising; premonitions of a bubble on verge of popping do not ruffle those who are bullish on real estate. Also, the can't-miss aura of real estate has helped nudge many families to invest more of their personal wealth in real estate by buying more expensive homes and taking on riskier mortgages (Interest-only mortgages and risky ARMs).

So what could happen if the real-estate bubble pops in 2006? A decline in home prices in some cities could trigger problems in our financial institutions. A decline in home prices after the peak of the home price market in 1925, and accelerating down after 1929, did so. Widespread mortgage defaults contributed to the biggest banking crisis in US history in the early 1930s (and the Great Depression). The decline in urban land prices in Japan after the peak of their market in 1990 led to the kind of banking crises that have been part of the Japanese malaise ever since. A decline in home prices in the US starting in Texas in the 1980s led to the savings and loan crisis. The decline in home prices on both coasts starting in 1990 led to a recession that had negative effects on the economy for years, and a recession that had particularly severe effects on some cities (such as Los Angeles and Hartford) that had some of the sharpest declines.

The national situation could be more severe this time than it was after 1990, since this time the loan to value ratio is much higher (as home prices, compared to rentable value, are so much higher), and so the effects of the decline on defaults would be bigger. Our financial institutions did nothing to hedge their exposure to home price declines in 1990, and they are not doing so now. Of course, one might not blame them too strongly, since hedging instruments for real estate price risk do not exist. But, if these institutions had shown any initiative, they could have put the impetus in place to create such hedging vehicles. In fact, Fannie Mae and other institutions, which face risks associated with home prices, appear to be unconcerned about home price risk, even though problems that they could encounter if home prices fall could have systemic effects and might require a government bailout.

Mortgage insurers are another institution that is very vulnerable to real estate price risk and that do nothing to hedge this risk directly. If there are substantial price declines in real estate, even regionally, municipal governments might find the credit ratings on their debt reduced (what if that City of Oakland Muni bond you own becomes worthless??). A real estate price decline could also put state governments in a difficult budget situation, just as the strong effects of the stock market decline did after 2000.

The ultimate solution to this troubling condition, would involve better-designed public institutions such as a revamped social security system (to protect people impacted by significant real-estate declines), new forms of insurance to protect people's incomes and homes, and a broader array of investment options (other than just stocks, bonds, mutual funds and real estate).