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The Bubble Sitters: Dean Baker

Dean Baker, a macroeconomist and a believer in the scientific method, is so confident that a housing bubble exists that he is performing an experiment on himself.

In May 2004, Baker and his wife sold their two-bedroom condominium in the Adams Morgan neighborhood of Washington, D.C., and rented a similar unit a couple of blocks away. They owned the condo for seven years and almost tripled their money.

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"I felt like a fool holding onto it," Baker says. "I'm pretty sure that prices around here will plummet."

As co-director of the Center for Economic and Policy Research, a liberal-leaning think tank, Baker has been warning about a housing bubble for years. Scientists welcome disagreement as a way to improve knowledge, and Baker has invited debate: At the beginning of 2004, he sponsored a $1,000 essay contest to solicit the most convincing argument against the existence of a housing bubble. CEPR posted the winning essay by economist Hilary Croke, along with a rebuttal by Baker.

Decision to sell
A few weeks after the essay contest, Baker sold his condo. He doesn't characterize his decision to sell and rent as an experiment, but that's what it looks like: a financial, clinical trial with Baker as his own subject.

Dean Baker

When Baker listens to the housing market, he hears an echo of the tech-stock bubble of the late 1990s. The housing bubble will pop a lot louder, he thinks.

"People lose sight of things," he says. "If you go back to '98, '99, I was talking to people who said price-to-earnings ratios don't matter anymore. They were just saying kind of nonsense. You get a similar sort of mentality today with the housing market."

The rental ratio
Houses have something similar to a stock's price-to-earnings ratio: their rental value. In a sane housing market, Baker says, a home's annual rent is roughly one-14th of the home's value. So if a house is worth $140,000, the annual rent should be around $10,000, or $833 a month. That's not a hard-and-fast rule; the proper ratio depends on the level of property taxes and whether utilities are included in the rent.

Baker says the rent-to-value ratio is out of whack in his neighborhood. The annual rent he pays on his condo is roughly one-17th of its value -- and that's not taking into account high property taxes. Add those to the equation, plus condo association fees, and the ratio is closer to one-20th.

"If you look back through the postwar period, you find two things," Baker says. "One, house sale prices have moved pretty much in step with the overall rate of inflation, and two, they have pretty much stayed in step with rents." But sale prices have outpaced overall inflation and rents in the last eight years, he says.

Baker attributes the swift rise in home prices to bubble psychology in which buyers don't ask whether a home is worth $500,000 to themselves; instead, they predict that the house will be worth $600,000 to someone else in a year or two or three. They look at the house primarily as a quickly appreciating investment and secondarily as a place to live.

Baker's contrarian view
Baker has the opposite mentality: He wouldn't be surprised if prices fall by one-third in his neighborhood. He doesn't know what will trigger the bursting of the bubble -- he's not even sure what burst the tech stock bubble in 2000 -- but one possible detonator is a rise in long-term mortgage rates. He thinks prices might fall if long-term rates hit 6.5 percent or 7 percent. (Right now, in August 2005, the 30-year fixed-rate mortgage has an average rate of about 5.88 percent, and housing economists don't expect it to hit 6.5 percent for a long time.)

Baker bought his condo for $160,000 in 1997 and sold it seven years later for $445,000. His rental condo is comparable, and he pays $2,200 a month.

If he were to buy the condo with a 5/1 hybrid ARM at 5.5 percent, his principal and interest would be about $2,500 a month, taxes would add about $200, and condo association fees would tack on another $400 to $500 a month. It costs him $2,200 a month to rent and it would cost upwards of $2,800 a month to own, plus any maintenance and repairs he would be responsible for. Even with a mortgage interest tax break of about $500 a month, he comes out ahead by renting.

'I could be wrong'
He would prefer to own if it made financial sense. "I expect we'll probably end up buying again, but only when prices adjust," Baker says.

This brings up a delicate question: Baker is a morally serious man. Did he have ethical misgivings about selling his home at what he believes to be an inflated price?

"I don't feel any qualms about this," he says. "I've been jumping up and down, yelling, 'There's a problem here.' I've done everything I can to publicize it and warn people. I don't know what else I could do. I didn't feel good about it. But this guy was going to buy a place. If he didn't buy my place, he was going to buy someplace. I could be wrong. I don't think I will be."



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-- Posted: Aug. 25, 2005
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