The Fed’s massive money printing campaigns flood the canyons of Wall Street with ZERO-COGS. That is, our rogue central bank enables speculators and gamblers to amass huge asset positions while paying virtually nothing for the short-term borrowings used to carry them. Its like making cars with zero-cost steel, tires, batteries, electronics and paints. (See “Yellenomics: The Folly of Free Money”)
This rigged equation is supposed to produce “wealth effects” and thereby trick the masses into spending more today on the theory that they can live off fattened IRA-stock accounts tomorrow. Alas, after three devastating bubble collapses this century—dotcom, housing, and the 2008-09 stock bust—-the unwashed aren’t taking the Fed’s bait.
So the only “wealth effect” going on is that the central banking branch of the state is deploying its vast powers to print money and levitate asset prices to help the rich get richer. After all, the top 1% own more that 40% of financial assets and the top 10% own close to four-fifths.
Were the academic zealots who run the Fed merely operating a perverse system that gifts the top strata with unearned windfalls, it would be bad enough. But ZERO-COGS actually punishes and undermines Main Street, and there is no better place to see this than in the phony housing recovery now underway—especially the mini-boom in house prices that has erupted in the very same precincts of Phoenix, Los Vegas, Sacramento, Southern California and Florida that were so badly bombed-out during the crash of 2007-2009.
Speculators and hedge funds armed with nearly free money are always on the prowl for a new “asset class” that can be drafted into the carry trades. Thus, when housing prices dropped by 40-70 percent in the most devastated sub-prime markets and caused a massive surge in foreclosures, Wall Street gamblers wasted no time pouncing on the Next Big Thing. Soon their agents were on the courthouse steps scooping-up foreclosures by the hundreds and thousands. And in America’s Fed-fostered casino economy, nothing will attract carry traders like “new asset classes” with smartly rising prices.
Housing prices in many of these born-again markets had been dead-as-a-doornail, but suddenly reared-up and soared by 25-50 percent during a remarkably brief interval of 10-20 months in 2012-2013. And the reason for this shocking reversal is crucial to understand. The Wall Street hedgies and LBO guys driving the buying frenzy in places like Phoenix never purposefully over-pay—since they pride themselves in buying low and selling high. But they do chase hockey sticks generated by spreadsheet financial models, believing that any price is “cheap” so long as the model spits out their stipulated IRR (internal rate of return)target.
And here’s where the baleful effects of our monetary central planning regime come in. These models postulate 2-5 year holding periods and incorporate the Fed’s promise that it will keep interest rates “low for long” during most of the investment horizon. On this predicate of cheap and stable carry costs, 29 year-olds in $5,000 suits figuratively ride into Scottsdale AZ on the back of John Deere lawnmowers to work their new asset class—that is, to function as landlords of single-family, detached homes throughout sand-belt suburbia. Having accumulated thousands of such properties at the court-house steps, they are now in the newly created ‘”buy-to-rent “business.
How do these Harvard Business School ”landlords” know what to pencil-in for operating expenses such as crab grass control, tree infestations, mold in the basement, plumbing repairs, roof maintenance and renter churn? They don’t! The huge operations put together by the likes of Blackstone ( @40,000 houses) and Colony Capital (@20,000 houses) are actually “virtual” businesses in which nearly everyone is a ”contractor”. But that’s a euphemism for former carpenters, sub-prime loan brokers and real estate appraisers who were made redundant by the housing bust. They have now been recycled as buyers, experts, advisors and operators in the single family landlord business. And overwhelmingly, their incentives are to generate volume–just like in the days of sub-prime mortgages: Same old boiler room— just a different drill.
Is it possible, then, that Wall Street’s spreadsheet jockeys are cranking out models that include ridiculously low and unsustainable interest carry costs, and on top of that are also seriously under-providing for operating expenses? No—its absolutely certain that they are! Accordingly, their goal-seeked models have been telling them to bid way too much for busted properties. If truth be told this new gang of landlords are not at all the bottom fishers they claim to be; they are just another variant of bubble surfer.
