Tuesday, July 27, 2010

House Price Bowel Movements - A Two-Part Opus (Supply/Demand)

I was chatting with a couple last night who is contemplating moving to Denver and was looking to buy an apartment. I suggested that they should rent rather than buy, because prices are going lower. They looked puzzled and asserted that they thought we were at a bottom. This motivated me to put together an analysis which should explain in no uncertain terms why housing has a lot farther to fall in price.

I think most people still buy into the argument that housing goes up in value over the long run and that price declines are to be bought. That fact of the matter is that if you look at housing prices since 1891, prices have gone up nominally around 3% per annum, or roughly in line with inflation. Net-net in real terms, housing has not increased in value (you can use google to source the data).

The current housing bubble and subsequent "pop" can be traced back to roughly 1991 and occurred in two-stages. The first stage of the housing bubble was fueled by the Fed taking interest rates from historic highs back in 1980 to historic lows still being plumbed today. When I started as a junk bond trader back in 1991, the yield on the 10-yr bond was around 8%. Today it is flirting with going below 4%. The Fed was able to engineer an increase in real estate by significantly lowering the cost of financing a home.

The second stage of the housing bubble, and the one which proved to be housing's demise, was the Fed and the Government in tandem proliferating the widespread expansion and use of credit. By 2005, there was so much fraud and abuse in the mortgage system, that there's actually accounts in which people were using their dog's name to get a mortgage and buy investment homes and criminals buying a portfolio of investment homes from prison cells (true stories). The Fed used this fraudulent increase in housing values to fuel all kinds of consumption-based economic expansion and the result was complete destabilization of the financial system, culminating with the de facto collapse of the banking system in September 2008.

So what now? The Fed is out of the gun powder it used to inflate the housing market from 1991 - 2007. Short term interest rates are essentially negative (on an inflation-adjusted basis) so rates can not go any lower, mortgage rates hit new record lows almost on a daily basis and still fail to stimulate new buying, and the reckless, fraudulent use of credit has been severely curtailed, though not eliminated entirely. If you take away these two factors, what dynamic can possibly keep housing prices from falling futher? 

The myth out there is that the consumer is deleveraging.  Does this look like that's a fact?:

(click on chart to enlarge)

The fact of the matter is that the only segment of our system that has somewhat deleveraged (off-balance-sheet derivatives notwithstanding) is the financial sector.  But that debt was transferred to the public sector via Tim Geithner Treasury guarantees and outright Treasury monetization (thanks Tim, Barak!). If you add that into the blue line above, the consumers debt burden has actually increased.  Those are irrefutable facts.  I don't care what kind of garbage CNBC or the Wall Street Journal or Barron's or Obama want to propagate.  They are lying.

Once you remove the two extremely artificial, unsustainable stimulative tools of lower interest rates and unlimited credit, the two real economic components which drive price are supply and demand. Let's examine those.

Demand. Now that the taxpayer subsidy of home buying as expired, the demand for housing has literally dropped off of a cliff. Contracts on new homes hit an all-time low in May and hit an all-time low for June as reported yesterday (this data goes back to 1963, so you can see how extreme these numbers are). Existing home sales are also hitting record lows. What can possibly stimulate demand? The job market continues to contract, unless you include the public workers who are standing around watching other workers dig up our roads, clog traffic and build sidewalks to nowhere. But they already likely own homes or do not have the credit scores rquired to finance a home. So I don't see rising income and employment as a contributing factor. Anyone else have any ideas?

Supply. Although I don't know why, new homebuilders continue to build new homes. Of course, the last thing this market needs is a new sources of supply. The existing home base is in the process of being puked back onto the market in the form of "strategic" defaults - otherwise known as "jingle mail" - in which the underwater homeowner turns his keys into the bank; rapidly rising levels of bank and GSE-repossessed homes (REO inventory); rapidly rising levels of delinquent and in-default homeowners; growing numbers of "shadow" sellers who would like to sell their home but see the equivalent home across the street on the market for a lower price than the would-be seller is hoping to get.

Here's some proof:

14% Of Mortgages In Foreclosure OR Delinquent
Strategic Defaults Rising
Jumbo Mortgage Delinquencies 50% Higher Than Average
S&P Expects 70% Re-default Rate On Modified Mortgages
Foreclosure Supply Grows Pushing Prices Lower

More On Supply.  Here's a chart that I find really interesting.  The source is cited on the chart:

(click on chart to enlarge)

What these two graphs show is that 1) it is taking longer every month for banks to unload their foreclosed housing inventory - and we know this inventory is growing by the month and 2) there's a growing inventory of homes that are sitting delinquent for more than 2 years.  You want to live rent free?  Go buy a home and then default on the mortgage.  According to chart on the right, you might be able to go at least 24 months without making a payment before the bank kicks you out. 

