For the bubbleheads, overshooting is a thing to be embraced. After all these years of being priced out of the housing market, they say, we will finally be able to buy houses for pennies on the dollar. For the economists, overshooting is a thing to be feared because it would prolong and deepen the recession.
I would love it if housing would overshoot. Who wouldn't want to buy a dollar's worth of house for 50¢? However, predictions should be based, not on hope or fear, but on historical data. Those who predict overshooting do not have history on their side.
The two most prominent examples of previous housing bubbles come from Japan and Los Angeles in the late 1980s and early 1990s. Here is Japan. Notice no overshooting:
Here is Los Angeles. Notice inflation-adjusted prices fell right back down to where they were in 1987, with no overshooting. Nominal prices never fell back to their 1987 level:
People who predict overshooting—especially the professional economists—have a responsibility to back up their predictions with actual historical data. Martin Feldstein, especially, has been using a baseless fear of overshooting as an excuse to justify propping up the bubble.
I challenge people who believe in overshooting to back up their belief with actual historical data. It is certainly possible that housing will overshoot—Las Vegas and Phoenix are looking like they will—but in most parts of this country, it is far from probable.
Posts
Good post James. I have/had my doubts, but you have been very consistent about this - no overshoot. I think one of the best examples locally is PWC. Notice how for the longest time it looked like it would overshoot only to take a sharp sudden turn to flat
ReplyDeletehttp://www.recharts.com/mris/mris_11.html
I guess the good thing about this is that it shows we are NOT headed into a deflationary spiral - as much as I would like to see an overshoot in certain parts of fairfax county. Oh well.
Im not sure I understand overshooting because houses are based on fictional prices anyway.
ReplyDeleteI would be happy if prices just fell to their prebubble prices here in Montgomery county....which would be nearly half of what they are listed for this very moment! However, would that be considered an overshoot??
Well what exactly IS "overshooting"? If you mean simply that prices will be below their inflation adjusted average, well yes they do. This isn't Lake Wobegone, where "all prices are above average." Sometimes prices are higher, sometimes they're lower.
ReplyDeleteBut I and others have argued that the minimum price is set by prospective (intentional) landlords, not by owner-occupiers. And prices really CAN'T stay below ones for which they ACTUALLY cashflow by much or for long. Now I don't mean the "this property cashflows" of flipper-idiot accidental landlords. Something that breaks even at 100% occupancy if you don't have to do any maintenance is not an investemnt. And rents and occupancy rates are likely to fall in areas where there has been a huge amount of new housing. But the bottom where all the knives land is more like a concrete floor than a rubber sheet.
--Jim A.
Anonymous said...
ReplyDeleteWell what exactly IS "overshooting"?
Different people can have different definitions for what exactly is overshooting. People can also have different opinions on what the specific intrinsic (i.e. investment) value of an asset is. However, I'd say that in general if assets cost less after a bubble than before the bubble, you're in overshoot territory.
If you want me to draw a specific line in the sand, I'd say that if home prices fall below their inflation-adjusted 1997 level, they're overshooting. I think Las Vegas and Phoenix will overshoot, but most places will not and the D.C. area will not.
But I and others have argued that the minimum price is set by prospective (intentional) landlords, not by owner-occupiers.
I think that's exactly why housing doesn't overshoot. Martin Feldstein's worry is that potential investors won't be able to get loans to buy real estate even when it is unquestionably a great long-term investment.
"James said...I think Las Vegas and Phoenix will overshoot, but most places will not and the D.C. area will not."
ReplyDeleteJames - you dont think they can pull ouf of a steep decline to flat - a la PWC?
Interesting post.
ReplyDeleteBut let's take that LA graph. We're just now breaking through the previous price/income peak. Yes, interest rates are lower, but the move up market is broken. Look at that 1990 to 1997 trend.
LA incomes, at best, support a $300k price. I do not expect to ever see 1997 'nominal prices' again. Nor inflation adjusted. But rentals will not cash flow in most areas. Until that is the case... we haven't found a bottom. Undershoot? Not by your definition. But it will by mine. ;)
But last time LA lost 8 years of nominal appreciation. Japan lost 20 years of appreciation.
