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Can You Fog a Mirror?


When does the trouble start?


Let's talk about real estate, shall we? One recently floated theory maintains that real estate can't be a bubble because so many people say it's a bubble. Anyone with an ounce of common sense knows that statement is completely ludicrous. To thoroughly refute it, all you'd have to do is think back to the stock mania -- when the fact that many of us said it was a bubble didn't stop it from being a bubble.

What real-estate bulls could argue: Several recent stories about a bubble existing in real estate may need to be discredited before the party ends. That would be a defensible line of logic, although for me, the Time Magazine cover below ("Home $weet Home: Why We're Going Gaga Over Real Estate") would trump that argument.

Of course, that debate would just be the bears and bulls promoting their own favorite theory about how long the mania can last.

A Bubble's End: Up in the Air
The fact of the matter is, what you can't know about a bubble is when it will end. During bubbles, people's hopes about how the future will turn out, together with their greed, completely overrule whatever common sense or analytical skills they once had. When markets get as out of control as they do in bubbles (as happened in the stock mania, and as is happening now in the real-estate mania), it's impossible to accurately predict the lifespan of that psychology, or the magnitude of the lunacy.

Therefore, while we can't know when a bubble will end (notwithstanding our own pet theories), what's knowable is that folks are taking far too many risks. And, the collapse, which is sure to follow, is an outcome that we can discuss with some degree of certainty. In an illiquid market like real estate, which is so dependent on financing, when the credit bubble that's been powering the house-price bubble bursts, it will be very ugly.

Up to the Rafters in Interest-Rate Risk
Stop for a minute and consider the fact that interest-only and adjustable-rate mortgages now comprise roughly 60% of all home loans (with "interest-only" contributing one-half to two-thirds of that), when just about four years ago, they may have accounted for less than 20%. That's not to say these two flavors of mortgages couldn't become even more popular -- because they could -- but to just illustrate the magnitude of the potential problem we could ultimately face.

For those who think that real estate can never go down, I might note a likeminded belief among Japanese property owners in the late 1980s, where values have subsequently declined for the last 14 years. (That may finally be in the process of changing.)

Another prevailing myth in the real-estate market: We can always ride out any bumps in the road. While that may have been partially true in the past (assuming you didn't lose your job), it may be less likely in the future, given the huge percentage of people taking out interest-only and adjustable-rate mortgages.

For instance, if you had a 30-year $300,000 mortgage at 5.5%, it would cost roughly $1750 per month. If you took out an interest-only mortgage, your payments would start out at $1375, but would rise in a few years to between $1800 and $2200, depending on how rates fluctuated in the future, assuming they went up. (Of course, rates could be higher or lower, depending on the prevailing policy.)

If you pick one of the super-duper interest-only mortgages that permit borrowers to basically choose their payment, you could shoehorn into the same $300,000 loan with a monthly payment of about $965,000. But a few years down the road, that would rise to around $2200, a mighty hefty jump. (These numbers are meant as approximations, just to give you some feeling for the size of the jump that's staring lots of folks in the face.)

A Man's Home Is His Lodestone
Thus, I believe that over time, the financial pressure on people who've paid huge prices to get into the red-hot real-estate market -- and who have misjudged their ability to ride out what lies ahead -- will only increase. I don't think that's debatable. Furthermore, given the fact that so many people are actually priced out of the market (which is why they've been attracted to these financing schemes that make the impossible "possible"), once the fever breaks, house prices will be under tremendous pressure (meaning those folks will be under water).
Recent statistics that I saw for California suggest that the percentage of households able to afford the median price home -- now about $520,000 -- has dropped to 16% (which I'm sure is an extreme). I haven't seen the data for other states, but if only 16% of California households can afford a house, while home ownership nationwide is running at approximately 70%, then lots of folks own a house that they couldn't afford to live in, if forced to buy it using conventional financing methods.

Of course, that brings me to the point about what has allowed this folly to take place: the fact that financial institutions have totally taken leave of their senses. Rather than being even slightly concerned about getting paid back, they only seem to care about generating loans, such that anyone with a pulse can finance anything.

Somewhere down the road, when home prices begin to sink and problems start to arise, the financing mechanism will change. Then it will become far more difficult to obtain a mortgage -- which will of course cause the problems in housing to feed on themselves. To my mind, there's no escaping the fact that a huge financial accident lies ahead. The only question is, when does the trouble start?

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