Surreal Estate on the San Andreas Fault

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“Surreal estate.”
I wish I were the originator of this phrase. I am merely an appropriator.
It is the title of a column in the November 20th Sunday supplement
on real estate in the San Francisco Chronicle, written by
Carol Lloyd.

I have returned
from the edge of the San Andreas fault. What I saw was not comforting.

You may think
that you are immune. You are not. What you are about to read will
affect you. Why? Because of the banking system. I learned something
from a banker at a conference I attended that has forced me to reconsider
my own plans.

Since 1996,
bankers have built the banking system along an economic San Andreas


Here is the
headline of the November 18 issue of the San Jose Mercury News:

home price: $714,250

The article
reports that one year ago, the price of a single-family home in
Santa Clara County was “what now seems like a modest $600,000.”
This is a 19% increase, October to October.

The article
reported a yellow light: sales are down by 10%.

In San Mateo
County, the median price home is $799,500. In San Francisco, $800,000.

Consider the
economics of buying an $800,000 home as a first-time buyer. What
if you were 25 years old, living in the Bay Area? Assume that you
somehow qualify for a 30-year mortgage with a 3% down payment.
You need $24,000 cash. What about the interest rate? In the real
estate supplement, there was an Associated Press article with this
headline: “Mortgage rates keep climbing: 10th consecutive weekly
increase pushes 30-year home loans to 6.37%.” As recently as last
February, I secured a 30-year loan for 5.375%.

So, let’s
assume that the first-time buyer pays an average rate. He puts $24,000
down. He must borrow $776,000. His monthly mortgage payment will
be $4,119. To this add insurance, taxes, and maintenance. His monthly
housing payment will be in the range of $5,000.

A median priced
home there is not where I would want to live. It is a frame house
on a tiny lot. It looks a bit seedy. My $90,000 home in Mississippi
is half again as nice. Yet these trapped first-time buyers are in
hock for the rest of their working careers. A recession, an unexpected
pregnancy, an unexpected firing, and these owners’ plans are in
disaster mode. There is no wiggle room. There is no exit strategy.

Everyone needs
an exit strategy.


A friend of
mine, who owns a nice condo in San Francisco and a 6,000 square
foot home in an upscale San Mateo County suburb, is looking to buy
a replacement home in the city. Problem: he is getting older, and
housing in San Francisco has always been vertical.

He took me
to view a property for sale. We walked less than a mile. The steep
hills were such that my legs were sore for two days. (Note: I must
begin an exercise program . . . next week.)

The house’s
front door was located up a steep flight of stairs. Inside, rooms
were divided by more stairs: five or six, as I recall. You cannot
walk through the home without climbing stairs. It was an old place
— maybe 100 years old. It had no thermostat. It had a hot water
heating pipes system.

The house
had been offered for sale at $2.1 million a few months ago. No takers.
It had been reduced to $1.7 million. The agent admitted that only
one other person had come to see it.

Here is the
situation: a person rich enough to buy it is too old to want it.
That person will spend his golden years, then his leaden years,
hiking up and down stairs inside his home. He will become a prisoner
inside his home because of the hills. Then he will become a prisoner
of those few rooms that have no stairs. One stumble, and he could
lie with a broken hip in the living room, dying.

I don’t think
my friend plans to buy it.

No one should
build on the San Andreas fault. Millions of people have. No one
should build there without taking care to provide an exit strategy
if the Big One comes. Few people in the Bay Area have an exit strategy,
least of all the investors who hold mortgages on houses and property
built close to that fault. But investors don’t care.

As I learned
last week, the nation’s banking system resembles an edifice built
on just such a fault.

But first.
. . .


I visited
another friend of mine on my trip. He is a pastor of a small congregation:
under 50 adults. The building is small. It cannot hold more than
80 people. He has been there for 35 years. He is approaching retirement
age: age 68.

He made the
mistake that most pastors make when they are offered free housing
in lieu of a higher salary: he took it. When he came to the Bay
Area, the house cost $30,000. It is on a tiny lot, just a few hundred
yards from the San Andreas fault. It is now worth at least $700,000.
He has no equity. He is going to have to move.

He introduced
me to a fellow pastor, age 70, who had just resigned his post a
week ago. He had made the same mistake 35 years ago: free rent.
He is now looking for a position in South Carolina. He does not
have a pension large enough to support him. He cannot afford to
live in the Bay Area now. He must start over in a small church in
a new denomination at age 70.

What should
they have done? When they started out, they should have told their
congregations to pay them more money. Then they each should have
bought a home for $30,000. They would have $700,000+ equity. They
should have bought a home every few years to use as a rental property.
They would both be multi-millionaires.

My friend
should now be looking for a new pulpit in some heartland state.
But he does not want to leave California. He has a vague hope that
the congregation will let him live in the house rent free until
he dies, whereupon his wife (a decade younger) will be allowed to
live there. But they both know this is unlikely. The church could
not afford to pay the new pastor enough to rent a home locally.
The church’s asset is that paid-off house. The church will evict
him when he can no longer serve as pastor. That day is not far away.

Most people
make decisions based on what is comfortable today. They refuse to
face economic reality. They do not face the reality of the mortality
tables while they still can make adjustments.

Because real
estate is surreal in the region, any company hoping to attract bright
young employees, or any church hoping to attract a dynamic young
pastor, faces a recruiting problem: the prospects are locked out
of the housing market. The company had better be extremely profitable,
or the church had better have a manse to offer the new pastor. Problem:
the kinds of people who will respond to the offer are not looking
at their long-term futures. They do not understand the burden of
mortgage debt. They do not see that they must either become renters
without any hope of equity or else speculators in a bubble market.