I think we're two years from the bottom with this being the last year of major price drops. Many areas will start to recover in 2010. DC might bottom this year (as its not one of the areas with 10%+ unemployment). Let's see what the resets/recasts do in 2009/2010.
Got Popcorn?
Neil
Maybe I'm looking at things the wrong way, but this chart seems to say otherwise. http://www.investingintelligently.com/wp-content/uploads/2006/08/a_history_of_home_values.png
ReplyDeleteIn my opinion, looking at a 20 year chart doesn't provide a very accurate historical trend, nor it accounts for what is probably the biggest driving force in RE: demographics.
You list very good arguments against overshooting, but it seems to overlook the very people that helped drive the boom - the baby boomers, which are due to start retiring in the next few years and will most likely downsize.
Why are demographics being left out of the discussion, when it's such an important factor in determining demand? Good article, keep it up.
"In my opinion, looking at a 20 year chart doesn't provide a very accurate historical trend, nor it accounts for what is probably the biggest driving force in RE: demographics."
ReplyDeleteAnon - I agree, demographics and "overshoot" go hand in hand. For example, Phx & LV have built far too many homes - enough to where they wont need any for years. Thus, since supply exceeds demand, they will adjust to a new (lower) market clearing price.
Same thing with detroit. No houses were built, but they werent destroyed either. People are leaving detroit in droves. Again supply exceeds demand, prices adjust lower than they were before.
So maybe its not undershoot, but its just moving to a new (lower) trendline.
Incidentally, I dont know if you saw that census report but after years of 0.5 to 0.7% population growth year over year, Arlington has jumped up to 3% population growth. If that holds demand is too great meaning supply will have to rise (build more) or prices move up to accomodate (or maybe just dont fall as far).
Anonymous said...
ReplyDelete"Maybe I'm looking at things the wrong way, but [Shiller's] chart seems to say otherwise."
I think Robert Shiller's data probably gets less reliable the further you go back in time. That's not his fault. He's limited by the data collection that was done at the time. For example, from 1934-1952 he is using a 5-city index to measure the entire country.
That said, it's an inflation-adjusted graph, and notice that there's no overshooting since 1950.
According to the text on the graph, the big price drop that occurred during and after World War I was due to new mass production techniques. Thus, it was due to an increase in supply, not a decrease in demand as we're experiencing now.
Looking at Shiller's data set, I can see that although nominal home prices fell 24% in the early part of the Great Depression (1929-1933), inflation-adjusted prices only fell a little bit before bouncing right back to where they started.
The 27% nominal home price decline we've experienced since 2006 is greater—and faster—than the decline experienced during the Great Depression. (27% down in 3 years vs. 24% down in 4 years.)
Oh, and I forgot to mention: his 5-city index was developed by going back and looking at newspaper advertisements from the time. It's a pretty ingenious method he used to fill a two decade gap in measurement.
ReplyDeleteDC does have 10% unemployment, according to what The Post published today.
ReplyDeleteWell argued post.
Not sure if embrace it completely in as much as I wonder if other types of data, prices in relation to rents in incomes, wouldn't lead to a different analysis.
"DC does have 10% unemployment"
ReplyDeleteYou aren't taking demographics into consideration.
Uh, James. Did you notice any difference between the angle of the downwards trend of Japan versus the U.S.?
ReplyDeleteI don't see many similarities between Japan and the U.S., do you?
Good post James.
ReplyDeleteAnonymous said...
ReplyDelete"Uh, James. Did you notice any difference between the angle of the downwards trend of Japan versus the U.S.?
I don't see many similarities between Japan and the U.S., do you?"
Other bubbles have to have the same SHAPE to be relevant? You're sounding a bit like Lance. (No offense, Lance.)
OK, fine. Show me a bubble with the same shape as the current one that resulted in overshooting.
Let me also point out that many bubbleheads have been predicting overshooting since before they knew what the downward angle would look like.
James, first, thanks for the great site!
