Housing Bubble: A Rude Investigation
Housing Bubble: In The Beginning
There comes a time in every man’s life when he seeks to become the lord of his own castle…rather than the tenant of another lord’s castle. There comes a time when he wants to break free of the tyranny of landlords and rent checks…to own his own home.
Let’s ignore the fact that he is merely transferring his indentured servitude from a landlord to a mortgage lender, he FEELS that he “owns his own home.”
So what happens when the security of this lifetime investment is threatened? What happens when the housing bubble hisses and finally bursts, when his castle comes under siege? With his back against the wall, Mr. Homeowner must face some hard facts.
The Anatomy Of A Housing Bubble:
These are difficult illustrations to digest. Indeed, many homeowners will not survive the oncoming crisis…but there are a few ways he can protect himself.
Housing Bubble: The Case-Shiller Index:
“We’ve had the biggest housing boom in the history of this country,” explains Yale professor, Robert Shiller. “That can’t go on forever…I’m thinking that this boom is so much bigger, that we will see a substantial fall that will affect the country overall…We’re not [automatically] bound for an enormous decline, but I think it’s likely.”
Shiller aired his skeptical remarks during an interview with Bloomberg News recently. The housing boom has been so large and all-encompassing, Shiller argued, that the coming bust also promises to be large and all-encompassing.
Helpfully, Shiller does not warn of impending disaster without also providing a partial refuge. The Yale professor helped to create indexes that track home values in ten major metropolitan centers. These new indexes, dubbed the Case-Shiller Indexes, underlie a new batch of futures contracts that debuted three months ago on the Chicago Mercantile Exchange (CME).
The new contracts reflect home prices in most of the nation’s hottest property markets, namely: Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York Commuter Index, San Diego, San Francisco and Washington D.C.
“Why did you create these futures contracts?” the Bloomberg interviewer asked Shiller.
“They’re designed to allow people to adjust their exposure to a risky market,” he replied. “The total value of real estate owned by households in the United States is $20 trillion. Bigger than the stock market. Not everyone needs to hedge. But a lot of people should be adjusting that risk exposure.”
Housing Bubble: An Unprotected Liaison
Remarkably, very few homeowners are availing themselves of these new hedging instruments. Only $71 million worth of housing futures are currently changing hands. “That’s peanuts by Wall Street standards,” Shiller admits.
Furthermore, $71 million would not amount to even a single peanut in relation to the $20 trillion of household real estate equity. In other words, our nation of leveraged homeowners remains completely unhedged against the prospect of falling home prices – a prospect that seems increasingly likely if we are to trust the newly minted Case-Shiller futures contracts.
“In all 10 [futures contracts],” Shiller reports, “we have what’s called backwardation. That means that the futures price is below the price that it is today. All of the markets are predicting price declines. And these price declines range from 4% to 5 1/2% by May of 2007…That’s not me talking; that’s the market.”
To help frame his bearish expectations for the housing market, Shiller refutes the myth that residential real estate has been a great long-term investment. “It has not been a great investment,” he says flatly.
Between 1890 and 2004, Shiller’s book, “Irrational Exuberance” explains, U.S. residential real estate increased by only 66%, in real terms – that’s only 0.4% per year. By comparison, U.S. home prices soared by 52% between 1997 and 2005 – or by 6.2% a year. Since home prices have soared so far above their long-term trendline, he reasons, a reversion toward the mean would not be surprising.
“Many contend that a sustained pullback in house prices is unthinkable,” remarks James Grant, editor of Grant’s Interest Rate Observer. “But the unthinkable – or, at least, the highly atypical – has already happened. In 2001-2005, prices levitated.”
“So why did it happen?” The Bloomberg News interviewer wanted to know.
Shiller, an economist by trade, cited no economic rationale for the boom. Rather, he provided an explanation rooted in the curiosities of human behavior.
“One of the mysteries of human society is how we interact with each other,” he said. “We are an empathic species. When you have emotions, I see it in your face and I feel the same emotions. That means we kind of move as herds. And so when other people are getting excited and they are talking about the real estate market, it gets me excited too. You can’t stay above it. If you are human, you get drawn in. But then when the emotions start changing, you get drawn into that too. And the emotion does seem to be changing. It looks like we’re at the beginning of a change in psychology.”
