This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

The books are officially closed on a decade which will be remembered for an historic real estate boom in the United States that busted in spectacular fashion, nearly taking the entire world financial system down with it.

Of course, the real story is a touch more complicated: Our housing bust was merely the most glaring crack in a global economy that grew far too dependent on cheap debt, where flows of money around the world magnetized to the hot asset, blowing bubbles first in stocks, then real estate, then commodities.

During each subsequent bust, governments rushed to the aide of markets, stitching them up with a patchwork of looser regulations, low interest rates and promises it would never happen again.

Late in 2008, the collapse of the credit markets culminated in the failure of some of this country’s most storied financial institutions. When the dust settled, Bear Stearns, Lehman Brothers, Merrill Lynch,
Washington Mutual, Wachovia, Fannie Mae, Freddie Mac, AIG, Countrywide and a host of smaller, lesser known entities had either gone bust or been bought for a song by stronger, better capitalized firms.

Some simply melted into this or that government agency, while many members of our financial complex survived only with historic government aide. Citigroup, Bank of America, Wells Fargo, JP Morgan Chase, Goldman Sachs, Morgan Stanley, GM and Chrysler are alive today thanks to massive taxpayer-funded bailouts.

But enough looking behind us; historians and journalists will be employed for decades slicing and dicing this most turbulent of decades.

Surveying the horizon, the primary fear among economists, investors and ordinary Americans is that the inflationary effects of pumping trillions of dollars into an economy must eventually come home to roost.

To be sure, there are those who remain firmly in the camp that believes the more pressing concern is inflation’s less-well understood counterpart, deflation. But even the most ardent deflationists believe theirs is a debate that is more accurately painted as one of time horizons, rather than absolutes.

The US dollar is in the crosshairs of this philosophic, as well as very practical debate. The greenback’s standing as the global reserve currency has been thrown into question as investors around the world scratch their collective heads and try to figure out how we’ll ever repay our staggering, ever-growing debt.

And now, as our economy appears to be slowly healing, the Federal Reserve faces the unenviable task of withdrawing its generous stimulus. In March, the Fed plans to scale back its purchases of mortgage backed securities, spooking more than a few market participants.

The fear, particularly for the housing market, is that any Fed pullback will push up interest rates.

Higher interest rates translate into lower purchasing power for buyers, curtailing the steady stream of homebuying demand that, coupled with ongoing foreclosure moratoria, has propped up prices in recent months.

We kick off 2010 with mortgage rates approaching the all-time lows set last spring. Sure, they could always go lower, but the smart money is betting it’s just a matter of time before rising prices force regulators to ease their foot off the monetary accelerator. Higher mortgage rates are likely on the horizon.

So as we begin the first true test of our nascent economic recovery, Cirios would like to take you through a bit of history. We’ll look first at the macroeconomic picture as it relates to home prices, inflation and interest rates. Next we’ll examine a few California real estate markets illustrative of the localized trends masked by most broad economic measures.

But first, a word of caution: As Mark Twain’s oft-cited saying goes, “History doesn’t repeat itself, but it often rhymes.”

It goes without saying that the financial upheaval of the past 24 months has been, in a word, unique. There is no historical analogue, no matter how neatly we try to jam this experience into some mold cast in the 1930s, 1970s or 1980s. By extension, any conclusions drawn from this historic perspective should be taken with a very large grain of salt.

Nevertheless, understanding where we stand and how we got here is essential to understanding where we’re headed. And understanding where we’re headed is essential to finding and taking advantage of the plentiful investment opportunities the previous decade’s turmoil has created.

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This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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Life is always so much clearer in hindsight.

The graph below shows the US Median Home Price (blue line, as measured by the 6-month moving average of the Median Price, admittedly as arbitrary a metric as any other) graphed against the year-over-year change in prices (red line). While it doesn’t take a degree in econometrics to identify the ongoing correction as the most significant in recent memory, here are a few additional items to glean from this broad view of history.