ReplyDeleteHowever, I disagree with the idea we won't overshoot on the downside. As a matter of fact, we already have in California.
I'll provide proof two ways.
First, affordability {the percentage of families who can buy the median priced California houses, is currently 54%. The highest this data point has ever been was about 45% in the mid 70s. It reached 40% from 1994-1998. California is currently more affordable that anytime in its history.
The amount of money it takes to pay for a median priced California home is about 24% of the median income earners wage. The all-time record low prior to this was 31% in 1996. Right now, in 2009, owning a California house takes less monthly to own a home in relationship to earnings than ever before.
This doesn't mean California won't continue declining, but at this point, we will continue to "overshoot" the downside as we go lower.
We know California will continue declining for three main reasons.
1. Unemploment will continue to rise and make people who lost their jobs sell over-encumbered houses in a very tough market.
2. Rising unemployment forces migration to go leave California. As people leave, we sell less homes
3. The ratio of sales is dominated by lender owned inventory as never before. In San Bernardino Couty, banks took back twice as many homes as were sold in 2008. That means an entire years supply of homes was already locked and loaded January 1, 2009. 50% of all California sales is currently lenders owned. We've never come close to that percentage before.
California housing still has a long way to fall, but it is nowhere close to overshooting. Housing PRICES in California are still very expensive by historical standards. (See the L.A. graph I posted.)
ReplyDeleteThe problem with the whole affordability because of low interest rates belief is that it is based entirely on short-term thinking. If interest rates rise, then the price of the house should plunge, possibly leaving the owner underwater. It's the same dumb mentality that got us into this mess to begin with.
The affordability argument also depends on buyers making a very small down-payment. The greater the percentage down payment, the more a buyer has to care about the PRICE of the house, rather than just the monthly payments. The financial crisis we are currently experiencing would not have occurred if buyers still had to make 20% down payments like they used to.
"James said...
ReplyDeleteThe problem with the whole affordability because of low interest rates belief is that it is based entirely on short-term thinking. If interest rates rise, then the price of the house should plunge, possibly leaving the owner underwater. It's the same dumb mentality that got us into this mess to begin with."
Agreed James - methinks this financial crisis has brought a whole new slew of bubbleheads to the blogs, which unfortunately need to be educated on the things that matter A TON and those that matter A LITTLE
Like Mr. Norris citaiton to unemployment. Unemployment certainly matters but it is a lagging indicator. Housing will bottom out long before unemployment quits rising.
I know, it seems strange, and it took me a long time of reading and staring at graphs of prior downturns to accept this. Unemployment lags, housing is leading or coincident.
Unfortunately, if this is the bottom in say PWC, its possible that a year from now, prices rise 3-5%. At the same time, PWC unemployment will certainly be higher, causing more bubbleheads to look at it, cite it, and conclude any gain is a dead cat bounce (i.e. we are going down baby!!!)
Problem is, outside of deflationary spirals which now seem unlikely, it just doesnt work that way.
Regardless of graphs or trends, all I know is that the median household income in montgomery county is about $70K a year. An average home in a decent area of Montgomery county is at least 6 to 7 times that salary.
ReplyDeleteWould it be considered overshooting for prices to drop back to 3 times the median salary?
To answer the 3.0 question, all you have to do answer this. When was the last time the median price of California was 3x the median income? The answer is never. The lowest until now was 4.1x median income in 1996. So, yes, it would be overshooting considerably.
ReplyDeleteTo answer the comment about unemployment being a lagging indicator, California prices went down until 1997. California had positive employment growth in 1994, 1995, and 1996 and prices still went down...why? Because migration did not turn positive until 1997. Migration is the leading indicator of a real estate comeback, not improving employment.
Unemployment peaked in California in 1993 at 9.4%. Then went to 8.6% in 1994, 7.8% in 1995, 7.0% in 1996. In each one of those years, the California median price declined.
Regarding the comment, "Housing will bottom out long before unemployment quits rising." I can't find evidence that has ever happened. In the 1980s, unemployment went down from 9,3% in 1983 to 7.5% in 1984. The real estate market in California didn't improve until 1985.
