A housing bubble? Not like the South Seas.

The papers are full of stories about a housing bubble. Everyone from the FT to USA Today is writing about it. How about this headline from Money magazine: “Milking the bubble: Your house has soared in value, here’s how to capitalize.” (The answers: sit tight, sell and move, or take out a HEL to make home improvements, pay off credit card debts and ”improve your lifestyle”.) Are we in a housing bubble? We believe the answer should be ”no.” The data don’t support it, and history doesn’t support it. In sum, while the returns to housing have been strong, they hardly resemble a bubble, nor do they portend a crash in value. On a national basis, prices have been rising in single digits. But there have been spikes in value in local markets, and the homeowner by some measures is nearing the upper range of indebtedness. We wouldn’t be nearly as sanguine if we owned a portfolio of home equity loans in San Jose, California, but let us examine the issue a little more closely.

Observers have posited that poor performance by financial assets-a weak stock market-has prompted investors and savers to put their money in a real asset-housing-that pays no dividend but seemingly appreciates with clockwork regularity. The following table sets forth return data on these different asset classes:

Housing hasn’t been a bad investment, relatively speaking, but hardly a bubble. Certainly, the facts would seem to support the PR about a strong market. In April, US sales of previously-owned homes rose at a rate of 7% to an annualized pace of 5.79 million from 5.41 million in March. The National Association of Realtors, which keeps the data, expects that existing home sales in 2002 will hit a record 5.38 million units, eclipsing the record 5.3 million set last year. April’s total was the third highest level on record, behind January and February. The Northeast rose 11.1%, followed by the South with a 9.5% rise, 4% in the West and 3.3% in the Midwest. The median price of an existing home sold in April was $153,300, a 7.13% increase from April 2001. In a portent of even more strength in home sales coming in the future, the Mortgage Bankers Association purchase applications index spiked to a record 414 in the week ended May 31. As Chart 1 (at the end of this memo) shows, the pace of growth in applications is accelerating. Finally, a report out last week showed that fully one-half of last year’s 1.2% gain in real GDP growth was due to housing activity.

Reasonable people can disagree about the existence of the bubble. FDIC Chairman Don Powell has said that rising home prices are a “yellow flag” for the banking industry that “bears watching.” Bill Gross warns of a “possible” bubble in housing. Then again, there are those who deny it, but they are the most self-serving. The Mortgage Bankers Association minimizes the risk: “We do not believe there is some likelihood of a burst of prices. We do not believe there is a decoupling of house prices from underlying supply and demand,” said the MBA’s chief economist, David Duncan.

And here’s Alan Greenspan in a May 10 speech: “I don’t think we have a bubble in house prices. First, let’s remember it’s very difficult to get one. Unlike stocks, where you have a single market, low transaction costs and an ability of people to pile on nationally and cumulatively, residential housing markets are all local. And they have certain structural impediments to creating bubbles. Transaction costs are quite large. Most importantly in order to unload your asset, usually you have to move. And that is a big deal. So you do not have a type of market dynamic that leads to the types of acceleration in prices that ultimately crack. That is not to say it is impossible. It is possible...[L]et me just say, we did have overall a fairly significant pickup in home prices in the last couple of years, even adjusted for changes in the mix, quality and size of homes [but] it’s not showing itself in the most recent data.”

We think that if Greenspan says there is no housing bubble, we should at least consider the possibility that the opposite might be true. In the same speech, he said, “England has had [a bubble], because it’s a much smaller geographical country, it had some significant price fluctuations in housing.” Indeed, UK house prices have been increasing at a nearly 20% annual pace the past five months. Economists in England don’t seem to have any doubt about the bubble they are in. This isn’t the first bubble in recent memory in England, either: In the seven years to 1989, the London property market gained 200% and UK prices overall rose 130%. By 1993, London prices had fallen by a third and UK prices overall fell 20%.

