THE ECONTRARIAN

A tad askew from the traditional view

Sunday, August 07, 2005

BUBBLES IN THE AIR

Probably nothing has been written about lately as much as the real estate bubbles that have developed in many of our metropolitan areas. And while I haven't thought about it much for several months now, a couple of points bear mentioning at this time.

First, it has been my opinion for quite awhile, along with many others, that one of the best bets in the financial world is that the real estate boom will eventually come to an end with extremely unpleasant consequences. With the excesses that have been encouraged by buyers, lenders , builders, and Alan Greenspan & company alike, it seems to me that a soft landing is out of the question. The real estate market will either be the victim of: (a) massive foreclosures resulting from escalating interest rates associated with a strengthening economy, or (b) massive foreclosures resulting from a new recession. And, perhaps the most likely scenario might be (a) followed by (b). In any event, Greenspan's efforts to continue to extend our current period of "stagflation," while representing one of the great tight wire acts in the history of the Fed, is ultimately doomed to failure. And when it fails, the economy will lose what has become a major part of its foundation. The contribution of real estate activity to our nation's health over the past few years cannot be overstated. The purchases of hard goods, as well as the use of loan funds to finance personal acquisitions, such as boats, autos and even second homes have made an enormous impact on our economy, and yet these are only some of the peripheral advantages of the red hot market that has been experienced in many metropolitan areas - Southern California, New York, Miami and Boston to name a few.

It's perhaps easier to grasp the concept that a recession would impact negatively on the real estate market, than that an upswing in business activity would have the same effect, but it would. Over the last several years, as rates declined to their lowest levels in four or five decades, more and more people became suddenly qualified to be home owners, and then as home prices began to rise, the industry increased the number of interest-only loans in its continuing attempt to make the ability to own homes available to as many people as possible. And as noble an effort as this appeared to be, the flip side is that if and when the rates do go back up - as in the case of a business upswing - the people who would normally have become qualified over the next few years will, in fact, already be homeowners. Under these conditions, the industry will essentially be looking into a vacuum.

Now, none of the above is particularly new, but there are a couple of recent trends that may be causing some people to raise their eyebrows a little. Bubble watchers have been somewhat comforted lately by the fact that the unsold inventory of homes has remained fairly low. Today, however, in the hottest of the hot markets, the San Diego real estate market, we hear that the unsold inventory of homes and condos has doubled over the past year. This is a development that bears watching.

Nearly fifty years ago, when I was working for a major home mortgage lender, we were constantly drilled on the lessons to be learned from the Great Depression of the 1930's, a nightmare that was fresh in the minds of many of my co-workers. And of these lessons, none was given more importance in our field than the theory that interest-only loans granted in the galloping years leading up to the depression contributed mightily to the country's near financial collapse. Never again, we were told, would the country be foolish enough to let loans be granted with little or no amortization. This leads me to my second point. It was also announced today that over the past two years in Southern California, more than 50% of all real estate purchase loans have involved interest-only features, and it is well known that many of the remaining loans have been based on 30-year amortization tables, with little write down in the early years, or have been adjustable-rate mortgages, perhaps the most evil of the foregoing triplets. Presumably the other hot markets share these trends. The countless numbers of purchasers sitting on these three types of loans are basically sitting on time bombs that may well go off - not only under them - but also under the economy as well.

I can foresee no greater economic event, short of a "bank holiday," than the stampede of home sellers that will ensue after this real estate market turns down. ........



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