Clearly, emotions are changing. The feel-good era of the housing market is visibly yielding to the feel-less-good era.
Housing Bubble: What the Numbers Tell Us
Recent existing home sales data confirm the fact that the housing boom-boom is going bust-bust. Sales of existing homes fell 11.2% from a year earlier, while the absolute number of homes for sale jumped to a new record. Based on the current rate of sales, a 7.3-month supply of homes awaits buyers, the most in 13 years. Net-net, the housing market does not appear to be heading for the “soft landing” that Ben Bernanke says he expects, but rather, the crash landing that many of us fear.
By now, everyone knows the housing boom has busted. Even the National Association of Realtors admits as much. Just last week, David Lereah, the NAR’s Chief Economist delivered a sobering presentation to the NAR Leadership Summit in Chicago entitled, “Reality Check,” in which he flatly declared, “The housing boom ended in August 2005.”
To illustrate his point, Lereah provided the nearby table, detailing the magnitude of the year-over-year sales declines in the nation’s hottest property markets.
The only issues worth pondering, therefore, are how low prices might fall and/or how long the bust might last. Without trying to be too specific, we’d guess that prices will fall a lot and/or that the bust will last a long time…But that’s just a wild guess.
The key to these mysteries probably lies somewhere within the Golden State, the epicenter of housing unaffordability.
Housing Bubble: Los Angeles Case Study
Imagine a country of 10 million citizens. Imagine it is one of the wealthiest countries in the world. And yet, it is a country where only 14% of the population can afford to buy the median-priced home.
The reader requires no imagination…This “country” is Los Angeles County, the least affordable metropolis in the nation, according to the NAHB/Wells Fargo Housing
Opportunity Index. Only 1.9% of the new and existing homes sold between January and March of this year were affordable to L.A. County residents earning the median income. Orange County, home to both Disneyland and your California editor, ranked #2 on the list. (For the record, your editor is renting).
How did California housing become so ridiculously expensive?
One word: Credit.
Housing Bubble: Fueled by Credit
Without easy credit, and lots of it, California real estate could never have achieved its epic valuations. Credit not only enabled first-time buyers to “stretch” a bit, it also enabled and emboldened speculative buyers, speculative builders, second-home buyers, second-home builders and every other variant of housing market participant/speculator.
But because financing became so exotic, and speculative participation in the market became so great, the simultaneous unwinding of both will be as pleasant as hanging out with your in-laws during a root canal.
The unwinding is already beginning. The NAR’s Lereah offers a succinct explanation and post-mortem:
As a result, Lereah explains:
We all know what happens NEXT. But we just don’t know how bad it will be.
Please allow your editor to offer a prediction:
The California real estate market provides some helpful clues about the likely depth and duration of the bust now underway. Since the California boom relied heavily upon exotic financing to plug the gap between affordability and purchase prices, the gap between affordability and purchase prices widened to extreme proportions.
Every valuation gap that relies on credit, rather than cash and income, is likely to narrow eventually…especially when the burden of existing credit is on the rise. And that’s exactly what’s happening in California.
Almost 40% of the state’s homeowners – compared to 29% nationally – pay at least one third of their income for housing, according to the Public Policy Institute of California. Even worse, one fifth of all recent home-buyers pay more than HALF of their income for housing. Furthermore, California home-buyers have increasingly financed their purchases with unconventional loans, such as adjustable rate, negative amortization and interest-only mortgages, rather than traditional fixed mortgages. Just under a third of mortgages initiated or refinanced in California this year have interest-only components, compared with 1.4 percent in 2000, according to LoanPerformance. This tactic may have seemed quite savvy when rates were low, but it seems much less savvy now.
Highly leveraged, adjustable-rate home-buying has become so prevalent in the Golden State that the California Association of Realtors (CAR) recently changed its “affordability” methodology. The Housing Affordability Index (HAI), when the CAR launched it in 1984, assumed a 20% down payment and a fixed-rate mortgage. But that’s “old school” now. The new and improved affordability index assumes a 10% down payment and an adjustable-rate mortgage.
