Warning signs of the housing bubble crash (part two)

Sunday, January 01, 2006 by Mike Adams, the Health Ranger Editor of NaturalNews.com (See all articles...) Tags: housing bubble, real estate bubble, interest rates

This is Mike Adams talking about the looming housing bubble burst in the U.S. real estate market. It's coming. As I said before, I predicted the dot-com bust, but I was three years early. It's impossible to predict the exact timing on these things, but when the signs are there, you know it's coming. Eventually, it will go so far and people will get sane, and then things will start to unwind. It will accelerate towards a price collapse because there is a cascading effect. Once the housing prices collapse in one region, it can spread to another region.

That's what's going to happen in the near future. This bubble market cannot stay propped up for very long. Now it may be three months from now or it may be three years, or even five years, before this happens. I can't say for sure. I can tell you, it's coming. I see a major correction in store for this trend. So what are the warning signs? Why am I so sure this is happening? There are a lot of signs.

The first warning signs of the bursting housing bubble

First, remember that things get overheated when the general public begins to spend money on investment vehicles with the idea of quickly doubling their money. When enough people get into speculation, it is a sure sign of a bubble. When people aren't buying a house for a place to live or as a long-term investment vehicle to rent out, you know the market is overheated. When you hear a lot of people talking about "making money on their house", then you know there's a big bubble. So, that's one interesting sign. It's not very scientific, but there are far more scientific signs to be seen.

Normally, when you buy a house as a landlord, the rent that the renter pays you covers your mortgage costs, plus a little bit more. That's what happens in a normal, healthy economy. Let's say you go out and buy a home valued at $200,000 and you rent it out for $1,500 a month. That $1,500 a month should cover your mortgage payment, plus a little bit more for maintenance. This is what happens in a normal market. But in a bubble economy, or a bubble housing market, there are so many people buying houses for speculative purposes that this is an oversupply of houses available for rent. Therefore, the demand from renters stays the same, but the supply of houses available for renting expands. This glut of houses for rent becomes unusually large because all these investors have bought houses and condos with the expectation of making money on the speculation. It's not just houses, either; it could be condos or apartments as well. I'm just using "houses" in a generic sense.

How do you know when there is a glut of houses for rent on the market? You know because rent prices begin to fall relative to the price of buying a place to live. It's standard supply and demand economics. Prices begin to fall because there are too many houses available for rent and not enough renters. No landlord wants their house to go un-rented for five years, so they start lowering the rental price to get renters in. So, there's an artificial suppression, a lowering of the monthly rental prices on houses available for rent. This creates a gap between how much you get in monthly rent for a house (as an owner) and how much you have to pay the bank for the mortgage. Let me give you an example...

Let's say you bought a $200,000 house, a second home, because you intend to double your money as property prices go up. You're hoping to spend $200,000 today, pay the bank for a few years, and then sell that house for $400,000. This is what people are thinking. Well, unbeknownst to you, everybody else is doing the same thing, and all of a sudden, there are a whole lot of houses available for renters to rent. What does this do? It suppresses the monthly rent fee. The market is too competitive for you to get $1,500 for monthly rent. You can get only $1,200 or maybe you can only get $1,000.

Now you're only getting two-thirds of what you used to get, and what you're getting may not even cover your mortgage. When it crosses that line, it is a sure sign of a housing bubble. When the monthly fee you charge to rent your house drops below the monthly mortgage payment on that house, that's the sign of a housing bubble. That's the sign of a supply-side glut of housing, and that's what's happening today. In other words, you can go out and buy a home and you can rent it out, but you can't get enough from the rent to cover the mortgage payment. It's because there's a housing bubble.

Low-interest, easy-qualification home loans

So far, that's two signs. The first sign, remember, was what I call "the word on the street." Everybody thinks they're going to get rich by investing in houses. The second sign was when the monthly fee you get in terms of rent runs below your monthly mortgage payment. So, what's the third sign that there's a housing bubble in this country? It's found on the lending side.

You see, lenders are getting very creative. They only make money when they lend more money to more people, right? When you're a lender and you've got to close some deals, how do you do that? You make it easier and easier for people to get home loans. This is especially important as house prices continue to increase.

Fewer and fewer working people can actually afford home loans under the old, tighter rules of home loan qualification. So, if you are in the banking industry or the lending industry, you have to loosen those requirements so that more people can qualify. As a result of this, we're seeing some really radical stuff in the home lending market. Essentially, we're seeing home loans go out to people who should not qualify for home loans, and they're being structured in a way that almost guarantees financial disaster.

A recipe for disaster: variable rate mortgages

Here's how it works: You've heard of the variable rate mortgages, where you have a low interest rate today, but that rate is tied to the prime rate. If the Fed raises the interest rate, mortgage payments go up. There's really no limit to how high it can go. In the late 1970s, interest rates were 18 percent, and today people are complaining about how much interest they're paying on a house at 6.5 percent. Wait until it's 18 percent. If it gets that high, your monthly payment will essentially triple.

