A Stitch in Haste

One of the things about my real-world job that drives me nuts is when people, especially financial professionals, misuse financial terminology. For example, an easy way to prove to me that you don't know what you're talking about is to say "secondary offering" when you mean "follow-on offering."

Anyway, an extremely common misuse of financial terminology is to call something "investing" when it really isn't. Politicians do it all the time (e.g., "We're not spending the money on highways...we're investing in transportation."). Imagine if someone were to say "I'm not 'spending' money at the cruise bar...I'm 'investing' in my sex life."

But, for once, politicians are not my focus. The still-lingering question of whether we are in a housing bubble is: (WSJ - $)

It isn't only that housing prices keep rising faster than almost anything else, up 10% on average nationally in 2004, according to the U.S. Office of Federal Housing Enterprise Oversight, and up 25% or more in the hottest markets in California, Florida and Nevada.

It isn't only that the clever mortgage industry keeps coming up with new ways to lend people money to buy houses that involve ever-more leverage and little — or sometimes no — down payment.

It's that more people are buying second and even third homes, expecting that prices will continue to rise so they can sell the houses quickly at a profit — and that is drawing the Fed's attention.

That's not investing, folks, that's speculation.

An "investment" is an instrument or enterprise that generates its own intrinsic return, or, stated different, has some claim to some form of cash flow. A share of stock is a claim on the net earnings of the company. A corporate bond is a claim on the gross cash flows of the company. A government bond is a claim on future taxes. A rental property is a claim on the rents paid by the tenants.

Something that does not represent a claim on cash flows is by definition not an investment. Buying something only on the expectation that it will "go up" is speculation, not investment.

Hillary Clinton did not "invest" in cattle futures; she speculated in them. One does not "invest" in a bar of gold or diamonds or art or Seventeenth Century dutch tulips or the outcome of the Kentucky Derby. Those are all forms of speculation.

I threw in that last example to make another point. Investing is not gambling — speculation is. (Which is not to say that investing is without risk, but "risk" and "chance" are two entirely different concepts — see generally "Against the Gods — The Remarkable Story of Risk" by Peter L. Bernstein). Keep that in mind when you hear the g-word from opponents of Social Security reform (see also this post).

But I digress. There is one clear distinction between conventional, healthy financial speculation and manias such as the Tulip Craze or the Nasdaq Bubble of 1998-2000. Healthy speculation has speculators on both sides of the trade; manias only have speculators on the buy side of the trade.

For example, in the speculative commodity markets such as gold, coffee or cattle futures, people are generally betting in both directions — some think that the price will go up, some think it will go down (see generally, "Trading Places"). The commodities exchange simply tries to match those counterparties up so they can make the bet. And, very loosely speaking, half of the speculators will win and half will lose. No different really from betting on the Super Bowl.

But this is not what we are seeing in the housing market — the only speculation is up: people may disagree on where to buy, what to buy, how far up, or how long "up" will last, but they are all betting on "up."

That's a bubble.

The house you buy so you can live in it is an investment — you have a claim on the money you save by not renting. If you buy property to go into the landlord business, then that too is an investment — you have a claim on the rents your tenants pay you. The "fixer-upper" that you in fact fix up is yet another investment — you have a claim on the (Lockean) value your own effort has created in the property.

But if you buy mulitple properties with no other intention than sitting back and "flipping them" in a month or a year to make a quick buck, then you are not investing — you are speculating.

And the fact that many of these speculators are doing so with little or no equity and with variable (i.e., rising) interest rates certainly doesn't help matters.

And the fact that the housing market, which drives so many other markets (appliances, furniture, consumer finance, etc.), is such a vital component of the economy certainly doesn't help matters either.

I am always a long-term bull on America and the American economy. But the short term is looking mighty ominous.

All this housing speculation has placed us on very shaky ground indeed.

Other thoughts at Power2thePeople.

Suggested Reading:

Yesterday I blogged about the (possible) housing bubble that is drawing increasing attention by, um, everybody.

Today, we get some unhelpful noise from TCS Overlord James "Always Wrong" Glassman. (Remember "Dow 36,000"? The only thing dumber than the book was his half-hearted non-apology for it.)

Now he's fanning the flames of "What, us worry?" for the housing market:

Since 1950, according to data gathered by Freddie Mac, which provides financing for mortgage lenders, U.S. home prices overall have never declined over the course of any year.

Of course, they never went up 20%, 30% or even 50% in a single year either.