Bubbles always
continue for months or even years after old timers say they will
pop. Old timers have trouble estimating the fear of the buyers at
being left out and the fear of lenders at being left out. The two
sides — debtors and lenders — keep the dance of doom going much
longer than old timers can imagine possible. But eventually the
dance ends.

I spoke at
Rockwell’s conference
. One of the speakers is a banker. He lives
in Las Vegas. He was taught by Austrian School economist Murray
Rothbard. He earned a masters degree in economics. Then he went
into banking.

As an Austrian
School economist, he understands the business cycle. He understands
that the Federal Reserve system has pumped money into the economy,
creating a housing bubble since 1996. He knows this boom will bust.

He has no
illusions about this housing market. Compared to him, I have been
Pollyanna. He spoke of the mental outlook of the builders in Las
Vegas. They all know it can’t go on, but they are determined to
party until it does. “Then they will declare bankruptcy and start
over,” he said. This is their exit strategy.

A one-acre
lot sells for $200,000. Then the developer must build a home on
it to sell. But rising building costs since Katrina are creating
disasters for their plans. They are coming to him for extension
loans. He doesn’t plan to make them. But there is no doubt that
other banks will.

He was a participant
in a panel that closed the conference. I was also a member. There,
he tossed a grenade. He said that in his region, the banks’ loans
are 80% in real estate.

I sat there
stunned, trying to take this in. He was not speaking of the savings
and loan industry. He was talking about banks.

There is none.

I still could
not quite believe it. I approached him privately after the conference.
I asked him if I had understood him correctly. “You are saying that
bank loans are 80% in real estate in Las Vegas.” “No,” he replied,
“I said in the 80s. In fact, it’s the high 80s.”

I asked if
Las Vegas is unique. He said that he has heard similar figures about
Phoenix and the southeast, presumably meaning Florida.

He explained
that loans are first made to builders. Then they are made to companies
that depend on builders. In other words, what may appear on the
books to be a diversified portfolio is in fact tied almost exclusively
to real estate.

The implications
of what he said are staggering. The post-2001 boom in real estate
is the heart of the American economy today. The housing market did
not fall during the 2001 recession. The FED pumped in fiat money
in 2001 to drive down the federal funds rate from 6.5% to 1.25%.
That unprecedented fall in the fed funds rate provided the incentive
for borrowers to buy a new home. The economy responded accordingly.

Now the FED
is steadily raising short-term rates. Those institutional speculators
who borrowed short and lent long — the carry trade — are now facing
a squeeze. Short rates are rising. The spread between the cost of
short-term money and the return on long-term money is shrinking
fast. You
can see this here

We are not
yet at the inverted yield curve, where 90-day T-bills have rates
higher than 20-year T-bonds. This is a crucially important indicator.
I explain why
this is so important here


There is a
life cycle to personal investing. There is a life cycle in the capital
structure. People grow old and die. They must be replaced. Businesses
and churches must plan for the retirement of today’s leaders.

How will tomorrow’s
leaders be able to move through the cycle if they are locked out
of the housing market?

I asked the
audience this question: “With the median price of a home this high,
how will all those kids at the check-in desk ever become home owners?”
I gave the answer in one word: “Later.” The price of houses will

There is another
answer: “They will move.”

In either
case, today’s home owner in San Andreas fault country will see the
bubble burst. I think the mortgage market will do the job. But if
I am wrong, then greener pastures will. California has lost 100,000
residents over the past year.

The American
economy as never before rests on the housing boom. Yet this boom
cannot be sustained much longer in the bubble regions. A recession
looms. Even without a recession, the boom will falter because of
ARMs: adjustable rate mortgages. These time bombs are about to blow,
contract by contract.

If nothing
changes — if short-term rates do not rise — monthly mortgage payments
are going to rise by 60% when the readjustment kicks in. Yet buyers
are marginal, people who could not qualify for a 30-year mortgage.
This will force “For Sale” signs to flower like dandelions in spring.

The FED’s
present policy of announcing a .25 percentage point hike every few
weeks is going to force the late-comers to sell. It is going to
bash the plans of home builders, whose industry moves from feast
to famine.

If you remember
the S&L crisis of the mid-1980s, you have some indication of
what is coming. The S&L crisis in Texas put a squeeze on the
economy in Texas. Banks got nasty. They stopped making new loans.
Yet the S&Ls were legally not banks. They were a second capital
market. Today, the banks have become S&Ls. They have tied their
loan portfolios to the housing market.


I think a
squeeze is coming that will affect the entire banking system. The
madness of bankers has become unprecedented. They have forgotten
about loan diversification. They have been caught up in Greenspan’s
counter-cyclical policy of lowering the federal funds rate. Now
this policy is being reversed. Rates are climbing. This will contract
the loan market. Banks will wind up sitting on top of bad loans
of all kinds because the American economy is now housing-sale driven.

You may think
that you are shielded. But your banker is not shielded. You may
not deal with bankers. But your employer does.

Your employer
had better have a signed line of credit to keep the doors open.
Without this, there may not be money to borrow when the housing
bubble pops.

will be great opportunities to buy houses at discounts during the
down phase of the cycle. Be patient.

25, 2005

North [send him mail] is the
author of Mises
on Money
. Visit
He is also the author of a free 17-volume series, An
Economic Commentary on the Bible

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