Economist Corner – John Sanchez

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There are two things that fundamentally move the housing market in the United States. Changes in Interest Rates and Taxes.

Everything else is interesting and valuable and can be very lucrative. But all of those other things don’t move the housing market. Buying in a good location, improving schools, painting your exterior, knocking out a wall, building a new freeway off ramp. These things might be very important to you or your neighborhood, but they don’t move the housing market.
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By moving the housing market I mean the average sales price of houses in the United States moves significantly* higher or lower than previously experienced.
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To understand how and why our housing market has been so volatile (volatile is another word for unstable, erratic) let’s look at the last time in history we’ve had major changes to our Interest Rates and Taxes in regard to real estate.
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Bill Clinton, in his second term signed the Tax Payer relief act of 1997.
“The act exempted from taxation profits on the sale of a personal residence of up to $500,000 for married couples filing jointly and $250,000 for singles.” http://en.wikipedia.org/wiki/Taxpayer_Relief_Act_of_1997
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That particular tax exemption doesn’t sound like a terrible thing does it? To you it might not, to Bill Clinton it might not have… To the 280 congressional Republicans it sounded like a great idea! Same for the 201 congressional Democrats. There were 43 no votes for that “act”. One Independant, one Republican and 41 Democrats.
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To be fair, that exemption by itself may not have caused the economic destruction that we’ve experienced these past few years. It’s only when combined with the drastically reduced interest rates of the 2002 post 9/11 stimulus that we got the makings of a Real Estate Tsunami.
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You see, before 1999 (when the tax exemption kicked in) we used to pay taxes on the gains of our houses. We couldn’t fix and flip without very careful consideration to the tax ramifications. The ‘rules’ required that we sell one home and trade up, in order to avoid a significant tax hit. This meant that if you couldn’t afford to trade up, you bought bunk beds and that was that.
But when the big juicy $500k tax free was dangled in front of America’s eyes it was a way for the Baby Boomers that had missed out on the Internet IPO market to get some for themselves! Anyone that had significant equity in their homes now had 500 thousand reasons to sell their home.
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Because of the way the rules were structured, it made sense for anyone that owned a second property to move out of their primary residence, move into their second property (physically or on paper…) and after 24 months sell them both and be able to collect $1,000,000 tax free.
People that had second homes (vacation, rentals) moved into them in 1997 and by 1999 were selling them to grab all of that tax free cash. What a great time to be a real estate agent! A lot of that money flooded the stock market in big chunks in 1999, remember that? What a great time to be a stock broker or day trader!
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I bet that wise old stock market saw it coming all the way back in 1997 when the act was passed and rose in anticipation of the flood of cash.
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Fine, we had a market top less than 12 months later… but the real estate market wasn’t nearly done reacting to the new tax structure. Prices barely dipped in Q4 2001 (the 9/11 quarter). That rocket was just getting started… Think of all the people that hadn’t gotten the million dollar memo “move into your other property, then sell them both in 2 years for $1,000,000 tax free”.
People with only one house were selling their primary residence, getting the $250,000 tax free and then rolling that either into fixer-uppers (to do it again) or into 2 properties to go for the $1,000,000. Good times!
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Then, with all that fuel on the fire the Federal Reserve reacted to the events of 9/11 with a significant interest rate reduction. This caused the ‘walk in’ price of a new home to fall considerably. But the sale still brought in buckets of tax free cash so more people could afford more home and they had all their tax free dollars there to get that house.
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Prices really began to take off. Banks were making a lot of cash by writing new loans to people. For some reason the regulators of the banks were allowing people to buy homes even if their W-2s weren’t part of the loan application. The bank regulators seemed to think it was OK if the person just stated that they made enough income. Sometimes the person didn’t know how much income they needed to make, so the loan officer told them how much they needed to state.
Why were the bank regulators OK with this? Could it be that the government was afraid that if our economy, which had just gone through 18 months of Y2K recession, might fall back into stagnation unless we really stimulated it? Did they not know that the 1997 act already stimulated it significantly?
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Maybe if they hadn’t appointed a bank lobbyist to be the head of bank regulators then there might have been more conservative regulation and practices.
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“Over the course of nearly a quarter-century, Dugan has proved himself a staunch ally of the American financial elite as a Senate staffer (1985-89), a Treasury official (1989-93) and a lobbyist (1993-2005), building a career that culminated in 2005 when George W. Bush appointed him comptroller of the currency. When the financial system finally succumbed to its own excesses in September 2008, Dugan’s fingerprints were all over the economic wreckage, but almost nobody noticed.” http://www.alternet.org/economy/145782/how_did_a_bank_lobbyist_score_the_top_bank_regulator_job?page=entire

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This is how we got here. Significant tax changes, followed by significant Interest Rate changes. The lack of regulation certainly helped those two things take off and effect the housing market, first higher… then lower.
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And you thought you were making the decision to fix and flip all on your own?! You were guided to it by the currents of our economy.

John Sanchez
Mr. Sanchez is the founder of Blue Herring Advisory Group.
Significantly = More than most economists are currently predicting!

Ask piggybankblog.com Economist a question: johnsanchez@gmail.com

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