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First, on a year-over-year basis, even at the height of the real estate boom in 2004, at no point did prices rise as quickly as they did in both of the booms in the early 1970s or mid-late 1980s. Instead, prices grinded upward without a meaningful correction: Prior to late 2007, the last annual decline occurred back in 1992.

Second, although prices are now roughly back in line with the historical trend of appreciation, understanding what drives this particular dataset paints a somewhat cloudier picture. Of the myriad ways to measure home prices, Median Price, despite being the most ubiquitous, can be misleading. Foreclosures and other distressed sales have driven the most active housing markets in recent years, so a larger-than-normal portion of sales have occurred in lower priced markets. This, in addition to nominal price declines, has skewed median price data to the downside. Now, as lower-priced markets stabilize and luxury markets continue to tumble, the dataset should return to a more historic mix of cheap as well as expensive homes. This means median price data could show appreciation where, in reality, no such rise in prices exists.

Finally, it is crucial to understand home prices in relation to inflation and the value of the dollar. Continue reading for some interesting comparisons between home prices and inflation while considering this: Simply adjusting for inflation and ignoring all other factors, a house bought in 1965 for the median price of $17,200 would cost $118,123 in today’s dollars. With the current median price just over $200,000, that means more than half of all home price appreciation in the past 45 years can be attributed to inflation. Nothing more, nothing less.

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This post first appeared in the SPECIAL EDITION: Cirios Trends: A Decade in Flux

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We wrote back in June of 2008: “The Holy Grail de jour of financial market prognostication is predicting the bottom in housing. It’s a fool’s errand, however.”

Identifying the low point in any asset class is an effort best left for speculators and academics. The former must be willing to be wrong and lose big, the latter can play Monday Morning Quarterback and look back in time to identify turning points that happened months, if not years in the past.

With all that said, it’s still helpful to look at how far home prices have fallen since their peak in 2007. As can be seen below, we are now back to prices as they stood in 2004, during the height of the boom. This is hardly comforting.

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Statistics being what they are, however, it also depends on how you keep score. The Case-Shiller Home Price Index, a widely quoted metric that compares paired sales (which measures the change in sales of individual homes over time), places us closer to 2003 values. Some individual markets look a bit better, others far worse.

Another interesting item to note is the lag between the peak in year-over-year home price appreciation and a peak in prices. Looking below, we see that it took almost 3-years for the high of 14.3% y/y appreciation to be matched with a high median price of $248,467. Even the nominal peaks (ignoring moving averages) are 20 months apart, meaning year-over-year data can be viewed as a leading indicator for nominal prices.

Heading in the other direction, there is a similar lag between the most precipitous fall in prices and the actual bottom in prices. Comparing what we see below to the chart on the next page foretells patience before hailing the all-clear: A mere 6-months have passed since what many believe to be the nadir of home price declines.

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The aforementioned warning about historical analogues notwithstanding, let’s take a look at how the housing market recovered the last time there was a persistent decline in home prices.

As an aside, one of the most challenging aspects of analyzing the current housing recession is how infrequently home prices have fallen for an extended period of time. Since 1965, this is only the third time the US housing market has experienced two or more consecutive months of year-over-year price declines.

The most recent such decline occurred in 1991 as the housing market reeled from the Savings and Loan debacle. For those unfamiliar with the S&L crisis, banks and thrifts found themselves overleveraged to residential mortgages as home prices fell. Clearly, we learned our lesson.

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The peak of the 1980s real estate boom, as measured in year-over-year appreciation, registered 28 months earlier than the top in prices, not a dissimilar tally as our the most recent boom. On the way back up, from the bleakest moments in 1991, it was 18 months until we saw a meaningful pickup in home prices.

Of important consideration in examining this historical example, however, is the way in which government action affected the cleanup of each respective housing bust. The Resolution Trust Company, or RTC, was created in 1989 to liquidate distressed real estate assets gumming up the country’s banking system. And while many argue this strategy ushered in a de-facto policy of moral hazard that culminated in our recent financial crisis, others widely hail the strategy as cordoning off the damaged segments of the banking system so the rest of the industry could heal on its own.

