A Stitch in Haste

Tech Central Station overlord James "Always Wrong" Glassman has yet another piece dismissing the (potential) housing bubble.

Although the piece is somewhat more reality-based than his last contribution (the point of which was to accuse Fed Chairman Alan Greenspan of a vast bubble-switching conspiracy), Glassman continues his tactic of distracting readers by suggesting that, if it isn't raining, then you can't be drowning:

Also, remember that housing markets aren't stock markets. When tech stocks started to fall, investors panicked and dumped their holdings, but, even if the prices of new houses declines [sic] sharply, most homeowners won't sell their dwellings at a loss. They live in them! The value at any moment doesn't matter. In addition, high transaction costs — sales commissions plus transfer taxes — put a damper on rapid turnover of homes.

This is, of course, utter nonsense.

First of all, an investor who bought a stock at $40, then sold it (for a loss) at $30 can hardly be accused of "panicking" if the stock then fell to $20. Some of the worst losses in the stock market bubble came, not from buying at the top, but from people who bought as the market was falling, since they had been brainwashed by gurus like Glassman that the only sane response to a falling market is to "buy the dip."

But more important is Glassman's inexcusable comparison of the stock market volatility and housing price volatility. It is of course true that the stock market fluctuates far more widely than housing prices tend to. But the relative stability of the housing market is offset by the substantially greater leverage used in real estate.

Most stock investors, and almost all individual investors, do not buy stock on margin. They are 100% long (short selling, a leveraged strategy, is obviously not a concern in a falling market). And even those who do buy on margin must put 50% of the purchase price down, up front. Furthermore, margin positions are "marked to market" daily, such that any shortfall must immediately be covered.

The result is that in order for a falling stock market to "hurt," prices must fall substantially — which is of course exactly what happened in 2000. But the margin crash of 1929 did not (and could not) happen in 2000 because people weren't leveraged — they were investing their own money, not the bank's.

The housing market is the exact reciprocal of this framework. The fundamental reason people are concerned about a (potential) housing bubble is not because anyone thinks home prices will fall 25% or 50% across the country. The problem is that prices don't have to fall anywhere near that much for a serious impact to be triggered.

If you own a share of stock outright (i.e., not on margin), then it can fall 100% and still no banker will come a-knocking at your door. But if you have zero (or negative) equity in your home (or a second or third property that you had planned to "flip") and prices fall just 5%, then you are in trouble. Big trouble. (And if you have an adjustable-rate mortgage that may soon result in higher monthly payments as interest rates rise, then the trouble only becomes wider and deeper.)

Some other points:

--The idea that "people won't sell their homes at a loss, they'll just keep living in them" is ludicrous. One word: foreclosure. Unlike stocks, it's not solely the homeowner's decision whether to sell his house or not. And again, much of the "froth" in the housing market is coming, not from primary residences, but from secondary, speculative properties. Meanwhile, the rise in "creative" financing, especially interest-only mortgages, makes the sell decision even more likely to be made by the lender and not the homeowner.

--Another key difference between the stock market and the housing market is which industries are affected in a decline. Although Glassman insists that "most Americans make good choices about their own finances" (oh really?), Glassman does get one thing right:

The concern for policymakers should be lending institutions: are they making bad loans that might lead to system-wide failures and an expensive government bailout?

Exactly. Other than some wealth effects and the (important) impact on corporate pension funds, the stock market bubble was more of an embarrassment than anything else for most investors and most industries. If there is a housing bubble that bursts, on the other hand, then it won't be investors who bear the brunt of the pain, but the financial sector — mortgage lenders, mortgage insurers, credit card companies, auto finance companies, consumer finance companies and perhaps even full-scale banks. And that can send negative shockwaves throughout the economy.

I'm still not saying I think it's likely, but to suggest that it can't possibly happen, that it's foolish to even suggest the possibility of it happening, is — well, it's irrational exuberance.

UPDATE: If you want to attach some hard numbers to the "creative" mortgage phenomenon and its threat to the housing markets, then see this New York Times piece on the subject. A sample:

This year, only about $80 billion, or 1 percent, of mortgage debt will switch to an adjustable rate based largely on prevailing interest rates, according to an analysis by Deutsche Bank in New York. Next year, some $300 billion of mortgage debt will be similarly adjusted.

But in 2007, the portion will soar, with $1 trillion of the nation's mortgage debt — or about 12 percent of it — switching to adjustable payments, according to the analysis. The 2007 adjustments will almost certainly be the largest such turnover that has ever occurred.

This is an entirely new mortgage market — with entirely new risks. Turning a blind eye to this fundamental shift could prove very dangerous indeed.

UPDATE: Alex Tabarrok makes exactly the same mistake as Glassman --

The real question is not whether there is a bubble[;] the question is, What are the chances that housing prices will fall dramatically?

No, no, no. Since the housing market is immensely more financially levered than the stock market (at least with respect to individual investors and homeowners), the probability of housing prices falling "dramatically" is totally irrelevant; they need only fall slightly if a property owner has little, zero, or negative equity in the property. Aggregate this over the entire "creatively financed" housing sub-market, and serious trouble could be brewing.

Another error:

Do note that only a small fraction of the housing stock is available for sale at any one point in time.

Perhaps, but if an increase in interest rates triggers an increase in distress sales and outright foreclosures resulting from all these "creative" interest-only and negative amortization mortgages, then a greater fraction of the housing stock will become available. And, given the inelasticities of supply and demand that Taborrok cites, the result can be quite traumatic, if not for traditionally-financed homeowners, then certainly for the various financial industries I mentioned above that derive their demand -- and their profits -- from a stable housing and mortgage market.

Finally, I'd like to move a comment up into the post -- it deserves it:

As the old saying goes...if you owe the bank $1k and can't pay, you have a problem; if you owe the bank $1m and can't pay, the bank has a problem; and if you owe the bank $1b and can't pay, the government has a problem.

I love it.