In the US markets we have certainly observed tremendous price appreciation in housing. But there was no real “crash” after those price spikes. The experience that would most closely resemble a housing bubble in the US was Texas in the 1980s. If you recall, in Texas in the early 1980s wide swings in the price of oil-inflation-adjusted oil prices spiked from about $24 a barrel in 1979 to close to $60 by the end of 1980-led to a concomitant buildup in employment (lagging a little bit), which led to what some academics have called a “lending frenzy,” aided and abetted by easy monetary conditions. The increase of available funds and the pursuit of real estate lending by thrifts and commercial banks led to a burst of construction and an over-supply condition that was more pronounced than in any other part of the country. Single-family home construction in particular grew at a faster pace than the local economy, more so than multifamily or commercial construction. Values of Texas residential building permits tripled from 1979 to 1983. But the market turned. As the Austrian economists would say (if they were prone to pithy sayings), “the bigger the boom, the bigger the bust.” In 1986, with the national economy performing well, the Texas economy and real estate sector entered a period of prolonged decline, with several factors contributing, including the plunge in oil prices, a change in Texas laws governing depreciation and interest rate fluctuations. Texas employment fell by approximately 250,000 that year and people were leaving their homes, and their mortgages, to leave the state. It was not until 1991 that construction activity came back in line with pace of the Texas economy.

A market bubble is a pricing phenomenon, when the decision to purchase the asset in question switches from an investment decision to a speculative one. Price increases stir buyer enthusiasm, which leads to increased demand because buyers expect recent price increases to persist. Capital is misallocated and prices exceed value. This leads to more price increases until the inevitable occurs and the whole thing reverses. It was (and still is, in many cases) a straightforward exercise to see how the technology-laden Nasdaq was “mispriced” and “overvalued” because of the bubble mentality. The fallout from the correction in this market is being played out right now, in real time.

A graph of a true bubble would look like London or Texas real estate or the Nikkei in 1989 or the Nasdaq circa March 2000. But even these bubbles are pikers when compared to those of earlier times. Bubbles have been popping up for as long as there have been markets. There were two bubbles in Europe in the early 1700s-the Mississippi Scheme in France and South Sea Bubble in England-and before that the even more infamous tulip mania in Holland 1634-1636. The descriptions of these bubbles (from Charles Mackay’s exceptional “Extraordinary Popular Delusions and the Madness of Crowds”, 1841) is worth repeating, if only to delineate between a true bubble and what we are seeing now in our national housing market.

The South Sea Company was established in 1711 by Parliament and given the monopoly on all trade in the south seas. Everyone at that time believed the natural resources of South America and Mexico to be inexhaustible and that all one had to do was strike the right trade agreements with the local governments and then uncover the riches of the land in order for the company to flourish and enrich its lucky shareholders. Extravagant rumors and the frenzy of the populace pushed the stock to unbelievable heights. The stock of the company traded at 130 in January 1720 and peaked at over 1000 in June, when confidence was broken and the promise of the company proved to be unfounded. The stock fell back to 130 by September. “During the progress of this famous bubble,” wrote Mackay, “England presented a singular spectacle. The public mind was in a state of unwholesome fermentations. Men were no longer satisfied with the slow but sure profits of cautious industry. The hope of boundless wealth for the morrow made them heedless and extravagant for today....Enterprise, like Icarus, had soared too high, and melted the wax of her wings; like Icarus, she had fallen into a sea and learned, while floundering in its waves, that her proper element was the solid ground.”

The Mississippi Scheme, in France, was a similar bubble occurring at about the same time, only the French government made it even worse by tying the value of its paper currency to the value of the shares of a new company that would have exclusive privilege of trading with Mississippi and Louisiana. The shares, worth 130 livres when the company was chartered in August 1717, peaked at 10,000 livres in early 1720 and were worthless by the end of that year. “For a time, while confidence lasted, an impetus was given to trade which could not fail to be beneficial. In Paris especially the good results were felt. Strangers flocked into the capital from every part, bent not only upon making money, but on spending it....No sooner did the breath of popular mistrust blow steadily upon it, than it fell to ruins, and none could raise it up again.” The country was financially ruined and the architect of this plan, one John Law, was run out of the country a pauper.

