The movie The Big Short explores the runup to the housing market crisis of ’07 to ’09. One of the protagonists is a fictionalized character (Mark Baum) based on real fund manager Steve Eisman. In one sequence, Baum meets with a Florida stripper — not to see her strip, but to talk about her investments. She tells him that she has bought several condos, with no money down, via back-loaded mortgages. She says she is going to make a fortune when they appreciate in price. In this moment, Baum realizes that when strippers are into property flipping, the housing market bubble has become really huge.
2018: Is It 2009 All Over Again?
The nasty question is: are we there again? And the answer is: probably.
The signs are ominous.
With the benefit of hindsight, we can plainly see what happened at the turn of the 21st century. The dotcom bubble had popped in early 2000, sending the NASDAQ plummeting by 80% by late 2002. Over the same period, the Fed desperately lowered its funds rate from 6.5% to 1%. People distrusted stocks, but there was easy money to be had, and they needed somewhere to live. A flood of investment poured into the housing market.
A lot of people were persuaded by unscrupulous brokers to buy properties they couldn’t really afford. Subprime loans — those made to borrowers with the worst credit histories and most likely to default — took off like a rocket. From less than 4% of the market in 2000, they shot up to 20% by 2005; in dollar amounts, subprime originations jumped from less than $100 billion to more than $600B.
And how did that bubble inflate to such an enormous degree? Yes, it was partly a result of the Fed’s easy money policy. But it was at least equally due to a fundamental change in the banking industry.
As Banks Offload Risk, Lending Standards Plummet
There used to be a firewall between commercial banks (those that used savings depositors’ money to make home and business loans) and investment banks (those that put client money into higher-risk, higher-return deals). The wall was erected by the Glass-Steagall Act of 1933, as federal legislators sought to prevent a repeat of the Crash of 1929. It worked pretty well for the next 65 years. Commercial banking, with its relatively low profit margins, was considered just about the most boring of businesses; investment banks catered only to the high rollers, not Joe Six-pack. Neither was allowed to poach on the other’s territory.
So a commercial bank would write a mortgage after careful consideration of the borrower’s finances. If the borrower looked like a good credit risk, the bank would make the loan and it would be paid back with interest, allowing the bank to profit off of that.
No longer. Glass-Steagall was repealed as part of the Gramm-Leach-Bliley Act of 1999.
The change was profound. Now, virtually as soon as a mortgage is written, it is sold off to an investment broker. That broker then re-sells it, often packaging it with a collection of other mortgages (called tranches), to create an investment vehicle called a mortgage-backed security (MBS). A given MBS will contain tranches of notes with different maturities and different quality ratings, but its overall rating may be far higher than many of the individual tranches inside it. (The major ratings agencies conspired to overrate a whole host of MBSs, but that’s another story.)
This is why those unscrupulous brokers — like Countrywide Credit, the largest, which in its heyday financed 20% of all U.S. mortgages — were writing loans for anyone with a pulse. When you can immediately sell off any loan you originate to the next sucker in line, then you have a very high-yield, low-risk business. Or at least you do until the carny ride ends, which it did for Countrywide in ’08, when the company went belly up.
At the same time, the federal government became increasingly enmeshed, as the backer of last resort, in the mortgage market. Banks saddled with boatloads of crappy mortgages somehow became “too big to fail.”
That was then. What about now?
The New Housing Bubble
One of the best indicators of how the housing market is actually doing is the Case-Shiller Composite Index, a 20-city snapshot of home prices nationwide. Looking at it over a 20-year timespan, one can see the earlier housing bubble as the Index more than doubled from 2000 to ’07.
The Crash of ’07-’09 drove prices down by over 30%, and they remained flat until the beginning of 2012. But then, in a surge reminiscent of the century’s early years, they took off again, rising to a point that currently exceeds even the ’06 peak. That in itself is worrisome. Normally, real estate values just do not appreciate that rapidly.
But there’s something more dangerous lurking. Historically, the cost of buying a house has been positively correlated with the percent of American households that own their home. As one goes up, so does the other, and vice versa. This was true even during the prior bubble, when it was buy buy buy and so many of the financially unfit suddenly became “owners.”
It isn’t true any longer. During the escalation of 2013-present, home prices went up nearly 45%. But at the same time, home ownership, which fell during the Crisis, kept dropping even after prices began to recover. From the time prices turned up until mid-2016, home ownership fell by 3%.
Since then, ownership has been in a mild uptrend but the gap is still enormous.
An Unsustainable Market Dynamic
What does this mean? That nearly all of the volatility and price change was driven by something other than an increase in long-term home ownership: speculation, inflation, supply constraints, or some combination, just not from the demand side. In fact, the US home ownership level today is lower than it was 38 years ago, and remains near historical lows.
This is not normal. It’s an indicator that things are seriously out of whack. With prices steadily rising and ownership still at very low levels, it is an indicator that home prices are only rising in certain regions, most likely, with already-occupied stock flipping for increasingly overvalued prices.
This jives with data that shows only extreme markets like Seattle and San Francisco have experienced double-digit annual price increases, fueled by a self-reinforcing cycle of speculation and strict zoning rules that limit new development and freeze lower and middle-income folks out of those markets.
Demand from people buying houses they don’t intend to live in and the continued migration of people to economic hotspots is outstripping supply by so much in select areas that it’s dramatically skewing national data.
We’ve forgotten the lessons of just ten years ago, when speculative chasing of a housing market warped by well-intentioned but idiotic regulation fed a massive bubble. That’s an unsustainable trend. It must end, and will end badly for those left holding the bag.
Moreover, MBSs never went away. Despite some half-hearted reform attempts in Washington, they’re still with us. Only more so. MBSs are a part of the shadowy, unregulated, over-the-counter derivatives market. That market, which was considered at dangerous levels in ’06, with a nominal value of some $650 trillion, is almost twice as large now, at about $1.2 quadrillion.
The evidence is compelling that the housing market is once again a bubble awaiting a pin. When it pops, the prudent investor is going to want to be holding the only investment sector not currently in the midst of an extraordinary overvalued bubble scenario: hard assets.