I'm enjoying the discussion and am open to learning new info. Thanks for the feedback.
I picked the Dow peak TO THE DAY by trusting my gut. I saw the tech bubble and housing bubbles by trusting my gut.
ReplyDeleteMy gut feeling comes form keeping my ear to the ground, reading as much as possible, and observing as many peoples habits (low throuhg upper class) as possible.
My gut is telling me that we are in for a period of stagnancy very similar to Japan. Our citizens will really never "get it" that the party is over - but rather will live in limbo yearing for the old days of instant, easy gratification and free lunches. We are in for a long period of painful yearning, thanks to our leaders. A collapse and cleansing of the system would have been painful, but much quicker. No we will suffer a slow, prolonged, dreadful period of ho-humm-ness
Anon 3:05, I completely agree. The signs are pretty clear. Unprecedented government debt, unprecedented personal debt, the productive part of the economic system increasingly under attack, and bigger and broader entitlement programs being thrown on the taxpayer's backs. Government DOES NOT create wealth, it only takes it away from the private sector. Does anyone seriously think any prosperity is going to come out of this?
ReplyDeleteLooking at the RE market from a micro view, is like measuring the force of the ocean by the strength of one wave. There are bigger forces at play here. They should be taken into account. My 2 cents.
affordability is what its all about,...and no, rates wont be going back up for quite some time because the fed is now using it as a stimulous tool similar as they have done with the over night rate. the fed wont allow rates to increase until the economy and the housing market can withstand it. You think the feds gonna just let rates rise, only to have housing prices fall again endangering the economy? i find that highly unlikely
ReplyDeletepeople dont care about real prices, poeple care about the monthly payment and if they can afford it and if offers more than their current situation of renting. the reason your graphs of real prices seem to look like a nice way to look at the market is because mortgage rates have typically been in the 7.5 - 8.5% range for much of your shown data period. but that changed starting in 2001 and still today. Sorry, but a borrower just cant ignore the affects of a 5% mortgage vs a historical 8% mortgage,.. its too big a difference in monthly payment. A borrower can afford 36% more loaned dollars...thats a huge difference.
What wont happen for quite some time is home price appreciation in many areas (although many non bubble areas are seeing it today due to lower rates even though lower rates apparently dont matter).
main reason there wont be an overshoot to the downside is its hard for home mortgage payments to fall much below rents for a comparable house.
"Regardless of graphs or trends, all I know is that the median household income in montgomery county is about $70K a year. An average home in a decent area of Montgomery county is at least 6 to 7 times that salary."
ReplyDeleteMy guess is you are comparing apples to oranges here - median does not necessarily = "average home in decent area" - often its a "average home in a lower middle class" area.
Chances are good most everyone on this blog is well above that standard.
First, I have to agree with James - most of the country will not overshoot (not by >10% anyway). Bubble zones, yes. Everyone else, no.
ReplyDeleteBut looking at those graphs, I don't really see the proof. On the first one, Japan is still declining. On the second, we need more data to the left. With what we are given, LA had a 10% overshoot in 1997.
I'm also not convinced by "housing reacts much more slowly and is usually resistant to decline". I'd phrase the second part more like "it is usually resistant to change". Once it starts declining, I think the resistance is reversed - to the upside. The mentality becomes "wait and it's cheaper next month", which continually repeats (at least that is what I've seen). Now, I do think that it takes fairly significant declines (i.e. bubble areas) to really solidify this in peoples' minds, which is why I only think we overshoot in those areas.
"people dont care about real prices, poeple care about the monthly payment and if they can afford it"
ReplyDeleteOnly if they are idiots. As was already explained, an overpriced house is an overpriced house.
A low monthly payment is nice, but being underwater is never a good thing. Interest rates are not going to stay at all time lows. When they rise, housing prices will have to continue to fall.
It seems counterintuitive but higher interest rates offer a lot of advantages to buyers. For one thing, it makes it easier to pay off a greater percentage of the principal on a home with a down-payment and if your earning power grows over time, as it does for many, it allows you to more easily pay down the remaining principal of the loan early.
