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Foreclosures.com: "House Prices Will Roar Back in 2009"
Howard Richman, 1/6/2010

If you are about to buy a house because of this forecast, then you are a sucker. Here's a quote from the story:

SACRAMENTO, Calif., Dec 09, 2008 (BUSINESS WIRE) -- The nation's foreclosure hemorrhage has finally slowed and 2009 should see a significant decline in foreclosures as buyers return, pushing home prices up and fueling a real estate recovery, according to the 2009 Outlook from ForeclosureS.com, the leading real estate and property information and education specialists.

"Recovery is underway. Affordable is back in the housing market," says Alexis McGee, real estate expert, educator, and president of ForeclosureS.com. "In 2009, housing will not only recover, but we'll see buyers leap into this market in droves, depleting our housing oversupply, and actually put higher price pressures on the market."

"With 4.5% fixed mortgage rates, housing prices lower than they were 'pre-housing bubble', commodity prices lower, tax credits available for homebuyers, and the government eager to stimulate our economy, for the first time in years I can see prices rising again in 2009," adds McGee. "This is a great time to buy properties for investors -- to buy properties at wholesale prices below today's already low prices -- rent them out for positive cash flow and then sell them for big profits in late 2009 once price appreciation kicks in."

But, here's the graph of the housing bubble so far:

As you can see, house prices are nowhere close to their normal levels. (.) A little review of how we got here could help.

From 1951 through 1997, whenever a homeowner sold his or her primary residence to buy another residence, the capital gains tax was deferred (i.e., rolled-over) until the new home was sold. Homeowners would typically build up their equity in one home, sell that home, and then use their savings to make a downpayment on a larger home. During that period, there were large changes in interest rates, yet home prices were quite stable as shown in the graph below:

This is non-seasonally adjusted data through September 2008

Interest rates probably caused some of the price appreciation after 1997. Governments around the world have been building up their dollar reserves since 1996, sending their countries’ savings to the United States. The increase of foreign savings flowing into the United States caused real-long term interest rates to fall precipitously from 4.5% in 1996 to 1.3% in 2005 (see Chapter 2 of our book). The fall in interest rates tends to push up house prices, both because it reduces mortgage interest rates and also because it reduces the returns to competing investments.

But it took Congress to get the house price bubble started. In 1997, at the urging of President Clinton, they eliminated the capital gain tax paid by most homeowners. This action told speculators that the capital gain that they would earn if they bought a house with plans to sell it would probably be higher, since it would be tax free.

Under the new provision, almost anyone who had lived in a house for 2 years of the past 5 years could sell the house free from capital gains tax. The new policy encouraged people to gamble on real estate. If they saw that houses were going up in price, they would buy in hopes of getting a tax-free capital gain.

Here is how Kenneth Harney (2008) described how the 1997 tax treatment encouraged speculation in a Washington Post article about Congress’s 2008 attempt to tighten its provisions:

[Property owners] can claim the exclusion [from capital gains taxation] even if they convert an investment property or vacation house into their principal residence and live there for at least two years. This flexibility has been a boon to many tax-wise owners of multiple houses – particularly during the bubble years when values doubled in some parts of the country.

Property owners in markets with high appreciation rates could sell their principal residences for hefty profits – pocketing the first $250,000 or $500,000 tax-free – and then move into their rental condo or vacation property for a couple of years and repeat the process.

In effect, it was a form of financial alchemy where taxable profits could be magically transmuted into tax-free gains – at least up to the $250,000 and $500,000 limits.

The Housing Bubble that began in 1998 had other contributing factors, but Vernon L. Smith, a Nobel Prize winning economist largely due to his laboratory study of economic bubbles, held that it was primarily caused by the 1997 legislation. He pointed out that, at the time it was enacted, the 1997 legislation was quite popular among the industries that were most severely hurt when the bubble burst. He wrote, sarcastically:

Thank you President Bill Clinton for your 1997 action, applauded by the banks, the realtors and all citizens in search of half-millionaire status from an investment they could understand and self deceptively believe to be low risk; thank you for fueling the mother of all housing bubbles; thank you for enabling so many of us who bought second or third homes, and homes before construction began, which we then sold to someone else who dreamed of riches from owning homes long enough to sell to another fool.

Smith argued that, instead, Congress should have done exactly what we recommend in our book. Specifically:

More daring than the action to exempt real estate from the capital gains tax -- and in lasting service to the poor -- would have been actions allowing capital gains on all assets to go tax free, provided that the capital was reinvested -- i.e., not consumed, and yes, good citizens, housing counts as consumption.

During the asset bubble, homeowners depleted their savings, leaving them with less money for a future downpayment. Tyler Cowen (2008) described this psychology in a New York Times commentary:

The fundamental problem in the American economy is that, for years, people treated rising asset prices as a substitute for personal savings. The thinking went something like this: As long as your home’s value rose every year, you didn’t have to set aside so much from your paycheck….

In fact, people did more than stop adding to their personal savings. They began subtracting from their personal savings. As documented by Louise Story in the New York Times, bank advertising campaigns encouraged people to consider the rising value of their homes to be income, to be consumed in the present. They urged homeowners to take out second mortgages on their homes so that they could increase their current consumption and coined the new term “equity access” to replace “second mortgage.” Borrowing on home equity increased steadily.

You'd think that economists would understand what was happening at the time, but as recently as September 2005, Charles Himmelburg, a senior economist at the New York Federal Reserve, co-authored a NY Fed staff report and an NBER working paper which claimed that there was no housing bubble. You really have to read this one to believe it.

Just 9 months later, in June 2006, house prices peaked and the house price bubble began to burst. Now house prices will probably keep falling for awhile unless overall inflation forces prices upwards.

Howard

p.s. Follow the following link to see the original Shiller index starting with 1890 as it appeared in his 2005 book Irrational Exhuberance: http://graphics8.nytimes.com/images/2006/08/26/weekinreview/27leon_graph2.large.gif

[This piece was initially published on our old blog on December 9, 2008]