Irvine Housing Blog

Home Sales Data thru 6-12-2007

Congratulations to 92614 for dipping under the $500,000 mark!

What do you see?

Letter from a Reader

Whenever I read Calculated Risk's blog, besides being impressed with a man who is much smarter than I am, I am always struck by the fact I am getting his opinion at all. Everyone has an opinion, but some opinions are better than others. The opinions at Calculated Risk should be paid for as consultancy, but he offers them up free-of-charge as a public service.

Aren't blogs great?

One of the great things about blogs is that it gives an outlet for ideas which would never have seen the light of day years ago. There are many people who saw this crash coming (see letter below), just like there were probably many people who saw the last one coming as well. In the past, there was no forum to get this information into the public realm. The National Association of Realtors through their advertising clout used to controlled the flow of information regarding the housing market: Not anymore.

I receive email from many people asking me about my opinions on the market or whatever. I thought this one was interesting, so I thought I would share it will all of you.

To keep everyone anonymous, I have edited the letter wherever you see parenthesis.
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Hi,

My wife and I really love your blog. She accurately accuses me of being a dung-sniffer with my sometimes negative views, but the housing market collapse was something we both saw coming.

We bailed out of Woodbridge in April 2004. I cant tell you how many of my Irvine friends told me then, and still tell me, that I was crazy to think that house prices could drop--level off possibly--but NEVER drop. I have even been bad-mouthed by someone that took my advice to sell a condo that they were moving up from in 2005 rather that keep it. I would have never imagined the lunacy of lenders and buyers to begin signing up for caustic loans beginning that year, further driving up prices.

I guess I don't share the same sentiments as some of your readers regarding home sellers. I don't have any charity towards the flippers and I see them as losers who happened to discover a way to make a quick buck with little risk. These are not real business men who have a lot at stake. I think the majority of them will, or would have, just walked away from any losses regardless of what promises they made. On the other hand I don't rejoice in another's misfortune even when they bring it on themselves, much like the speeding motorist getting ticketed on the roadside..unless his behavior is reckless to others.

While I am shocked that people will not educate themselves at all when it comes to the biggest investment they will ever make, and instead just listen to that NAR propaganda, I still feel sorry for them..maybe because they are stupid?

The main reason for writing you today is to point out 2 very different types of sellers. I know both of these people, they live on the same street in Woodbridge.

The first bought in 1997 and has his house listed at a 2005 price. The house is in great shape, but still it sits. Unless there is a HELOC he wont get hurt.

The other one is a guy ( with family) that moved to Irvine in 2003 for the schools. They sold their house (elsewhere) and rented in Irvine, he asked my advice back then and I told him to keep renting. He would periodically ask me the same question and I gave him the same answer..rent. One year after we moved they must have bought into the belief that trees grow to the sky and bought with no down payment..something I would have never imagined for someone who is (smart) and very conservative. I guess he found out that the $5.5k/mo payment is too much and listed it last month with an out of area agent for $60k more than he paid. Not a knife catcher, this poor guy just keeps taking bad advice from realtors and it will eventually cost him everything.

Do I offer any advice now? Heck no! Been stabbed in the back already. What would I tell them? #1 needs to drop his price $100k, dump the agent who is not spending any money on marketing, list it on the MLS, Craigslist, YouTube, WWW, and offer a 5% commission to the buyers agent. And the $100k is only if he would have done it 2 months ago. Next spring it will be >$150k.

#2...uh well. I am torn since I feel bankruptcy is a license to steal. He will take a $200-$250k hit on this place due in part to condition. The first thing he needs to do is to contact the 2nd mortgage holder and tell them he will be bringing them some short sale offers, then do all of the above with at $225k price reduction....then pray! Alternatively he can just mail in the keys.

I feel really bad for #2 and I think I could help #1, These are both good friends. What would you advise?

Once again I enjoy keeping tabs on the market down there and I really get a kick out of the wit you and your readers often post. Most of all I like the feeling of vindication I get from your blog.

Thanks

(anonymous)

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I replied:

Thank you for writing. It is comments and emails like yours that keep me going. If you didn't see it, I think you might enjoy The Reservoir of Schadenfreude, you are not alone in your frustration with advising people who refuse to see the obvious.

