The Housing Bubble and the Million-Dollar Trailer, Part 1

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We are still not sure that the housing bubble, that great bull market in U.S. residential real estate has come to an end. What we are sure of, on the other hand, is that it isn’t at the beginning.

The great housing bubble may be dead, but it already has a certain corpse-like stink to it. The relatives are gathered in the parlor. The silver has already been packed up. The local priest is already on the scene, administering last rites.

True, we still don’t know exactly how the story will turn out. But it is time to begin preparing the obituary.

We begin, like all good requiems, in the middle of it…or at least at one of its many comic high points.

In the fall of 2006, the news appeared that Donald Trump had put his Palm Beach mansion on the market for $120 million. He had bought the place less than 10 years before, for less than $50 million. If he were to get his price, the profit would be about $7 million for every year he held it. Which is good work if you can get it – earning more than half a million dollars per month – just for owning one of America’s greatest beach houses.

But pity the poor next owner. He’ll have carrying costs of $6 million per year ($120 million at 5% interest)…plus property taxes, plus upkeep, plus staff costs and other expenses. Instead of earning money, he’ll probably be out of pocket more than a million dollars per month. And here, we let the fellow in on a little secret: houses don’t go up every year, especially those that rose $70 million in the last decade.

We thought The Donald had set the pace for extravagantly-priced houses when, only a few weeks later, came news that Saudi Arabia’s former ambassador to the United States, Prince Bandar bin Sultan, put his ranch near Aspen, Colorado, on the market for $135 million – making it the most expensive private house ever offered for sale in America…perhaps in the whole world. But that was the charm of the housing bubble; one absurdity always seems to lead to an even bigger one later on.

And all over the world, the rich were on a spending spree. They bought ranches in South America; even the Bush family bought one – a 98,000-acre estancia in Paraguay. (In the interest of full disclosure, and a confession of partial insanity, your editor admits that he, too, bought a little spread south of the Rio Plata. He is pleased that the Bushes have chosen to locate north of the river; he was concerned for property values in his area).

Rich people pulled out their fat wallets and bought diamonds, art, apartments in Mayfair, on the Place Vendome, and at the Puerto del Sol. Prices soared, as the cost of living it up headed for the moon.

But down at the other end of the income spectrum, the lower and middle classes were having a rough time. In the 10 years leading up to 2006, they had added $5.2 trillion to their debts – most of it on mortgages. This was nothing to worry about, said the experts, because their net worth had also gone up.

The price of the average house in America rose approximately 60% in the period. Compared to the type of gains the rich were getting in Malibu, Manhattan and Miami, a 60% gain was peanuts. But it was enough to lift the spirits of millions of ordinary people. Besides, in the preceding 100 years nothing like it had ever happened. Normally, house prices merely followed income and GDP gains…like a good hooker, walking 10 paces behind so no one notices. But in the last 10 years of Alan Greenspan’s reign, they took off at a sprint and were soon racing past everyone.

A rich man can watch his property go up in price with a calm detachment…as though he were watching a beer truck overturn. But a poor man can barely contain himself. He feels he must seize the opportunity. Before you know it he is feeling a little loose and reckless, and after a while, he becomes light in the head.

Rising property prices were caused by a lie – that the feds could increase the world’s purchasing power by introducing additional ‘money’ into the economy. Then, the lie led to a humbug…after which followed a delusion trailed by a hallucination.

At the center of all these swindles was the idea that houses actually can go up in value. Readers may be taken aback. Everybody in America now knows that houses always go up in value. But it is not true. For 100 years…from 1896 to 1996…houses went nowhere at all – merely keeping up with GDP, inflation and income growth. Then, in the following 10 years – they rose remarkably.

The homeowner didn’t know what to think. Predictably, he made the wrong thing of it. He came to believe that his pile of blocks, bricks, 2 x 4s and faded paint had somehow grown in real worth – like a fine wine that had aged or a bond that had matured.

This sentiment was extraordinary because it was completely at odds with the evidence before his very eyes. He had only to open them to realize that his house was not, in fact, becoming a better thing. Instead, with each passing day…it became a worse thing. He knew damned well that the wooden floor joists rotted and warped. The concrete foundation cracked. The aluminum windows corroded. The shingles on the roof wore away. The gutters clogged. The pipes rusted. The carpet matted down and stained. Every item – big and small – about the house actually lost value as it aged. How was it possible that the ensemble of them went up?

As the years passed, he turned the front door knob…it squeaked. He turned on the hot water in the bathroom…the faucet leaked. He turned on the air-conditioning and it sputtered and creaked. How was it possible that the aggregated collection of all these corroding, deteriorating things put together actually became more valuable? It seemed to defy reason and good sense.

But out came the theorists, the economists, and the real estate salesmen. Property was rising, the homeowner was told, because there were so many new people coming in. But how could it be that houses were rising everywhere – throughout the 50 states? Where were all these new people coming from? And it was rising, they said, because the country was running out of buildable land and building codes were more restrictive. New houses were actually becoming rare…that’s why older houses were so sought after.

