-By Dan Scott
This is the second time since 1987 that the country faced the consequences of a housing bubble. Both times, home builders, local governments, speculators, lending institutions, and home owners were at the center of the problem. It seems like the Bush Administration’s response to is a bureaucratic fix to systemic problem leaving us with uncertain outcomes the next time around. Trust me, there will be a third housing bubble in the future as long as all the actors in this drama are not held accountable for their part. The failure to hold people accountable means a guarantee that they will act in the same way again given the opportunity in the future.
So who are the actors in this drama and what part did they play? Home builders, local government, speculators, mortgage lenders and home owners. Let’s examine each actor starting with home builders. The home builders naturally wanting to turn a profit by building homes in the most efficient and profitable means use economies of scale and thus propose developments or tracts of houses to ensure a steady stream of income. The benefits of a planned community certainly are good for the consumer in that groups of new houses support each other’s value and bring the overall housing stock more into line with the current building codes, safety and energy efficiency. The problem occurs when builders ignore the housing market trends and flood the market with so many new homes that sales of existing and new homes suffer. The first response of a builder to a softening housing market is not to build less houses but give larger discounts in order to keep up the sales volume. They engage in price cutting since the time horizon they are looking at discounts the long term housing inventory because they are so invested in the fallacy that extrapolation is prediction. The extrapolation fallacy always occurs when someone refuses to consider that factors outside of their control will change and that all things are not equal forever. How do you tell the operator of a well oiled machine they are doing everything right but their efforts are becoming self defeating? The market forces act to curb this fallacy with the cold dose of dropping sales. However, the home builder is not alone in this extrapolation fallacy, others willingly participate to maintain the inertia of growth to create a bubble.
Local governments participate in the fallacy because they too project rising property tax rolls with no practical end in sight. They are equally obsessed with money coming into the treasury since the more money they get, the more money they can spend. Just as businesses exist to turn a profit, governments exist to spend money. They see their role as issuing permits to increase the tax base in complete exclusion of the consequences of explosive growth or excess housing inventory. Increasing property values fuel the growth in the treasury like a bureaucrat’s narcotic. Every time a new house is built or a home is sold, the property tax revenue increases based on the new value. The paradigm is more building permits equals more property tax. Flush with extra money, instead of lowering the property tax rate to offset increased revenue, the bureaucrats easily create a justification to promptly spend the money on projects to fritter away surplus funds. A bureaucrat will always find or create a reason to spend money, it’s an axiom of government. Restraint does not apply to a bureaucrat, it only applies on others. To a bureaucrat, spending once justified, becomes a self perpetuating necessity which only a heartless conservative would cut. It’s only when the bubble bursts resulting in lower property values and thus decreasing property tax revenues do bureaucrats scramble to do something, but their first reaction like the builders is not to cut spending but propose as tax increase to continue the unsustainable rate of spending. High property taxes discourage new home buyers, it’s not just the mortgage that must be paid, it’s also the annual property tax. The only form of restraint comes from the tax payers hewn cry of enough is enough do politicians tell the bureaucrats they must cut spending. Of course, bureaucrats fully vested and justified in their spending cut the most public of spending to elicit the “shame on you guilting of emotional terrorism” to make everyone feel sorry so they, the bureaucrats won’t get blamed for over spending in the first place.
Mortgage lenders provide the necessary investment to keep the building going. Every new loan means profits in the pockets of the bankers. Rising real estate prices create the fog of unending equity to justify the extrapolation fallacy that LTV’s (Loan to Value) percentages are more encumbrances to the bottom line than protection against bad debits or mortgage defaults. After all, if a home owner gets in trouble, in a rising market, all they need do is sell the property to avoid foreclosure and default. Financing a brand new home comes with the false security that something new is more reliable and salable than something old. The problem with such thinking is that it totally obscures the fact that a home owner moving up the housing ladder to a larger nicer house leaves behind another house to be sold and thus is built in competition to the new. Only a first time home buyer reduces the inventory of housing to be sold. In the end, supply must be balanced with demand and once the imbalance occurs values must change either higher or lower to bring things back into balance. When a mortgage lender excessively lends money not to home buyers but to builders to put up houses on speculation, without regard to housing inventory, the risks multiply and sets the stage for the bubble to burst. However, the problem with the mortgages doesn’t stop with value of the house or someone defaulting on the mortgage, bankers turned around and used those mortgages and income stream from the mortgage payments as collateral for other debt instruments, and then someone figured out a way to sell insurance on these debt instruments in the form of derivatives. Just as people make money in a rising market, people also loose money in falling market, and those same derivatives that made bankers like Bears Stearns lots of money now cost them dearly. All of this is based on the price of the house.
Then comes the housing speculators, or house flippers, who create an artificial demand for houses. Now speculators do have a place in the housing market as they like regular apartment landlords need someone to rent the house in the short term to offset the mortgage and property taxes. The speculator like the landlord provides a living accommodation that ordinarily wouldn’t exist for people who don’t have the financial resources for a down payment. The speculator and landlord are in competition with one other and so act to hold down rental rates, but unlike the landlord, the speculator is not in the housing market for the long term. The speculator, egged on by get rich schemes of easy money, play the lottery to arbitrage a home in the hopes that property values will rise just fast enough that they can flip the house in a short period of time to turn a profit. The profits come so easily that they start buying multiple houses and of course the artificial demand created spurs the bankers, the builders and local governments to turn the gears of their well oiled money making machine. Once there is a critical mass of house flippers, the bubble is about to burst. The first signs occur when rental vacancy rates go up and then unsold housing inventories increase well over 6 month inventories thus starting the dominos of the market correction.
