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Monday, July 04, 2005
Pictures of a mania? - US Housing
John Mauldin's Weekly E-Letter
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Once again we look at one of my favorite analysts and behavioral finance thinker, James Montier of Dresdner Kleinwort Wasserstein in London. James wrote a fascinating book several years ago called "Behavioural Finance: A User's Guide" and puts out ongoing research like the one we will enjoy today. Long time readers will recognize the name because I have discussed many of his ideas in my weekly letter "Thoughts From the Frontline," my book "Bull's Eye Investing" and in "Outside the Box."
This report by James explores whether there is a bubble in the US housing market. He has pulled together data from numerous sources and gives his conclusion that there is a definite bubble. In fact he does not understand how others like myself could argue otherwise and that is why it was picked for this weeks Outside the Box.
- John Mauldin
Pictures of a mania? - US Housing
By James Montier
First, let me confess my ignorance, I know very little about housing.
However, I do know something about bubbles and something about psychology.
The debate over the possibility of a US housing bubble raging in almost
every paper, and even within the exalted shrine of the Federal Reserve
Board, has prompted me to take a cursory glance at the housing market to see
if I could spot signs of a speculative mania.
Frankly I am amazed there is even a debate. All I can see are signs of
speculative excess. Let me take you through the key pieces of evidence for
the prosecution which, I believe, represent a prima facie case that a bubble
exists.
Firstly, the near-exponential rate of price increases that characterise
bubble behaviour are clearly visible in the chart below.
However, prices alone don't define a bubble. Rather it is the deviation of
prices from their fundamental value that truly create a bubble. The chart
below shows the 'PE' ratio for US housing. It is constructed as the ratio of
house prices to rental income. Once again the exponential explosion that is
so typical of a bubble can clearly be seen. Either historically, housing has
been remarkably undervalued (unlikely, we suspect), or prices have been
driven way out of line with underlying values.
Of course, people don't think about housing in this fashion. Instead people
tend to think about housing in terms of affordability. That is to say, most
people examine housing in terms of the amount of their monthly salary that
will be consumed by the mortgage. This might sound perfectly reasonable, but
it flies in the face of the rational investor's view of the world.
The chart below shows the interest rate on a typical 30-year mortgage with
10% down, as a proxy for the average interest rate facing homeowners. It
also shows the household mortgage debt payments as a percentage of
disposable personal income as calculated by the Federal Reserve Board in
their flow of funds statistics. Despite the near record low interest rates
that home owners are enjoying, the repayments have soared to over 10% of
monthly income!
An alternative source shows an even higher percentage of income going on
mortgage repayments. According to the Joint Center for Housing Studies
(JCHS) at Harvard University, after-tax mortgage payments consume nearly 20%
of income. The JCHS also found that nearly one in three are now spending
more than one third of their monthly salary on mortgage rates. Around 10% of
Americans spend more than 50% of their monthly income on mortgage
repayments!
Evidence of loosening standards is also fairly typical of a bubble. For
instance, investors were happy to buy firms with no track record of earnings
and value them on the basis of clicks and eyeballs during the dot.com years.
Within the housing market we can find evidence of a general easing of
standards. The percentage of loans with a loan to price ratio above 90% is
18%. New measures of financing have become increasingly popular. 35% of
mortgages are now adjustable rates (ARMS) leaving borrowers very vulnerable
to rising rates. Perhaps the US homeowner has bought into our Ice Age
philosophy, but we doubt it.
Other exotic mortgage types have become increasing common. Interest-only
mortgages are now commonplace. Negative amortisation loans are easily
available. These beasts allow buyers to pay less than the interest due, and
the balance is then added to the principal repayment. Indeed 105% loan to
value mortgages are also available, so buyers can cover the costs of buying!
Indeed even the bubble blowers who run the Fed seem to be getting
increasingly nervous about the state of play in the housing market. Susan
Schmidt Bies gave a speech (Current Regulatory Issues, June 14 2005 Remarks
by Susan Schmidt Bies) recently in which she stated:
We see indications that underwriting standards are beginning to weaken. For
example, "affordability products" - such as interest-only loans, negative
amortizations, and second mortgages with high loan-to-value ratios - are
becoming more popular; sub-prime lending is growing faster than prime
lending; adjustable-rate mortgages, or ARMs, have grown substantially and
now account for more than a third of all mortgage originations, the highest
level since 1994. Industry experts are increasingly concerned about the
quality of collateral valuations relied upon in home equity lending and
residential refinancing activities.
As Bies noted, sub prime (lending to those with blemished credit histories
or unusually high debt to income ratios) lending has seen a meteoric rise.
The evidence of a slippage of credit standards doesn't come much clearer
than this. Sub-prime lending now accounts for nearly 17% of all home equity
lending.
Another tell-tale sign of an investment mania is the generally relaxed
nature of those investing in the asset in question. William Goetzmann and
Ravi Dhar from Yale University have just completed a major survey of
institutional perspectives on real estate investing (Goetzmann and Dhar
(2005) Institutional perspectives on real estate investing: the role of risk
and uncertainty, available from www.ssrn.com. 200 Funds took part in the
survey).
They reveal some unsettling attitudes towards property investing. A couple
of questions in particular are highly relevant to our discussion here.
Firstly, they asked investors how comfortable they were at extrapolating
past returns into the future across a wide range of assets. Investors were
most relaxed about extrapolating fixed income returns into the future, then
came equity and then real estate. Bubbles of belief (see Global Equity
Strategy, 12 January 2004 for a discussion on the taxonomy of bubbles) tend
to be characterised by investors extrapolating past returns into the future,
so the prevalence of professional investors willing to do precisely that is
disturbing.
The second question of relevance to us is the percentage of investors who
think that a crash is either 'not at all likely' or 'not too likely'. As the
chart below shows, investors still have tremendous faith in fixed income
with nearly 65% believing a crash is unlikely. 50% think a crash in real
estate is unlikely, and 30% think a crash in equities is unlikely. The high
percentage of those who think a crash in real estate is unlikely is
surprising given the immense amount of press coverage that housing market
seems to be generating!
The final question of use to us in the current context is an examination of
the top factors influencing real estate allocation decisions. The top three
factors citied were "statistical estimates of risk and return", "long-term
historical performance" and "advice from external consultants". So these
investors are essentially extrapolating the past on the basis of advice from
the guys who told them to be 80% in equities during the dot com years - well
that is alright then!
The final characteristic of a bubble is people buying simply because prices
are going up (the greater fool element). According to the National
Association of Realtors, 23% of all home purchased in 2004 were for
investment, while another 13% were vacation homes! They also found that 92%
of all second homebuyers saw their property as a good investment. 38% said
it was very likely they'd purchase another home within two years!
A simple but worrying proxy for speculative buying in the housing market can
be found by looking at the number of new houses that have been sold but are
not yet under construction. This category now accounts for 40% of all new
home sales!
Surely this evidence amounts to a prima facie case that the US housing
market is undergoing a bubble. The bulls rely on arguments on immigration
and demographics to support their views. But with a home ownership rate of
70% these amount to little more than betting that prices will keep rising.
Of course, bubbles can and do run for longer than everyone expects them to
do. But the US housing market is looking increasingly vulnerable to any
change in 'fundamentals' (interest rates and unemployment) or sentiment.
Conclusion
I hope you enjoyed Montier's critique of the US housing market.
Your wishing we had a bubble in Texas real estate analyst,
John Mauldin
JohnMauldin@InvestorsInsight.com
www.2000wave.com
July 4, 2005
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