The &O Blog

      CNBC recently reported that over the next 12 months, approximately 2 million US mortgages will reset to higher interest rates. Included in these changes will be negative amortization loans, mortgages with teaser rates that were below market, and interest only loans. The anticipated sharp upward movement of the payments related to these loans will likely cause the US housing recession to deepen. CNN Money reported in August of this year that some homeowners may see their monthly payments increase by 35% or more. Similarly, the Mortgage Bankers Association estimates that 600,000 home owners will fall behind in their mortgage payments, with nearly 50% of them losing their homes to foreclosure. Another study performed by First American CoreLogic, a real estate and mortgage tracking company, estimates at as many as 1.1 million homes may enter foreclosure over the next 6 to 7 years. These additional homes coming onto the market will be a further drag on the housing market throughout 2008 and beyond.

      Importantly, mortgage lending standards are beginning to tighten, particularly after the credit crunch that occurred in August, 2007. As a result, it will likely be more difficult for individuals to become homeowners as mortgage products like 100% financing, stated-income loans and negative amortization options begin to disappear. Perhaps most importantly, interest rates for home ownership may continue to rise, despite the efforts of the Federal Reserve to keep them in check, as home loans become more risky in a falling price environment.

      Indeed, central bankers in both the US and Europe continue to try and create liquidity with their respective markets in an effort to stave off another credit squeeze. Increasing mortgage defaults and foreclosures, which will impair bank profits, may be too much for many lenders to absorb. As a result of these negative influences working in tandem, the current US housing malaise is likely to continue well into 2009.

      Much has been written about the overbuilding that occurred all over the United States and the housing overhang that currently exists, especially in Las Vegas. Indeed, some articles assert that the Las Vegas overhang is in excess of 25,000 single family homes and countless condominiums and hotel-condos. Despite the pessimism, however, between January 1, 2008 and December 31, 2012, more than 40,000 hotel rooms are scheduled to be added to the Las Vegas landscape. Properties currently under development with scheduled opening dates include:

      It is difficult to gauge how many jobs will be created city wide per hotel room built, but based on the numbers announced by the hotel operators themselves, approximately 2.5 new jobs will be created per new hotel room. This estimate does not include the number of jobs created to support these new Las Vegas employees and residents. Some pundits have estimated that the number of jobs created city wide is nearly 7 per hotel room, when consideration is given to feeding, providing medical care, education and other essential services to the people brought to Las Vegas by the hotel boom currently underway.

      Taking a conservative view by assuming that only 4 jobs are created per hotel room city wide, more than 160,000 jobs are being created in and around Las Vegas over the next 5 years. These jobs do not account for other areas of growth in Las Vegas, outside of tourism and gaming. In other words, not only is the current Las Vegas housing overhang going to be short lived, Las Vegas should come out of the current US housing recession before most other major metropolitan areas. Indeed, absent other limiting factors, such as an extended credit crunch within the mortgage industry or a terrorist attack that stymies US travel, the next 12 to 18 months should prove to be the best time to buy in Las Vegas.

How Long Will the Housing Recession Last?

        Several times each week I am asked my opinion of how long the current real estate recession will last.Most people who have paid attention to the rising, and now falling, prices of real estate will agree that a speculative bubble occurred throughout the US real estate market.In order to answer the question, however, a broader look at past financial bubbles is an appropriate first step. Although fairly uncommon in the history of financial markets, major speculative bubbles have occurred from time to time, often with ruinous effects. Sometimes they are triggered by inexplicable phenomena, such as the spontaneous tulip craze in the Netherlands in the 1630’s, or are kindled by the manipulative actions of individuals or corporations.In this blog, a review of the more memorable speculative financial bubbles will be given, concluding with the use of history to predict the future of the current real estate malaise.

The Tulip Bubble

        Beginning as early as 1620, the Dutch became enamored with the flower commonly referred to as the Tulip.The Dutch love for the flower was so great, botanists began experimenting with them through cross-breeding in an effort create new variations of the Mediterranean flower.As a result of these experiments, a virus called “mosaic” developed, infecting the flowers.This virus was special, however, because instead of killing the Tulip bulb or flower, the virus caused the petals of the Tulip to develop contrasting flame patterns.Once these flame patterned flowers came to market, prices skyrocketed for Tulip bulbs, the seeds of the flower.In other words, people were speculating that the tulip bulbs, not the finished flower, would be valuable.Today, we would call this form of speculation buying futures, or perhaps in the real estate context, purchasing preconstruction real estate.Speculators began selling and trading their homes, land, carriages or anything else of value for the Tulip bulbs.The speculative buying and selling of Tulip bulbs lasted roughly 17 years, with its greatest impact occurring over the last 3.

        In February of 1637, as spring drew near and the bulbs were close to flowering, consumer confidence evaporated and the market suddenly collapsed.Individuals found themselves in possession of bulbs no one would buy.Prices dropped nearly 75% overnight.The Dutch government then stepped in and ruled in May of 1638 that tulip contracts could be annulled upon the payment of 3.5% of the agreed upon price.In addition, the Dutch declared that because the contracts were speculative and the Dutch laws did not provide for enforcement of speculative agreements, the majority of the contracts were void. In other words, the downside of the Tulip bubble only lasted one year due to government intervention.