Skipping in and out of a house in a day or two isn't particularly feasible, and the vast majority of home buyers, unlike stock buyers, are in for the long haul.

Yet that's exactly what more and more people are doing: buying only for the sake of "flipping" in the anything but "long haul."

The house you live in is not an investment.

As I blogged yesterday, that's 100% wrong: an owned primary residence generates the cash flow of saved rent and therefore is an investment. But anyway, the concern is not over speculation in primary residences (although actually we're seeing that too, through maxing out home equity loans, second mortgages, etc.), but rather the fear of people purchasing multiple properties not to live in, not to generate rental income, but simply to "flip" for a quick profit. As I said yesterday, that's speculation of the worst kind (i.e., "up and only up" speculation).

And don't forget the consumer's best friend: the glorious 30-year fixed-rate mortgage. You can get a loan that's only slightly above the rate at which the U.S. government borrows.

But again, people are increasingly abandoning the traditional 30-year, 15% down model. They're instead leveraging up the wazoo with "innovative" interest-only, no-down-payment mortgages. The "stabilizing element" that Glassman invokes in real estate is the equity within the property. But the speculators have no equity in the properties, and no equity means no stability. The fact that lenders are increasingly relaxing credit standards doesn't help matters either.

Glassman tries to calm us with statistics from the past, while failing to see that the reason some of us are worrying is precisely because the past no longer applies the way it once did.

In any case, a very good rule of thumb is that whenever Glassman says "zig," you should immediately start zagging.

"Has he decided whether he exists yet?"
--Ayn Rand on the young Alan Greenspan

So exactly one week after I blog about the (potential in my opinion) housing bubble and invoke the memory of "Dow 36,000," Paul Krugman writes an op-ed about the (de facto in his opinion) housing bubble and invokes the memory of "Dow 36,000."

I'm just saying...

Of course, unlike me Krugman has an ulterior motive in his essay, namely to level even more cheap shots at Federal Reserve Chairman Alan Greenspan:

Even Alan Greenspan now admits that we have "characteristics of bubbles" in the housing market, but only "in certain areas." And it's true that the craziest scenes are concentrated in a few regions, like coastal Florida and California.
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So what happens if the housing bubble bursts? It will be the same thing all over again, unless the Fed can find something to take its place. And it's hard to imagine what that might be. After all, the Fed's ability to manage the economy mainly comes from its ability to create booms and busts in the housing market. If housing enters a post-bubble slump, what's left?

[A Wall Street strategist] believes that the Fed's apparent success after 2001 was an illusion, that it simply piled up trouble for the future. I hope he's wrong. But the Fed does seem to be running out of bubbles.

This is, of course, utter nonsense.

I suppose during this current "Episode III" mania it's tempting to create Palpatine analogies where none exist, and it would probably please Krugman no end to fantasize about Greenspan as a sinister, manipulative back-stabber ("That's for the housing market to decide..." "I am the housing market!").

Interest rates have been, and to a lesser extent remain, abnormally low for one very simple reason, one that Krugman conveniently omits: September 11th! The Fed had been lowering interest rates consistently from mid-2000 and had generally been thought to be done when Fed funds stood at 3.5% on September 10, 2001. But after the attacks and in light of non-existent inflation signs, the Fed decided to keep lowering rates to help prevent a recession (which, remember, it did). With the risk of economic crisis averted, the Fed has been consistently raising rates since June 2004, eight times in eight meetings, yet rates are still half a percentage point below where they were on September 11. How exactly is that Alan Greenspan's fault? Would Krugman have been happier if Greenspan had rammed larger, more disruptive increases into the system?

And let's remember a few more things about Alan Greenspan and "conspiracy theories." It was Greenspan who argued tirelessly, and long before it was fashionable, to fix Social Security and to adopt the highly disciplined "pay as you go" system for the rest of the federal budget. It was Alan Greenspan who argued relentlessly that the best thing to do with the budget surpluses of the 1990s was to pay down the national debt. It is Alan Greenspan who never misses an opportunity to remind politicians that the best of all possible fiscal policies is to have low taxes and low government spending, and that preferring either higher taxes or higher deficits is a Hobson's choice.

I'm not saying Greenspan was a genius over the past five years, but to accuse him of manipulating interest rates to manufacture a housing bubble to "hide" the stock market bubble is close to defamatory and way beyond moronic. (And how exactly did he "cause" the stock market bubble again? Oh right, by decrying "irrational exuberance.")

