U.S. house prices have risen for the past year, provoking calls that the market has stabilised; But American investment broker Peter Schiff – the famous ‘Dr Doom’ who accurately predicted the 2007 crisis – says the correction is temporary and he predicts big falls to come as the U.S. economy stagnates and interest rates rise.
In retrospect, the 2007 U.S. housing crash looks like the inevitable consequence of an overinflated price bubble, but it is easy to be wise after the event. Few economists predicted the crash at the time and these ‘lone wolves’ were usually dismissed as cranks.
Investment broker Peter D. Schiff was one of the most strident voices back in 2006, predicting that the bubble would burst. On December 31, 2006 in a debate on Fox News, Schiff said: “what’s going to happen in 2007 is that real estate prices are going to come crashing back down to Earth”.
Journalists mocked Schiff by nicknaming him “Dr Doom”, but a later article in BusinessWeek said Schiff was one of very few analysts to accurately predict the financial crisis of 2007-2010.
Now, Dr Doom is at it again. Schiff, whose most recent book is The Real Crash: America’s Coming Bankruptcy, confidently asserts that the much-heralded recovery in the U.S. housing market is a temporary phenomenon.
“This is just the first correction up in the bear market,” he said. “It succours people in and they think there’s a bottom, like all bear markets. But it will turn around because the economy will be weaker than people think, the unemployment rate will start to kick back up and interest rates will rise so mortgage rates will go higher.”
Schiff said it would take years before U.S. house prices bottomed out. He pointed to the example of Japan, where the housing bubble burst in 1991 and it took 14 years for prices to fall 70 percent to reach their lowest point.
“The U.S. economy is in decline. We are using the least amount of gasoline in 16 years because lots of people don’t have jobs so they are not driving to work. We have 47.7 million people collecting food stamps. The economy is downsizing and people are moving in with friends, parents and children. That’s not good news for the market for single family homes.
“I don’t think we’ve hit the bottom. We need to flush the market out and get rid of all the foreclosures and all the people in negative equity before the market can bottom out. How can we do that? They default, or move out, and their loans are restructured. You can’t have a sustained recovery in the housing market when so many people are upside down in their houses.”
Yet, just like back in 2006, Schiff’s view is a marginal one and optimism is returning to the U.S. housing market. All the figures point to a recovery. In December, U.S. house prices rose for a 10th consecutive month on a year-on-year basis. The U.S. CoreLogic home price index rose 0.4 per cent from the previous month and has added 8.3 per cent compared with a year earlier. Some 46 of 50 U.S. states registered gains in 2012. The biggest increases were in Arizona (up 20.2 per cent), Nevada (15.3 per cent), Idaho (14.6 per cent), California (12.6 per cent) and Hawaii (12.5 per cent).
Other indicators confirm the CoreLogic data. The S&P/Case-Shiller home price indices, which monitor 20 U.S. cities, showed prices up 5.5 per cent between November 2011 and November 2012. Meanwhile, the National Association of Realtors said home sales in December were up 12.8 per cent from a year earlier, with the total number of sales in 2012 rising to the highest level in five years.
Schiff says, however, that the recovery is an illusion. The U.S. Government is up to its old trick of artificially inflating the housing bubble, Schiff claims, the same strategy that led to the housing collapse in the first place.
“The problem was not that prices were falling. That’s the solution. The problem is that they went up in the first place and got to a level that was too high and still is.
“Prices are too high so most Americans can’t buy a house unless there’s a Government subsidy involved. Instead of reflating the bubble, we need to let real estate prices find a natural level. The natural level is when people can afford houses without help from the U.S. Government. People don’t need help to buy TVs, cellphones or cars. Why for houses? Because the price is too high! So let it come down.”
A Government-Mandated Housing Bubble?
Historically, the U.S. Government played a major role in blowing up the bubble in the first place. U.S. Presidents from Carter to Bush Jr. wanted to expand home ownership so they mandated government-sponsored enterprises, such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), to cover the risks of loans to people who would otherwise be ineligible.
According to a 2010 World Bank report, Freddie and Fannie bought 47 per cent of these toxic sub-prime mortgages. Harvard financial historian Niall Ferguson has estimated that between 1980 and 2007 the amount of government-backed mortgages increased from US$200 million to US$4 trillion. The U.S. Government actually forced banks to provide these loans.
Government meddling in the housing market is still ongoing. Not only are Freddie and Fannie still on the scene, but the Federal Reserve is playing a major role in attempting to reflate the housing bubble. The Fed has kept interest rates at close to zero for several years, to keep borrowing rates low. Recently interest rates were left unchanged at below 0.25 per cent.
As a result, super-low average mortgage rates of around 3.53 per cent on a 30-year mortgage allow buyers to purchase houses that are 50 per cent more expensive than they could have bought under average mortgage rates over the past 20 years.
The Federal Housing Administration (FHA) has also become a much more significant force in the U.S. housing market. After the sub-prime crisis, with Fannie Mae and Freddie Mac tightening up their criteria, the FHA faced a glut of mortgage financing. The share of home purchases financed with FHA mortgages went from 2 per cent before the crisis to over one third today. The FHA’s annual audit shows it doesn’t have enough in reserve to cover expected losses, leading to a US$16.3 billion net worth deficit.
