Surreal Estate on the San Andreas Fault

“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 fault.


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

Median 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 Lew 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.

Diversification? 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 fall.

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.

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

November 25, 2005

Gary 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.

Copyright © 2005