I think the course of action you advised these would be sellers is right on. Perhaps the only thing I might add is to tell them to come read the analysis posts on our blog to help them feel comfortable with what you are telling them. Sometimes when people read something from a disinterested third party, it carries more weight, and some people just need a bit more convincing that the market is going to crash.

Beyond that, I would just offer up your advice when asked, and avoid the topic otherwise. You can only lead a horse to water...

Birds of a Feather

Birds of a Feather Flock Together, or so the saying goes. In Woodbridge, crazy asking prices are where the birds roost -- 2 Mallard and 30 Bluejay.

Asking Price: $1,299,900

Purchase Price: $875,000

Purchase Date: 10/21/2005

Address: 2 Mallard, Irvine, CA 92604

Beds: 4
Baths: 2
Sq. Ft.: 2,077
Lot Sq. Ft.: 7,150
Year Built: 1976
Stories: 1
Type: Single Family Residence
View: Park or Green Belt
County: Orange
Neighborhood: Woodbridge
$/Sq. Ft.: $626
MLS#: S491397
Status: Active on market
On Redfin: 19 days

From Redfin, "MOST BEAUTIFUL & UPGRADED SINGLE STORY HOME EVER, COMPLETE REMODEL CUS TOM KITCHEN, BATHS, BEDROOMS, YARD, ON ONE OF WOODBRIDGES'S PREMIER STREETS, SELLER SPENT $300,000 IN IMPROVEMENTS. ONE OF A KIND LOCATION. ACROSS FROM ARBOR PARK, STEPS TO LAGOON."

Do realtor's keyboards have the caps lock jammed? And who writes this stuff:

"The most beautiful... ever?" Never ever in the history of mankind has a better home been built? Wow! I have to see this one... Not.

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$626 per square foot in Woodbridge? There are only two other homes I could find asking more than $600 / SF: a previous WTF winner Melodylane, or Out-of-Tune? and 55 Lakefront which is actually on the lake (Not that it is worth the price, but at least you can make the case). This house is not on the lake, and is, in fact, adjacent to some condos -- not a strong selling point. The renovation is well done, and the house is beautiful inside. With the improvements, perhaps this seller will get out at the $875,000 he paid for it. As for the improvements; well, I hope he has enjoyed them...

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Asking Price: $829,000

Purchase Price: $433,500

Purchase Date: 11/4/2002

Address: 30 Bluejay, Irvine, CA 92604

Beds: 3
Baths: 2
Sq. Ft.: 1,549
Year Built: 1976
Stories: 1
Type: Single Family Residence
County: Orange
Neighborhood: Woodbridge
$/Sq. Ft.: $535
MLS#: S489221
Status: Active on market
On Redfin: 34 days

From Redfin, "Newly remodeled and decorated patio home. Custom mouldings, windows, l ighting and hardwood flooring. New concrete roof, heating and air conditioning. Beautiful kitchen and master bath. Newly landscaped yard with barbeque. "

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This seller obviously did not get the memo on the state of the market. It takes a lot of denial to believe your house doubled in value since late 2002. Why would you buy this small 3/2 for $829,000 when you could go down the street to 10 Bluejay and get a large 4/3 for $839,000? Realistically, this house could sell today for $350 / SF which would put it at around $550,000. This would get the seller out with a small profit after commissions. The price will do nothing but drop from there. A year or two from now, this seller probably will be underwater.

If you were this seller, do you sell now and take a small profit, or do you hold on and wait for the market to provide your asking price? I suppose it depends on whether you want to sell in 2007 or in 2027.

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I hope you have enjoyed Woodbridge Week. Come back next week when I will profile... Oh, I don't know, I will figure it out this weekend. So many properties, so little time...

Leaves of Grass

A Promise to California

A PROMISE to California,
Or inland to the great pastoral Plains, and on to Puget sound and Oregon;
Sojourning east a while longer, soon I travel toward you, to remain,
to teach robust American love,
For I know very well that I and robust love belong among you,
inland, and along the Western sea;
For these States tend inland and toward the Western sea, and I will also.

Walt Whitman - Leaves of Grass

The dream of riches in California real estate is a Siren's Song to many with a robust love of money. Unfortunately for the rollbacks I am featuring today -- 3 Woodleaf and 28 Meadowgrass -- the lure of easy money caused them to crash on the rocks.