If you want to chastise homebuyers, or lenders, for irresponsible conduct in the (potential) housing bubble, by all means do so. I tend to concur. But leave Alan Greenspan out of it. In this context, he doesn't exist.
Other thoughts at Lifelike Pundits.
Suggested Reading:

In macroeconomics classes, we usually teach that the Federal Reserve has several tools with which to control monetary policy:

--Change the reserve requirement (i.e., the fraction of a bank's total deposits that must be held in cash on on reserve at the Fed). This is rarely invoked.

--Change the fed funds rate and/or the discount rate. This is what is meant when you hear, as you have eight times in the past year, that "the Fed raised interest rates."

--Use open market operations to add or remove money directly, through buying or selling treasury securities to banks.

--Invoke moral suasion to "suggest," rather than require, that banks adjust their policies.

Well, the Fed quietly invoked moral suasion over the home lending market, probably due to concerns regarding the (potential) housing bubble.

"Financial institutions may not be fully recognizing the risk embedded in these portfolios," the Fed, the Comptroller of the Currency and three other regulators warned in a May 16 letter on home-equity loans to lenders and bank examiners.
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"The new development is the volume of these interest-only first mortgages we're seeing," acting Comptroller Julie Williams said in an interview. "Banks should be evaluating the risks of these types of loans, not just based on the initial loan terms, but based on the loan terms that may roll into effect over the life of the loan."
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So-called "guidance letters" such as the one issued May 16 are aimed at improving lending standards without interfering with markets. Another letter, this one dealing with first mortgages, is under discussion, Kevin Mukri, a spokesman for the Comptroller, said.
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Interest-only mortgages accounted for only 6 percent of adjustable-rate mortgages in 2002. By the end of 2004 they accounted for 23 percent nationwide, according to LoanPerformance, a mortgage-data provider based in San Francisco.

Real estate buyers generally don't use interest-only loans because they want to — they use them because they have to. And since by definition an interest-only loan means that no equity is accumulating in the property, any shock to the buyer (e.g., unemployment) or to the market (i.e., a decline in housing prices) spells trouble for both the buyer and the lender. And these mortgages are adjustible-rate debt, so as interest rates continue to rise (and sooner or later mortgage rates will follow short-term rates up), the sustainability of these lending trends may end. And without these risky "creative" financing arrangement, the stratospheric rise in real estate prices cannot continue. Some markets are already showing signs of faltering.

I'm still willing to refer to the "(potential) housing bubble." But with each new data point the need for the parenthetical seems to diminish.

Hat tip to Housing Bubble blog, which is now the definitive source on the subject. Eclectic Econoclast also has a good post. And keep in mind that Fed Chairman Greenspan is testifying before Congress today; expect the housing market to be on the agenda.

For a primer on how the Fed controls monetary policy via the four methods listed above, see here.

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.

I've blogged repeatedly that the so-called "housing bubble" debate really has little to do with housing and everything to do with mortgages, specifically their affordability among sub-prime borrowers and speculators servicing multiple mortgages on multiple properties.

Well, at least somewhat related to the issue of mortgage affordability is this ominous story of yet another unjustifiable government intervention in a well-functioning private market (WSJ -$):

The Department of Housing and Urban Development plans to revitalize the Federal Housing [Administration], a mortgage-insurance program that puts relatively low-interest loans within reach of low- and middle-income homebuyers who have little or poor credit -- and provides an alternative to the commercial subprime lenders, which take on risky borrowers but charge them interest well above the prime rate.
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Among the forces prompting its comeback plans are community activists, who say too many consumers are getting a raw deal from subprime lenders, and some members of Congress, who worry about the agency's declining market share [SIC!].

The FHA is losing share to hordes of aggressive subprime mortgage lenders, which offer a range of flexible products, including no-money-down mortgages and interest-only payments. They also have high rates and hefty closing costs. But because the subprime lenders offer fast approvals, instant home appraisals, less paperwork and fewer hassles, they are attracting many consumers who could easily qualify for a lower-cost FHA mortgage.

Some hasty stitches:

--It seems to me that an activity where one talks of the government's "market share" does not qualify as a "public good." The only legitimate "government market shares" are 100% or 0%, nothing in between.

--Stated differently, a government bureaucracy sees a legal industry (i.e., subprime mortgage lending), one that provides a vital economic function, one that is fiercely competitive (i.e., not a powerful monopoly, but rather "hordes" of smaller companies) and still decides that, gee, they "charge too much," despite the fact that consumers are tripping over themselves to do business with these companies. If the borrowers seem content with the rates and fees they're being charged, then why should the government care one way or the other? (Hint: See the reference to "community activists" in the piece.)

