Housing with other people's money
The Coming Crash in the Housing Market,
by John R. Talbott
McGraw Hill, 2003, 195 pages.
Reviewed by Frank Conte

In the current economic climate, it is rather difficult to argue that real estate is not a very good, low-risk investment. The rush to “bricks and mortar” and the run-up in housing prices in the wake of the Internet stock crash is a natural, risk-averse response to the uncertainty of the new economy.

After the wild Wall Street gyrations, the value of a home is now preferable to ambiguity of outrageous valuations of high tech stocks that have now vaporized into the cybersphere. A house may not appreciate in value over Internet time exponentially like Microsoft, Intel or Ebay. But in the end there is always the roof over one’s head. Unlike the stock market, a home is the old comfortable shoe. And with good reason-- in no year during the last 34 did housing prices decline year to year.

This phenomenon of increasing housing values -- even through the most recent recession -- provides the overall economy with a much-needed psychological anchor. Since January 2000, housing prices have soared even when consumer confidence and the stock market plummeted. Consumers may be worried about their jobs and the future but one wouldn’t be able to discern this apparent contradiction by walking up the busy aisles of the local Home Depot on a Sunday morning. The home is where the heart is.

Most observers are sanguine about the rosy scenario on the housing front, identifying the sector as one of the economy’s great strengths thanks to the major boom in housing refinancing.

John Talbott, an enterprising consultant and visiting scholar at UCLA buys very little of this conventional wisdom. A former investment banker, Talbott believes a housing market crash is inevitable and will be far worse than the savings and loan crisis of the 1980s. If there’s a housing crash, he writes, “the ramifications could be so severe that it not unrealistic to think that such an event could trigger a worldwide depression as the credibility of all banks and investment companies would be threatened.”

Were it not for his extensive detailed research and the force of his argument, Talbott might be dismissed as yet another doomsayer who might find his new book quickly in remainder bins. Given the fragile nature of the housing market, it is a surprise no one has written such a book earlier.

Housing prices pose a problem because of a number of factors. Since 1968, the price of an average home has increased by 70%. Some of this increase can be explained by the demand for larger homes and even the demand for tax avoidance in the form of the vaunted home mortgage deduction. But as Talbott shows, the real value of the home mortgage deduction has declined remarkably in part because of inflation. (Inflationary periods make the tax deduction particularly valuable but we’ve experienced very little in recent years.) By his count only 10 percent of the price of the home is due to this tax advantage.

That leaves low interest rates as the major reason for the dramatic increases in housing. Low interest rates clearly distort the market. Feeling they can no longer sit on the sidelines, prospective homeowners are lured into higher prices because “banks and other lending institutions are giving people more and more money to transact house purchases.” But, is getting people to realize their American dream not a good thing?

Not at the aggressive rate we’ve seen in the last few years says Talbott. That’s because the average owner-occupied residential household has approximately $80,000 in debt compared to renters who carry only $22,000 in debt. Rather than fueling growth in the economy, recent refinancings have allowed homeowners to run up their debt to 90 percent of their home’s market value. If, as a society, we were truly wealthy, we would not find ourselves spending so much on a basic necessity such as shelter says Talbott. Nor would foreclosures be on the rise. “The really shocking news is that foreclosures would be increasing at all, given that home prices are increasing in value at the fastest pace in history.” Since 2000, foreclosure rates have increased 25 percent. It can get worse should the economy stagnate and home prices ever decline. With debt ratios exceeding 10 to 1, housing prices need not decline that much for one’s investment to be “underwater.” A 20 percent decline in the average home price would bankrupt many Americans. Such devalued homes would be difficult to turn over in a down market, preventing people from moving and accepting better jobs elsewhere and creating a drag on the economy.

How can this happen in the most robust housing market? Talbot blames just about everyone in the housing market including poorly informed homebuyers, realtors, bankers and regulators. And with good reason.

To Talbot the housing market is not a “true” market. Market exchange requires that (1) buyers and sellers enter into contracts voluntarily; (2) that exchanges be at arm’s length, and (3) that the benefits and costs of any transactions must accrue to the buyer and seller not a third party. While the housing market satisfies the first it fails on the last two. Mortgage bankers have a vested interest in higher priced appraisals; appraisers fail to provide independent judgments about the historical price, rather than the market price, which is endemically exaggerated. Banker to homeowner: “If you want to borrow $240,000 you better have a $300,000 house, and I know just the appraiser to make sure you do.”

Talbott’s criticism of the interlocking relationship may be overly cynical. But what is not debatable in the current environment is the extent of the U.S. government’s implied guarantees for the two major mortgage lenders Fannie Mae and Freddie Mac, two quasi-governmental corporations that were “privatized.” However, unlike true private enterprise, the FMs, Fannie Mae and Freddie Mac upon their transition from “public” to “private” retained important advantages such as exemptions from filing Securities and Exchange reports and paying state and local taxes. Both can also borrow at roughly the same preferred rate as the federal government, creating a subsidy of $6.5 billion according to the Congressional Budget Office. This is small change compared to the $3 trillion in mortgages they currently hold and the implied government guarantee.

This would not be news if the FMs were staid old public utilities. But in fact the FMs are doing riskier things everyday that jeopardize the economy, including the aggressive pursuit of sub-prime lending business. They also provide dubious stock options to their executives who aggressively seek to prop up the FMs stock prices. The moral hazard is pretty clear. As Talbott notes, “No matter how badly they run their business, their financing costs do not change, thanks to the federal government’s implied guarantee.”

In the final analysis, the FMs are playing dangerously with other people’s money. This loose money not only allows housing prices to increase wildly but places the entire economy at risk. Recently reformers have moved to bring both FMs under the authority of the U.S. Treasury. Whether that’s enough remains to be seen.

In the meantime, one solution would be to privatize the FMs and expose their risk to the discipline of the market. But Talbott says that’s not politically expedient, given the well-protected relationship executives at FMs have with Congress. Another solution calls for requiring prospective homeowners to make at least a 10% down payment. This would assure that people pay attention to prices and constrain excessive borrowing.
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