Interest-only home loans

The second part of this is that lenders are qualifying people for home loans and structuring these loans so that you are not required to pay principal for the first few years. If you know anything about personal finances, you know that normal home loans are structured as interest and principal. If you pay $1,000 one month on your mortgage, you might pay $900 in interest and $100 in principal. The hundred dollars goes to actually pay down what you owe on the house. The $900 goes to pay the money you borrow that month. So, you can pay on a house for 10 years and have very little equity, depending on how the loan was structured.

But today, there are radical loan structures that are interest-only loans. You pay for five or 10 years, and you own nothing. You pay interest only. There are people who think they own their homes, paying interest only. They're building zero equity. Some of these people are qualifying on 5 percent down. There are people qualifying for even less, but that's the typical low qualification happening today. You can buy a $200,000 house for $10,000 in cash, and you pay no principal. You pay nothing but interest for five or 10 years, and it's a variable rate interest, as well. This is a financial time bomb just ticking away.

The domino effect of rising interest rates

The first thing that will happen in this country when interest rates go up, as they eventually will, is that a huge percentage of homeowners won't be able to make the payments on their home. Their credit card payments are due, and those are higher, too (thanks to higher interest rates). Then their house payment comes due. They were paying $500 a month. Now they have to pay $1,000 a month because interest rates are 12 percent. What happens? They can't make the payment. What do they do? They sell the house, or they try to hang in there for a while until the house gets repossessed, and the bank sells it. Either way, the house is getting sold. The house then goes on the market, adding to the supply glut of homes for sale. It's not just this one family that's affected, because interest rates affect everyone. Suddenly, a large group of homeowners can't make the payments all at once.

So, what happens to the price of houses when, say, a mere 4 percent of all homeowners suddenly decide to sell their homes at the same time? Prices plummet, and they plummet so fast that all the people who own homes can't sell them quickly enough. The condo you paid $100,000 for is only worth $80,000, and then it's only worth $70,000, and then it's only worth $60,000, and it continues to drop. Your condo ends up being worth only half of what you paid. Now you owe $90,000 because you didn't sell it yet. You owe $90,000 on a condo that's only worth $50,000 because the housing market popped. The bubble burst.

Banks recall their home loans

What do you think the bank is going to do? Do you think the bank likes to have a loan out to an individual who owes them $90,000 on property that is only worth $50,000? Do you think they want that kind of risk exposure? Absolutely not. In fact, they will not let it stand. They will recall your loan.

Read the fine print on your home loan. Your bank can make you pay the difference between what your property is worth today, and what you owe them, plus a little bit more to make sure that you have at least 20 percent equity. So, let's do the math:

Your property is worth 50K now, and you owe 90K to the bank. The bank wants you to only owe 90 percent of 50K, which is $40,000. The bank only wants you to owe 40K, but the difference between 40K and 90K is 50K. In other words, the bank will come knocking on your door and say, "Write me a check for $50,000 today, and if you don't, we will foreclose your condo, take your property, and you still owe us $50,000. We'll take that out of your other house." So what happens next? Well, the owner panics and agrees to sell the condo, so that is one more condo on the market, suppressing prices even further.

The cascade continues. The domino effect accelerates across the entire economy. This is the house of cards collapsing right before your very eyes, and now the bank is after your primary residence, and they want 50K. You paid $200,000 for your primary residence, and let's say you have $50,000 worth of equity. Do you think you can take out $50,000 on a house that's worth $200,000 when you only have $50,000 in equity? Of course not. The bank will not loan you 50K on a $200,000 house that you already owe $150,000 on. In the best-case scenario, they will loan you $10,000 on that house, because they don't want to go beyond 80 percent of the market value.

Basically, the maximum you could take out of that house is $160,000, because that's 80 percent of $200,000, and you already owe $150,000. So you can only borrow $10,000. You get a second mortgage, you take out $10,000 more. You pay that to the bank that you owed $50,000 to, because you lost $50,000 on the condo. Guess what? You still owe them $40,000. What are you going to do now? You still owe them $40,000 and you're maxed out on home equity loans on your primary residence. To make matters worse, the value of your primary residence may be falling, too.

Do you see how this cascade continues? What people will be forced to do, unless they happen to have $40,000 sitting in the bank, is downsize. They're going to sell their primary residence and move into the condo (that they thought was their "second home" but now becomes their primary residence). Do you see what I'm saying? They're going to sell their bigger property and move into their smaller one. Before all this happened, they thought they were going to live in their big house and make a fortune on the price doubling of this secondary residence. What they didn't figure was that the housing bubble would crash. So, what they end up doing is selling their primary residence and moving into the condo or secondary residence.