...and you can always refinance down to lower interest rates should they fall, you can't lower your principal.
ReplyDelete"My guess is you are comparing apples to oranges here - median does not necessarily = "average home in decent area" - often its a "average home in a lower middle class" area."
ReplyDeleteYeah, I guess you are right. However all those $65K earners living in Potomac must know something I don't...cause I make double that and Im looking for houses in silver spring.(aka mexico)
"As was already explained, an overpriced house is an overpriced house."
ReplyDeletecan you define an appropriately priced house in an equation for me? what are the paramenters that determine if it is over/under priced? and dont just give me some list of paramenters, i want the an equation.
"Only if they are idiots. "
i would guess over 90% of buyers dont know what "real prices" even means, nor ever learned about it.
that makes them idiots?
buyers only need to know their monthly payment, and if its something they can afford
"Interest rates are not going to stay at all time lows. When they rise, housing prices will have to continue to fall. "
yes, low mortgage rates are not optimal for a housing market for a couple reasons. but the reasons behind it arent an issue if the fed is controlling rates as they are now. And it is not true that home prices have to drop with higher rates, the fed can raise mortgage rates over a long period of time, allowing inflation and a growing economy to support higher rates, keeping home prices stable.
"if your earning power grows over time, as it does for many, it allows you to more easily pay down the remaining principal of the loan early."
in what way would they be able to pay off principal easier during the life of the loan with a higher rate vs a lower rate?
its stretch for me, but i think i understand the complex concept of refi'ing from a higher rate to a smaller rate and the benefits.
Only if they are idiots. As was already explained, an overpriced house is an overpriced house.
ReplyDeleteBut as I said in a discussion of appraisals, "We've already determined what the greatest fool will pay. The appraisal is supposed to tell the bank what the second greatest fool will pay. If the bubble has taught us anything, it is that the price is set by the dumbest borrower, the most idiotic bank, and the most ignorant bond purchaser acting together.
As for the sensativity of house prices to interest rates...Well along with the reappearance of downpayments, we're going to have the declining popularity of ARMs. At some sort of theoretical level, ARMs should make the current interest rate less important because the borrower SHOULDN'T anticipate paying that interest rate for the life of the loan. But it is clear to me that many bubble buyers never did price in the possibility that interest rates could go up or principal values decline. A vastly reduced number of people are willing to make the bet that "they'll just refinance" in a year or two, and sign up for a series of payments that they have no reasonable expectation of being able to afford.
--Jim A.
"can you define an appropriately priced house in an equation for me? what are the paramenters that determine if it is over/under priced? and dont just give me some list of paramenters, i want the an equation."
ReplyDeleteSorry dude, life isn't that simple. This simply isn't the kind of thing that can be reduced to a nice simple one size fits all equation, and any effort to that end will inevitably produce a result with as many exceptions as valid results.
"i would guess over 90% of buyers dont know what "real prices" even means, nor ever learned about it.
that makes them idiots?
buyers only need to know their monthly payment, and if its something they can afford"
You sound like a used car salesman.
The whole "sell the payment, not the price" gimmick is one of the oldest in the book. The idea of course is to get the potential buyer to stop thinking about how much they are actually paying, and instead happily agree to take on as large a debt-load as they think they can carry.
As "Jim A" said above, one unfortunate consequence of the government's intervention in our housing market is that those individuals most willing to engage in risky behavior end up setting the market.
Without government intervention we would see a return to more traditional lending standards, including significant down-payments.
Down payments benefit everyone involved in the housing market.
They protect both the lender and the borrower. The lender is protected because if the borrower has put down 20% of the purchase price, they are far less likely to walk away from the home, and if they are foreclosed on, the bank has a safety buffer of 20%, reducing its loses.
Downpayment requirements also protect the borrower. It prevents borrowers for recklessly overpaying, by making the cost of their intended purchase "real." It forces them to demonstrate the ability to put aside money for a significant period of time and live within their means before signing up to pay more money than they have likely seen in their lives.
