| Why Home Prices Are Going
through the Roof:
A Brief Guide to the
"New Economy"
by DAVE HOPKINS
San Francisco, Cambridge, Mass., and,
increasingly, small "art towns" such as our own Northampton have
seen their property values skyrocket over the past 20 years, especially
since 1995. The influx of money into the Pioneer Valley has begun to drive
out the quirky, creative souls that put
these towns on the map (and I include here the natives of the town, not
just "artists") as it drives up rents and home prices.
How did this happen? It's not so simple
as pointing to newcomers who, attracted by the Valley's culture and
natural beauty, have often brought considerable wealth with them (having sold hyperinflated homes in the
towns they are fleeing from). Most of these
newcomers fit in quite well here, and they have added immensely to the
quality of life in the Valley.
The problem, in fact, is a much larger one. I'll try to explain it as simply as possible.
WHY HOUSES GET FAT
Whenever there is a massive influx of
money into a community or country, this creates all kinds of imbalances.
It is like a boy made hyperactive by a steady diet of refined sugar. There
is elation, energy, a kind of mania, but it tends to be destructive in the
end. And it often ends up metabolizing into fat deposits. Well, this fat
is the asset
inflation of both the stock market and real estate. Instead of
nurturing a small lean business that will generate jobs and real wealth
and will create new assets, money is diverted into existing assets,
inflating their price far above their fundamental value. Needless to say,
this is completely unproductive and, in the end, harmful for the economy.
That, in a nutshell, is the story of our
"new economy." Puffing up stock prices became the name of the
game, whether in company buy-backs of its own shares (to increase the
per-share value) often with borrowed money, or the Enron-like accounting
that moves liabilities off the balance sheets or counts future income as
present income. And that is only a small part of it. The externalization
of social costs such as pollution and worker stress and the driving down
of wages by exporting industry to low-wage countries have all been done in
the name of shareholder value or the inflation of stock prices.
The overflow from this went into real
estate, which historically has been a sink for excess money or liquidity in an
economy. That is, in plain words, as people grow wealthier on paper from
stock market gains, they tend to invest in real estate, a seemingly more
"solid" store of wealth, and a manifest symbol of their
new-found wealth and status. It is not coincidental that the highest
inflation in the country has taken place in high-tech or financial centers
such as Boston or San Francisco, for that is where most of this excess
liquidity or money is sloshing around.
WHERE DOES THE MONEY COME FROM?
So why was there such a massive influx
of money? Well, the last surge in the stock market, in 1998-2000, came in
part from the capital flight from the Asian currency crisis (caused by an
earlier influx of hot money into Thailand, Malaysia, and other Asian
countries, which also inflated their real estate markets to
unsustainable levels) and from Brazil and
other Third World countries. With the deregulation of global finance,
it was easy to flee from your home-country currency, which may have been
under immense pressure from speculators like George Soros, to a strong
currency like the US dollar, and to dollar assets such as the stock
market.
Alan Greenspan and the Federal Reserve
also injected a massive amount of money (they call it
"liquidity") into the economy during the crisis, to prevent the
whole system from collapsing. This "high-powered" money also
found its way into the stock market, or quite a bit of it did, and
subsequently into real estate..
So the Asian currency crisis had a
powerfully stimulative effect on the US stock market (and real estate). I
could give similar examples of immense flows of capital into our asset
markets, which inevitably drive up prices.
"FANNIE AND FREDDIE
WERE LENDERS"
Home financing was originally done
locally, by savings and loan institutions and genuinely local banks. Part
of the money came from deposits, and part was credit money created legally
on the basis of the bank's reserves. (In our fractional reserve system,
banks have the power to create credit money on the basis of their
reserves.) But essentially mortgages were locally funded.
Fannie
Mae and Freddie Mac are government-sponsored enterprises (GSEs) that
were created by Franklin Roosevelt to buy mortgages from these local banks
so that the banks would have money for additional mortgages. Today they
are publicly traded companies under pressure to make profits for their
shareholders, which is one reason they are growing into the largest
non-bank financial institutions in the world. Fannie and
Freddie basically borrow from international capital markets to buy up
mortgages from US banks and mortgage companies. The bonds they issue to
borrow the money (to pay the local banks) are called mortgage-backed securities
(MBSs). They bundle together, say, a
hundred million dollars worth of mortgages and create a security or investment
instrument. They then sell shares of this MBS to pension funds, money market funds,
mutual funds, insurance companies, or foreign investors, and they guarantee the mortgages (against
default). In effect, they are securitizing the housing debt of the
American people and selling these securities in international debt
markets.