The Telegraph Bubble

        Beginning in 1840, the US Congress learned that information could be sent via wires all over the country.Shortly thereafter, the nation caught telegraph fever. Between 1846 and 1852, the number of telegraph miles in the United States rose more than ten-fold, from 2,000 to 23,000. Unfortunately, the demand for use of these lines never materialized as anticipated and many of the lines duplicated others already in existence.By 1849, three telegraph companies vied for the tiny amount of traffic between Boston and New York, and many of the others were plagued by floods, weather, and poor connectivity. The combination of excess capacity, brutal competition and technological kinks led most of the start-up telegraph companies to fail and by 1850, the stock of these companies was wholly worthless.Despite the collapse of the majority of the telegraph companies in 1850, construction of additional and unnecessary telegraph lines continued for 2 years.Ultimately, one company came to the forefront of the industry, American Telegraph and Telephone or AT&T.The downside of the telegraph bubble lasted more than 2 years, with many of the operators in bankruptcy, and ended with AT&T in control of the market.

The Railroad Bubble

        Beginning in 1880, with the end of the Civil War, the United States witnessed what historian Maury Klein dubbed an “orgy of railroad construction.” In the 14 years ending in 1894, 71,000 miles of track were constructed – practically double the previous total in the country. As is often the case with quick and extensive expansion, redundant national rail lines were created, which in turn caused rates to fall drastically.With falling rates and excess capacity, the booming railroad market began to sour.

        The boom ended with a bust in 1894, when about one quarter of all railroad companies went bankrupt. Despite the numerous bankruptcies, travel and the delivery of goods via rail was a viable and necessary industry.As a result of falling freight prices, the railroad emerged as a powerful commercial infrastructure for new businesses. Mail-order retailers like Montgomery Ward and Sears, consumer products companies like Procter & Gamble and Coca-Cola, rapidly built efficient national enterprises and brands using the railroad to reach throughout the country.Finally, banker J.P. Morgan financed the conclusion of the rapid build-out of the railroad network in the late 19th century and picked up the pieces after the fallout of 1894. The downturn was short lived due to the efficiencies created by the railroads, however, the fallout was extensive as a significant number of the railroad companies went out of business.

The Florida Real Estate Craze of the 1920’s

        Beginning in 1920, many Americans became enamored by the materialistic and prosperous lifestyle of the time. During this period of American history, commonly referred to as the Roaring 20’s, the stock market was rising at an extremely fast pace and many investors were becoming quite wealthy. Florida became a destination spot for the newly wealthy and soon illegal casinos and drinking parlors became widespread in Miami.

        In 1922, the Miami Herald became the heaviest newspaper in the world as a result of the lavish real estate advertisements being placed. In fact, real estate prices in some places quadrupled in less than one year and at its peak, it is estimated that as much as one-third of Miami’s population consisted of realtors. By 1925, real estate prices had become so exorbitant that buying land wasn’t affordable any longer. New investors failed to arrive and old investors started to sell. The result was panic and the Florida real estate market quickly crashed.The real estate boom of the 1920’s was finished for good when South Florida was ravaged by a hurricane in 1926, with over 13,000 homes destroyed and 415 killed.What started in 1920, ended abruptly in 1925, and with the onset of the Great Depression in 1929, Florida’s real estate market did not recover for more than a decade.

The Dot.Com Bubble

        The dot.com bubble, much like the telegraph bubble, was brought about by the onset of new technology, the Internet, and took place from 1995 through 2001, with the bubble peaking in 2000.Any company seeking to gain prominence through the Internet quickly came to the public market.Examples of the some of the successful companies formed during that period include Ameritrade, AOL, Amazon, eBay, E*Trade, Hotmail, PayPal, Yahoo and Travelocity.Despite the success of these companies, roughly 50% of all dot.com companies failed.Indeed, a combination of rapidly increasing stock prices, individual speculation and easily acquired venture capital funds created an environment that gave businesses the freedom to dismiss traditional operating models and focus instead on increased market share.The results were devastating and the technology industry did not begin to recover in earnest until 2004.

The Housing Bubble

        The current housing bubble began as a result of several factors occurring at the same time, including the fall of the dot.com companies, the many bankruptcies within the airline, energy and telecommunication industries, the terrorist strikes of 9/11 and the subsequent drop by the Federal Reserve of interest rates.In response, funds began to flow out of the stock market and into real estate.The following craze, which was fueled further by creative lending practices, including subprime loans, interest only mortgages and negative amortization options, caused the US economy to cycle out of the stock market and into real estate. As housing prices soared, millions of Americans began to view houses as assets to be bought and sold several times over. In 2005, it is estimated that 28 percent of homes bought were purchased as investments.According to Barron’s Magazine, “The Bubble’s New Home”, “these days the only thing that comes as close to real estate as a national obsession is poker.”

        As recently as August 30, 2007, MSN Money reported that bubble theorists are growing louder in the insistence that prices must revert all the way to pre-boom levels before a recovery begins.Bruce Marks, the CEO of the Neighborhood Assistance Corporation of America believes prices could drop 10% to 15%, and in some places as much as 25%.“You are not seeing bubbles bursting in certain parts of the country – you are seeing a nationwide decline,” said Marks.

        Finally, credit markets are beginning to tighten, making homeownership more difficult and more costly.Moreover, home ownership is more risky with prices receding almost throughout the country.Based on some of the hangovers left by the previously mentioned bubbles, coupled with the tightening of credit in this country, several of the largest US builders and mortgage lenders will go bankrupt (several already have) and the current US real estate recession will likely last well into 2009.