20 December 2004
What Is a Housing
Recent bursts in property appreciation
suggest to some observers that we are in a housing bubble. A bubble is a marked
price increase fueled partly by expectations that prices will continue to rise.
Once that expectation comes into serious question, the bubble bursts, and prices
In writing about this question last year, I
pointed out that house markets are much less vulnerable to bubbles than
financial markets because the cost of buying houses in order to resell them is
very high. Costs include sales commissions on the purchase and sale, and the
costs of carrying the property until the sale.
But I may have overstated the case. Steep
price increases and the expectation of more to come can overcome sales
commissions and carrying costs, and there is evidence that this is happening in
some markets. One of these is southwest Florida, from where I have recently
received many letters.
Evidence of a
One letter points out that on new
construction, it is possible to speculate on a price increase without incurring
any transaction costs at all, and without even having to qualify for a loan!
"Here is how it works. Borrower A puts down a
$10,000 deposit to reserve a condo unit at $300,000�. 12 months later, with 2
months to go before completion, A sells his reservation to B for $450,000. B
gets a loan and purchases the condo, with A shown on the closing documents as a
lien holder. A never has to qualify and walks away with $150,000 on a $10,000
This letter came from a lender who sells the
loans he originates to one of the government-sponsored secondary market
agencies, Fannie Mae and Freddie Mac. The question he had for me was whether
they would accept a house value of $450,000?
This is a good question, since lenders and
those who buy loans from lenders face increased risk in areas experiencing price
bubbles. Because the risk of a future collapse in prices is high, it would be
rational for them to tighten their lending policies.
But Fannie Mae and Freddie Mac would allow
the $450,000 valuation without any change in their underwriting requirements.
Setting different requirements for different areas would be discriminatory and
Competition for loans in the face of a
shrinking refinance market can also overwhelm any effort to tighten lending
terms, as suggested by the following letter from southwest Florida.
"I�m a mortgage broker and the realtors in
this area won�t give me the time of day because my terms are not competitive. I
need 5% investment loans and the best I can offer is 10%�Do you know a lender
who can help me be competitive?"
An investment loan is one where the house
buyer intends to rent the house or sell it, rather than live in it. Investment
loans have always been viewed as more risky than loans to occupants, and they
are especially risky in house bubbles. Yet here we have a broker who is
distraught because his lenders require 10% down on investment loans while his
competitors have access to 5% loans. Housing bubbles can go a long way on 5%
Option ARMs Help
The prime driver of bubbles, of course, is
speculative buyers looking for price appreciation. Our system provides an array
of mortgage choices for them, including the so-called option ARM. This an
adjustable rate mortgage designed to maximize a borrower�s buying power by
providing exceptionally low payments in the early years. It is the instrument of
choice of the buyer from southwest Florida who sent me the following letter.
"Looking for advice on financing a $500,000
home that I know will appreciate to $700,000 in 3-4 years, or an $800,000 estate
that will appreciate to $1.2 million...This will be a second home, I will flip
it in 3-4 years�I�m leaning toward an option ARM that will calculate my starting
payment at 2%, with only 7.5% increases the first 5 years�"
This buyer is convinced his property will
appreciate markedly, so he stretches his buying power to the limit. The more
expensive the house you buy, the more money you make. This is the mindset of a
housing bubble buyer.
The loan balance on the option ARM rises in
the early years but this doesn�t discourage him because he expects much larger
increases in property value. This ARM is also vulnerable to a sizeable increase
in the payment after 5 years, but that doesn�t matter either; he expects to be
long gone by then.
When prices collapse, such buyers will have a
rude awakening. The lenders and investors who are financing the bubble will
share their misery.
Copyright Jack Guttentag 2005