To manage this mountain of debt, Fannie
and Freddie have become major players in the unregulated derivatives
market. Some, including the Wall
Street Journal, have repeatedly accused Fannie and Freddie of turning
into giant hedge funds and of creating systemic risk for the entire global
economy.
The upshot of all this structured
finance is that our local real estate markets are now tied into an
unregulated global financial system. An Easthampton homeowner may, as a
result, be paying her principal and interest payments ultimately to an
investor in China. This access to global financial markets has flooded our
real estate markets with easy credit and has helped
to drive prices up.
DEFLATION OF THE BUBBLE?
So the hot air in the real estate market
is made up of:
- Money
injected into the economy by the Federal Reserve, in response to
various crises (the collapse of the then giant hedge fund Long Term
Capital Management, or the Asian currency crisis in 1998, e.g.), which drove up prices in the stock
market. This liquidity then spilled over into the real estate market.
- Massive
capital inflows from Asia and the Third World, a result of capital
flight, which also drove up the prices of US assets
- The mortgaging of America: Fannie Mae
and Freddie Mac's securitizing the housing debt of homeowners and
selling these securities in the global financial marketplace,
expanding credit for housing in this country exponentially and, again,
driving prices sky-high.
Naturally, just as the asset bubbles in
Southeast Asian collapsed when foreign capital fled in 1998, our asset
bubble will collapse when the air escapes. Some of it already has blown
out of the stock market, and real estate bubbles tend to trail stock
market bubbles by about two years.
A steady weakening of the dollar, rather
than a catastrophic collapse, is the scenario I envisage. As US assets
continue to decline, and our interest rates move toward zero (and our
trade deficits toward the stratosphere), foreign investors will begin to
withdraw from US dollar assets, and this will weaken the US dollar. A
downward spiral of dollar weakness, capital flight from US assets, and
further declining asset prices will create problems for the Federal
Reserve too. For the Fed cannot inject money into the system if there are
no buyers for its bonds (if no one lends them the money, that is). Now we
are living on the savings of 80 percent of the world's peoples. This
cannot continue much longer. Once this begins to correct itself, we'll see
this hot air in our property markets escaping slowly but surely.
Moreover, to defend the dollar and to
attract buyers of its Treasuries, the Fed may have to raise interest
rates, which could drive many buyers out of the market and have a dramatic
deflating effect on house prices.
LOOKING DOWN THE ROAD
Our asset inflation has been exported to
the UK and Australia and other developed economies, and the smaller real
estate market in the UK is a kind of canary in the mineshaft for the US
market. Just yesterday (January 12,
2003) I read a Daily Telegraph
(UK) article on the prospect of homeowners' falling into negative equity
over the next two years, as the property market in the UK deflates (that
is, where the value of the home is less than the mortgage amount!).
Halifax, one of the largest mortgage
banks in the UK, estimated that the rise in property values (which went up
over 20 percent in 2002 in some UK markets) would grind to a slow halt in
many towns mid-year in 2003, and would decline about 9 percent in the
second half of 2003 and another 20 percent in 2004. A few other British
real estate mavens who were quoted (probably all bearish) seemed to concur; one expected property market values to decline by
30 percent by 2005. These figures and this timeline ring true to me for
the US real estate market as well.
Much depends on the larger economy, actions taken by the Federal Reserve,
and geopolitical events like the expected war on Iraq. It's quite possible
that the Fed will forestall the inevitable this year, and that prices will
plateau or continue to rise at a much slower pace.
CONCLUSION
So, what's a homebuyer to do? Well, I've
been advising my clients since June 2002 that the market is peaking and
they should not expect the gains of the last ten years anytime soon. If
they are in no hurry to buy and this purchase will have a lifelong effect
on their finances, I suggest waiting at least a year or two. If they need
to move in two years, I caution them about the possible loss of equity if
prices fall. In all cases, I advise buyer-clients against overextending
themselves, indicating that they may need as large a cushion of equity as
possible if there is a credit crunch and the real estate market heads
south. Things doubtless will turn up again, once these excesses are worked
out, so buyers who expect to live in their homes for ten years should be
fine.
The larger issue here, of course, is the
dilution of our money supply by the Fed, which seems to be working more
for the well-being of Wall Street than it is for ordinary Americans.
Another serious issue is the way asset inflation has made purchasing a
home increasingly difficult for most Americans. We are becoming mortgage
slaves as a result.
And to think that it all comes down to
asset inflation, to money that is being used for the benefit of financial
markets rather than for the real economy and the commonweal of the
American people....
The skyrocketing property values of Northampton and other Valley towns
are one repercussion of this asset inflation. And these inflated values
are linked --ironically-- to the very forces of
globalization that we thought our Valley was a refuge from.
***
Update: May 14,
2003
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