The Coming of the Second Wave

The Daily Reckoning PRESENTS: Serious housing declines mirror very closely the life cycle of tsunamis. Their initial impact on land is often a wave trough as opposed to a wave crest… with most of the damage yet to come. And that is how housing markets typically crash. Read on…

THE COMING OF THE SECOND WAVE

Imagine a column of water in the Pacific Ocean, 4,000 meters deep and seven kilometers wide. And it’s heading toward you literally at the speed of a bullet.

A volume of seawater traveling at that speed is classified as a Tsunami – the biggest and most devastating of all ocean forces.

The seventh most devastating natural disaster is the 2004 tsunami in the Indian Ocean that killed 287,000 people.

Now imagine that the pattern of that tsunami’s formation, its growth, and its ultimate destructiveness perfectly mirrors an industry in our country.

And the damaging effects of the industry to which I’m referring on the U.S. economy have yet to make landfall…

It is astounding how closely events of nature mirror events of business. It shouldn’t be much of a surprise, really. Leaders in finance have used the physical world to help describe and predict the events of finance for decades. The most famous example of this in my mind is the Nobel Prize winning work of Fisher Black and Myron Scholes. They adapted a heat transfer equation from physics to explain and value options contracts.

And that’s only one example…

MIT economics professor Xavier Gabaix, along with a team of physicists from Boston University discovered that the movements of the stock market follow a mathematical pattern similar to earthquakes.

These findings could allow traders to protect their investments by pinpointing periods when market volatility is likely to be significant.

“The frequency of crashes such as those in 1987 and 1929 follow patterns,” says Gabaix. “Although that doesn’t mean we’ll be able to predict with certainty when movement will occur, or in which direction it will go, we can still predict – better than with other methods – whether it will be a big move or a small one. And that information can be useful.”

The patterns that give us clues of huge equity market changes and devastating earthquakes are known as power laws. Power laws define mathematical relationships between the frequency of large and small events. Typically, the larger the event, the less frequently it happens. The importance of these power laws is in the way they describe nature as well as artificial constructs…

What I’m worried about, though, is something that will affect everyone in America, not just stock investors…

It will be the second wave downwards in housing that will catch everyone off guard and send the economy into a sharp, protracted consumer-led recession. And that second wave is about to hit.

Housing peaked in summer of 2005 right along with the cover of Time magazine proclaiming “Home $weet Home – Why we are gaga over real estate”. Since then home sales have fallen dramatically nearly everywhere and price drops in the bubble areas such as Florida, Massachusetts, Phoenix, Las Vegas have been as large as 25% or more taking into consideration incentives, interest rate kickbacks, and even “free” vacations and cars.

Building permits in November dropped 31% from the year earlier level. Note that seven out of the last eight times the annual rate of change on permits was negative 20% or lower, the economy went into a recession (not counting the current situation).

Furthermore it was a plunge in the annual rate of change on permits that preceded every recession that makes permits a strong leading signal. The only miss was 1987 where the annual rate of change exceeded negative 20% but there was no recession. There was also a recession in 2001 even though the threshold of negative 20% was not hit (but the number did at least get strongly negative). That likely explains why the recession of 2001 was not as severe as most. Indeed when housing is strong hiring is strong and people also tap into the equity on their houses and spend it.

In early December of 2006, in One on One with Robert Toll of Toll Brothers Robert Toll proclaimed that things are “dancing a little bit above the bottom” and that “all the ingredients to have a very rapid recovery are in place and I suspect you will see a rapid recovery once the pent-up demand understands that if they don’t buy now, they may miss an excellent opportunity to buy a home with a low mortgage rate.”

Actions however speak louder than words as Robert Toll has personally been bailing on his shares at a tremendous rate. The key elements however, are land options and cancellations.

Nearly all of the homebuilders have had high cancellation rates and have also been taking big writeoffs on land. Here is a prime example: Lennar posted a quarterly loss after land writedowns:

“Market conditions continued to weaken during the fourth quarter and we have not yet seen tangible evidence of a market recovery,” Chief Executive Officer Stuart Miller said in the statement. Lennar said it’s taking a charge to write down land it doesn’t intend to purchase. It’s also writing off deposits and pre- acquisition costs for land it has under option.

Would Lennar or any of the homebuilders be dumping land if they really thought the bottom was in?

It has now been over 18 months since housing peaked in the summer of 2005.

But the average decline in housing starts from peak to trough is about 46 months. By that standard this decline has a long ways to go yet.