We have no RTC2 to clean up this mess, but we are certainly flush with government schemes to prop up the housing market. The relative effectiveness of these programs will go a long way to determining when the good old days of steady home price appreciation will be back again.

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At the heart of some of the most contentious debates in the otherwise drab world of macroeconomic theory is that of inflation (yes, there are in fact contentious debates about macroeconomic theory). To wit, economics can’t even agree on a definition for the term.

The laymen understanding of inflation is the rising of prices. Some economists agree, while another camp argues that higher prices are merely one of many signs of inflation, which they define as an increase in the supply of money within an economy.

Commonly, inflation is measured by the Consumer Price Index, or CPI, which purports to be a representative basket of goods and services that reflects what the average consumer buys with his or her hard-earned dollars. And while there are myriad criticism of the CPI and how government bean counters arrive at the final tally, that is a debate for another forum.

Suffice to say, as can be clearly seen below, prices in the US have been steadily rising for about as long as anyone can remember. And as some generations remember better than others, during the 1970s and 1980s, prices rose rapidly indeed.

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Most credit then-Federal Reserve Chairman Paul Volcker (currently the chairman of President Obama’s Economic Recovery Advisory Board) for breaking the back of inflation in the early 1980s with a hard-line policy of high interest rates. High borrowing rates discourage investment, curtailing economic growth, which can slow the pace of rising prices. This politically unpopular monetary policy led to persistently high unemployment and a deep recession, but ultimately inflation was brought under control.

Since Volcker’s tenure as Chairman, successive Fed Chairmen have kept interest rates low, while presiding over a period of slowly rising prices. While this sounds like a perfectly healthy economic balance, many argue this “balance” fostered the eventual imbalances that threw the global financial system into such wild disarray.

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A cursory look at the long term trends for inflation and home prices reveal strikingly similar patterns. Until, that is, right around 2003 (see dotted line below).

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In the wake of the short recession caused by the dot-com bust and September 11th terrorist attacks, then-Federal Reserve Chairman Alan Greenspan aggressively lowered interest rates to spur economic growth. Leaving rates at historic lows for several years encouraged active borrowing, helping to bring the US economy out of its tailspin.

Greenspan critics now wonder, at what cost?

As homeowners, real estate speculators, investment bankers, mortgage brokers, real estate agents, appraisers and credit rating companies (among others) rushed to grab their piece of property values, the historic relationship between moderate inflation and steadily rising home prices broke down. Home prices leapt, while inflation continued its casual march upward.

Then, around the beginning of 2007 (the “peak” of our 6-month moving average dataset), the relationship flipped inverse (see arrow above). Rising prices as measured by the CPI faced off with tumbling home prices, feeding the feverish macroeconomic debate of inflationists vs. deflationists.

Now, as what feels like the entirety of the financial world awaits the inevitable inflation that “must” come after trillions upon trillions of dollars in economic stimulus, we hope the following few pages shed some light on what we can expect if it turns out the majority (in this case, the inflationists) prove to be correct. Since policy-makers’ key tool to fight inflation is higher interest rates, and higher interest rates translate into more expensive mortgages, future inflation has serious implications for real estate markets around the country.

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It stands to reason that falling interest rates leads to higher home prices. After all, for every one percent drop in mortgage rates, buyers can afford around 10% more house. Against that backdrop, the chart below makes sense: After sky-high interest rates of the late 1970s and early 1980s, a consistent decline in interest rates helped usher in an historic increase in home prices.

But, as is often the case when complex macroeconomics are at play, there’s more to the story.

In order to fully understand what on the surface seems like a relatively straightforward relationship, we need to more fully understand what moves mortgage rates, which have such a direct effect on home prices.

