Recent bursts in property appreciation suggest to some observers that we are in a housing bubble. A bubble is a marked price increase fueled partly by expectations that prices will continue to rise. Once that expectation comes into serious question, the bubble bursts, and prices drop sharply.
In writing about this question last year, I pointed out that house markets are much less vulnerable to bubbles than financial markets because the cost of buying houses in order to resell them is very high. Costs include sales commissions on the purchase and sale, and the costs of carrying the property until the sale.
But I may have overstated the case. Steep price increases and the expectation of more to come can overcome sales commissions and carrying costs, and there is evidence that this is happening in some markets. One of these is southwest Florida, from where I have recently received many letters.
One letter points out that on new construction, it is possible to speculate on a price increase without incurring any transaction costs at all, and without even having to qualify for a loan!
“Here is how it works. Borrower A puts down a $10,000 deposit to reserve a condo unit at $300,000…. 12 months later, with two months to go before completion, Borrower A sells his reservation to Borrower B for $450,000. Borrower B gets a loan and purchases the condo, with Borrower A shown on the closing documents as a lien holder. Borrower A never has to qualify and walks away with $150,000 on a $10,000 deposit…”
This letter came from a lender who sells the loans he originates to one of the government-sponsored secondary market agencies, Fannie Mae and Freddie Mac. The question he had for me was whether they would accept a house value of $450,000?
This is a good question, since lenders and those who buy loans from lenders face increased risk in areas experiencing price bubbles. Because the risk of a future collapse in prices is high, it would be rational for them to tighten their lending policies.
But Fannie Mae and Freddie Mac would allow the $450,000 valuation without any change in their underwriting requirements. Setting different requirements for different areas would be discriminatory and possibly illegal.
Competition for loans in the face of a shrinking refinance market can also overwhelm any effort to tighten lending terms, as suggested by the following letter from southwest Florida.
“I’m a mortgage broker and the Realtors in this area won’t give me the time of day because my terms are not competitive. I need 5 percent investment loans and the best I can offer is 10 percent…Do you know a lender who can help me be competitive?”
An investment loan is one where the house buyer intends to rent the house or sell it, rather than live in it. Investment loans have always been viewed as more risky than loans to occupants, and they are especially risky in house bubbles. Yet here we have a broker who is distraught because his lenders require 10 percent down on investment loans while his competitors have access to 5 percent loans. Housing bubbles can go a long way on 5 percent investment loans.
The prime driver of bubbles, of course, is speculative buyers looking for price appreciation. Our system provides an array of mortgage choices for them, including the so-called option ARM. This is an adjustable-rate mortgage designed to maximize a borrower’s buying power by providing exceptionally low payments in the early years. It is the instrument of choice of the buyer from southwest Florida who sent me the following letter.
“Looking for advice on financing a $500,000 home that I know will appreciate to $700,000 in 3-4 years, or an $800,000 estate that will appreciate to $1.2 million…This will be a second home, I will flip it in 3-4 years…I’m leaning toward an option ARM that will calculate my starting monthly payment at 2 percent, with only 7.5 percent increases the first 5 years…”
This buyer is convinced his property will appreciate markedly, so he stretches his buying power to the limit. He figures the more expensive the house he buys, the more money he makes. This is the mindset of a housing bubble buyer.
The loan balance on the option ARM rises in the early years but this doesn’t discourage him because he expects much larger increases in property value. This ARM is also vulnerable to a sizeable increase in the payment after five years, but that doesn’t matter either; he expects to be long gone by then.
When prices collapse, such buyers will have a rude awakening. The lenders and investors financing the bubble will share their misery.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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