To be sure, the veteran speculators who run these Wall Street shops didn’t end up billionaires by being reckless or falling for implausible investment stories. But they do have the Fed’s serial bubble cycle down cold. We are now in the third round since 1990 and the winning formula is clear. First, accumulate busted asset aggressively after the bottom is in; then “finance-out” these holdings with junk bonds and securitized paper when money managers get desperate for yield; and finally head for the IPO exit ramp as soon as a few quarters of pro forma operating results and forward hockey stick profit projections can be shown to late-to-the-game mutual fund and retail stock investors.
Given this playbook, the overwhelming imperative is speed, volume, growth and investment turnover. Not surprisingly, therefore, when Wall Street speculators hit the bombed-out housing markets 24 months ago the last thing they were thinking about was sinking funds for roof replacement. Instead, they embraced ”O&M Lite” (operations and maintenance) investment models—confident that the Fed’s patented bubble cycle would allow them to extract their winnings before, so to speak, the roofs actually caved-in.
So the miraculous recovery of housing prices in these markets is not all that. Its another housing bubble—this one based on an institutional form of sub-prime rather than dodgy retail mortgages. Specifically, the meth labs of Wall Street have already concocted a new variant of toxic waste in the form of securitized rents. Stated differently, they are now slicing and dicing rental income streams based on model assumptions about average occupancy, tenant turn-over, rental rate increases, repair costs and much else. All of it is untested and probably unknowable since this industry—detached home rentals— was only born yesterday.
In all, it should not be hard to see why the Fed’s bubble finance is so perverse. Just consider the contra factual case: imagine there is no cheap carry on the bank lines and other borrowings used to fund the asset accumulation stage; postulate that to meet their return bogeys fixed income managers are not forced to chase yield way out to the foggy end of the risk spectrum where rental stream CDOs are hatched; and presume the absence of red hot IPO markets which now predictably crank up during the late stages of these Fed sponsored bubbles.
Under those conditions you would not have $5,000 suits riding their John Deere’s into Scottsdale, nor spreadsheet jockeys low-balling roof repairs. What you would have is free market outcomes where households which did choose to rent single family homes would patronize competitively advantaged, operationally competent and financially sober local landlords. The idea that Colony Capital of Los Angeles or Blackstone of Park Avenue posses magical economies of scale in the nationwide single family rental market is just plain bonkers.
Most importantly, under the contra factual case, which is to say the free market, you would not have 35% price moves in 15 months. That might happen in wheat markets when there is a drought, but not in the owner-occupied home segment were asset turnover is slow, transaction costs are high and organic demand is constrained by glacier-like expansion of household incomes, not excited surges of hot money.
Unfortunately, the PhD’s who comprise our monetary politburo are strictly paint-by-the-numbers monetary plumbers. They envision themselves as aggressively pumping “demand” into the nation’s economic bathtub, otherwise known as potential GDP. Accordingly, the fact that housing prices have been rising for 19 straight months and experienced their largest gain last year since 2005 is taken as evidence that the water level is heading toward the brim–right where they have aimed.
The screaming error here is the failure to consider the quality and source of the numbers, not merely their quantitative magnitudes. Self-evidently, the surging prices in these housing bubble 2.0 markets are not due to organic, healthy, sustainable owner-occupier demand. The latter is a function of household wage and salary growth and that is downright scarce. In fact, real wage and salary incomes are only 2% higher than the were 7 year ago when the first housing bubble was cresting.
In truth, the Fed is now caught in an economic puzzle-palace. Its chosen instrument of ZERO-COGS generates nothing more than a feedback loop of rising asset prices utterly divorced from the real Main Street economy. In the brilliant summation of the case below, veteran housing expert Mark Hanson lays out in careful detail the split-level reality in America’s residential neighborhoods.
Two key factors stand-out. First, all cash sales have rising from a historic rate of about 10% of home purchases to 50% today—- a stunning rise that is most definitely not an indicator that Main Street households are flush with cash. But the truckloads of cash that have actually been brought in to residential neighborhoods by the new Wall Street landlords have disabled what Hanson calls the “mortgage loan governor” on residential housing prices—-a mechanism that historically kept housing prices anchored to down payments, documented incomes and cautious debt-to-income ratios.
In turn, the Fed’s ZERO-COGS driven housing price fly-up has squeezed honest-to-goodness wage earners out of the market. Notwithstanding, today’s still historically low 30-year mortgage interest rates at 4.5%, the household income required to finance a standard mortgage on an average price home is $52,000—s figure 30 percent higher than at the 2006 peak of housing bubble 1.0.
