Wednesday, February 27, 2008

Housing Crisis Will Get Worse, Much Worse

Home prices in certain cities like L.A. and Miami have dropped quite a bit recently, but I believe that the pain has only begun. When it is all said and done, home prices in these two cities may drop by as much as 41% and 44% respectively. This will financially destroy thousands upon thousands of people.

I don’t usually buy into hysteria, but I think that the data and the logic are there. Also, let me caution those that live outside of the West Coast, Arizona, Las Vegas, Florida, and the urban Northeast. I have found virtually no evidence that any bubble exists at all for you. To explain this bubble, let me start with a little background.

How did the housing bubble happen?

The housing bubble happened for three reasons:

1) The federal reserve has been lowering interest rates for 25 years now and those interest rates trickle down into the mortgage rates. The lower the interest rates, the more house we can all afford. The more house we all can afford, the higher home prices will go.
2) Subprime, no down payments, and adjustable rate mortgages allowed people in high cost cities to overextend themselves. Companies relied on default rates to price the interest rates on these loans. These default rates were masked by continually rising home prices. That is, fewer people walk away from a mortgage when they have rapidly rising equity in their home. They sell quickly instead of foreclosing.
3) Smart Growth urban planning restricted the supply of houses and drove up prices. A number of economists believe along with a gentleman named Wendall Cox who I was privy to hear speak on Feb. 26, believe that smart growth planning has been the largest contributing factor to the home price spike in many cities around the U.S. Smart Growth limits the supply of new houses and condos, and in a popular city that will lead prices to soar.

Why has the bubble burst?

The bubble busted in three different waves, and I think a third fourth is coming. The first wave came when the amount of capital (or money) needed to maintain this upward climb simply started to run out. There is a limit to the amount of resources we put into real estate. Eventually we have to start thinking about other priorities. The second and third waves came with the nature of mortgage lending. Adjustable Rate Mortgage rates suddenly jumped and many people, especially those who intended to flip a house with an ARM, could no longer afford their mortgage and had to default. Those with other exotic loans who could no longer afford them had to default as well because home prices were no longer rising fast enough to avoid foreclosure. The fourth wave is coming, and I will talk about it later.

How did you calculate this?

According to the S&P/ Case Shiller home price index which measures home prices in 20 large metropolitan areas throughtout the U.S., home prices in LA have already dropped almost 15%. In Miami, Phoenix, San Diego, and Tampa the price drops are even more shocking at 18.9%, 17.5%, 17.5% and 15.9% respectively. So, it may be surprising to hear that I believe that prices will continue to fall much further.

First, I looked at the stock market bubbles in the S&P and the NASDAQ in and around 1999. When I graphed the data, I was a little surprised to see that there seemed to be a modest growth trend for many years and then suddenly a sharp upward turn, hitting a peek, and then a sharp slide back to down to where that growth rate pointed before the bubble. It was true for the S&P and the NASDAQ.

I graphed the historical data available for the S&P/Case Shiller home price index as well. It appeared that, so far, home prices in many of these “bubble” markets looked almost exactly like the S&P and NASDAQ bubbles. I then calculated the home price growth rate between 1987 and 2002 (before the bubble). I then projected that growth rate out to Jan. 2008 to see what the home price “should be”. This is what the projection portends for certain markets:

Miami -32%
Los Angeles -31%
Tampa - FL -28%
Las Vegas -28%
Washington -24%

These drops are in addition to the drops that have already occurred.

It won’t be that bad will it?

I have seen several articles claim that home prices won’t fall dramatically, that there will be a “soft-landing”. They claim that as prices fall many people just won’t try to sell their houses. When fewer people try to sell their houses, the supply of homes for sale drops which causes buyers to compete for the remaining supply.

Hopefully, this is true, but I suspect that it will not be enough. Earlier I mentioned how many economists believe that smart growth urban planning have limited the supply of housing which has driven home prices sky high. This is only part of the economic story.

Not only has supply of homes been limited, but the supply curve has become more inelastic. In laymen’s terms, this means that even small changes in demand lead to big price swings. The very nature of the market that lead to rapid price spikes, like when homes in Pheonix and Las Vegas shot up by over 40% in a single year, can lead to rapid price drops.

The other thing working against this “soft-landing” theory are the number of foreclosures. Many people can pull their homes off of the market, but the hoards of foreclosures will limit the ability of the market to absorb all of the homes for sale.

What about this "fourth wave"?

There are two components to the fourth wave. Most of the focus on mortgage borrowing is on initial mortgages, but there are also millions of Americans who have borrowed from their home equity. These people are at risk of foreclosure if prices plummet and they get into a situation where they have to sell their home, like extended unemployment.

