Visitors to the Golden State like to joke about “The Big One” turning Las Vegas into oceanfront property. But what if the “Big One” was an economic earthquake rather than a physical one?
Like a salmon swimming upstream, I figured I was the only person to raise an eyebrow when Alan Greenspan stoked the flames of adjustable rate mortages by suggesting that Americans were making a mistake in selecting fixed-rate loans over ARMs.
Since I panned one of Washington Monthly’s columnists recently, I thought it might be worth noting that I don’t always disagree with them. In fact, Benjamin Wallace-Wells’ article is one I could have written myself. I’ll save you the time and myself the effort by just linking to his excellent analysis of Greenspan’s comments and predictions on the fallout.
Why would Greenspan encourage anyone to select a variable rate mortgage when interest rates were at 50 year lows and virtually guaranteed to move higher in the near future? He’s aware that underwriting standards are low, savings are low, consumer debt is high, and that many mortgage products border on insanity. Negative amortization, interest-only, and 110% loans are just a few examples of an industry that has no compunction about letting anyone and everyone get way over their heads in debt.
This system works great — as long as home prices are going up. But unlike the poor sap who bought Enron at $90.56 per share in August of 2000, folks who have leveraged themselves into hot real estate markets run the risk of winding up on the street when interest rates shift. And talk about a break with reality — I’ve had the most surrealistic discussions with homeowners who refuse to entertain the notion that prices cannot continue to rise forever.
This isn’t a nationwide phenomenon. Real estate prices are reasonable throughout much of the country. Traditionally, it was just New York that was overpriced. Fine, it’s New York. Unique New York. The town’s so nice they named it twice. But San Francisco joined it ten years ago, followed by Los Angeles in the late 90s. Then Seattle, Chicago, Boston, and many other metropolitan areas started to rise. Wallace-Wells points out the disparity:
Truth is, in most of the country there’s no housing bubble. Perhaps the crucial ratio from which economists determine whether housing markets are out of whack is the ratio of home prices to annual income. In most of the country, it is modest, 2.4:1 in Wisconsin, 2.2:1 in Kentucky, 2.9:1 in Illinois. Only in about 20 metro areas, mostly located in eight states, does the relationship of home price to income defy logic. The bad news is that those areas contain roughly half the housing wealth of the country. In California, the price of a home stands at 8.3 times the annual family income of its occupants; in Massachusetts, the ratio is 5.9:1; in Hawaii, a stunning, 10.1:1.
Read the article. It’s quite eye-opening. I return to this topic so frequently because I think Southern California will be hardest hit. Not only is this state home to many of the overpriced areas, but we’re also facing serious infrastructure, education, and financial problems. Yet it’s not uncommon to see $500 a square foot for outlying communities and nearly $1000 per square foot in highly desireable areas.
I hadn’t considered the role FHLMC played in this ecosystem, but Wallace-Wells is right when he says:
Once banks knew they could automatically hand off the mortgages they wrote to Fannie and Freddie with basically no risk, the old incentive system dissolved. “Banks and other mortgage lenders are not watching home prices carefully because they rarely hold onto the mortgage paper they create–they just sell it upstream to mortgage investors,” John R. Talbott, a housing researcher at UCLA’s Anderson School of Business, has argued. “It is a dangerous situation indeed when neither home buyers nor the institutions that finance them are concerned with the ultimate price being paid for the housing asset.”
A particular kind of speculative frenzy ensues, captured in a recent story in The Washington Post which detailed a new phenomenon: home buyers camping out overnight for the chance to be the first in the next morning’s open house, ready to buy $700,000 houses in built-out, lush-lawned suburbs like Arlington. The phenomenon has created temporary, yuppie tent cities. The story’s authors interviewed several buyers in the tented line who planned to sell their purchases back into a steadily rising market, and concluded, dryly: “There is an element of speculation to the lines.”
What he’s not mentioning is that these $700,000 homes and the lots they sit on are smaller than ever before. The same phenomenon is taking place here in Irvine. Even owners of pre-existing homes often attach conditions to the very showing of their property. I’m starting to see MLS listings with things like “seller states home is not to be shown until a prequalified offer is submitted in writing”. In other words, the owner wants you to commit to spending half a million dollars on his home before he’ll let you see it.
And yet people just refuse to see what’s coming down the tracks. “It will be different this time.”
They’re right, actually. It’s going to be much, much different.