THOMAS SOWELL WARNED ABOUT THE HOUSING BUST IN 2005

Common sense, down-to-earth economist, Thomas Sowell, is a master of taking complicated economic principles and making them clear and understandable. Sowell has authored dozens of books, including his most recent, "The Housing Boom and Bust". Many praise Thomas Sowell's ability to deliver economics to main street America. What Sowell hasn't received enough credit for is his prophetic warning about the housing bust. On May 26, 2005, when virtually no economist, including the wizards at the Federal Reserve and the Treasury Department, were warning of a housing bubble, Sowell wrote predictive op-ed in the Wall Street Journal:

Federal Reserve Chairman Alan Greenspan refuses to call the rapid increase in housing prices in recent years a "bubble" but does refer to it as having some "froth." Moreover, he sees skyrocketing housing costs as a problem in particular localities, rather than being nationwide.

One of these localities is the peninsula stretching from San Francisco to Silicon Valley, about 30 miles to the south. This is an area where housing prices are more than three times the national average and are rising rapidly. It is not that housing in this area is more grand than elsewhere, but that very ordinary houses have very grand prices. There are communities on the peninsula where the average home price is a million dollars and where it would be hard to find a house that anyone would call a mansion.

It is not the houses, as such, that are so astronomically expensive. It is the land--and the high price of the land is due to severe restrictions on building anything on it. Before those land use restrictions--"open space" laws, planning commission requirements and environmentalist regulations--became severe during the 1970s, California housing prices were very much like those elsewhere in the country. Since then, California housing prices have been some multiple of the national average. Nowhere is this more true than in the San Francisco Bay area.

How can people afford to live where housing is so expensive? One of the ways of coping with high housing costs is with "creative"--and risky--financing. Roughly two-thirds of the home mortgages in the San Francisco Bay area are interest-only mortgages. Theoretically, you could make mortgage payments forever without acquiring a cent of equity in your home. You would essentially be renting with an option to buy, should your income ever reach the level where you could afford to pay something extra toward the principal.

In reality, the interest-only mortgage payments apply for only a limited number of years--three to five years in most cases--after which the payments rise, so as to contribute something toward the payment of the principal. People who expect their incomes to rise significantly in a few years assume that they will be able to handle the higher payments then. Of course that assumption can turn out to be wrong and the house can be lost.

Such desperate financial arrangements are due not only to the extraordinary housing prices in the San Francisco Bay area but also to a rapid rise of those prices, creating opportunities for speculative profits. During a recent month, home value appreciation averaged $2,000 a day in San Mateo, one of the communities on the San Francisco peninsula. Such rapid appreciation makes it possible to acquire significant equity in a home, even while paying nothing toward the principal on the mortgage loan.

The extraordinary rise in housing prices in the San Francisco Bay area in the past few years has been accompanied by a corresponding rise in the percentage of home buyers who resort to interest-only loans. As recently as 2002, only 11% of the new mortgages in this area were interest-only mortgages. But today 66% of new mortgages in the area are financed that way. While such mortgages are not as common nationwide, the upward trend extends across the country. Fewer than 10% of new mortgages nationwide were interest-only mortgages in 2002 but that has now risen to 31%.

READ THE REST FROM: THE WALL STREET JOURNAL

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