Despite the new methodology, a Californian must still earn almost $100,000 per year to “afford” the state’s $482,000 median-priced home. And Despite the new methodology, the ability of first-time home-buyers to purchase the median- priced home stands at an all-time low.
Very few Rude Awakening readers will be shocked to read that California homes are beyond the means of most California residents. But what you may be shocked to read, i s that California homes are also beyond the means of the folks who actually own the homes.
If wanna-be home-buyers cannot afford to buy homes, and EXISTING homeowners could not afford to re-purchase the very roofs over their heads, who will be buying houses? Or to re-phrase the question, how much lower must prices fall to restore some semblance of affordability?
A lot lower, we predict.
Housing Bubble: Profiteering in the Chaos
“We conclude that a decline in house prices is underway,” Grant’s Interest Rate Observer recently remarked. “If the house market, like the stock market, were mean-reverting, the sell-off could carry a far way. A return to the post- 1968 trend line would imply a drop of 22%. Which, of course, for these real estate-centric United States, would imply disaster.
“We do not predict disaster,” Grant continues, “but we do expect a pullback severe enough to inhibit the leveraged American consumer and to stunt the growth of the U.S. economy…”
Your California editor does not predict disaster either, but he does not rule it out. Nor does he rule out the possibility that mortgage-lending stocks like Newport Beach-based, Downey Financial Corp. (NYSE: DSL), might fall a lot lower…before they move higher once again.
Real estate transactions – and related economic activities – have become a disproportionably large contributor to the overall U.S. economy. Therefore, we would miss them greatly if they took a sabbatical.
“Between 1997 and 2004,” Grant relates, “the value of these residential transactions amounted to 16.4% of GDP, almost double the median reading from 1968 through 2005.” This monumental real estate boom fostered “echo-booms” in all housing-related industries. Since the end of 2001, according to Northern Trust economist, Paul Kasriel, housing-related industries have produced a whopping 43% of the nation’s total net private sector employment growth.
Obviously, therefore, any slackening of real estate activity could convert the nation’s largest job-creator into a job-destroyer.
“In the months ahead,” says Kasriel, “Econ 101 predicts that the prices of existing dwellings will continue to soften. This will serve to reduce the excess supply as some not-so-serious sellers take their homes off the market and as those sellers who have to sell acquiesce to the reality of lower prices. The knock-on effects of all this will be subdued consumer discretionary spending as those ‘home ATMs’ are not refilling as rapidly as before. Another factor that will curtail consumer discretionary spending is slower income growth in housing-related industries as employment and sales commissions moderate further.”
Membership within the California Association of Realtors, for example, might slip a bit, once home-selling becomes more tedious – and less remunerative – than raking rock gardens.
“We know that the behavior of the residential real estate sector tends to lead the behavior of the overall economy,” Kasriel conntinues. “That’s why folks at the Conference Board stuck housing building permits into the index of Leading Economic Indicators rather than the coincident or lagging indices. Might it be in this cycle that the behavior of the residential real estate sector is even more important than other cycles?”
“Yes,” is the implied and worrisome answer.
Housing Bubble: Real Estate Casualties
The casualties of a real estate-induced recession would be many and varied. So varied, in fact, that we could not begin to anticipate them all. But we could certainly anticipate that those closest to the front lines – namely, builders and lenders – would suffer first and most.
Acknowledging this likelihood, the homebuilding stocks have been falling sharply for months. But the mortgage-lending stocks, as a group, have not…at least not in relation to the sharp drop in mortgage-lending activity. Over the last 12 months, the shares of Kaufman and Broad, the nation’s largest homebuilder, have plummeted 50%; while the shares of Downey Savings have not dropped at all.
Probably they should have.
Downey’s loan origination volumes are tumbling in lock-step with the drop in California home sales.
During the second quarter of this year, Downey managed to originate only $2 billion worth of mortgages. That might sound like a lot, but it was less than half as much as the company originated during the second quarter of last year.