Professor Robert Hardaway, of Sturm College of Law, has authored an acclaimed book about the housing crisis, The Great American Housing Bubble: The Road to Collapse. Hardaway says that the Government had not yet learned its lesson.
“They want to get the bubble going again. They see it as the short-term solution to the economy, but it’s like treating a fever by throwing a sick person in a tub of cold water. It’s based on the idea that if people feel they have more money in equity, they will spend more and get the economy going. But that’s the same mistake as before,” he said.
Hardaway said the inexorable rise of house prices between 1950 and 2007 had created the illusion that real estate was a sure-fire investment. Over that long stretch of time, there was no two-year period when prices went down. Government subsidies encouraged the price inflation.
“People started to think of their houses as personal piggy banks. They thought their houses were worth more than they paid for them and that fuelled the economy because people felt richer. But, ultimately, it’s really bad for the economy for the Government to foster the notion that houses are piggy banks. If we didn’t have government subsidies, we wouldn’t have the bubble and prices would be affordable,” Hardaway said.
A Losing Bet?
Another major influence on the temporary resurgence of house prices is the influx of investors buying up homes on a massive scale. Hedge funds and private equity firms have been buying companies and assets in every part of the housing supply chain, including undeveloped land, homebuilders, foreclosed homes, and building parts manufacturers.
One of the biggest players is the hedge fund manager John Paulson, best known for his lucrative bets against subprime mortgages in 2006 and 2007. Over the past couple of years, Paulson & Co has bought up enough land in California, Arizona and Nevada to build up to 25,000 homes and is aggressively scouting for more.
Private equity firms are also getting in on the act. Global investment firm Blackstone (BX), for example, has spent more than US$2.7 billion on 17,000 homes to manage as rentals and is now the country’s largest investor in single-family homes to manage as rentals. Others, such as Colony Capital LLC and Two Harbors Investment Corp. (SBY), are also trying to turn this market into a new institutional asset class.
Hardaway says the financial investors have been forced into betting on the housing market by a lack of other options.
“Where else can they invest? If you invest a million dollars in Treasury Bills (T-Bills) right now, your monthly income is US$65 a month. Lots of people can’t live on that. In 1983, when interest rates were 16 per cent, you could have expected an income of US$160,000 a year. So investors say why put it into T-Bills?
“Well, how about stocks? Well, they got burned so badly back in 2007-8 when they dropped by 50 per cent, they don’t want to risk that. So how about long-term Government bonds? They pay a little more at 2-3 per cent, but when interest rates rise - and everyone knows they will - you lose your principal almost as drastically as if stocks start to tank.
“So now what do with your money? The only thing you can do is put it into real estate as all know the Government is trying to create another bubble.”
Schiff believes the private equity funds and hedge funds have placed a losing bet. He says they will soon be forced to offload thousands of properties, which will provoke another slump in the housing market.
“There will be a glut of rental homes in big cities and this will force down the price of rents. It’s already a small market as most families prefer to rent smaller, cheaper apartments. The investors will have calculated that they can get, say, US$4,000 a month, but they get what they expect. As a landlord you have short-term financing, so rising interest rates will squeeze you and property taxes and maintenance taxes will go up. So, the investors will want to offload the houses.
“Meanwhile, if you are a potential buyer and you think that a mortgage would cost US$6,000 a month, but you can rent for US$2,500, you’ll choose to rent unless house prices go down. So, now, all of a sudden, the glut of rental properties will cause real estate prices to fall.
“The whole market is going to blow up. You’ve got speculative money coming in bottom-picking the market. At the same time, you have a shadow inventory of homes out there where the owner is upside down in the mortgage and they still owe a lot more than it’s worth.”
The psychology of the market mitigates against the Government’s attempts to reflate the housing bubble.
“The mindset between 2001 and 2006 was that you couldn’t lose in real estate and that helped inflate the bubble, but that psychology doesn’t exist any longer, which is a good thing,” Schiff noted.
Related: Bubble Economy
According to Schiff, the Government’s fear of falling house prices is misplaced. Millions of home-owners plunged into massive amounts of negative equity would actually be better off, he insists.
“If you’re living in a house that’s worth US$300,000 and the mortgage is US$350,000, even if it goes up by 10 per cent you’re still under water and the banks will refuse to negotiate. Prices are still so high you can’t afford another one.
“But if real estate prices drop by 50 per cent, – so now it’s worth US$150,000 on a mortgage of US$300,000, it’s better for you. When you’re under water by that much money, you can say to the bank ‘look, no one will pay this mortgage and if I move out and you try to sell it, this is all you’re going to get, so here’s the deal, write me a new mortgage, forgive what I owe, reduce the principal’.
“Banks might have to do it and even if you leave and walk away and buy another house, if it costs US$100,000, it’s a lot easier to save the US$20,000 deposit. So, falling real estate prices will hurt lenders and people who own their houses outright with no mortgage, but from the perspective of negotiating with the lender, or walking away and buying a different property, buyers want prices as low as possible.”
By David Smith, EconomyWatch.com
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