The reason is perverse. Households back then needed only $40,000 in income to finance the average home price due to the availability of pay option arms and other exotic sub-prime mortgages which artificially ballooned the buying power of home mortgage borrowers. Cleaning that dreck out of the system perforce required a substantial downward adjustment of bubble era prices, and one that would keep prices down for an extended duration so that household incomes and home prices could revert to their historic relationship.
Instead, the suits on the John Deere’s have artificially and suddenly levitated housing prices based on financial engineering, not household income improvements. So now with mortgage standards and terms somewhat normalized— the off-setting reduction in average home prices has been largely vaporized by bubble finance.
At the end of the day, we do not have a healthy recovering residential housing market at all, but one that is being hit with a triple whammy of bubble finance. The traditional first time home-buyer is drastically under-represented because young families are buried in more than $1 trillion of student debt.
Secondly, up to 20 million of the 50 million mortgage borrowers in the nation are still economically underwater—that is, they took on so much debt during housing bubble 1.0 that they cannot pay-off the old mortgage and come up with 20 percent needed for down payments and brokerage fees needed to move-up. Finally, even those households that are above water are being forced to chase an artificial surge in housing prices caused by speculator buying with ZERO-COGS.
In many respects, therefore, the nation’s housing market has never been so unhealthy. Instead of millions of Main Street speculators who believed up to the very end that housing prices would rise to the sky, we now have a few thousand institutional speculators who will head out of town on their John Deere’s as fast as they came—as soon as they can find some doctors and dentists to buy the junk stocks and bonds that are being issued to fund a Wall Street based landlord business that is entirely an artifact of Fed policy.
Why We Could Be Back In A Housing Bubble Right Now, by Mark Hanson
Let me preface this note by saying “I am a raging bull over houses”. I love real estate. On any given Sunday you can find me and my family touring open resale houses or new builder communities. My grammar school-aged kids love it too; especially the free cookies and peering into the beautifully staged rooms and really believing that some lucky kid has every gadget or musical instrument ever made and with utter amazement on how clean he keeps his room. Of course, my wife and I fully propagate the lie by saying “did you two see how clean the Lennar boy and Pulte girl keep their rooms? Why can’t you do the same?”
I think it’s safe to say that America — especially the American media and Wall Street firms — has fallen in love with real estate again. But, this time around it’s not ‘all of America’ like the last time; when the most exotic mortgage loans known to mankind turned every ma and pa end-user homeowner into a raging speculator. One has to look no further than the generationally low level of purchase loan applications — with rates at generational lows — to realize something isn’t ‘normal’ about this housing market. Rather, controlling this housing market over the past three years has been a small, unorthodox slice of the population that “invests” in real estate using tractor-trailer trucks full of cash-money slopping around the financial system put into play specifically for this purpose. Over the past few years so much cash-money has been deployed into the housing sector by unorthodox parties, that in many regions ma and pa end-user hasn’t stood a chance to buy. Especially, if they need a mortgage loan, which of course presents numerous risks to the seller vs the all-cash buyer.
In part, this is why I believe we could be back in a house-price bubble right now and not even realize it. And also because everybody is looking at the wrong thing…house prices. Sound confusing? It’s not, really.
A brief history of the “mortgage-loan, house-price governor”.
1) In a normal housing market, in which at least 80% of all house purchases are done with “fully documented” mortgage loans, house prices are solidly rooted to contemporary “end-user fundamentals”. That is, the mortgage loan with it’s LTV, appraisal, DTI etc guidelines is the “house-price governor“.
Bottom line, when the majority of houses are purchased with mortgage loans it is virtually impossible for house prices to wildly detach from end-user fundamentals unless credit goes haywire like from 2003 to 2007. Sure, there have been exceptions to this over the decades. But, for the most part housing is a pretty simple asset class that for decades leading into the change of the millennium remained mostly in-check to fundamentals and a great inflation hedge.
