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May 28, 2005
Housing bubble? Not in the midwest
Brad Setser is visiting Kansas (which, we learn in today's post, is where he grew up) and finds no housing bubble. As a lifelong midwesterner, I can tell you the same thing. I haven't harped on it in this blog, but I have commented on some other blogs, like Calculated Risk. I don't know if there's a lot to be gained by my telling you that there isn't a housing bubble in most of the rural areas of the country. But I am glad that Brad agrees.
Brad does make an observation that I would like to expand upon.
To paraphrase Paul Kasriel's summary of Greenspan, there is no housing bubble in Manhattan KS (where I grew up), but there is one in Manhattan New York (where I now live). That characterization is a bit off. Manhattan KS (a growing university town and regional medical center) is far more frothy than say Stafford or St. John's KS, but it has a grain of truth.
Likewise, Peoria, IL is far more frothy than smaller communities in central Illinois. But I would not say Peoria is a bubble market. As I said in a comment on Calculated Risk, referring to data on this site,
I see that Wichita is near the bottom of the list with only a 2.48% appreciation for 2004.
I visit Wichita now and then. I can tell you there is a new construction boom going on there too. I see this as pretty strong support for my hypothesis that new construction in small/medium midwestern cities is biasing their median price listed in the NAR report.
Peoria comes in with a respectable 5.27%. Since their methodology includes refinancing, I'd go along with that as quite realistic from my experience. I would guess that the "purchase price" for a refi is the appraised value, which is a little higher than the price it might actually command on the market. Excluding refis might shave a percent or two, don't you think?
Definitely not a bubble. Whether 2 to 5% is a boom is your call.
That's 2 to 5% nominal return, subtract a couple points for inflation and it's 0 to 3% in real terms. But real estate sales in the Peoria area are brisk. There is a pretty massive building boom in the bedroom communities, mostly in the $200,000 range. Thus, the sales of those new homes are pushing the median price up. Rural areas are not seeing that kind of boom.
We just aren't seeing the kind of speculative mania that the coasts appear to be seeing. People buying houses in Peoria actually plan to live in them. As long as that is the case, there is less to worry about. "Flipping" of properties, such as is happening in the more bubbly areas, is disturbing to me indeed. The pundits who decry this behavior have a point. (See here for one of my statements on the subject.) A lot of statements about the housing market in the bubble areas sound like statements about the stock market in 2000, or dare I say 1929. But does that imply that a crash is around the corner? No. Houses are different from stocks in some important ways (even though modern financial markets have caused them to behave in some similar ways). I do think, however, that there will come a time (if I knew when I wouldn't tell you anyway) when the market will slow down from this torrid and, by all accounts, unsustainable pace.
What does worry me is that many people, especially in coastal metro areas are leveraged to the hilt on these properties. Interest only loans, ARMs, and so on, could potentially bite some of the last ones in on the bubble. And I worry a little bit that even in small/medium midwestern cities like Peoria, people are buying those cute little $200,000 homes (that would probably sell for $500,000 or more where many of you live) using the same interest only loans and ARMs.
There are reasons to be concerned, even about the midwest, and reasons to be downright worried about the coasts. Ultimately, this situation demonstrates yet again that the U.S. is a large and diverse economy. The mechanisms driving real estate in Miami are very, very different from those at work in Peoria.
Posted by William Polley at May 28, 2005 8:58 PM
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Comments
I'd be hard pressed to claim there is a bubble here in Eugene, Oregon. If I could magically transport my house to San Diego ...
Posted by: Mark Thoma at May 28, 2005 10:58 PM
Well said. I'm looking forward to the OFHEO data next week to try to understand just how widespread the bubble really is. For the non-bubble markets, I share your concern about the creative financing. Did you know that Georgia leads the Nation in IO loans?
Creative mortgages heat up
Georgia leads nation in interest-only loans
http://www.ajc.com/business/content/business/0505/29mortgages.html
That indicates to me that the creative financing boom is widespread.
Posted by: CalculatedRisk at May 29, 2005 2:18 AM
is it possible that IO loans are the rational way to go? i'm an economist by training, finance specialist by vocation and i decided the only rational thing to do was to get an IO loan.
mobility is the cause. who ever even thinks of a "mortgage" burning party these days?
Posted by: dc at May 29, 2005 4:22 PM
Are IO mortgages fixed or adjustable rate? (am not in the market, and don't know much about its mechanics)
Am thinking out loud, which is always risky, but an IO mortgage feels a lot like certain kinds of derivative contracts. For a low ongoing payment, the buyer of contract gets all the upside of an appreciation in the "house" (could be a security) from the initial purchase price -- but also all the downside if the price of the "house" (could be a security) falls. Would someone who buys a house with an "IO" loan have to post "margin" if the home equity falls below the nominal value of the loan? Or does the lender assume that the borrower won't default on the interest payment and put the house back to the lender b/c of reputational reasons? Or maybe current bankruptcy law makes that option costly if you have other assets?
Posted by: brad at May 29, 2005 5:21 PM
dc,
IO loans are indeed a rational way to go for some borrowers--those whose income is likely to rise, those whose income is variable (e.g. commission based), and those who plan to invest the savings or periodically pay down the principal. They are generally not a good idea for people who have wage income or whose income is not likely to grow as quickly.
The difference is in how the loan is amortized. Say you get a 30 year mortgage with 5 years interest only at a fixed rate. At the end of the 5 years, the payment will rise to a level that will fully pay off the loan in 25 years. I have read that the interest rate may be higher for the last 25 years as well. (In effect, what I read made it sound like the loan is reamortized after 5 years.)
As for Brad's question, perhaps it is at the end of the interest only term when the loan is amortized is where a "margin" would have to be paid. Perhaps if you make a principal payment at that time, you'd lower your interest rate (because your loan-to-value would be more favorable). But I don't have one of these loans, so I don't know those details.
Posted by: William Polley at May 29, 2005 9:56 PM
If homeowners used IOs as a financing choice as opposed to a necessity - then I have no problem with them. But I believe many people are using IOs as their only means to qualify and that exposes them to serious risks.
Here is an excerpt from an LA Time article:
http://www.latimes.com/business/la-fi-afford3apr03,0,4296610.story?coll=la-home-headlines
"The number of buyers falling into this category in any given month is unclear. But a California home builder recently got a sense when he sought to answer this question: How many of the potential buyers of his houses could still afford them if interest rates went up even a little?
To find out, the builder conducted a little experiment.
His firm's preferred lender had pre-qualified 90 potential buyers for a group of new houses. Since the houses wouldn't be ready for another six months, the builder tightened the loan criteria. He didn't want buyers to sign up for a house and then get frightened into canceling by rising rates.
He raised the threshold from a fully variable loan, the easiest to get since it immediately moves upward when rates increase, to a mortgage that was fixed for the first three years. That would shield buyers from rate jumps for at least a little while, but it's also more expensive.
Under the higher threshold, only about 15 of the buyers still qualified."
The slightest change and only 1 in 6 still qualified.
Posted by: CalculatedRisk at June 2, 2005 1:24 AM