Defying Economic Gravity on Home Prices

I’ve been trying hard not to get into politics, but let’s take a quick detour there and try to hurry back before we cause too much of a ruckus.

For a short synopsis on the financial crises, see Scott Adams here.

Once house prices started rising, too many people were hooked on the drug. This means not just the banks and the speculators, but also government, desperate to shore up a struggling economy with a mountain of debt (they kept rates low, helping to inflate the bubble), home owners using rising equity to finance more debt and the broader economy that benefited from the consumer spending that drives the American economy.

That a bubble was coming was obvious to anyone who cared to pay attention. But once various sectors of the economy were hooked, they didn’t want to get off the gravy train.

How did we know a bubble was coming? Putting on our pricing hats (which should also mean our value hats), it’s not enough to show that prices are rising. They were rising faster than other sectors of the economy that should be tied to the value of homes, such as incomes and, even more critically, rental prices. A Value Price Waterfall comparing purchasing a residence to renting one would show some differences in taxation, maintenance, convenience, and other attributes, but they should be pretty similar. When purchase prices greatly exceed rental prices, you have a speculative bubble, betting on rising values making the asset more valuable than it should be. For a country that just went through the bubble, where company values outstripped any reasonable valuation, simply on the expectation that the valuations would keep going up, we have a very short memory. (Plenty of other people could write more insightfully about that.)

What’s worse than the run-up in house prices are the financial derivatives based on those house prices that Warren Buffet called “financial weapons of mass destruction” and that Adams calls “diseased livestock.” Now the politicians and bankers are trying to cover their losses and put a voter-friendly face on it by trying to prop up housing prices. The problem is that they are too high. You can try various ways to subsidize them, but it’s going to be expensive and the people who are politically well-connected will benefit more than the average homeowner.

The fact is that housing prices have to fall, and this is going to cause a lot of pain. It was a big party, and the whole global economy has a hangover, whether or not that’s fair. While some form of government intervention is probably desirable, trying to prop up home prices brings back memories of Soros’ famous and very profitable bet against Great Britain trying to prop up the value of the pound.

Imagine that instead of houses, there had a been a speculative run-up in the price of iPhones. Apple, Wall Street, and others drive the price up to $5000. When the bubble bursts, the government tries to keep the prices close to $5000 and asks taxpayers to foot the bill. Sounds absurd, right?

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