Interview With Chris Thornberg
Christopher Thornburg is a senior economist at UCLA Anderson Forecast, an economic forecast group based within UCLA's Anderson School of Business. Thornburg argues that California and some other parts of the US are clearly in the middle of a real estate bubble. Below are edited selections from his interview with NOW.
A real estate bubble, or any asset bubble is not a situation where you hear a pop. Everyone always associates bubble with a pop. They think, gee, if there's a bubble, there must be a pop! coming at the end. That's not what a bubble is. A bubble is when the price of an asset becomes misaligned with the fundamentals that truly determine the price of that asset.
Let me give you an example of what I'm talking about here. Amazon dot-com -- let's go back to the NASDAQ days. At one point in time, Amazon was worth $180, $190 a share. The big question is: was that stock worth $180, $190 a share? Well, what determines the price of a stock? It's the net present value of the profits that accrue to that stock in the future. That's what we teach our MBA students. When they buy that stock, you're buying a share of the profit stream that comes from that company today and in the future. Some bright economist at one point in time, sat down and said, "Well, gee. What if Amazon dot-com captured 100 percent of the DVD, book and CD market in the U.S.? Would they ever make enough profits today or in the future to justify a share price or the market capitalization implied by the share price of $180, $190 a share?" And the answer was no way.
So, when you're talking about a house, and when I say we have a housing bubble, what I'm talking about is that the price of a house is determined by the stream of profits that accrue to that property today and in the future. And that of course is determined by the rental value of that property today and in the future.
Now, the reason I go through all this is, because you have to ask yourself the question, are we in a bubble market or not right now? And the answer is, as I firmly believe, is we are in a bubble market. And the reason I believe that is, there is no justification, there's no underlying fundamental that would make me think that a house in California today is worth 40 or 50 percent more than it was two or three years ago.
Because let's think about the fundamentals. There's two big fundamentals. There's two big drivers here that we have to worry about. One is mortgage rates and one is rental streams, which is a function of the supply and demand for housing.
So, the real question is: when you think about the price of a house in California, it's gone up something like 40 or 50 percent over the last three years. Now, let's think about the fundamentals. Let's think about rental values. Okay? What about rents today? Or let's think about rents over the last few years. Have they gone up? No. Actually, rents in California topped out in 2001. And since then, they've been basically flat. There's been no growth in the rental market. In other words, there is no kind of mismatch between supply and demand in housing, at least as implied by rental rates in California. Rents have been flat.
There's no indication that we have a big housing shortage on that particular front. Well, how about in the future? Are we gonna have a big housing crunch in the future? There's some reason to believe that there's gonna be this massive housing shortage in the future? Well again, the answer is no. If anything, the pace of homebuilding in California relative to population growth is much higher today than it was a couple years ago. That says to me the opposite, that we may actually end up with a housing glut in five or six years, which again implies weak rents, which implies that you should not be seeing this massive increase in housing prices.
Right now, the market should cool off. And it [hasn't]. [It's] accelerated. Prices went crazy. And that is in fact a bubble. Cause the fundamentals all say one thing: a flat market. And prices are doing something completely different
So then you ask yourself, well why would anybody buy a house in this particular market? What would cause them to do that? And the answer is, there seems to be this expectation that housing prices are gonna go up by ten percent no matter what. What you have is, you have a buying public who are not thinking about the fundamentals, who just assume that housing price appreciation is a given without thinking about the fact that the price of a house is related to two very important factors: rent and mortgage rates. And both those factors say the housing prices should've been flat over the last two and a half years.
So, just like in the NASDAQ bubble, you have a circumstance in which people just expect appreciation, and as a result of thinking that there's just going to be appreciation and that's the way the world works no matter what, they're making bad financial decisions. And that's really why I call this a bubble.
What happens is, is people say "Gee, housing prices went up by five or ten percent last year. I gotta get into the market. This is a great place to make money." So, a bunch of people run into the market trying to buy houses. And lo and behold, the prices go up, thus fulfilling their expectations and causing more people to turn around and go, "Hey. I gotta get into this market." And they go rush into the market, thus causing the prices to go up yet again. You see how this works? It becomes this cycle.
This can only work as long as you have new people to enter the market and keep this pyramid growing. Functionally what it is, it's a pyramid. And the pyramid works as long as you keep entering people at the bottom end.
Now when you start thinking about interest-only, variable-rate loans, what your talking about is a market that is so distended and needs these new buyers [to] enter the market so desperately that these mortgage companies will do anything to make these people qualify for a home. And that implies getting them involved in very risky loan situations that they should not be in, because that's the only way they can get into the market.
What you're seeing is a market that's really coming close to its last leg. It's running outta people entering the bottom of the pyramid, and therefore is resorting to crazier and crazier financial instruments to get these people in. It's just like back in the stock market days of 1928-1929, just before that big crash, when all sorts of people were borrowing against their stock holdings, to buy more stock, thus inflating the making-- to a greater and greater and greater extent. And that's sorta the same idea of what we're seeing in this particular market, where these loans of a symptom of an overheated market, not a cause of it nor necessarily any verification that we're not in a bubble.
I'm not saying don't buy a house. I mean, everybody should have a house. You want a place to raise your kids. You want a place to live. You want a place to call your own. I'm all for owning a house. But right now, it is a low return transaction. If you're thinking towards the future, thinking towards your retirement, and your kids' college education, if you're spending every penny on your mortgage, you're spending every penny putting money into a house, if you're even putting money into that house, if you have an interest only loan, you're not even doing that-- putting money into a house that is at best, a low return asset.
Where if you were spending more in line with your income, you would have enough left over to invest in more traditional assets, that will give you a much better return over the next ten years. Things of course like, stock portfolios, or bonds.