Property price crashes cascade quickly

This is exactly what happened in Texas in the 1980s: A big real estate crash. This is what happens in every real estate crash, and the thing about real estate today is that it's all more interconnected. The internet is teeming with real estate. Everyone can check everybody else's prices instantly. Click on a website and you can check the price for any home for sale, virtually anywhere in the world.

Plus, people are more mobile today. They can more easily move from city to city, and do you know what that means for the housing bubble? It means that every action is systemic. It means that once this bubble bursts in one city, it may more easily spread. It's going to be ugly because we may be left with what happened in the Bay area and Silicon Valley after the dot-com boom: Million-dollar condos were abandoned. Million-dollar homes were abandoned. The builders were going crazy, thinking they were going to get rich selling these half-million-dollar condos to software entrepreneurs, who thought they were getting rich, because on paper, they were worth $10 million because they owned stock in a company that was fueled by investor cash (but had no customers).

It turned out the whole fiasco existed only on paper. Almost none of the dot-com companies were making any money doing anything, except trading pieces of paper. The same thing may happen in the housing market. The whole thing is an empty shell. It's eventually going to come tumbling down. The only question is whether it's going to be a correction or a crash (the difference being the severity and speed of the inevitable price corrections).

See the big picture

There's no question whatsoever that this housing market will experience a correction. Whether it will prove a drastic bubble bursting, a crash or just a gentle lowering of the market is, of course, debatable. I tend to think it's going to be more of a harsh correction. Why? Because the Government cannot artificially keep inflation rates low in this country forever. I think the deficit spending by the Bush administration is a huge factor in all of this, and that practice stands at great odds with low inflation rates. Eventually, inflation is going to affect the housing markets.

Today, I don't care if anybody thinks I'm right or wrong. I'm writing this as a service to my readers, whom I respect and genuinely care about. This is a warning to all of you to look closely at what's happening in the housing market. I don't want you to lose your life savings. I saw too many people lose their retirement, their homes and their life savings during the dot-com collapse. I saw it happen to family members, close friends and business associates. I don't want to see it happen to you.

If I only cared about myself, I wouldn't say anything about this (because I don't own any second homes). But that's not my attitude. I want to help prevent this kind of financial disaster from happening to you. What am I saying, specifically? I'm saying if I owned a second home right now, I would sell now.

But I am not attempting to be your financial advisor, and I'm not taking responsibility for your finances. You've got to make your own decisions. You've got to work with financial experts you trust. Nearly every financial expert I heard during the dot-com boom was advising people to keeping buying. When it started crashing, these same people were telling people to buy even more. So, I don't trust many financial advisers. I've tried to explain some of these concepts to financial advisers, and they just look at me with glassy eyes, and tell me, "Too many numbers." Too many numbers? These are simple concepts.

Explained: Fictional stock market wealth

For example, let's say five people each own one share of a company that has only five shares. Let's say each share is worth $10. How much money is there total? Well, it's five times 10, so that makes $50.

Now, let's say that one of these five people decides to sell his share to his friend, but he's convinced his friend to buy it for $20 (a profit of $10 to the seller). He sells one share to his friend for $20. What's the share price now, for the whole company? The share price is $20 because the share price is based on the last sold price. Now there are five people and each of them has one share that's worth $20. Suddenly, there's $100 total instead of $50 total. All five people think they've just doubled their money!

That's what happens in the stock market. See, all five people think they're getting rich. But what really happened is that one idiot bought the stock at double the price. There was no new customer, no new business revenue and no new profit. There was just one guy who overpaid for the stock. That's how fictional wealth is created in stock market exchanges. It's just an illusion. Where did this extra $50 come from? It came out of nowhere. It's just numbers on paper.

The reverse also happens. Let's say there are five people who now own stocks that they think are worth $20, because that's what one person paid. Then, one person decides to sell the stock but can only sell it for $10. Suddenly, the stock price for the entire company drops to $10. Now these five people who thought they had $20 each just lost $10. They lost half their equity in the company. Now they only have $10 each, and the total worth is now $50. Where did the other $50 go? Well, it didn't go anywhere because it didn't exist. It was just on paper. This is what happened during the dot-com boom, except that larger sums of money were involved.

What does all this have to do with home loans? Banks loan money to people based on their individual assets, and those assets include fictional wealth that only exists as numbers on paper (or bytes in a computer database, actually). And these numbers can be easily distorted by irrational buyers who overpay. As a result, many banks are making home loans using little more than thin air as the assets backing the loans.

This is how a real estate bubble happens at the same time as a stock market bubble. This is San Francisco in 1999. This is Silicon Valley in 2000. It's exactly what happened. At that time, I was warning about the looming stock market crash, and it was poorly received. A few people listened and they sold their stocks and were safe, but most people didn't. They said, "You're crazy. This thing is going up forever. We are all rich. We are all rich!"

