U.S. housing boom goes pop

The May issue of Harper's magazine was a keeper. The cover illustration featured a sepia-toned man of middle age physically bearing the burden of a house (brick, two-story, detached), leather-strapped to his back. A whisk, a tin cup, a ladle and a wooden spoon were pictured hanging from the foundation of the home, heightening the Depression-era mood of the image.

The title of the cover story, The New Road to Serfdom: An Illustrated Guide to the Coming Real Estate Collapse, signalled the clear views of the essay's writer, Michael Hudson, a professor of economics at the University of Missouri-Kansas State.

"Housing prices have swollen to the point that we've taken to calling a mortgage — by far the largest debt most of us will ever incur — an investment," wrote Hudson. "In the odd logic of the real estate bubble, debt has become equal to wealth." This was a curious state of affairs, continued Hudson, seeing as how debt through history "has been little more than a slight variation on slavery."

Thematically, Hudson wasn't breaking new ground. Warning bells about the fragility of the U.S. real estate market had been ringing in some quarters, including The Economist magazine the previous June and, certainly not least, the office of then Federal Reserve Board chairman Alan Greenspan, who cautioned last autumn that house prices had risen to "unsustainable levels" and that "exotic" mortgage products had perilously wooed "marginally qualified, highly leveraged borrowers" into the land of home ownership.

The great strength of Hudson's essay was his 20-point examination as to why it was all going to come undone, each accompanied by a gripping graphic. Particularly striking was the graph that showed U.S. mortgage debt on track to surpass the gross domestic product of the United States by the end of this decade.

As for individual homebuyers, Hudson predicted that growing numbers who availed themselves of those "exotic" lending options would, in the face of falling house prices, no longer be asset rich, but rather "negative equity." And in that state, these same homeowners would find themselves indentured to a lifetime of debt service — hence the "serfdom." The whole economy would suffer as a result as the great U.S. engine of economic growth, the consumer, retreats to his or her foxhole.

There were many loud voices then protesting that no such bubble existed. But as the estimable Charles Kindleberger once wrote, "a bubble is an upward price movement over an extended range that then implodes." In other words, you have to wait for the popping sound to know that it is so.

We now know that it is so in the United States. Many observers have seized on the recent dire news from Toll Brothers Inc., the Horsham, Pa., based company that bills itself as "the nation's leading builder of luxury homes." Profits are down. More arresting, the company has substantially reduced its land position, thereby red-flagging its declining confidence in future sales. Robert Toll, the company's chief executive officer, assessed the situation this way: "The speculative buyers of 2004 and 2005 are now sellers; builders that built speculative homes are trying to move them by offering large incentives and discounts; and some anxious buyers are cancelling contracts for homes already being built."

As Paul Krugman wrote in The New York Times: "Pop!"

House sales are falling. Foreclosures are up. See Massachusetts, where foreclosures increased by more than 50 per cent in July from the same period the year prior. See Detroit. See Dallas, where the Dallas Morning News reported last week that mortgage defaults in the Dallas-Fort Worth area are up 30 per cent.

Those holding firm to the belief that housing woes exist only in such pockets could not have welcomed yesterday's news from the Washington-based Office of Federal Housing Enterprise Oversight, which reported the sharpest quarterly decline in home prices since its house price index was launched in 1975. "[T]he deceleration," said director James Lockhart, "appears in almost every region of the country."

Of course, it takes a real live person to hit the story home, as it were. And so we meet Eric Fenton, who told the Dallas Morning News that as his mortgage payments rose on his adjustable rate mortgage by $200 a month, and as the cost of utilities rose too, he had no choice but to put his house on the market. There were no buyers.

About the time that Michael Hudson's piece appeared in Harper's, GE Money, the Canadian consumer lending arm of the General Electric Co., said that it was launching a 40-year amortization mortgage option, and that it was the first lender in Canada to do so. The date was April 28. I know this because I wrote the words "tipping point" in red ink in my day book.

Two months later, Canada Mortgage and Housing Corp. announced that it would now offer mortgage insurance on interest-only mortgages for up to the first 10 years on the purchase or refinancing of a home. "This new option will give borrowers greater flexibility in managing their cash flow," the CMHC said in its press release.

Twenty years ago, when I purchased my first home, CMHC was the stern, faceless housing agency that insisted on a 25-per-cent down payment before I could consider being a home owner. The notion of waiting a decade before even touching the principal on the biggest debt burden most consumers will ever bear was unheard of. In those days, banks, wisely, were aggressively marketing accelerated amortizations. "Cut seven years off the life of your mortgage!"

Some of us remember confident assertions that the Toronto housing market would not deflate because Toronto was immune. Like Manhattan! Some of us remember the subsequent pain suffered by negative equity neighbours, not to mention 18 per cent rates of interest.

Times change. Interest rates have stayed pleasingly low. House prices have inflated to such a degree that it's easy to feel "rich." As an economist I spoke to on this topic said, homeowners would assay the increased value of their home and head out to enjoy a fine dinner "on the house." Without the real money to do so, you understand.

Home-equity loans became all the rage, and then interest-only home equity loans. If one's home is valued at half a million dollars, surely it deserves a stainless steel Sub-Zero "monument to food preservation," a.k.a., a spiffy refrigerator.

In such an environment it seemed not at all appropriate that CMHC would be marketing the very same exotica warned of by Mr. Greenspan. (An aside: the Australians have taken to calling 50-year mortgages, which I understand are on offer, "death-bed mortgages." You don't pay them off. You will them to your kids.)

The optimists persist in the view that Canadian real estate investors have nothing to fear. There is no bubble here.

Still, a recent report out of TD Bank Financial Group flashes what it calls "warning lights" because of dramatic price gains in Edmonton, Calgary and Vancouver. Here's a big number: in the second quarter of this year, resale home prices vaulted 43.3 per cent in Calgary. But, added Craig Alexander, the bank's deputy chief economist, affordability appears not to be an issue in that city, nor in Edmonton, where household related costs were 18 per cent of median household labour income.

Vancouver is another story. There the affordability ratio climbed from an already lofty 39 per cent in 2005 to 50 per cent last year. "In my mind the Vancouver market is the one to watch," Alexander said. "We won't know if it's a bubble until after the fact."

As for Toronto, price growth, said Alexander, has slowed to more historic norms. That's a comforting thought: no sudden movements. Less comforting in my neighbourhood are the For Sale signs that have popped up on a string of town homes that were initially sold preconstruction. It just smells like speculation to me.

We can hope that that's not true. But the news out of the U.S. has moved from denial, to segmented worry, to awful. Will that lead to a down-shifting in the U.S. economy? Absolutely.

The skittishness level is rising. Economists hate that. Why? Because it's unquantifiable. All it takes is a turn in investor sentiment and then, as Paul Krugman said, "Pop!" Or, as Michael Hudson phrased it, "Only the debt itself will remain."