Monday, June 09, 2003

The Real Estate Bubble

by Asim Jalis

Here are some possible outcomes of a weak dollar. Forbes points out the first few. Here is the article. 1. Companies with non-US suppliers will experience higher costs and lower margins. 2. Companies with non-US buyers will experience higher dollar revenues and higher margins. 3. Companies with both non-US suppliers and buyers might have the two effects cancel each other. 4. The perception that the Bush administration will not rescue the dollar will make it dollar denominated assets unattractive for foreign investors. This will cause it to drop further. 5. The lower interest rates also make it unattractive, again causing it to drop further. In fact this whole dynamic started because the feds reduced interest rates as a way to reduce the price of capital to spur the economy. 6. The net effect of 4 and 5 is that US assets will be unattractive to investors (both US investors as well as foreign). 7. 6 will cause the prices of stocks to drop as supply exceeds demand. The stock market will experience a decline. 8. The lower interest rates have created a bubble in real estate. There is a professor at UCLA called Didier Sornette who claims we are in the middle of a real estate bubble. 9. He reports that real estate borrowing is at an all time high. 10. Lower interest rates have made it easier for people to borrow money for mortgages. With the same down payment and the same monthly payments, the lowered interest rate allow people to borrow about twice as much as before the rates dropped. 11. People who could not afford houses are moving out of rental properties into houses. 12. Money withdrawn from the stock market after its crash is also being invested into real estate. 13. These pressures are causing the real estate prices to increase. 14. Banks are taking the higher prices at face value and lending money freely expecting the underlying real estate to act as safe collateral. 15. However, the banks' reasoning is circular. If the real estate market collapses their loans will become unsecured. 16. The lower interest rates allow people to afford more, which causes higher valuations. The higher valuations cause the banks to lend more money under the assumption that the valuations are real and that the money is secure. 17. People are leveraging over valued real estate to get large loans and causing real estate prices to go up further. 18. This is a recipe for an exponential, unstable bubble. in real estate prices. 17 describes the feedback loop. 19. Any disruption in the feedback loop will cause the market to collapse. Disruptions could include: (a) An interest rate hike by the feds to save the dollar. (b) Saturation of the real estate borrowing market -- any hesitation by real estate investors to borrow more. (c) Saturation of the lending market -- any hesitation by the banks to lend more. (d) News of an economic recovery that causes interest rates to go up. 20. Another source of disruption could be a shake-up in a major financial institution that deals with mortgages or loans. For example, a shake-up at Freddie Mac. Reuters: "The dollar fell broadly, with the euro climbing to session highs around $1.1788 from the $1.1700 area after Freddie Mac, the second largest source of U.S. home financing, said it fired president and chief operating officer David Glenn." Miami Herald: "The federal agency that oversees Freddie Mac, the Office of Federal Housing Enterprise Oversight, is investigating the company's accounting. In a letter to the company over the weekend, agency Director Armando Falcon said he has "become increasingly concerned about evidence that has come to light of weakness in controls and personnel expertise in accounting areas and the disclosure of misconduct on the part of Freddie Mac employees." Also: "Earlier this year, Federal Reserve Chairman Alan Greenspan expressed concern that Freddie Mac and its larger sister in the home mortgage market, Fannie Mae, may not have adequate capital and that many investors have the misperception that they are backed by the government." 21. If Freddie and Fannie are inadequately capitalized, this could be the pin that pops the bubble.