Markets & Finance

The Growl of a Housing Bear


John Talbott warned that home prices were ready to fall back in 2003, when he wrote the best-seller The Coming Crash in the Housing Market (McGraw-Hill). A former Goldman Sachs (GS) investment banker who sold debt for clients including Fannie Mae (FNM), Talbott criticized the managements of the housing-finance giant and rival Freddie Mac (FRE) for enabling noncompetitive forces to boost home prices. In this year's followup Sell Now! The End of the Housing Bubble (St. Martin's Griffin), Talbott's take is: "We are in for a fairly rough ride in the housing market for the next five to seven years."

Talbott insists the crash he predicted is right around the corner, as housing markets show signs of cooling. In his latest book, he notes that national home values, adjusted for general inflation, increased almost 61% from 1981 to 2003. In the past three years, home prices have shot up another 35%.

BusinessWeek Online reporter Sonja Ryst recently spoke with Talbott about his bearish outlook for housing. Edited excerpts of their conversation follow.

What do you think is happening to the housing market right now?

The smart money is getting out. The inventory of homes for sale is increasing dramatically across the country. That's typically what happens before you see price declines.... The investors who are flipping homes for profit, like non-owner occupied condominiums, those are the people you would expect to sell first. You're already seeing that happening.

In San Diego, for example, the homebuilders themselves are getting out. I know a condominium developer in San Diego who had properties he was building, and he made offers for people to take them out of the market. He hadn't even completed the building yet, but he was selling the condominiums for ridiculously low prices like $190,000 if the buyer would just come in and finish the floors. He was minimizing his exposure for the downturn. In San Diego, condos are off around 30% -- that's huge. Prices normally trade off 1%.

How much do you think prices will decline, and how long do you think it will take?

I think that it's a worldwide phenomenon, and in the 25 cities that have had price run-ups, which make up 40% of the market, we'll see corrections of 40% to 50% in real terms over the next six years. It has already started, and you'll see it happening in more cities in the May-June time frame.

How did housing prices get so high?

The banks have made a terrible mistake in how they calculate how much to lend. In the early 1980s, about a third of your income had to go to your mortgage and those worked out fine. Today, they've increased that limit to about 40% of your income, and they think those should work out fine, too. But the banks have actually been lending too aggressively.

We're seeing hints about the housing market all over the place. When and how do we know what's really happening to it?

Because of the cyclicality of the business, prices have been down in most places four months in a row. Most cities have seen slight declines in December, January, February, and March. What typically happens is when the weather warms up in spring, people want to move their children during the summer before school starts. The buyers start to come out and then prices start to shoot up in May and June. Those are the two key months. The question is what happens in May and June. Will there be a flood of for sale signs -- people trying to get out at the peak? Or will buyers return to the market?

What happens to the U.S. economy if the downturn you predict really happens?

I think it will be a disaster. Not only will people in fields like banking be unemployed but consumers themselves will spend less. They're spending a lot now because they think their house is worth a million. If they find out it's only worth $400,000, they'll spend less. As foreclosures increase, the banks will get hurt and pull back on lending. That can drive the country into a recession.

What role does the Federal Reserve play?

The Fed messed this up. They had a bad situation with the Internet bubble in 1999 and 2000, and to keep that from turning into a recession they lowered the federal funds rate down to 1% and held it there for four years. That created this real estate bubble.

Didn't you already say all this in 2003?

I wrote my first book in 2003 saying Fannie Mae and Freddie Mac were overleveraged and the market was too high, but I was careful in the book not to say it couldn't go higher. I wasn't trying to call the absolute peak in the market. But now with the Fed basically out of the picture and giving up on 1% interest rates, I think the cracks are beginning to show in the inventory of homes for sale and the way the nonoccupied real estate investors are behaving.

If you call the National Association of Realtors, they will say that prices are going to bounce back up, but there are a million signals that this is serious. It's not like in 2003, when I was talking theoretically that things are overvalued. Now they're more overvalued, foreclosures are up, and investor-owned property prices are going down. It's happening.


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