Asking Price: $449,900

Purchase Price: $469,000

Purchase Date: 10/24/2005

Address: 3 Woodleaf, Irvine, CA 92604

Beds: 2
Baths: 2
Sq. Ft.: 1,140
Year Built: 1982
Stories: 1
Type: Condominium

View: Trees/Woods
County: Orange
Neighborhood: Woodbridge
$/Sq. Ft.: $395
MLS#: M104975
Status: Active on market
On Redfin: 161 days
Unsold in 90+ days

From Redfin, "Upper End Unit - Tree Views - Newer Carpet, Tile Floor, Microwave & In terior Paint, Plantation Shutters - Shows Like A Model Truly Turnkey - Large Rooms - 2 Master Suites - Close To Schools, Shopping & Freeways - Lake - Pool & Spa - Very Clean & Bright - Scraped Ceilings - Mirrored Wardrobes - Storage Area -"

Tree views? So now if you have a tree out your window, you have a view? What next, air views?

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In the post, Wish Upon a Fallingstar, we showed comps for condos like this are going for $400,000 or less. This is about $50,000 overpriced if they really want to sell it. That fact aside, if they somehow manage to get their asking price, they still stand to lose $46,094 assuming a 6% commission. I am estimating this loss will be closer to $100,000 by the time they sell it. Losing $50,000 to $100,000 on a condo for which the seller paid less than $500,000 is a huge loss.

Asking Price: $710,000

Purchase Price: $730,000

Purchase Date: 4/29/2005

Address: 28 Meadowgrass, Irvine, CA 92604

Beds: 3
Baths: 2
Sq. Ft.: 1,545
Lot Sq. Ft.: 4,512
Year Built: 1977
Stories: 1
Type: Single Family Residence
County: Orange
Neighborhood: Woodbridge
$/Sq. Ft.: $460
MLS#: S486737
Status: Active on market
On Redfin: 51 days

From Redfin, "Nestled in the prestigious Woodbridge community and steps to the Stone Creek Swim Club, this home is upgraded throughout. Brazilian cherrywood floors highlight the open floor plan that includes separate dining and huge family room, breakfast nook, atrium, and step-down sitting area with cozy fireplace. Gourmet kitchen includes granite counters, recessed lighting and stainless steel appliances. Large professionally landscaped yard with slate patio, raised planters, and sculptured vegetation. "

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We saw a good comparable for this property in Woodbridge Knife-Catchers. 52 Shearwater, Irvine, CA 92604 sold on 3/29/2007 for $629,000. What chance does this seller have of getting $710? Again, even if this sells for asking price, the seller still stands to lose $62,600 after commissions. I am estimating the ultimate loss to be closer to $150,000 based on the recent comp sale.

As you can plainly see, we are rolling back all of 2005 and we are now back into 2004 pricing. Personally, I am amazed at how fast this is happening. Real estate markets usually do not collapse this quickly. Don't look at the wishing prices, pay attention to the transactions. This market is deteriorating fast.

Woodbridge Knife-Catchers

Apparently there are still people in Woodbridge who didn't read Monday's post Houses Should Not Be a Commodity. There are four knife-catchers I found while looking through the MLS listings on Redfin. There may be more.

One thing that puzzles me is the lack of pictures. You would think people trying to make a quick $100K would at least take some pictures of the properties they are peddling.

Asking Price: $535,500

Purchase Price: $500,000

Purchase Date: 12/14/2006

Address: 1 Cedarglen #29, Irvine, CA 92604

Beds: 3
Baths: 1.5
Sq. Ft.: 1,123
Year Built: 1976
Stories: 2
Type: Condominium
County: Orange
Neighborhood: Woodbridge
$/Sq. Ft.: $477
MLS#: S470156
Status: Active on market
On Redfin: 173 days
Unsold in 90+ days

From Redfin, "EXTREME HOME MAKEOVER. End unit townhome with extra windows and easy access to parking in the heart of Woodbridge. Private corner with nice size rear yard. Laminate wood flooring throughout. Near shopping, restaurants, theaters and North Lake with it's pools, tennis and much more. Rehab includes new heat and a/c"

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I call BS on the "EXTREME HOME MAKEOVER;" unless, of course, you like the color pink...

At 173 days on the market, I don't think the renovation was as successful as this knife-catcher had hoped.