People will say that this is an unfair analysis because post-crash “mortgage lending is too restrictive”. I say “compared to what?” The mostly thoughtful mortgage laws enacted by the Government post the great mortgage collapse still leave mortgages today — through the GSE’s and FHA — easier than most periods in history. Sure, non-GSE/FHA, bank portfolio lending (loans that the banks make to keep on the books) has suffered because of the lack of a robust securitization market and much tighter capital requirements. But, if a borrower has a downpayment, documented income, and good credit — three things that always should be present when buying a house anyway — mortgage lending is back. It simply isn’t as easy as from 2003 to 2007, which astoundingly is what everybody points to when saying “mortgage lending is too tight”. This is so radical to me, as they also point to bubble-years peak house prices as a benchmark to where prices should go. However, they fail to realize that if prices did return to 2006 levels — and 2006 was in fact a “bubble” — then housing would be in an even larger bubble than back then! Those looking/hoping/lobbying for a return to 2003 to 2007 mortgage lending will not only be disappointed, but if it somehow happened, would end up very sorry it did. Be careful what you wish for.
2) Enter 2003 to 2007, when the “mortgage-loan, house-price governor” was removed by the introduction and wide acceptance of exotic loans; in particular stated income, interest only, pay option arms, and HELOCs. Through the power of exotic lending, the ‘incremental buyer’ always earned $200k a year and had more-than-enough dollars in the bank when it came to qualifying for a loan to buy a house…credit went ‘haywire’. This allowed house prices to completely detach from fundamentals. Then, when the mortgage loan governor was strapped back on in 2008 — on the sudden loss of all the exotic loans over a short period of time — house prices quickly “reset to end-user fundamentals“. House prices quit plunging in 2009, as affordability using new-era 30-year fixed rate, fully-documented loans recoupled with real income and asset levels. This “bottom” should have set the stage for housing to once again be rooted to fundamentals / governed by contemporary mortgage lending guidelines. But, they couldn’t leave well enough alone.
3) Enter, the 2010 to 2013 “all-cash”, new-era “investor” era, which was almost identical to the 2003 to 2007 era in the effect it had on house prices . That is, during this period the incremental (the ‘majority’ in many markets) all-cash buyers work without a ‘house price governor‘, instead base their purchase and pricing decisions on individual, random, emotional, uneducated, or hopeful models or guesses. Some buy for appreciation, some for rental income, some to flip and some because they have to in order to get paid at their fund. In any case, without a mortgage loan governor the price they pay for a house is more often than not, subjective vs objective.
House prices being up 25%, 50%, or more in the past two years should have everybody sounding loud warning signals, as this is a tell-tale sign housing is being led around by the nose by something ‘other than’ end-user fundamentals. It’s not like employment or income gains in the past two years in the regions that experienced the greatest price gains — not coincidentally the same regions that were the ‘bubbliest’ in 2006; crashed the hardest in 2009; had the greatest institutional investor interest from 2011-13; and that were first to experience significant demand destruction beginning mid last year — grew at levels to support such gains. Rather, they simply assume this is the new-normal — in an era when anything in any financial market is possible — and point to the 2006 peak as proof housing is not overpriced yet.
In short, it’s very easy for an all-cash individual or institutional buyer to overpay for a house by 10%, 20% or even 30% in the heat of the deal, when competing against a dozen other all-cash buyers, and using flawed assumptions and return “models”. Overpaying for a house to this degree is impossible if mortgage loans and appraisals are required. As the bubble blows and prices become detached from reality there are always greater fools that can and will chase the market keeping it elevated for a period of time. But, outside of the all-cash cohort the number is finite unlike the 2003 to 2007 era when everybody could always overpay using exotic loans. Some will say “all-cash purchases for rental investment are rooted to fundamentals…that’s rents”. I say “hogwash”. I have seen many single family rental assumption models from some of the largest investors, and they are beyond rosy. I can easily change a few numbers in their Excel spreadsheet models and turn a 6% annual return into an 6% loss. Most all-cash, buy to rent or flip, flop, flap or frolic investor assumptions and models I have reviewed make the most bullish Wall Street sell side stock analysts look downright pessimistic.Bottom line: It’s very easy for a demand cohort — as flush with easy liquidity as this era’s all-cash cohort — to push national house prices well above what the average end-user can pay. And that’s exactly what’s happened over the past two years and why in leading indicating regions, in which new-era investors flocked first, demand is plunging and supply surging. Just like in 2007.
