Signs You Are In A Bubble

photo by Jeff Kubina

Trulia.com quoted me in Signs Your Local Real Estate Market Is A Bubble. It reads, in part,

If you were burned in 2008, the last time the housing bubble burst, you’re probably (and understandably!) gun-shy about jumping into the housing market again — especially if you think your local area could be experiencing another bubble. If you buy during a bubble, overpaying for your home, you might be forced to sell for less than the property is worth — either that or stay put longer than you’d like until you build up enough equity to sell. So if you’re thinking of buying, it’s important to have a sense of the signs that point to a real estate bubble. Here are five of them.

1. Shaky loans are common

As we learned from the 2008 recession, subprime lending (lending to anyone with a pulse) is not sound practice. And we have made changes. “Credit remains relatively tight,” says Jonathan Miller, CRE, CRP, and president of Miller Samuel Inc., a New York, NY, real estate appraisal company.

Yet the U.S. government still backs loans that some might consider risky, particularly ones that require only a 3.5% down payment, which the Federal Housing Administration (FHA) offers. Before you get too alarmed, keep in mind that the FHA has been helping people become homeowners since 1934. The underwriting standards are higher with FHA loans than with some of the subprime low-down-payment products offered in the early 2000s, explains David Reiss, professor of law at Brooklyn Law School in Brooklyn, NY.

2. There’s lots of leverage

When you take out a mortgage, you’re leveraging your money — the smaller the down payment you make, the more you have leveraged the deal by using the lender’s money to make the purchase. “A bubble means lots of leverage,” says Miller. “And this [current] cycle has been remarkably devoid of leverage.” Miller cites New York City as an example. “About 45% of the transactions are cash. And for the price points below half a million dollars, the average person puts about 35% down.”

3. Home prices are rising faster than salaries

When housing prices are rising and your salary isn’t, you’re left with two options: continue to rent, or buy a house you can barely afford. If you think your market is in a bubble, you might want to wait to buy, especially if you’re really stretching to make ends meet.

“I would review the mean income levels and employment levels compared to real estate prices for signs of discord,” says Michael Kelczewski, a Pennsylvania and Delaware real estate agent. “Indicators of a local real estate bubble are asset values exceeding the local market’s capacity to absorb prices.” Reiss says that when home prices rise faster than salaries, “It could be the sign of froth in the market.”

Miller agrees that a “rapid run-up in prices that don’t match wage growth leads to discussions about bubbles.” But he says that as long as credit conditions from bank lenders are tight, you won’t have runaway price inflation. In New York, prices aren’t rising like they were, but they aren’t falling either. Miller says they’ve leveled off and are “stuck on a high plateau.”

So what do you do when affordability isn’t improving in pricey markets like New York, NY, San Francisco, CA, Los Angeles, CA, or any other high-cost urban market? Buy in the burbs. Miller notes that for New York, the market is booming in the outlying suburbs.

 *     *     *

When there are no signs

Of course, you might think your market is (or isn’t) in a bubble, but you could be wrong. “The problem with bubbles is that we don’t know them when we see them,” says Reiss. He explains that San Francisco, CA, for example, a hugely unaffordable city for most people, isn’t in a bubble just because prices are high. “Bubbles do not refer to rapid price appreciation. They refer to unsustainable rapid price appreciation. [The market] is unsustainable because fundamentals do not support the appreciation.”

The bottom line is, it’s difficult to know whether it’s really a bubble. “If homeowners buy a house that works for their family and that they can afford over the long haul, they will have made a decision that benefits them every day, even if real estate prices drop significantly,” says Reiss. But heed his warning: “If homeowners instead buy a house that is a financial stretch in the belief that it will appreciate down the road and fund their retirement, there is a good chance that they have set down a road to ruin.”

CFPB Mortgage Supervision Highlights

The Consumer Financial Protection Bureau issued its Supervisory Highlights for Winter 2015. The highlights include a section on Mortgage Origination and “largely focuses on Supervision’s examination findings and observations from July 2014 to December 2014.” (9)

The headings of this section give a sense of the CFPB’s work in this area:

  • Loan originators cannot receive compensation based on a term of a transaction
  • Improper use of lender credit absent changed circumstances
  • Failing to provide the Good Faith Estimate in a timely manner
  • Improperly using advertisements with triggering terms without the required additional disclosures
  • Adverse action notice deficiencies and failure to provide the notice in a timely manner
  • Deficiencies in compliance management systems

For good or for ill, these are pretty modest examination findings. They certainly don’t reveal the fire-breathing regulator that some had prophesied. I was particularly interested in the last finding:

an effective compliance management system includes board and management oversight, a compliance program, a consumer complaint management program, and a compliance audit program. The board of directors and senior management should, among other things, adopt clear policy statements concerning consumer compliance, establish a compliance function to set policies and procedures, and assign resources to the compliance function commensurate with the size and complexity of the supervised entity’s practices and operations. A compliance program should include policies and procedures, training, and monitoring and corrective action processes. A compliance audit program should assist the board of directors or board committees in determining whether policies and standards adopted by the board are being implemented, and should also identify any significant gaps in board policies and standards. (13)

Compliance management systems are intended to create a culture of compliance within an organization, from top to bottom. The CFPB found that one or more financial institutions had weak compliance management systems that would allow for numerous violations of federal regulations governing mortgage lending. It is important for the CFPB to focus on these compliance issues now, before the mortgage market really froths up and carries mortgage professionals away from appropriate underwriting and servicing.