Knife Catcher #2:

Asking Price: $740,000

Purchase Price: $629,000

Purchase Date: 3/29/2007

Address: 52 Shearwater, Irvine, CA 92604

Beds: 3
Baths: 2
Sq. Ft.: 1,448
Lot Sq. Ft.: 3,994
Year Built: 1979
Stories: 1
Type: Single Family Residence
County: Orange
Neighborhood: Woodbridge
$/Sq. Ft.: $511
MLS#: S489742
Status: Active on market
On Redfin: 25 days

From Redfin, "Beautifully remodeled single story detached home located at the end of a cul-de-sac that features scraped ceilings, new sliding glass door leading to a patio area with a relaxing fountain and newly fenced private yard. New recessed lighting, new neutral paint, carpet, tile flooring, custom closet organizers, remodeled granite countertop kitchen with new appliances, updated bathrooms. Newer roof, new garage door, all new double pane tinted windows!! Lots and lots of new."

I didn't realize "new" was an object one could have lots of...

Here is another would-be commodity trader who just signed up to be a bagholder. I have to give all these knife-catchers respect for having courage; of course, I imagine that respect won't mean much to them in bankruptcy court.

Knife Catcher #3:

Asking Price: $599,900

Purchase Price: $490,100

Purchase Date: 4/30/2007

Address: 17 Seawind, Irvine, CA 92604

Beds: 2
Baths: 2
Sq. Ft.: 1,058
Year Built: 1984
Stories: 1
Type: Condominium
County: Orange
Neighborhood: Woodbridge
$/Sq. Ft.: $567
MLS#: P579402
Status: Active on market
On Redfin: 30 days

From Redfin, "Beautifully upgraded home in Woodbridge near the lake. Highly upgraded with hardwood floor thru entire house, tile floor in the bathroom, granite counter top, crown & base moulding, just painted, private spa in the backyard. Walk to lake, park, and lots lots more!!"

IMO, this is also a WTF award candidate. This buyer overpaid for what they have, and now they think they can turn around and sell it for $100,000 more. This unit does not see the lake, it isn't on a park, it is a nondescript, tiny tract home in the middle of Woodbridge -- for sale in a declining market. WTF is this seller thinking? This is a perfect example of the "buy and hope" strategy of the truly foolish speculator. This knife-catcher will really bleed.

If you don't think this seller overpaid, compare it to the listing below.

And finally, a knife catcher of a different sort -- bank real estate owned (REO):

Asking Price: $394,500

Purchase Price: $423,597

Purchase Date: 4/30/2007

Address: 87 Firwood #42, Irvine, CA 92604

Beds: 3
Baths: 2
Sq. Ft.: 1,150
Year Built: 1978
Stories: 1
Type: Condominium
County: Orange
Neighborhood: Woodbridge
$/Sq. Ft.: $343
MLS#: U7002379
Status: Active on market
On Redfin: 19 days

From Redfin, "OUTSTANDING LOCATION IN THE CITY OF IRVINE. THIS IS WOODBRIDGE! THE UN IT FEATURES THREE BEDROOMS AND TWO BATHROOMS. ASSOCIATION POOL AND SPA. OUTSTANDING SCHOOLS. CLOSE TO SHOPPING, TRANSPORTATION, ENTERTAINENT AND EMPLOYMENT. DO NOT MIS THIS ONE, THIS IS ONE OF THE BEST VALUES IN THE CITY! SUBJECT IS SOLD 'AS-IS' AND 'WHERE-IS' WITHOUT WARRANTY."

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This looks like a bank property as they tend to put the "as-is" statement in their listings. Did you notice the price? A 3/2 under $400,000 in Woodbridge. Now that is a comp killer.

It is easy to get angry over the behavior of the commodity-trading knife-catchers. If they were not a fixture of the real estate market, some family might have been able to buy one of these homes at a better price. The time to be angry at these flippers is past, for the next several years we can simply enjoy the schadenfreude as these Donald Trumps are going to get their comeuppance. I don't think any of us will be sad to see it happen.

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Wish Upon a Fallingstar

Welcome to Woodbridge Week at the Irvine Housing Blog. I thought I would begin with the serenade of the delusional kool-aid drinkers: an ode to market denial.