The mania for tulip bulbs is surely the strangest bubble from history because they were such ephemeral assets. The bubble was aided by a sophisticated options market created to purchase bulbs in the future. “Until the year 1634,” writes Mackay, ”the tulip annually increased in reputation, until it was deemed a proof of bad taste in any man of fortune to be without a collection of them....The rage for possessing them soon caught the middle classes of society, and merchants and shopkeepers, even of moderate means, began to vie with each other in the rarity of these flowers and the preposterous prices they paid for them. A trader at Harlaem was known to pay one-half of his fortune for a single root, not with the design of selling it again at a profit, but to keep in his own conservatory for the admiration of his acquaintance.”

Mackay continued. “In 1634, the rage among the Dutch to possess them was so great that the ordinary industry of the country was neglected, and the population, even to its lowest dregs, embarked in the tulip trade.” Entire fortunes were spent on bulbs, real estate exchanged, instant wealth was attained on a single trade. “Every one imagined that the passion for tulips would last for ever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them. Foreigners became smitten with the same frenzy, and money poured into Holland from all directions. The prices of the necessaries of life rose again by degrees: houses and lands, horses and carriages, and luxuries of every sort, rose in value with them, and for months Holland seemed the very antechamber of Plutus.” This bubble, too, burst when prices could go no higher and started to fall. When confidence was lost, panic ensued and the speculators were left with nothing more than a few bulbs that no one wanted to buy.

These stories are repeated for two reasons. First, to show how the descriptions of these bubbles resemble the story behind the Nasdaq bubble, up to and including the resulting recrimination, government inquiry and pillorying of executives and directors. [Mackay editorialized sarcastically about England in the wake of the South Sea Bubble: “Public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the legislature upon the South Sea directors, who, by their fraudulent practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South-Sea Company. Nobody blamed the credulity and avarice of the people-the degrading lust of gain, which had swallowed up every nobler quality in the national character, or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned. The people were a simple, honest, hard-working people, ruined by a gang of robbers, who were to be hanged, drawn, and quartered without mercy.”]

The descriptions are also apt to show how secondary markets to the original bubble also assumed bubble-like proportions. In Holland, for example, the rise in houses and lands were a consequence of the newfound wealth from their tulip speculations. In Paris, the market in Mississippi shares spawned a frenzy in apartments that were anywhere near John Law, who personally approved all share subscriptions. Or in Texas, where oil prices was the principal bubble that led to the excess in lending and construction. It’s being suggested that the current housing strength is a secondary event to the peak in the Nasdaq.

These ancient bubbles, as well as Texas and the Nasdaq, began from particular economic, financial or social circumstances and ultimately affected the economy itself. The volatility in Texas real estate resulted from changes in oil prices, tax law changes and interest rates more than from the economy itself. But eventually the growth and subsequent collapse in real estate construction in Texas affected the Texas economy rather than the other way around.

Second, it is clear from reading about these bubbles that what we are seeing in the national housing market is not a bubble. Unlike the housing market in England, which experienced 130% increase in value over 7 years, or London which saw a 200% increase over the same span, or the Nasdaq, which saw a 292% jump from 1995 to 1999, the US housing market has seen growth of 29.2% from the five year period of 4/97 to 4/02, and 45.2% over the last 7 year period. The current growth rates (YOY and YTD) are above trend, which suggests that we are witnessing unprecedented market strength on a national basis. It does not suggest a bubble. Furthermore, the collapse in a bubble is substantial, usually to levels below where they were before the bubble began, and sometimes total. We can’t envision a situation where houses in the United State are near worthless.