But here too, he opened his eyes and saw it wasn’t so. Everywhere he looked, houses were going up. There was clearly a house-building boom, not merely a house price boom. In some areas, every available lot was under construction. Single-family homes went up in former cow-fields and old auto lots. In other areas, single-family homes were knocked down to make room for condominiums. Acres of previously empty land were being converted to housing.

How was it possible – with all this new supply – that prices would go up? The very idea of it contradicted his intuition if not also his instruction. Rising supplies drive prices down…not up.

What’s more, these new houses had none of the defects of his old barrack. The paint was fresh. The doors opened and shut properly. The air-conditioning made no funny noises. The faucets didn’t leak. The new houses were bigger, cleaner, brighter…more modern. How was it possible, in face of this competition that his hulk of a house was going up in price? It should go down.

He might have asked himself, what was a house really worth? What is it, after all? It is shelter: it is a place to hang our hats. It is home sweet home. But who ever heard of home sweet home making anyone rich?

Then, his mind working on the problem like a gorilla trying to do long division, he realized that he had to look upon his house, not as a dwelling…but as an investment! Thus did another brick in the lunatic wall of the great housing bubble get laid in place. Between 2002 and 2006, in many areas of the country, residential housing rose at 20% per year or more. As an investment, it was actually a superb one, he noticed. What stock would do that? And what stock had granite countertops in the kitchen?

The more he looked at it as an investment, the more attractive it became. He could buy a house with no money down. That was another madness – which we’ll get to in a minute. But let us imagine that he acted as a conservative, prudent investor. He could buy a $200,000 home with a 20% down payment. So, he put down $40,000. Then, he got two forms of pay-off. Like a stock or a bond, he got a ‘dividend’ – in the form of a place to live. A $200,000 house might rent for $2,000 a month. So, he figured he got $24,000 there. Plus, he got a capital gain – when the house went up in price. At 20% per year, this came to another $40,000. Whoa…what a bonanza! His $40,000 initial investment was throwing off $64,000 in ‘profit’ – every year. All he had to do was pay a mortgage of say, $1,000 a month…and, of course, property taxes and expenses.

One absurdity led to another…each one bigger than the last. The householder began to see that not only was his house a great investment, but that he must be an investment genius for taking advantage of it. The average wage in the United States in 2000 was only $37,565. He was making more than that – much more – just by living in his own house.

A thoughtful man, left alone with his private reflections, might have wondered how it was possible. He might have considered his own good fortune and thought more deeply about what actually lay behind it. “How is money made?” he might have asked himself. By working. By saving. He knew the answers. And he knew he was doing neither. Ah, by investing! “Yes, that’s it,” he said to himself. “I am an investor…like George Soros or Warren Buffett.”

Only smarter. Buffett still lived in the same house he bought 40 years ago, he noticed. What a dolt! He should have traded up…flipped…and refinanced.

Then, another monstrous delusion developed. The homeowner came to believe that he had the equivalent of an ATM machine in his bedroom. If his house was making him so much money, he said to himself, surely he could take some of that money out and spend it? Using home equity lines…and refinancing money…homeowners found that they could make regular withdrawals from the Bank of Their Own Homes.

Borrowing against the house was easy – lenders saw little risk. And interest rates were low. It seemed like a no-brainer. A house that was bringing $60,000 a year in wealth to a family could easily provide $10,000 to help the family live better. Heck, the family was still $50,000 ahead of the game. And so the money flowed. And what began as a trickle…soon became an Amazon…a great river of no return. In 2004 and 2005, homeowners ‘took out’ more than $1 trillion from their houses.

Experts told them they were being very prudent. They were shrewdly ‘managing their household wealth,’ it was said. Mortgage credit was cheap credit; better to borrow from a home equity line than a credit card. And besides, with their houses rising in price, how could they go wrong?

We answered that question in these pages. It was not the price of the house that counted; it was the ability of the homeowner to repay the loan. Yes, he could sell his house to get cash. But then where would he live? It wasn’t as if his was the only house in America going up in price. The only way he could actually realize the inflated value of his house was by dying…or moving out of the country. Not many householders were ready to do that. Short of that, he had to service his loan, just like any other borrower. And as the weight of his borrowing increased, his legs began to wobble…and buckle. Nor did it help that his house was pricier – his insurance, his maintenance costs, and his property taxes were rising, too!

By 2002, houses were clearly going up in price – faster than they ever had before. And the homeowner was about to swallow his next big absurdity.

The rise in housing prices between 2002 and 2006 in certain markets – San Francisco, San Diego, Miami, Las Vegas, Washington, D.C., Manhattan – was breathtaking. By 2005, the average house in San Francisco was selling for $$820,482. In the Washington suburbs, ordinary split-levels and colonials had doubled in price in five years’ time. And along the California coast even trailers passed the $1 million mark.

More to come next week…

Bill Bonner
The Daily Reckoning

Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
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