When you wish upon a star, makes no difference who you are
Anything your heart desires will come to you

If your heart is in your dreams, no request is too extreme
When you wish upon a star as dreamers do

(Fate is kind, she brings to those who love
The sweet fulfillment of their secret longing)

Like a bolt out of the blue, fate steps in and sees you thru
When you wish upon a star, your dreams come true

Music by Leigh Harline / Lyrics by Ned Washington
Performed by Jiminy Cricket (Cliff Edwards)

Link to YouTube Video

Asking Price: $419,000

Purchase Price: $400,000

Purchase Date: 5/5/2004

Address: 452 Fallingstar #8, Irvine, CA 92614

Beds: 1
Baths: 1
Sq. Ft.: 863
Year Built: 1984
Stories: 2
Type: Condominium
County: Orange

Neighborhood: Woodbridge
$/Sq. Ft.: $486
MLS#: S488454
Status: Active on market
On Redfin: 38 days

From Redfin, "Light and bright spacious end unit. High vaulted ceiling in living roo m leads up to 2nd story loft. Located in the heart of Woodbridge. Unit has been well maintained and is emmaculate. The garage space for this unit also has a small storage closet. The almost new combo washer/dryer unit could possibly stay. Big closet in bedroom. Central A/C. New water heater w/ permit. Bathtub just refinished along with new enclosure soon. "

Is it just me, or the the meaningless expression "light and bright" make you cringe like nails on a chalkboard? And what is "emmaculate?" Is that like emasculate?

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This one is not priced below its 2004 purchase price, but when you see its competition, you can conclude it will probably sell for much less. Either way, after factoring in a 6% commission this seller will lose money on an April 2004 purchase in Woodbridge. Who would have guessed? (hint, I would have.)

I am speculating there has been a recent price reduction as this unit is listed twice in the MLS, and the second one has it at $449,000.

Let's see what the competition is doing...

Price: $435,000

43 FALLINGSTAR #27, Irvine, CA 92614

Beds: 2
Baths: 2
Sq. Ft.: 1,056
Year Built: 1984
Stories: 2
Type: Condominium
County: Orange
Neighborhood: Woodbridge
$/Sq. Ft.: $412
MLS#: S483813
Status: Active on market
On Redfin: 70 days

From Redfin, "Fantastic townhome nestled deep within safe & quiet family development. Charming curb appeal is well matched by light & spacious interior. Expansive living room boasting soaring vaulted ceilings & fireplace. Chef's kitchen featuring wrap-around breakfast bar & attached laundry room. Main floor master suite complete w/ private bath. Upstairs loft/2nd bed also w/ its own bath. Nice patio area. Short walk to pools, spa, lake, shopping & schools! WOW!"

I was OK with this description right up to the WOW! It must be a realtor dysfunction that all caps and exclamation points are required.

This is a 2/2 only asking $16,000 more than the above 1/1. Which would you choose?

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Or how about this one:

Price: $489,000

35 FALLINGSTAR #21, Irvine, CA 92614
Beds: 3
Baths: 2
Sq. Ft.: 1,227
Year Built: 1984
Stories: 2
Type: Condominium
County: Orange
Neighborhood: Woodbridge
$/Sq. Ft.: $399
MLS#: P561835
Status: Active on market
On Redfin: 122 days
Unsold in 90+ days

From Redfin, "Stunning Condo with new interior paint and remodeled kitchen. Originally, 2 bd/2ba + loft. Loft has been converted into an additional bedroom without permit. Huge master bedroom on the first floor accompanied by the huge living room with built in fireplace. Hurry !!! Seller will look at all offers."

Hurry!!! the seller is desperate (note our three exclamation points). Oh, wait, I guess you don't have to hurry. It isn't your problem, is it?

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This is a 3/2 only asking $70,000 more, and with 122 days on the market and sitting empty, it will probably come down a lot too. If the asking price drops much further, it will become a 2004 rollback as well.

Woodbridge is a very desirable neighborhood. As I have said before it is one of my favorites, but as we saw last week with Turtle Ridge, even the most desirable neighborhoods are not immune from the fallout of the housing bubble.

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Houses Should Not Be a Commodity

A great many people like it when houses go up in price. During a rally the bulls become intoxicated with greed and obsessed with owning real estate as an investment. However, once houses become an investment, the prices of houses begin to behave like an investment, and volatility is introduced into the system. You do not want houses to trade with the volatility of a commodities market. It causes more harm than good.

