How crazy was real estate?

Just how big was the real estate bubble? Unprecedently big.

As we discussed in prior posts, low interest rates and high overseas savings led to a credit-and-debt bubble, which fed the mortgage markets and, in turn, real estate prices.

Robert Shiller, author of "Irrational Exuberance," developed the now widely used Case-Shiller home price index. Looking at his numbers, the ridiculous heights the bubble reached become obvious. (They're available at standardandpoors.com, at the somewhat ridiculous URL http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html.)

Here are some charts based on his indexes (now owned and published by Standard and Poor's.)











The chart above show home prices from 1987 to September 2008 (ten city index). As you can see, home prices from 2000 onward (after Greenspan lowered rates to fight the 2000-2001 recession), were way out of line from the historical trend. That just sounds too depressing though...let's take the (very) optimistic assumption that the 1990s were a bad time for home prices, and that the 2000 level was the "right level." Here's the chart below.












What does this chart tell us? Well, for one thing, home prices were still way out of whack recently. The National Association of Realtors tells us that U.S. median sales price of existing single-family homes peaked at about $220,000 in 2006. (Data available here: http://www.realtor.org/research/research/ehsdata). Remember the guideline that home prices should be about 3 times a family's income? Well, the median household income was about $50,000 in the 2006-2007 time period (Data available from the U.S. Census Bureau at http://www.census.gov/hhes/www/income/incomestats.html.) So, home prices were over 4 times the average household's income - no wonder homes were unaffordable!

The big question now of course is, where are home prices going? Well, to reach the 3x level of affordability, home prices would have to drop to $150,000, a further 18% drop from the $183,000 level calculated by the National Association of Realtors for October 2008. Using the Case-Shiller indexes, it depends on your interpretation. I personally don't expect home prices to drop all the way to their historical averages - it would be too painful (and, we should build in a "natural" rate of home appreciation that includes inflation). Rather, I'd expect them to bottom out somewhere slightly above the historical average, and then inflation would eat away the remaining ~10% of home values. So, given an index value of 173 (10-city index) in September 2007, a fall to index values of 130-150 would imply anywhere from a 15%-25% further decline in home prices.

So in a nutshell, the news is really bad. #1: Home prices are not done dropping. #2: Even when they bottom out, they're likely to be above the historical average. #3: They're unlikely to bounce back once they've bottomed out. And as a corollary, all the talk of stabilizing home prices buy having Treasury but mortgage-backed securities doesn't make any senese - home prices need to be lower, and trying to prop them up is only delaying the inevitable. Yes, we should try to make mortgages available once again; yes, we should try to help consumers at risk of foreclosure re-negotiate loan terms; and yes, we should try to bail out banks with bad mortgages so our financial system doesn't melt down.

But, we should be aware that home prices have to fall further to reach a sensible point (i.e. historical affordability ratios), and that the road ahead will be very, very painful.

The economic outlook, Part 2

Picking up where we left off, what was the ratio of Debt/GDP for other sectors of the economy?

Using the same sources as before (BEA and the Fed), we can calculate Debt/GDP ratios.

For households, Debt/GDP was 47% of GDP in 1977, skyrocketing to 100% in 2007, for a total of $14 trillion.

For the financial sector, Debt/GDP was 17% of GDP in 1977, also skyrocketing to 116% by 2007, for a total of $16 trillion.

Both of these figures are absolutely shocking. Ultimately, it is these extreme leverage numbers that caused today's financial crisis. With debt levels like these, households and financial institutions were basically insolvent - that is, not making enough money to pay off their debts (well, maybe when times were great, but the slightest problem, and then everything crashes). Also, the ridiculous leverage versus the equity base meant that both households and financial institutions could see their net worth wiped out - which is exactly what we're seeing happening now. And finally, it's also likely with extreme leverage like this that most of it was wasted - buying houses in Phoenix or Miami that are no longer wanted, or buying super-senior ABS CDOs that are now called "toxic securities."

Why calculate these ratios? First, to understand what went wrong; second, to understand how we can watch out for problems in the future; and finally, to figure out what we need to fix to heal our economy. The news here is not good - we need to return leverage ratios to what they used to be, which would be trillions of dollars lower than where we are now. The problem is, the assets that households and financial institutions bought with all that debt are worth 20%-40% less now.

In the short term, the multi-trillion loss caused by the sharp declines of late are cascading through the system now, and the main reason why the government has already committed over $1 trillion to fix this problem.