Back in 2001, Downey Savings averaged about $2 billion of originations every quarter. The mortgage lender earned $4.25 a share that year. And now, once again, Downey is originating about $2 billion of loans per quarter. And yet, Wall Street analysts expect the company to earn $6.80 a share this year…and to earn $7.50 next year!
Housing Bubble: Up In ARMs
We don’t believe it. And even if we did, we’d be afraid to buy the stock. That’s because most of the “earnings” that the bank reports are not the type that someone could spend in a grocery store. In other words, the earnings reside only on paper, NOT in Downey’s corporate bank account. The reason for this curious condition is that Downey Savings has issued a very large number of “Pay-option ARMs,” also known as negative-amortization (neg-am) loans. These devilish little mortgages contributed more than half the bank’s earnings last quarter…sort of.
“Pay-option ARMs, which Californias took to like surfboards, allow the buyer to choose a form of monthly mortgage payment,” James Grant explains. “And if the choice is ‘none of the above,’ the unpaid interest can be added to the loan balance (up to a point that is).”
In other words, these loans allow the homeowner to skip monthly payments, thereby INCREASING the unpaid balance. And when a mortgage balance increases instead of decreases, the loan-amortization is running in reverse. Hence the name, “negative-amortization” (Neg-am) loans.
Here’s how neg-am mortgages work on Wall Street: Whenever a homeowner chooses to skip a payment, banks like Downey Savings still behave as though they received actual money. They treat the neg-am as if it were revenue. A little bit of this chicanery is harmless; a lot of it is worrisome.
It’s bad on two fronts. First of all, when a borrower skips a payment, he skips a payment. Call it what you will, no check arrives in the mail. Even if Downey considers a skipped payment to be revenue (which it does), no revenue actually arrives at Downey HQ. Secondly, repeated skipped payments by multiple parties builds up a liability, without also building up any of the cash reserves required to offset the liability. That liability ultimately belongs to Downey.
In the quarter just ended, negative amortization “revenues” accounted for a whopping 57% of Downey’s total revenues, compared to only 20% last year. “Accumulated negative amortization stood at $229 million,” Grant reports, “or 18% of June 30 net worth, up 218% from the same quarter in 2005.”
None of this would be so bad if the housing market were still booming. But that’s not the case. Southern California home sales have dropped to their lowest level in nine years. And yet, the shares of Downey Financial have barely slipped from their all-time highs.
If California real estate is peaking, can the shares of the Golden State’s mortgage lenders be far behind?” James Grant recently wondered aloud. “‘Yes they can be,” he replied to his own question, “and – up to this moment, at least – have been.”
Evidently, they can be far behind and – up to this moment, at least – have been…but they shouldn’t be.
Housing Bubble: The Endgame
Earlier this year, one of the world’s greatest living economists made three very shocking predictions. Now they are coming to fruition. Homeowners around the country are slowly coming to grips with the fact that the value of their biggest investment is eroding…and the dollars they used to buy it are becoming weaker and weaker all the while. You can continue to look the other way and hope for the soft landing that Bernanke is hoping for, or you can get real and protect yourself.
Eric J. Fry,
Downturn in Real Estate by Greg “Gunner” Guenthner
“…The debt-dealers are getting desperate. And you could cash in while the housing market starts to cash out…”
The Bubble Blues by The Mogambo Guru
“The Mogambo Guru discusses Housing Bubbles — in the US and around the world.”
Past Bubble Experience Was Different by Dr. Kurt Richebacher
“When bubbles burst, a ripple is sent through the whole economy – and the bubbles of today are much further-reaching that those of twenty or thirty years ago. Dr. Richebacher explains…”
Property Bubbles by Dr. Kurt Richebacher
“Housing bubbles heavily entangle banks and the whole financial system as lenders. For this reason, as a matter of fact, property bubbles have historically been the regular main cause of major financial crises.”
What Housing Bubble? b y Mike Shedlock
“Neil Barsky, managing partner of Alson Capital Partners, LLC, wrote an absurd opinion piece about housing in the Commentary section of the July 28 online issue of The Wall Street Journal in which he claims there is no housing bubble. Mish responds with vehemence.”