We agree with Greenspan that the nature of the asset itself, and the transaction process, makes the strength of housing activity different than, say, the bubble in the Nasdaq. Do people buy houses at ever increasing prices because they are looking to sell quickly? Is there a “decoupling” between price and value in a house the way there is with a tulip or a tech stock? Chart 2, which shows how the median sales price of existing homes marches ever upward, would lead one to conclude that this is a pretty bulletproof asset class. Chart 3 supports this idea, showing that only in rare instances does the year over year change in that price go below zero. Moreover, the information on credit trends found in Chart 4 indicate that on a nationwide basis, while credit trends are worsening, the delinquency index, at 4.65%, is still within the range of the last two decades. (The slight rise in the foreclosure index is, we believe, as much a secular trend in foreclosure policies at financial institutions as it is a reflection of cyclical credit trends.) Chart 5, a measure of supply in the market, shows no abrupt spikes in its history. While at 4.8 months it is on the low end of the range since 1990, it has been in a narrow range since 1998 (the low in this series was 3.9 months in March 2000).

Chart 6 lends support to the idea that we are in a strong market, although not a bubble. The Housing Affordability Index, is akin to a corporate interest coverage ratio. To interpret the index, a value of over 100 means that a family with the median income has more than enough income to qualify for a mortgage loan on a median-priced home assuming a 20% down payment. An increase in the HAI shows that a family is more able to afford the median priced home. This, then, is an index that captures income and house prices together. Currently, the HAI, at 134.3 in April, is within the range we have seen since 1993.

Charts 7 and 8 are two looks at the growth in prices in the national housing market relative to the economy, both in rate of change and in absolute level. In neither case do we observe any appreciable spike in the home price market, although the growth rate in house prices has come up somewhat. That relationship is coming back in line.

We do agree with Greenspan on one other thing-true housing bubbles will always be local and we have seen some local bubbles. The San Jose and San Diego markets have seen their bubbles come and go with the rise and fall of the tech and VC markets. Chart 9, the YOY change in real home prices in San Jose and the nation, is a picture of a real local housing bubble. Other areas and markets are still riding the wave of price appreciations, like New York City, second homes, jumbo loans and certain other high growth areas such as Broward County, Fla., Seattle, and Northern Virginia.

What would cause the current strong housing market in the US to reverse? A change in credit trends brought about by poor job data, a slowing economy, stagnant incomes; a terrorist attack that causes panic selling in urban or other target areas; economic upheaval in a local market; a powerful change in the relative investment merits of other asset classes. This last point makes more sense if that change is bearish. For example, further collapses in the stock market could result in more pronounced negative wealth effects, outright risk aversion or just plain old defaults, while powerfully bullish developments in the stock or bond markets would suggest a rotation of assets into stocks or bonds. That scenario is probably unlikely.

The local markets that have experienced the highest growth rates would be affected the most. According to the National Association of Realtors, out of about 135 MSAs, 29 have experienced year over year growth in median sales prices of greater than 10%, 7 that have experienced growth rates of greater than 19%, and 18 that have suffered negative growth. (Highest growth? Nassau/Suffolk County, NY at 26.5% YOY. Lowest? Poor Peoria, IL, at -7.2%.)

The worst case scenario is unlikely to occur. We have to remember that the average homeowner still has significant equity in his or her house and that the housing market does not move at the same speed as the stock market or the tulip market. If there is any conclusion at the end of this thought process, it is this: There are many edges to the sword of MBS, and some of those edges work in our favor. Unlike unsecured investments, ours are secured and, at that, secured by a basic element of human existence. Geographical diversification protects the MBS investor.

June 28, 2002
By Jeremy Diamond, Executive Vice President
Annaly Capital Management

This commentary is neither an offer to sell, nor a solicitation of an offer to buy, any securities of Annaly Capital Management, Inc. (“Annaly”) or any other company.

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