--People who pay higher interest rates do so for a reason: because they are higher credit risks. Whether through moral failure, financial incompetence or just plain bad luck, those who have poor credit are, for lack of a better term, deadbeats. And deadbeats are expensive. This is not "discrimination" in the invidious civil rights sense; it is assigning respective costs according to how respective customers impose those costs. This is somehow bad?

--Similar to the FEMA hurricane nonsense, we see with FHA a "private benefits, public costs" model of backdoor-socialism. The borrowers benefit, the banks benefit (do they really need government subsidies?), the politicians and bureaucrats benefit. Until a FHA-insured borrower defaults. Then everybody, especially those who were responsible enough not to need FHA in the first place, starts paying. That's not providing a public good, that's not even Rawlsian redistribution theory. That's brazen pandering -- the Politics of the Warm Fuzzy Feeling. (NOTE: The FHA claims that it is entirely self-funding and costs taxpayers nothing. But that is patently false -- if there is a "mortgage bubble" crisis and FHA goes under, of course there will be a taxpayer bailout, just as there will inevitably be a taxpayer bailout of the "harmless to taxpayers" Pension Benefit Guaranty Corporation.)

If there is a mortgage bubble and it bursts, then it will be the subprime mortgage lenders that will be first and worst hit. And they'll deserve it, since it will have been their policies that brought about their own demise. So be it. But why should the government catalyze that chain of events by underwriting even more bad credit risks and injecting an unhealthy dose of moral hazard into what, so far, is still a functioning industry?

Private parties, private risks, private benefits, private decisions.

Exactly how it should be. The government should leave well enough alone and abolish the FHA outright.

Befuddlement:

The housing bubble may be deflating in the rest of the country, but the New York City real estate market is hotter than ever.
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The average price of condos is up by 22 percent, while co-ops jumped 5 percent.

For those who need a primer, the basic consequentialist difference between a condominium and a co-operative is that with a condo you can (pretty much) buy and sell the apartment at will, while with a co-op any sale requires approval of the board of directors. Mainly for this reason, condos will, ceteris paribus, trade at a premium to co-ops.

But why should rising prices, whether from a bubble or not, result in such a wide differential between condo and co-op price increases? If condos sell at, say, an average premium of 25% to co-ops, then one would think that this premium should, in percentage terms, stay relatively constant as the market rises and falls. Whence comes this "22% v. 5%" expansion of the premium?

I suspect there's a bit of multicollinearity occurring here. Perhaps condos tend to be newer buildings, or larger apartments, or more concentrated on the luxury end of the spectrum? Something other than the basic "condo premium" has to explain these disparate increases. Otherwise there would have to be a bubble not just in real estate but in the condo premium itself. Is that likely?

Any thoughts?

It only took twenty-one months, but my (not-so-dire) warnings about a mortgage bubble have finally proven correct:

Late payments on U.S. mortgages increased in the fourth quarter to their highest level in three and a half years and foreclosures rose, driven by subprime borrowers with weak credit, the Mortgage Bankers Association said on Tuesday.
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Delinquencies rose for all loan types but were largest for subprime adjustable-rate loans that reset at higher interest rates, the industry trade group said in its quarterly National Delinquency Survey.
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The percentage of loans in the foreclosure process rose to 1.19 percent of all loans outstanding in the fourth quarter to the highest level in nearly three years.

It's about time.

This is certainly not good news, and yesterday's stock market decline was principally caused by it.

Having said that, remember: The mortgage market is not the housing market, and is especially not the stock market or the economy. Now is not a good time to own stock in a subprime lender, to be sure. Or a consumer finance stock or maybe even a credit card stock or a bank stock. But does that mean that your home is about to lose 30% of its value or that an immediate nationwide recession is inevitable? Of course not.

Some people have larger mortgages than others. Some have no mortgage at all. Some people own lots of mortgage lender stock, many own none at all. The S&P 500 contains financial stocks, but not exclusively. Housing is part of the national economy, but only part.

I remain confident that several more shoes will drop, mainly because the yield curve is unsustainably low and flat (of course, that's exactly what I was saying a year ago — go figure). But catastrophe for some is not catastrophe for all. As is always the case in a dynamic capitalist economy: some will do very very well, some will do very very poorly. Most will do just fine.