What the hell were they thinking?

It’s when I read articles like this that I realize just how naive most people want to be:  http://blog.oregonlive.com/breakingnews/2008/06/oregons_housing_slump_hits_hom.html.

Specifically I’m referring to the section where the home-building industry “didn’t think the boom and bust would be so severe.”  Let’s step back and think for a moment about that shall we?  First of all, the article cites the primary reason for a housing market boom as being the relaxation of crediting and financing policies to include previously untapped consumers.  Between 2004 and 2007 loans were issued to consumers with poor credit, no down payment, or salaries that didn’t justify the amounts borrowed.  Why is it a surprise that this isn’t sustainable growth?  This is another classic case of people being naive on purpose.

I know, here’s a great idea.  Let’s pretend everyone earns twice the salary that they actually take home with them.  What we’ll do is allow them to spend more than they make every month by loaning them some large amount up front and see how long the growth lasts.  Oh look, after a few months we ran out of new consumers.  Even worse, the consumers that did sign up now can’t make the payments.  Hmm, I wonder why it wasn’t sustainable?

My advice to everyone who is reached by the “Buy Now Oregon” style campaigns is to hold off for a while.  At the end of the day houses sell for “$$as high as possible” (read largest amount of money we can get you to pay).  This is how people expect to make money by turning houses over.  Long-term it’s a myth.  I’ll explain my reasons for that belief in a moment.  For now, suffice to say that the housing market is tumbling.  Oregon is typically one of the last to fall and one of the last to recover.  Therefore, why would buying a house now be a good idea?  All you’ll end up with is something that is going to lose value over the coming months.  As always, I could be completely wrong on this so please use your own judgement wisely as your mileage may vary.  However, my instincts tell me that things have yet to truly tumble.  Do you really want to buy a house for $400,000 today that is worth $280,000 in two years time?

The point I’m making here is to view the model in the long-term and see if your common sense tells you this is a good idea.  Expanding your house-manufacturing business in times of high demand is a good idea.  However, not thinking that the bubble would burst- not so smart.  If this was genuine growth I’d be singing a whole different tune, but those who know me have heard me saying this for the last five years.  I saw the boom coming and predicted the bust over half a decade ago.

Think of the US as one big monopoly board.  The amount of money “in play” on the board fluctuates a little, but in general (and especially for your average US family) the amount of money on the board stays fairly constant.  Minimum wages (and subsequently the wages above that) rise about in accordance with inflation but it’s not like we all doubled or tripled our salaries between 2000 and 2004.  In Oregon the minimum wage went from about $6 to a little over $7 per hour.  Salaries above that grew in roughly similar proportions.  People earning $15 per hour rose to about $17 per hour and so on and so forth.  So assuming that the amount of money people have available to spend has remained about constant, how is it that everyone’s house suddenly gained $100,000 (for the sake of argument) in value?

The answer is that they didn’t.  It’s a trick, a clever trick, but a trick nonetheless.  Back to the monopoly board.  It was flagging.  The number of players who owned hotels wasn’t growing, no new hotels were being built.  Many players were going around the board with hopes of buying property, but they spent so much time paying money in rent or getting “Car repairs due, pay $50” chance cards that they never got ahead enough to actually buy a place.  Then someone had a great idea and said “this game is getting a little boring, how about if we spice it up by letting you purchase a property and only pay of $1 of the price every time you go around the board?”  That way everyone can have a property and everyone can grow.  The game will be more interesting and we’ll generate more money.

What are the flaws here?  The first obvious one is that no extra money is actually present on the board.  People are still going around the board at the same speed because the dice rolls didn’t get higher.  They still collect $200 for passing Go about once every 8 – 10 turns.  But wait!  Everyone owns a property now.  They should be making money by having the value of that property rise shouldn’t they?  Well, in theory yes, but in practice no.  Given that there is a fixed amount of money on the board, who is paying for the growth?

That’s where the problem comes in.  Nobody is paying for the growth because no-one has really grown.  This was illustrated very clearly to me during a discussion with a friend of mine on the topic:

Friend: But we made $40,000 on the sale of our first house.
Me: Wow!  That’s great.  You were able to put $40,000 into a savings account from the sale of the house?
Friend: No.  We still owed $290,000 of the original $300,000 mortgage.  But we sold it for $360,000.
Me: Hmm, I think I see.  What did you do with the profit?
Friend: We bought a house for $360,000.
Me: How are the payments going on that house?
Friend: Well, we took out a mortgage (or two) for $360,000 and used the $40,000 profit from the first sale to cover some of the gap.
Me: So now you owe $310,000 on your mortgage?
Friend: No.  With closing fees and some payments to get the 2nd mortgage sorted we out about $350,000.  But we cut a deal to only pay the interest on that loan for the first 3 years.
Me: Oh, so the profit you made is in equity in the house.  You could sell it today and come away ahead?
Friend: No, we have to wait for the house to appreciate.  Then we can get a bigger loan for the house we really want.

Now don’t get me wrong.  I’ve seen a lot of people make a lot of money in real estate and appreciation.  I’m not saying that bricks and mortar aren’t still one of the best investments you can make.  The point I’m making here is that it only works if you’re actually paying off some of the mortgage at some point, otherwise all you’re doing is paying more interest to banks on bigger loans.  This is not sustainable growth.  Period.

At the end of the day, everyone has to do what is right for them.  Truly.  However, to stand there with big doe eyes and say “How could this have happened?”.  No.  Not so much.  Pretending that everything we put our money in doubles in value is great in theory, but who’s paying the bill here?  I would love to give everyone in the world a $200,000 appreciation on their house.  The problem is: “Where did that $200,000 for everyone come from?”  Someone has to lose.  Salaries and equity have not increased by that much, therefore the values of houses haven’t either.  Everything grows in value, that’s why we work, pay our taxes, and build equity.  To think that the price could gain more in 4 years than houses have gained for over three decades — well, I’m laughing as I type this.

What we did here was fake the appearance of growth by injecting demand.  We did this by selling people houses they couldn’t afford and loaning money to people who think they are making a profit when really they are just paying bank interest.  Bottom line: if you can’t afford to make twice your monthly mortgage payments then you can’t afford for a “crisis” month.  If you can’t show me the $40,000 in the bank then you didn’t make a profit, you just wrapped up the numbers in the next loan.

When it comes to investments, always remember that at some point you actually need to realize profit in the form of $$$ in the bank.  I highly encourage people who have managed to sell a $280,000 house for $360,000 to put some of the profit in a high interest or retirement account.  Buy your house, do it up, appreciate the value, sell it, and bank the profits, don’t just buy a bigger house.  Otherwise, when the bubble bursts, and yes it will burst, you are the one left holding a $360,000 house that is worth $180,000 wondering where the hell your life went wrong.

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