The unemployment picture in many states most affected by the housing bubble is growing dramatically worse.

California Unemployment 9 months ago 4.8% Today 6.1%
Nevada 9 months ago 4.3% Today 5.8%
Arizona 3 months ago 3.3% Today 4.7%
Florida 9 months ago 3.3% Today 4.7%

Compared to states where the bubble never hit:

Texas Unemployment 9 months ago 4.3% Today 4.5%
North Carolina 9 months ago 4.5% Today 5.0%

What can we do?

My concern for the next few years is that the housing bubble will be solely blamed on reckless mortgage companies, and not on smart growth urban planning. If smart growth does not get the blame, this cycle will repeat in just a few years. Excessive urban planning is the main reason why prices have soared and plunged.

And, of course, don’t buy houses in any of these bubble markets.

Friday, February 22, 2008

Down on the Border

I had another letter-to-the-editor printed in the Houston Chronicle. The text of it is here –

Mexican President Felipe Calderon's recent decision to begin talking about partially privatizing Pemex provides an enormous opportunity for the United States to achieve progress on immigration and oil dependence. Calderon faces an uphill battle in the fight to allow foreign investment that could, coincidentally, help the United States secure more oil from a stable democratic government. We should help push this legislation over the top by offering a bilateral agreement in which we exchange a larger allocation of work visas or citizenships. This is a unique opportunity to get something more in return for opening our borders to immigrants from Mexico. More secure oil, more jobs for Houston companies and a reasonable compromise to face the realities of immigration.

If you recall, this relates back to my position I stated back in October of last year that part of the solution to immigration is to engage Mexico on a path to economic growth.

Wednesday, February 13, 2008

Why the Free Market II

From the feedback I got, it seems that I was convincing on why not the controllers, but did not explain much in favor of the free market.

As I have stated before, we are the Free Market. It is the sum of all the individual decisions made by each person in society. We also need to be aware that not everyone who says they are in favor of the Free Market understands what they are saying. To merely reject Soviet Communism does not make one a believer in the free market. There are many on the political left who embrace some concepts of the Free Market, but they reject other parts of it and believe in broad limitations to it. Rejecting the truly free market does not make someone a Communist or a Socialist, but it does mean that you believe in control on some level. As I said last week, the Free Market is a rejection of control.

We usually think of the economy in terms of money, but this is the wrong perspective. If we were stuck on a deserted island, a briefcase full of money is worth no more than toilet paper. The real measure of the economy is the amount of goods and services we are able to produce. This is why economists talk about the Gross Domestic Product (or GDP). It is a measure of all the goods and services produced within the United States.

Our economy can grow in three ways.

1) Invention of a new product or service
2) Perfecting an existing product or process of making existing products
3) Discovering a new resource such as new oil deposits, new foods, new water supplies…

The free market is the best at achieving these three things.

Invention – Many dream of that one brilliant idea with which they can make their fortune. If that fortune did not exist, we would spend less time dreaming about new inventions. If we spend less time thinking about invention, fewer things will be invented. Kids dream of flying through the air like a bird, but the laws of physics eventually put this dream to rest. However, many adults still dream about inventions because nothing prevents the hope of making our fortune. We see a little craft we could make, a book we could write, a store we could open, or any of a million other possibilities. It would not just be fun to try; it is that we could make money too.

It is not that no one in other economic systems invents; it is that the reward is less so they think about it less. I showed evidence recently how countries with socialized medicine invent fewer medical breakthroughs. It is because they limit the rewards. No system rewards invention more than the free market.

Perfecting - We all do this every day. When we are at work or home, we figure out time and effort saving techniques. It can range from learning a short cut key in Microsoft’s Excel to a hip bump to shut a drawer. The primary way that we increase the economy, is to figure out how to produce more with the same amount of resources, or to produce the same using fewer resources. Our resources are our time, our labor, and the physical like wood and steel.

In a free market system, employers bidding for your services offer you wages and you take the best offer. If you are consistently discovering better ways to get more with less, employers will value that skill and reward you with higher wages. Sometimes people find new ways of doing things that offer a reward so large they leave their old job to start their own business. The phrase, “I could do it for half that price” has launched thousands and thousands of businesses.

However, the controllers often think that wages do not match their ideas of “fair”, so they try to set wages arbitrarily by a committee or law using some arcane formula. Teachers and government workers suffer under this practice and have less reward for perfecting resource saving techniques. No system gives as large an incentive to work on perfecting production of goods and services than the free market.