But I knew better. When you sell a share and you have cash in your hand, then you can count it as money. Until then, it's just whatever somebody else paid for it. My point in explaining all of this is that I've told this same story to financial advisors. They would look at me and say, "What? I don't get that. What do you mean? What do you mean that money is created out of thin air?" They don't get it. When the dot-com crash happened, billions of dollars were lost overnight through that exact same method I just described. Billions of dollars did not fly away. Those dollars did not get transferred into some rich person's pocket, which is what most people believe. They think rich people ran away with the money. That's incorrect. The money never existed in the first place. The money disappeared overnight because suddenly the stock price was dropping rapidly.

Take your money and flee the housing market

Friends, I believe it is time to take your money and exit the speculative real estate market. The average person doesn't understand anything about finances and never will. The average person can't even calculate a 15 percent tip at a restaurant, and he or she is buying real estate because he or she wants to double his or her money. Are you kidding me? Take your money and run; that's my advice. Run from the inflated real estate marketplace before you become another victim. These super hot, speculative housing bubbles and stock market bubbles cannot continue. They always correct. Gravity kicks in, and, eventually, things unwind. A lot of people get hurt. They lose their money. To some of those people, I say, "That's a really expensive education you just paid for." A lot of life's lessons are hard to learn, but some of them can be rather expensive.

That's my personal advice. I'm not trying to play your financial adviser. You can make your own decisions in these matters. This is my personal opinion based on experience and analysis of the market. I've been watching this thing for quite some time, and the signs are now becoming very, very clear. Actually, I've been watching this thing for a couple of years. I saw it get overheated. I was seeing it in my own city. When you see property prices going up 25 to 30 percent a year, for six years in a row, that's pure speculation. House values don't normally go up that high. There's no justifiable reason. The population isn't increasing 30 percent a year. There's not that many more people bidding for the same house. There's something else at work if prices are skyrocketing that quickly.

So, it's December 2005. I'm going on the record as saying this bubble is going to pop, folks, and you can call me a pessimist or a doomsayer if you want. The fact is, if you understand math, you know I'm right. If you want to protect your own finances, you'd better take a good, hard look at this and make some decisions about what you're going to do. Do not leave yourself over-leveraged in speculative real estate. You thought you were going to retire on the beach, and it ends up you're flipping burgers as a second job to pay off what you owe the bank, and they garnish your wages on top of that. That's what happens to people who don't get out in time.

By the way, I have nothing for sale here. I don't sell home loans, and I don't have a book on this subject. I'm just passing this along, because I don't want to see people hurt again. A lot of people will never hear this message, and a lot of people who do hear it will say, "This guy doesn't know what he's talking about. He's not a real estate investment guru. He's not a banker. He's not a financial expert. What does he know?" That's why I'm going on the record. We'll find out.

We will find out what happens to housing prices in the years ahead. We'll come back and revisit this, and we'll disassemble the popping of the bubble after it happens. It will be interesting to see if anybody gets away unscathed in this big scam. The best way for you to escape unscathed is to make sure you are not over-leveraged. Have some equity in your home. If you can pay extra to pay down your mortgage, you should do it now, and don't go out and buy an overpriced home just for speculation.

Don't compromise the roof over your head. Don't compromise your family's residence just to try and make a quick buck in the overpriced housing market. Protect your residence and your family. If you have extra cash, put it into your own house right now. Own your house. This has been a rule I've lived by for many years. You should owe nothing to any bank on a house you live in. In my opinion, until you have 100 percent equity in your own home, you have no business investing money in a second home. You should first give yourself the financial foundation of owning your own home free and clear. Once you have taken care of that, you can afford to risk cash in the housing market, if you so choose.

Until then, you're crazy to do so, and I know a lot of bankers and financial people will strongly disagree with this line of reasoning. They'll say, "No, no, no. Mortgage everything. You should highly leverage your first home and mortgage your way into a second or third home, and you'll be rich when things go up." What they're not telling you about is the potential downside. What happens when those prices you just paid for those second or third houses are cut in half because the housing market pops? Then you lose your third home, abandon your second home, have to sell your first home, and you still owe money.

Don't let that happen to you. Be smart. Pay attention to what's going on. Don't follow the sheep. Do you know where the sheep are heading? They are headed to the slaughter, just like they did in the dot-com boom. People were led right into a financial slaughter, and they got taken, too. Their life savings were taken away virtually overnight. Don't let it happen to you.

Here's one more thing: what if I'm completely wrong about the timing on this? What if it takes five years for prices to correct rather than five months? My answer is simply this: it's better to be out sooner rather than later. It's better to miss out on some gain (opportunity cost) than lose your life savings in a real estate crash. And if you think the housing market will always go up -- forever -- then you have no business investing in the first place. The laws of economics have not been rewritten. When interest rates rise, this real estate balloon party is history.