Foreclosures are actually at a fairly low rate. It is the rate of change however that is alarming. Foreclosures increase 51 percent nationwide.

Foreclosures increased 94 percent last year to 157,417 homes in California, as homeowners struggle with fast-rising home payments and a slow-selling market, according to a Fair Oaks real estate investment advisory firm on Monday. California had the most foreclosures filed nationwide, while Nevada had the largest percentage increase at 175 percent last year compared to 2005, according to Foreclosures.com. Nationwide, almost 971,000 foreclosure filings were reported last year, 51 percent more than the 641,000 in 2005, according to the annual report.

There has been some excitement as of late by a small bounce in homebuilder sentiment as well as a small bounce in new home sales. This is like looking for starfish on the beach during the trough that precedes the big wave of the tsunami.

For starters, new home sales do not take into consideration cancellations and cancellations have been soaring. The current methodology is to count “new sales” as soon as a contract is signed, but sales are not subtracted by cancellations. Thus not only are sales overstated but inventories are massively understated. Builders are now scrambling to finish projects and unload as much inventory as possible before the next wave hits.

That second wave will strike when massive layoffs occur as the current projects are being completed followed by a decline on a lagging basis of commercial real estate. Already we are seeing an impact in residential construction employment. But do we really need more Walmarts, Pizza Huts, strip malls, nail salons, grocery stores, Home Depots, Lowes, and restaurants that follow? I think not and historically commercial construction follows residential construction with a lag. That lag is anywhere from 8 to 16 months.

Commercial business hires people and lots of them. When that buildout ends, and we are at the beginning of the end now, there is going to be no source of jobs to replace those service sector jobs going forward.

More to come next week…

Mike “Mish” Shedlock
for The Daily Reckoning
March 21, 2007

Editor’s Note: The tide on soaring real estate has ebbed…to some, it might even look like a chance to wander out and snap up property at new “low” prices… But the real wave of devastation still looms on the horizon.

Michael Shedlock (Mish) worked in the financial services industry for 20 years at some of the top institutions in the country including Harris Bank, the Bank of Montreal, Bank One, First National Bank of Chicago, and First Data Corp. Mish is currently doing economic and investment research for a number of clients and is the co-editor of The Survival Report. In addition, Mish runs one of the more popular stock boards on the Motley Fool, Investment Analysis Clubs/Mishedlo and one of the more popular boards on Silicon Investor as well, Mish’s Global Economic Trend Analysis.

“Behold, the liquid Thames is frozen o’er…”

Yesterday, we spoke of re-arranging chronology to suit us better. Today, it is geography we’d like to improve upon.

We begin with the weather report. Even though we are on the threshold of spring – with bushes and trees already in bloom all over London – it is freezing cold. The Thames is not really frozen over this morning, but there is ice on the puddles along the Southwark walk.

If only London could be dragged to the south! It is often cold, windy, rainy, gray and overcast here. Why couldn’t all of England be dropped down…say to the latitudes of Spain…or even Morocco?

It is clearly not possible to re-arrange the map, but is it possible to change the climate of a place? Apparently, yes. At least, that is the theory of global warming. According to the theory, mankind has changed the whole world’s climate. It seems unlikely to us, but what do we know?

And the Soviets thought they could, at least, change the climate of certain regions. Among their crackpot projects was one in which they were to grow peaches in Siberia. Anything was possible for the New Marxist Man, they said to themselves. They spent millions of dollars – and wasted thousands of lives in slave labor gangs – trying to realize this project. None of it worked.

The climate change projects that actually did work were accidental and, from most points of view, disastrous. Large parts of the ancient world – from Athens to Baghdad – were once covered in forest, with streams and springs – and many wild animals, including lions.

Gradually, the trees were cut down. Crops were planted. Goats, cattle and sheep were allowed to over-graze. The soil washed away. Without the trees to protect the ground from the sun, the entire eco-system dried up…the surface water evaporated…the animals disappeared…the seeds and berries blew away…and what remains is the area as we know it today – much of it dry, barren, denuded.

Apparently, much the same thing happened in the Andes Mountains. The story is less well known, and much of it is just conjecture, but some scientists think the Andes were also covered in forest until fairly recently. Then, the pre-Columbus Indians cut down trees…and introduced agriculture.

Later, the post-Columbus settlers increased demand for forest products – for building and for fuel. But it was too late. There were already goats, llamas, cattle and sheep on the land. And once the four-legged animals are on the ground in force, there is no chance that the forest can re-establish itself, because the young seedlings are eaten before they can mature…and then the seeds themselves disappear.