Finally, the home buyers also participate in the bubble when they so readily purchase a house based on emotional desire in lieu of practical need. The allure of a new house is intoxicating, all the new gadgets, large living areas, new neighborhood all combine to appeal to the emotion of wanting to have something better. However, when the prospective home buyer wants to move up in a bubble market, instead of factoring in the sale of their existing home, they play the lottery by using the equity of the house instead as a down payment for the new and then get stuck with two mortgages in a slowing market. The bankers who made and home buyers who agreed to the loan also based their decision on the extrapolation fallacy of never ending appreciating property values based on a never ending supply of buyers.
When home owners, speculators and builders can no longer transact purchases and sales in a timely basis, property values are left unsupported and thus the values must drop to attract buyers. The problem is the bankers faced with rising foreclosures now tighten loose credit terms back to the proper credit terms they shouldn’t have strayed from in the first place and thus keeps many new buyers out of the market. As foreclosures mount, the value of all housing is forced to compete with the foreclosures driving prices down. The first to be red lined by the banks are the marginal home buyers, those with Adjustable Rate Mortgages (ARMS), speculators and home builders, while intuitively a good move this pulls the props out from the bubble market and intensifies the downward spiral on housing prices by flooding the market with unsold homes both new and existing. With a dearth of buyers, all the home owners with two mortgages are now forced to sell at distressed prices or default on one of the two houses, thus dumping more houses on the market increasing the housing inventory. People with ARMS now have to face the bankers again in an attempt to get a 30 year loan, with a lower LTV (means they have to come up with a sizable down payment) when the banks are not inclined to loan money in a falling market to justifiably protect themselves.
So once this mess finally works itself out as it always has in the past, how do we prevent it from happening again? It’s very difficult to legislate common sense or good business sense when there are conflicting policies. First, we must face the fact that home ownership is not for everyone, it is not a matter of equality or entitlement, it is a matter of personal responsibility demonstrated by financial resources. If a person doesn’t have the financial means for a down payment or must pay an inordinate amount of mortgage in comparison to their income, they are not financially responsible to own a home, period. No one is entitled to own a single family home, but they are entitled to a roof over their heads which means they must avail themselves of what they can afford such as renting. Banks are not a means of social engineering as their stock holders have a right to invest their money without the inappropriate meddling of government. Banks, having a fiduciary responsibility to their stock holders should be using business sense and the appropriate indicators of the housing market such as unsold housing inventory and rental vacancy rates to determine the risk of the market to charge higher interest rates accordingly. When such rates are approaching 6 or more months, it’s their responsibility to red line risky loans such as those to speculators, home builders and those home owners trading up in value. Similarly, it is local government’s responsibility to limit the type and number of building permits according to the housing market and charge appropriate impact fees so as not to put a burden on existing home owners. It is the responsibility of local government to maintain a level of service, not increase it when a windfall occurs. Of course it should go without saying that home builders should not be flooding the market with unsold homes to meet their production schedule, they again have the responsibility not to build when inventories are getting high. Nor should builders only consider virgin ground for a new house, part of the answer is redevelopment. While the initial cost is higher to buy and bulldoze an older substandard house, doing so eliminates the competition of existing housing.
So what’s the answer here? Unfortunately, since we have been around this block now twice in 20 years, the answer seems to be government action of some sort. Bankers should not be allowed to market derivatives of any home mortgage given the variable nature of housing prices, yes this will limit their income but they don’t have a right engage in high risk monetary transactions at the taxpayer’s expense (bailout). The Fed, FHA, Freddie Mack and Fannie Mae must require a consistent reasonable LTV in the purchase of loans and not base those percentages on social policy but business sense. The bank regulators must allow banks to red line neighborhoods or areas where over-building is occurring as indicated by vacancy rates and unsold housing inventories. To protect the banks from frivolous Fair Housing Complaints, they must notify the bank regulators in advance when they intend to tighten up lending requirements which in effect red lines an area. Let’s face it, rules are created when people abuse their freedom of action to negatively impact others. Rules are necessary when common sense and corporate memory fall short. If the recently proposed shuffling of agency responsibilities fails to consider the practical side of the housing industry, then we are bound to repeat this fiasco a third time in the next 10 years. Third time’s a charm?
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Dan Scott calls himself a “Member of the Global Capitalist Cabal preaching Capitalism and personal responsibility as the economic solution to world poverty.” He is also a member of the 14th Amendment Society — victimhood is a liberal code word for denying the civil rights of others. He is also a proud member of the Global Warming Denier Cabal, insisting that facts not agendas determine the truth.
Dan can be seen on the web at http://www.geocities.com/fightbigotry2002/ as well as http://www.geocities.com/dscott8186/saidwebpage.htm, And can be reached for comments at dscott8186@yahoo.com.