Since it’s creation in 1913, the Federal Reserve has been charged with overseeing our nation’s monetary policy and maintaining price stability. Chief among it’s responsibilities is to set the “Federal Funds Rate,” which in simple terms is the rate at which banks lend to one another. Virtually all other borrowing rates are pegged at some “spread” above this baseline rate, based on the perceived riskiness of the loan.

With this tool, the Fed tries to maintain the modicum of inflation it believes strikes the proper balance between economic growth and stable prices. Lower rates encourage growth but push up prices, while higher rates curtail rising prices but at the cost of retarding economic activity.

However, with the Full Employment and Balanced Growth Act of 1978, Congress tacked on another mandate to the Fed’s list of tasks: “long-run economic growth.” The seeming contradiction of “stable prices” and “economic growth” is at the root of the debate over the role of the Fed in our economy.

So, using the logic laid out above, Paul Volcker and his inflation-crushing high interest rates of the 1980s should have sent home prices tumbling. Why then did home prices keep on rising during this period of high mortgage rates? Read on to find out.

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Given the widespread expectation for future inflation, and as an extension higher interest rates to combat rising prices, the question above is the most common one we hear from home buyers and real estate investors alike. To try and resolve the issue to completion on this short page would be ambitious, to say the least.

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During the inflationary period of the late seventies and early eighties (flip back to pg 5 for a picture of
inflation during this period), mortgage rates climbed to almost 20%. In a world where locking in a rate north of 5% feels like a rip-off, 20% mortgages are a thing of fantasy.

Yet, despite this seemingly gale force headwind, home prices still climbed. While there are number of reasons for this increase (demographic, regulatory, etc), let’s focus on one in particular: Inflation Expectations.

Thumb through speeches written by pointy-headed Fed economists and you’ll find this phrase, “Inflation Expectations” peppered throughout discussions of monetary policy and the fear of rising prices. This is one of the least appreciated, yet most important aspects of effective use of monetary policy to manage inflation.

At the core, all economic decisions reflect participants’ view of the future. Specifically, buyers consider what utility (ie, use) they can receive and whether the price for that utility is fair. Embedded within this decision is some expectation of what can be done with that money in the future: Saved, spent, invested, etc.

When consumers fear rising prices, that a gallon of gas will cost more tomorrow than it does today, they buy the gas today. This pushes future demand forward, increasing aggregate demand and in turn, prices. The cycle continues, and in extreme cases (think Zimbabwe or the Weimar Republic), hyperinflation ensues.

As inflation rises, so too do Inflation Expectations. Consumers deploy capital towards assets they perceive to be a better store of value than the worthless paper in their pockets. They buy gold, they buy oil, they buy real estate. So, even with higher rates, money still flows into housing.

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The belief that the Federal Reserve kept interest rates too low, for too long, is one which is now nearly universally held. Well, outside the Fed, that is. Here’s a smattering of quotes which show how the view of Greenspan’s loose monetary policy (and now Bernanke’s) varies from group to group, and from year to year.

“The best response to the housing bubble would have been regulatory, rather than monetary.”
- Fed Chairman Ben Bernanke, January 3, 2010

“Given the decloupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have prevented the housing bubble.”
- Former Fed Chairman Alan Greenspan, March 11, 2009

“The reason I wrote this book was so that the average person could understand the scope of the housing bubble, and what its bursting was going to mean and…where blame should be placed…at Greenspan’s Fed.”
- William Fleckenstein, on his book Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve

“Bernanke has done a great job, post-Lehman. But going into this crisis, he really was the architect, if not the co-collaborator, in creating some of the conditions in the economy that led to the recession.”
- Stephen Roach, chairman of Morgan Stanley Asia, Ltd, August 25, 2009

“We artificially lower interest rates. It’s been going on for 10 years and longer and now we’re bearing the fruits of that policy.”
- Ron Paul (R-TX) at Chairman Bernanke’s testimony to the Joint Economic Committee, Nov. 8, 2007

“American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”
- Then-Fed Chairman Alan Greenspan, during a speech on February 23, 2004

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