As far as we know, only on the East Coast of the United States have forests ever come back. There, livestock is generally restricted to fenced-off pastures. There is also more rainfall. So once land was no longer actively farmed, the trees came back.

What has this got to do with money? Maybe nothing. But economies are not so different from ecosystems. Besides, not much happened in the world of money yesterday, so we’ve got to use our imagination.

However, the euro did creep above $1.33…and gold rose to $659.

Stocks rose again, too. And subprime lending is really no problem at all; everyone says so.

What is happening, though, is that the noose around the average consumer’s neck must be getting tighter.

“Banks are…restricting access to credit months after Chairman Ben S. Bernanke stopped raising interest rates,” says Bloomberg.

“Countrywide Financial Corp., the biggest U.S. mortgage provider, last week stopped taking applications for no-money-down loans from risky borrowers without proof of income.

“General Electric Co.’s WMC Mortgage, the fifth-biggest U.S. subprime lender, said March 9 that it would refuse mortgages to borrowers with credit scores below 600. The Burbank, California-based bank also fired 20 percent of its staff.

“Three days later, Calabasas, California-based Countrywide limited subprime borrowers that don’t document their income to loans worth 85 percent of their homes. Wells Fargo & Co., the largest U.S. subprime lender, said in a March 7 statement to Bloomberg News that it changed standards effective Feb. 16 for some risky customers.”

Lenders are getting tighter. No longer is a man’s word good, not in mortgage lending. The mortgage providers want to see tax returns, pay slips, bank records. What this means is that the lowest rung of the housing ladder is being torn off. Down at the bottom, the weakest buyers have nowhere to put their feet. But if they can’t buy…to whom do the subprime builders sell their houses? And what about the marginally prime on the next rung up? Who will buy their houses…so they can move up…and eventually buy a McMansion?

It may be true, as we reported yesterday, that only 15% of subprime loans are in trouble…and that subprime represents only 10% of the mortgage industry. But everything happens at the margin. In a neighborhood of 100 similar houses, each one worth $200,000, if one of them is sold for $150,000 – the value of the entire neighborhood is suddenly marked down. The total implied loss in wealth is $5 million – even though only a single house was sold, and only at a $50,000 discount.

When the most marginal buyers can’t get credit, the not-so-marginal sellers can’t make a sale. If they can’t sell at anticipated prices, the value of their collateral is called into question, so they can’t borrow either. Then, the whole structure of credit begins to dry up.

Someday, and you can quote us on this, the lush, green forests of today’s credit expansion are going to go brown.

More news:

————–

Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…

“Did you see the housing starts data for the United States yesterday? Amazing! Astounding! And Incredible! Housing starts rose 9.0% in February to an annualized pace of 1.525 million units…”

For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig

————–

And more views:

*** Now, what’s this? “A bust in Spanish vacation homes?” asks the International Herald Tribune.

There has been such a boom in Spain in the last 10 years that property prices have risen there more than anywhere in Europe…with the exception of Ireland. Prices are up three times as much as in the United States. This is why, of course, when they polled Europeans about what they thought of the European Union, the Spanish were the most enthusiastic. No group has done better.

British and German vacationers go down to Spain as easily as New Yorkers go to Florida. Many of them buy houses and vacation condos. Why? The weather is better. And the Spanish quality of life is very high…at least, that’s what the northern Europeans think.

But now experts are predicting that property prices in Spain could fall 10% this year. Banks are cutting credit to builders. Agents are getting nervous.

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*** “The problem now is that everything is too expensive…”

That was the problem we discussed last night. We were not talking about stocks or bonds, or metals or property. We were talking about private businesses with a German publisher who studies financial strategies very carefully.

“Look, when you are in business, the best thing you can do with your money is invest it where you have a competitive advantage – in a similar business, where you know what is going on. So, I always look first at what is available in the publishing area. I don’t know anything about mining or about biotech, so it makes sense to me to invest my money in the thing that I do know – publishing.

“And because I know it, I know how to judge a publishing business…how to tell how much it is worth. But when I look at what is for sale now, I can’t find anything that is worth what people are asking. So I ask myself, ‘how can a regular investor – who doesn’t really know the industry – possibly expect to make any money?’ On the other hand, at these prices, he’s the only kind of investor who can buy – because he doesn’t know enough to be wary. So, if prices go up, he’s the one who makes the money.

“Still, you have to stick to your discipline.”