And here's the most horrifying chart of all.  Anyone who looks at this chart, understands it and still buys a home either doesn't care about money or is insane:

(click on chart to enlarge)
Let me explain this chart.  This chart shows the number of existing homes reported to be on the market for sale PLUS the number of homes that have delinquent mortgages. The literal interpretation of this chart is that if every deliquent mortgage defaults and goes into foreclosure, the total potential housing inventory is close to 12 million homes.  The average monthly sales annualized of existing homes going back to 1999 is 479,000.  In the worst case, assuming all of the delinquent mortgages default, the existing home inventory is over 25 months.  Typical inventory historically is 5 months.  You can play "what if" with 7.7 million delinquent mortgages to skew the result,  but that works both ways.  If only 50% of the delinquencies foreclose, that number months inventory goes down to 16 months.  Still 300% higher than normal.  BUT, banks are known to be dragging their feet in declaring homes to be delinquent or in default (in order to avoid more capital reserve requirments), which obviously implies the 7.7 million number is likely too low.  Any way you want "manipulate" the numbers, the end result is that there is a supply avalanche of existing homes on the market and soon to be on the market.

So there we have it.  Demand for homes is rapidly declining and the supply is rapidly increasing.  Now, I know that Alan Greenspan and Ben Bernanke and Larry Summers believe that they have the magic formula for changing the universal law of supply and demand (what Ivy League douche-bag doesn't think of themselves as being above the laws of nature?).  But that realistically not being the case, there is only one way for the market to resolve the supply/demand problem as described above and that's with substantially lower prices.  Sorry but those are the facts of life and the underlying natural laws of the universe.

John Templeton, considered one of the founding fathers of the the mutual fund industry and one of the most respected investors in our era, said back in the early part of the decade from his retirement home in the Bahamas that he would not consider investing in U.S. real estate in any capacity until the price level had dropped 90% from peak valuations.  At the time that was more extreme than my view that prices would fall at least 75% from top to bottom. But looking at the facts, I would not bet against Sir John's proclamation.  I don't know if the ultimate price decline will be 75% or 90%, but I do know for certain that as long as there are people out there like the ones I was with last night who believe that prices have bottomed, the housing market still has a long way to fall before the ultimate bottom is reached.


  1. Excellent laydown. The only way I'm going to sell this old house is to raffle it off. :-)

    Good thing it's paid off and I like where I'm living. The kids can worry about selling it.

    PMs getting beat up bad today. Your thoughts? I just bought some more silver and gold today.

  2. you know-some (many) consumers are de-leveraging via strategic defaults. Walk away from an upside down situation, rent for a while and then buy back in when prices are lower. Here is where not having a mortgage makes you wince.

    Then the 6 year loans on expensive cars, or leases. Just walk away and buy a corolla.

    I am not sure what the game plan is on credit card default (if you listen to banks there is no major problem with past due credit cards and the 29% interest), but if you can walk away from these 3 you have de-leveraged.

    what happens to credit rating is a different issue.

  3. anonymous: my thought is that you don't need to ask my thoughts LOL. we bought gold/silver with both hands for our fund. both times i called Tulving I was put on hold for several minutes. every time there's a price hit, tulving has been getting swamped with buyers. this last 12 months is the first time during this bull market that I can recall this happening - people buying physical on price dumps.

    I don't know if the bottom of this correction is here or a bit lower, but when gold goes over $1300 I don't think you or I will regret buying today.

  4. Hal, unloading your mortgage w/a strategic means it ultimately gets transferred to the Treasury via FNM/FRE or TARP-like programs. Maybe on a micro level some consumers de-lever this way, but on a macro-level, overall debt per person goes up.

  5. Whats a credit score? And who needs one of those anymore, if your borrowing you cannot afford it anyway. Cash is king at the moment.

    And as far as Pm's I am buying the dips, but if you notice the spot prices are not moving to the down side a whole hell of a lot...So the dealers know this take down is artificial...Capitalize on it even though it is only a few dollars in savings, but hey a buck is a buck.


  6. There is a third reason to buy a house.

    3) My wife wouldn't agree to start making a family until we lived in a house.

    BTW, she's pregnant now.

  7. Guys, the Summer is not the time to buy, end of August will be better at 10% less than today. Why overpay?

  8. Excellent post, Dave. Too many citizens are caught in a debt trap where they cannot afford to pay down debt incurred during better times, especially those who only qualified for subprime or other 'exotic' fog-a-mirror-to-qualify loans. Paychecks are shrinking and the US is still shedding jobs at a nasty clip. I can't think of anything that might drive housing prices up except more gubbermint intervention.

  9. 3rd reason anonymous: LOL - we see how wears the pants in that household...congrats on the incoming!

  10. 2 years ago, guy that worked for me transfer to FL. At his going-away lunch I told him, "Do not buy a house when you get to FL". He started in about properties being down 20%, blah, blah. Today...
    Z-estimate: $190,000, and houses nearby are selling for $150,000
    04/18/2008 Sold $277,500
    08/29/2007 Sold $315,100

    Live and learn? Nope. The sheople refuse to learn.

  11. Dave, when I was shopping for a house in the Baltimore suburbs back in 2002 there were a couple hundred available in my price range. Now there are over 600 homes for sale just in my zip code. What's interesting though is that prices are still relatively high (I suspect that will change soon enough.)

    All the propping-up of prices by Ben is causing an undesirable effect, they simply aren't moving.

    The other major factor is that there aren't any buyers left. I'd like to see a chart of the available pool of buyers in 2002 vs today, factoring in credit-worthiness. Overlay that chart with your inventory data and it's not a pretty scenario for RE.

    Great post BTW.