Price volatility is a very disruptive feature in a housing market: the upswings are euphoric, and the downswings are devastating -- and there are downswings. Declining house prices are emotionally and financially draining both to individuals and to the economy as a whole. The upswings create massive amounts of unsustainable borrowing and spending, and the downswings create economic contraction, foreclosures and personal bankruptcy. Is the ecstasy of the rally worth the despair of a crash? I think not, but we shall see.

There are technical reasons for a market crash (foreclosures, credit tightening, etc.) and I have discussed those in great detail in earlier analysis posts; however, market psychology plays a large roll in how and why it all plays out. The technical factors cause shifts in psychology among the market participants which exacerbate market moves. Today I will examine the psychology of market bubbles drawing parallels between the commodity futures market and the real estate market. In this post want to clearly illustrate how and why the psychology of market participants will facilitate the ongoing price crash.

Commodities Trading

In a commodities or securities market, you simply cannot have a rally, unsupported by valuation measures, without a crash back to fundamental value. It is very clear the rally in house prices was not caused by a rally in the fundamental valuation measures of rent or income. This was documented in How Inflated are House Prices? and The Anatomy of a Credit Bubble. Many people forgot the primary purpose of a house is to provide shelter -- something which can be obtained without ownership by renting. Ownership ceased to be about providing shelter and instead became a way to access one of the worlds largest and most highly leveraged commodity markets: residential real estate.

Trading is a very difficult endeavor. The vast majority of active traders lose money, and most don't last very long. I paid my dues to the market, but I am one of the survivors. In the process, I spent many, many hours looking at charts and watching the chaotic gyrations of market prices in real time. I have also become keenly aware of my own emotional reactions and those of other market participants. It was these experiences, more than anything else, that kept me from participating in the real estate bubble. I have learned (painfully at times) that traders who "chase the market" lose money. I was not going to chase the real estate market.

The Psychology of the Bubble

The above graph is an excellent depiction of the psychological stages of a market bubble. It is fairly easy to put timeframes to each of these stages as displayed by our local housing market:

• Take off: 1998-1999
• First Sell Off: 2000
• Media Attention: 2001-2002
• Enthusiasm: 2003
• Greed: 2004-2005
• Delusion: 2006
• Denial: 2007
• Fear: 2008
• Capitulation: 2009-2010
• Despair: 2011-2013
• Return to the Mean: 2014

Obviously, the past is easier to document than the future, so we may reach future stages sooner or later than shown above, but we will reach them. I have made my opinions on timing and depth of the decline known in Predictions for the Irvine Housing Market.

The Stages of Grief

Markets are the collective actions of individuals, and the psychology of the markets can be broken down to the psychology of the individual participants who make it up.

When prices first drop and the market enters the denial stage, the individual market participants feel confusion and attempt to avoid the truth. This is motivated by fear they may have been wrong to purchase when they did, and they might lose money. They seek ways to quell these fears through drinking even more kool aid. Bulls in the denial stage will not come to a blog like this one because we will not feed their denial. Some will stop by, try to convince us we are wrong, and move on. The only person they are really trying to convince is themselves.

When the markets enter the fear stage, the little voice inside of each buyer gets louder and louder. This boils over into anger, frustration, anxiety, etc. The individual desperately is seeking ways to maintain denial -- perhaps they read Gary Watts Real Estate Outlook 2007 -- but reality becomes stronger than denial. As a mechanism to break down the denial they imagine the possibility that reality they are trying to deny is the truth. This leads to depression and detachment as reality is too painful to accept.

Finally, "as the going gets tough, the tough get going," and the individual seeks ways to get out of the problem through emotional bargaining. Some will take action. Perhaps it is lowering an asking price, taking the property off the market and doing some renovations to "add value." Some will not take action, and they lapse back into denial because the market is "coming back soon." Note that these psychological stages all occur in the fear stage of the market. Those owners who chose to lower their price as part of their bargaining may get out with minimal losses (assuming they lower it enough to actually sell.) Those that chose other courses of action, lose much more money.

Each individual only reaches acceptance when they sell their house. This is when we enter the stage of market capitulation. Collectively, everyone in the market accepts prices are going to drop further, and they need to get out: Now! Of course when everyone knows prices are going to drop, and everyone is trying to sell, there are no buyers. This puts prices into free-fall until buyers are ready to buy again.