4) All-Cash buyer demand
This chart from Black Knight (formerly LPS) says it all…the all cash cohort — without a “mortgage-loan, house-price governor” — has been fully in control of the US housing market for a long time. It’s very easy for a demand cohort — as large as this era’s all-cash cohort — to push national house prices well above what the average end-user can pay.
Housing market history is littered with instances of investors and first-time buyers flooding into the housing market all at once on some sort of catalyst, only to leave all at once, over a very short period of time. In ‘this’ housing market, however, first-time buyers are not a presence. This in itself, should be a huge red flag to anybody analyzing this sector. But, if the all-cash buyer cohort has finally eaten it’s fill and it’s demand drops back to historical levels, there is not another demand cohort to pick up the ball and run with it. In other words, if the all-cash speculators leave — or even downshift a bit — I am worried that certain housing market regions all over the nation — particularly the ones that have experienced a parabola in house prices over the past two years — could have substantial house price downside ahead.
5) House prices are more expensive today than in 2006 on a monthly payment basis using the popular loans of each era… a true apples to apples comparison
Those looking at “house prices” — especially relative to 2006 — for signs of a “bubble” are looking at the wrong thing. That’s because to the end-user, the monthly payment is generally more important than the price. As such, when comparing the ‘cost’ of houses today vs 2006 one has to normalize the data for a true apples to apples comparison.
On an absolute basis, investors have significantly lightened up their purchases in all of the leading indicating regions I track so closely. This paradigm shift from an “investor-driven market” to an “end-user driven market” is causing considerable consternation.
That’s because when all cash investors, without a “mortgage-loan, house-price governor”, hand the market off to the end-user cohort with a fully functioning mortgage-loan, house price governor a “demand void” can appear. Not necessarily because the demand isn’t there. Rather, because average house prices are too high for the average, fundamentally-driven end-user to afford. This is what’s happening now. And based on how expensive houses are today relative to 2006, this should prevent any further upside this spring and summer, especially with rates up 100bps from a year ago. In fact, we are seeing seasonal weakness in offer prices much further into the year than typical meaning house prices have a strong chance of going negative YoY in the summer.
The Bubble Data
The chart below compare the ‘cost to own‘ the average priced house today vs 2006 using the popular mortgage loan financing of each era. When normalizing the data in this manner — vs simply assuming everybody always used market rate 30-year fixed loans, which clearly wasn’t the case from 2003 to 2007 — one can see clearly just how expensive houses are today.
Bottom line, in the first ‘results’ column, house prices in 2013 were 11% lower than in 2006 yet the monthly payment was 35% higher and the monthly payment needed to qualify was 29% greater. Taken one step further, see the second “results’ column to the far right. That is, to buy the 2006 bubble priced house using today’s mortgage finance vs the popular loans of the 2006 era, the monthly payment is 54% higher and the monthly income needed to qualify 44% greater.
Every time I review these data after updating prices in our database each month, I am amazed. I ask myself, “if 2006 was a bubble then based on the data below if if costs more per month to buy today’s average house why isn’t the sector in a bubble again?”
In closing, I do think higher house prices are mostly always good. That’s of course unless the reason for the rise is “unfundamental”.
General consensus has once again returned to the overwhelming belief that “house prices always go up and 2007 to 2009 was a fluke”. That’s plain wrong and dangerous.
I am not calling for another house price crash even though I think that housing is back in a bubble based on the monthly payment comparisons between now and 2006. What I am saying is that housing runs a real risk of price downside if the new-era investors — that have largely supported the entire sector and run up house prices beyond the reach of the average end-user through cheap and easy liquidity over the past three years — take their balls and bats and go home.
On the other hand, bubbles can deflate while house prices remain flat if the underlying fundamentals improve rapidly…strong employment, income gains etc. But fundamentally-driven housing markets take a lot time to develop, especially after so many years of running on unfundamental stimulus. Perhaps our economy can “grow into” today’s house prices over the next few years. Perhaps not.
As we saw in 2007 nobody can predict what house prices will do and the general consensus is usually the wrong one. Be careful out there. Buy a house because you need shelter and buy what you can truly afford using a 30-year fixed mortgage. Don’t buy because everybody else is unless you can clearly afford it — both financially and psychologically — especially if next chapter for this housing market is a consolidation of the past few years of gains.
Reprinted with permission from David Stockman.