Discovery – Heroic figures fill the pages of American history taking enormous risks to make their fortune by setting out into the wilderness. Settlers went west in search of new land to farm. Miners rushed out to the Rockies in search of gold and silver. Wildcatters in Texas would bet their life savings to find oil. All of these people took huge risks to find new resources because the potential for reward was huge. Today we have people on the left who complain about “excess” profits and they want to take that reward away. If there is less reward, there is less incentive for discovery. No system gives as large an incentive to expand discovery as the free market.

The free market creates the largest incentives for invention, perfection, and discovery. Bigger incentives beget bigger ideas. No other system can match the growth of ideas and the growth of production than the free market. The more we embrace it the smarter and wealthier we will all become.

Friday, February 8, 2008

Why the Free Market

There are two choices on how to run a society. Either you try to control other people’s lives or you don’t. Choosing a free market is choosing not to control the economic affairs of others. The free market relies on few rules to control only those behaviors that cause real harm to your body or your property.

The rejoinder to this argument is that sometimes society needs to be planned. The free choices of individuals do not end up creating the society that we want. Therefore, we vote to correct the poor decisions that individuals make.

The glaring problem is who decides the society that we want. In a Democracy, the majority decides for the minority. In Venezuela, they have voted to allow Chavez to take property from the voting minority and shut down news organizations that disagree with him. In Russia, they vote for leaders who routinely take away rights and freedoms.

There have always been people like Hugo Chavez. They have convinced themselves that destiny has chosen them out of the ether to bring heaven down to Earth. They dream of utopia and work to build a Tower of Babel, vainly believing that control is the pathway to paradise.

For every tyrant who darkens the earth, there are a million others casting the shadow of their will over the choices of others around them. It can be a city councilman, a neighborhood association member, even a parent using their position to needlessly control others. It is one of the frailties of humanity to see things we don’t like and to blame everyone but ourselves. It is through hubris, a lack of humility, that we conceive that we are smarter and wiser than others we know. We think we have all the answers when we mostly don’t have a clue.

There are many times I see a vacant lot and think, “They should build a restaurant there, or a bank, or a hotel.” Should they really? I really have no idea whether it would be worthwhile for any of those things to be built. Usually, it is what I want, not what is best. I see a bad movie and think, “I could make a better movie than that!” Could I? I’ve never been to film school. I’ve never published even a short story. Isn’t it arrogant to think that I would be better than someone who has spent a lifetime in the film industry?

The world is a very complicated place, and in our heads, we hold a tiny fraction of the information needed to run it. It is ridiculous for me to think that I could do your job or your life better than you. How much more ridiculous is it then for me to look at a company or even a whole industry and think that I personally have enough information to set them straight. Unfortunately, this truth hasn’t stopped many from trying.

Throughout the centuries, they have worn different labels and excuses to exert control. Kings of Europe claimed divine right, and more ancient rulers claimed that Oracles and astrological events called them.

Amongst today’s most arrogant are the Socialists. They believe that a handful of people can fix every aspect of our economy by taking control. They believe that we as a people are collectively incompetent to run our affairs. Their utopia requires us to yield our feeble minds to their soaring intellects. Most people equate socialism with atheism, but this is not true. The Socialist must believe in a god, because when he wakes in the morning he sees the Almighty staring back in the mirror.

These controllers come in every stripe and color, but inside they are all the same. They have a dream and they want to force the rest of us to be a part of it. They mob around a new idea of utopia, dismissing defenders of individual freedom like me as out of touch. They lob their invective at the mention of consequences to their plans. I am the grinch, the thieving rich, the tree-killer, and the hard-hearted. It is vivid vitriol to silence dissent.

All of the plans of controllers are the same. They start with “Wouldn’t it be great if…” and end with terror or taxes to prod us to toe the line. Not all are so nightmarish as Nazi Germany or the Khmer Rouge of Cambodia. Many are like the annoyance of a hyper PTA president asking for ridiculously elaborate costumes for the annual play. They are all forms of control, and require your submission.

In our economy today, we see them hard at work to firm their grip. They try to run our health care, run our schools, run our retirement, and run the mail. They want to plan every building in our cities, plan every pill we take, and plan the weather 100 years from now. As Robert Burns would say, “The best-laid plans of mice and men often go awry.” We observe that they have failed our health, failed or schools, failed our cities, and fail our economy.

Belief in the free market is a rejection of control. The free market does not judge that one man’s dream is more valid than another, as long as you behave peacefully towards each other. It is a belief that no individual or group rises even to the level of tolerable incompetence at planning our society. Regardless of whether your name is followed by PhD or GED there is no difference, no one is smart enough to be in control.

The role of government is to allow your choices to find your dreams, not my control to fund my whims.

As always, tell me what you think.