Since buyers in the aftermath of a bubble tend to be the risk adverse who did not participate in it, they will make cautiously low offers on properties. This cautious buying together with desperate sellers causes the market to drop below normal valuation standards. The market enters the despair stage. Here the market participants think nobody wants the asset, and nobody ever will again. Of course, nothing could be farther from the truth as those who recognize the fundamental value of the asset are buying it in preparation for the next cycle.
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Why does it happen this way?

Now that we know what happens, the next logical question is why does it happen. To fully understand this, one must look into the mind of the market participants at key stages in the process, examine their circumstances and see the decisions they must make. While we go through this exercise, I am going to compare and contrast the thought process of a trader with that of the general public.

The first and most obvious difference between traders and the general public is their holding time. Traders buy with intention to sell for a profit at a later date. Traders know why they are entering a trade, and they have a well thought out plan for their exit. The general public adopts a "buy and hold" mentality where assets are accumulated with a supposed eye to the long term. Everyone wants to be the next Warren Buffet. In reality this buy-and-hold strategy is often a "buy and hope" strategy -- a greed induced emotional purchase without proper analysis or any exit strategy. Since they have no exit strategy, and since they are ruled by their emotions, they will end up selling only when the pain of loss compels them. In short, it is an investment method guaranteed to be a disaster.

A bubble rally is usually kicked off by some exogenous event. In a securities market, it may be a very large order hitting the trading floor, and in a real estate market it can be a dramatic lowering of interest rates. Whatever the cause, a series of events is set in motion which repeats with a remarkable consistency. It repeats on multiple timeframes in all financial markets.

Enthusiasm Stage

At the beginning of the enthusiasm stage, prices are already inflated, so there is cautious buying from traders looking for trends and momentum. Prices rise steadily and more attention is drawn to the market. The market sentiment turns very bullish. Buyers are everywhere and sellers are scarce. The general public takes notice and begins to participate in larger numbers.

Greed Stage

In the greed stage, the bullish sentiment reaches a feverish pitch and prices rise very rapidly. Everyone in the market is making money and everyone believes it will go on forever. The greed stage is where the behavior of traders and the general public really start to diverge. Traders recognize it isn't going to go on forever because prices are unsupported by fundamentals: They sell. The general public is convinced prices can rise forever: They buy -- from the traders. (If you don't think this happens in the housing market, I suggest you read Still Renting from Pimco trader Mark Kiesel.)

Think about this for a moment: most people who are bullish already own the asset, but for prices to continue to rise, there must be more buying. For buying to occur, someone who was either bearish or ignorant of the rally must be convinced to buy. In other words, a greater fool must be found. (Remember the National Association of Realtors $40M add campaign?) Once everyone is made aware of the market rally and is convinced to buy, you simply run out of new buyers. Once there are no more potential buyers, prices can only go down.

Denial Stage

Right now, we are in the denial stage. Prices have not dropped enough to cause real fear. Denial is apparent in polls like this one: Out of touch with realty reality where 85 percent believe their home will rise in value during the next five years, and 63 percent believe a house is a good investment. That is serious denial.

It is also apparent in the number of homes purchased during the greed stage that are held for sale at breakeven prices -- even if this is above market. When the inventory is large, and houses stay on the market for a long time, prices are too high. Sellers who refuse to lower their prices to take a small loss are in denial about the current state of the market. They believe bids will increase and some buyer will come along and pay their price -- after all, that is the way it was just 2 years ago.

Buyers who bought in the enthusiasm stage are still ahead, so they feel no urgency to sell. They have made good money already and they will hold on with hopes of making a little more. Since they believe the asset will appreciate again (and they have no exit strategy), this group of buyers does not sell.

In contrast, the few traders who still hold positions liquidate and go back into cash. Successful traders recognize denial as a signal to exit their positions to lock in profits or prevent further damage.

So why can't prices rally here? There are two reasons: First, the pool of buyers is depleted as discussed above, and second, the excesses of the bubble are causing a contraction in credit terms. There are fewer buyers, and those who might want to buy can't borrow the large sums needed to push prices higher. Market psychology hasn't really turned yet, but technical factors are getting in the way. This same phenomenon occurred in our last credit induced financial bubble which resulted in the savings and loan fiasco of the 1980's and it helped facilitate the decline of the early 90's. What is Past is Prologue.