In the long term, only saving, by businesses, household and government alike, will reduce these debt ratios. That reduced amount of consumer spending and business investment will likely lead to sluggish economic growth for a long time to come. Yet, like the Fed-induced recession in the early 1980s that Paul Volcker introduced to squash the inflation of the 1970s, this may be the only way we can wash our hands of this extreme leverage. I wish I had happier news - I really do.

Next up...real estate...

The economic outlook, Part 1

So what's the economic outlook going forward?

Well, first, let's start with the big question - what got us to this point of crisis in the first place? In a word, debt.

A combination of low interest rates from Alan Greenspan, excess Chinese savings, and Wall Street securitization led to investment banks, consumers, and government alike taking on too much debt. How much? Absolutely unprecedented amounts.

Let me show you why. At the level of a country, debt is usually expressed as a percentage of a country's GDP. At 100% Debt/GDP, you should start to get worried; Japan is in the worst debt situation of any major country, at over 150% Debt/GDP.

Let's calculate Debt/GDP for the US. According to the Bureau of Economic Analysis "National Income and Product Accounts" table, GDP was $14.4 billion in 2008 (nominal annualized rate as of the third quarter). According to the United States Treasury Department's "Treasury Direct" site, total federal debt is $10.6 trillion, less than 100% of GDP.

Not so bad, right? You know where this is going...there's a lot more, and the numbers are scary. According to the Fed's "Flow of Funds Accounts for the United States" (Q2 2008), total United States was nearly $50 trillion. Households accounted for $14 trillion of this, with $11 trillion coming from mortgages. Financial firms accounted for another $17 trillion. (Non-financial businesses made up the remainder.)

Of course, debt in itself is not a bad thing. It's when assets and liabilities are mismatched, and a borrower becomes insolvent, that debt becomes a problem. Even a federal debt of 100% Debt/GDP wouldn't be terrible if the federal government can pay that debt (and it can, because of its taxing power).

Obviously, as we learned in September-October 2008, it's an entirely different matter for households and financial institutions that can't work their way as easily out of excess leverage. Tomorrow we'll look at ratios of those entites' debt to GDP, which was totally out of control relative to historical standards.

Is it time to buy? Part 3

Let's try to get a little more clarity on the earnings question. In our last post we noted that S&P operating earnings were still forecast at $97.32 for 2009, but almost sure to come down. The question is, how much?

Professor Robert Shiller (of "Irrational Exuberance" fame) has compiled some helpful statistics for us at http://www.econ.yale.edu/~shiller/data/ie_data.xls. What does his data show us?

It looks pretty scary. From 1917-1921, the S&P index's earnings fell from 29 to 4, a 90% drop. Let's hope that doesn't happen again.

What if we try something more familiar? In 1989, earnings were $45; in 1992, $26, a drop of 40%. More recently, from 2000-2002 earnings declined from $69 to $31, a 55% drop. By comparison, the 1974-1975 drop from $40 to $32, a decline of 20%, was downright mild.

How bad will it be this time? Profits were high for a prolonged time. Costs were kept low by cheap labor from China. And there's massive deleveraging that needs to happen throughout the economy. Sounds like this is more of a 40% drop scenario rather than a more benign one. I hope I'm wrong, but I'm afraid I'm right.

So, if we take 40% off of $97.32, we get $58.39. If we apply a P/E ratio of 12, which gives me a comfortable cushion versus the long-term P/E of 15 (though still well higher than the truly rock-bottom P/E range of 6), that gives me a price target of 700 on the S&P 500. Ouch!

Finally, a note on the rock-bottom P/E of 6. If we take out the Great Depression, the lowest P/Es of the early 1980s happened during the super-high interest rates brought on by Paul Volcker's fight against inflation. The math gets complicated, but basically, why hold stocks when bond interest rates are high? So I think we would only see a sustained P/E below 10 if long-term rates rise. How likely is this? Not that likely, I think - there's still a lot of liquidity in the world (if on the sidelines), though there are some serious imbalances ahead that will reduce available savings even as national expenditures rise - i.e. the retirement of the baby boomers. But as long as that doesn't cause an extreme rise in interest rates, P/Es shouldn't go super-low.

But even so, these calcluations make me nervous looking at today's S&P 500 of 966. We'll see. Like I said, I hope I'm wrong, but fear I'm right.