Most importantly, in a market where significant downpayments are required, the lowest common denominator element of the market will be eliminated. During the housing bubble rising prices drove a wave of exotic lending... which in turn drove prices still higher. The end result is the mess we are currently dealing with. If downpayment requirements had stayed at 20% the bubble would have been impossible.
"yes, low mortgage rates are not optimal for a housing market for a couple reasons. but the reasons behind it arent an issue if the fed is controlling rates as they are now. And it is not true that home prices have to drop with higher rates, the fed can raise mortgage rates over a long period of time, allowing inflation and a growing economy to support higher rates, keeping home prices stable."
In order to keep interest rates at artificially low levels the Fed is being forced to waste countless billions of dollars. The longer it draws this out, the more costly it will prove to be. You need to understand that there is no such thing as a free lunch.
Now that interest rates are at all time lows, even small increases will result in large increases in payments. Take a look what going from 5% to 6-7% does to payments...
Not only is this clumsy attempt at market manipulation destined to fail, the entire goal is misguided. Inflated housing prices are no more beneficial than inflated food prices. Housing is a basic necessity. Drawing out the correction simply means another generation of buyers will overpay only to see their home's value drop for years after they purchase it.
"in what way would they be able to pay off principal easier during the life of the loan with a higher rate vs a lower rate?"
Because the principal would be smaller in the first place. If interest rates were to shoot up to 10% tomorrow, housing prices would plummet. A potential buyer with the same budget would be able to save up their downpayment more quickly, and although they might end up with a similar monthly payment, the principal would be much smaller. In the future if any excess funds became available they would be able to more quickly pay down the smaller principal.
YOU WANT OVERHSOOT?!?
ReplyDeleteHERE'S OVER SHOOT.
http://latimesblogs.latimes.com/.shared/image.html?/photos/uncategorized/2008/09/03/chart.png
http://latimesblogs.latimes.com/laland/2008/09/nerdvana-chart.html
Price-to-income ratios below 2.8 were reached in the late 80s and early 90s. This is overshoot.
CASE CLOSED
"Sorry dude, life isn't that simple. This simply isn't the kind of thing that can be reduced to a nice simple one size fits all equation, and any effort to that end will inevitably produce a result with as many exceptions as valid results."
ReplyDeleteyou were the one trying to tell us that people were overpaying in your prior post, I was just curious how you knew that they are overpaying. thanks for helping me make my point for me, that you really dont know.
"The whole "sell the payment, not the price" gimmick is one of the oldest in the book. "
its an old gimmick, that has nothing to do with this issue or these loans. the terms of the loans is the same, 30 years, fully amortizing. nothing different other than the interest due annually. if we were talking about interest only, option arm loans etc, i would agree, but it has nothing to do with this situation at all.
"If interest rates were to shoot up to 10% tomorrow, housing prices would plummet."
so you are saying we should only buy houses that are affordable at 10% rates, even though today they are 5%? gotcha, so people will be paying $1000 in rent (what they can afford), when they can buy the same place for $600/mo...that makes sense.
"In order to keep interest rates at artificially low levels the Fed is being forced to waste countless billions of dollars. The longer it draws this out, the more costly it will prove to be. You need to understand that there is no such thing as a free lunch. "
how is it costing billions of doaalrs? and even if so, it would
depend on what the alternative cost is. you do realize the US government cost of funds (treasuries) is about 2-3% annually while they are buying MBS that pays them 5%. (these are agency bonds, so the government is basically on the hook already for any losses, even if they dont own them.)
last comment regarding paying down principal and mortgage rates: Do you know that a lower mortgage rate loan actually pays off more loan principal faster? After 10 years an 8% rate loan would be paid down about 12%, while a 5% loan would be paid down about 19%. So in my eyes, the lower rate is more beneficial directly to paying down their debt. then on top of this, they can pay down any "excess funds".
"Drawing out the correction simply means another generation of buyers will overpay only to see their home's value drop for years after they purchase it."
not necessarily if there is any inflation
price to income ratios are missleading.
ReplyDelete