Friday, April 08, 2005

The house built on sand.

I recently read an article, which, I'm afraid to say, was in an actual magazine, so I can't link to it (curse these darn analog formats). In this article, the author stated that one was "better off buying than renting, because when you buy, you're funding your own investment, not someone else's." I had difficulty restraining my incompetence-seeking fist o' death. What did the author think was happening to all the interest paid on the mortgage? Did it evaporate? Was it thrown to the wolves? Whose money did they borrow to get the mortgage? Was it not "someone else's investment"? The things that people can publish in relatively reputable magazines astounds me. You would think that they author would have heard of Fannie Mae, Freddie Mac, and the wonderful things called Mortgage-Back Securities.


But I digress. Here is why I think we are experiencing a housing bubble, and why it will pop, rather than deflate. This is going to be dull. Art, theater, english, and literature majors: you have been warned.

First, what is a bubble? A bubble occurs when investors confuse prices with productivity. A price is how much someone is willing to pay; productivity is how much of a good it actually creates. Thus a simple, reliable car produces the good of transportation. A fancy roadster, while it may produce some intangibles such as sex appeal, produces very little more--you don't get much more transportation value. However, the price people are willing to pay rises dramatically with those intangibles. If investors start piling into the roadster market, prices will go up and excellent returns will be realized, causing more people to enter the market, causing prices to go still higher, and so on. However, when investors realize that the return on investment is coming solely from people purchasing intangibles, rather than from the actual productive output, the bubble bursts. In the grand-daddy of them all, the Dutch Tulip Bubble, people were paying astonishing prices for all things tulip, because they were "sure" they'd get their money back as prices kept rising. When people realized that they were trading away their livelihoods for glorified weeds, the bubble burst.

Second, what makes this a bubble? Houses are often misunderstood because they function both as usage and capital investments. One can buy a house and rent it out, but one can also buy a house and live in it, thereby reaping as a profit the money that would otherwise go to a landlord. Thus the value of a house is directly linked to the amount of money either earned by renting it or saved by living in it. We would thus expect that owning a house should be only marginally less expensive than renting (the difference being the profit the landlord takes from their investment). Since house prices are, the nation over, advancing by leaps and bounds above the historical rate for rents, we definitely have a bubble. If it is not a bubble, then houses have been significantly undervalued for most of history, which seems unlikely.

Third, why will this bubble pop? Some argue that, because houses are major investments, people will not sell them when prices begin to fall, rather, they'll hold them off the market until they can get a decent return. In short, they'll become speculators. There is one difference, however. Most speculators purchase the goods in which they are speculating straight out. Homebuyers purchase their homes on the margin; they purchase them with borrowed money. They are therefore subject to fluctuating interest rates, particularly with this latest round, due to ARMS, interest-only mortgages, 100+% mortgages, etc. People have stretched their financial resources to the limits to buy the biggest, best, tulips, er, houses they can afford. Thus when interest rates climb and stretched finances mean people can no longer afford the mortgages on the houses they "own", they will be forced to place their houses on the market. (And, as Noumenon pointed out to me, we have a brand new bankruptcy bill for just such an occasion.) They will become price-takers, accepting what they're offered, since they can't hold out for more. Thus the bubble will burst.

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