Fear Stage

This fall and winter, we are likely to see a liquidation of bank held inventory. Banks will try to get their wishing prices through the prime selling season, but by the end of the year, there will be pressure to get these non-performing assets off their books. The fire sale of bank foreclosures and the continued tightening of credit will drive prices down an additional 5% to 10%. This will cause some major problems for owners of residential real estate.

At this point, successful traders have all exited the market, although a few knife-catchers jump back in during the bull trap and become bagholders. Greed stage buyers are now seriously underwater. Comps are selling for 10% less than their breakeven price, and there is little hope that prices will rally. Some will sell at this point and take a loss, but most will not.

People who bought in the enthusiasm stage come up to their breakeven price and face the same decision our greed stage buyers faced earlier: sell now or hold out for a rally. Even though there is reason to fear, most will not sell here. They will regret it later, but they will hold on.

• The most important psychological change in the market as we enter the fear stage is the belief that the rally is over. Price rallies are self-sustaining: prices go up because rising prices induces people to buy which in turn drives prices even higher. Once it is widely believed that the rally is over, it is over. Market participants who once only cared about rising prices now become concerned about valuations. Since prices are far above fundamental values and prices are not rising, there is little incentive to buy. The rally is dead.

• Another major psychological change occurs in this stage after people accept the rally is dead: People reassess and change their relationship to debt. During the rally, debt became a means to take a position in the housing commodity market. Nobody cared how much they were borrowing because they never intended to pay off the loan through payments from their wage income. Everyone believed they would pay off whatever they borrowed in the future when they sold the house for more than they paid. Once prices stop going up, people realize they are simply renting from the bank, and the only way to get ahead and build equity is to pay off a mortgage. The desire to borrow 10 times income diminishes rapidly as people realize they could never pay off such a large sum. What started in the denial stage as an involuntary contraction of credit, in the fear stage becomes a voluntary contraction of credit as people simply do not want to borrow such large sums.

So why can't prices rally here? There are even fewer buyers in the market and a reduced appetite for debt due to the change in market psychology. There are more and more sellers are either choosing to sell or being forced to sell. Since there are more sellers than buyers, prices continue to drop.

During the fear stage, a majority of buyers during the rally go underwater on their mortgage. Most will endure the pain and stress. In the past, since the bubbles of the 80's and 90's were built on conventional mortgages, people just held on. In this bubble, people used exotic loan financing terms, and they simply cannot afford to make the payments. They will borrow from other sources until finally the entire system reaches a breaking point and they implode in foreclosure and bankruptcy.

Capitulation Stage

The transition from the fear stage to the capitulation stage is caused by the infectious belief that the rally is over. There is a tipping point where a critical mass of market participants either decide to sell or are forced to sell. Once this point is reached, selling causes prices to decline further. This convinces even more people the rally is over which begets even more selling: a downward spiral. The capitulation stage is the counterpart of the greed stage. Sellers are everywhere and buyers are scarce.

In securities trading, the mechanism for compelling people to sell at a loss is anxiety and emotional distress, and the mechanism for force is a stoploss or a broker's margin call. In residential real estate, people are also compelled to sell by anxiety, and the mechanism for force is foreclosure. We know foreclosures are going to be particularly bad in this bubble due to the exotic financing and adjustable rate mortgage resets.

Each market participant has a different threshold for pain. Some give up early; some give up later; some stubbornly try to hold on, but in the end, by choice or by force, everyone sells out and capitulates to the forces of the market.

Despair Stage

From a perspective of market psychology, it is difficult to tell when the capitulation stage ends and the despair stage begins. Both stages have an extremely negative bearish sentiment. The general public is still selling. What makes the despair stage different is that buyers who focus on fundamentals like rental savings or positive cashflow return to the market and begin buying (Remember Rent Savers and Cashflow Investors from How Inflated are House Prices? ) These buyers are not concerned with appreciation, they simply want an asset which provides a cash return on their investment. They are not frightened by falling prices because their financial returns are independent of the asset's market valuation. It is the return of these people to the market which creates a bottom.

Conclusion

Houses should not be viewed as a commodity to trade. Most people lack the financial sophistication to successfully trade in commodity markets. Buying and hoping prices go up is not a successful strategy (as a great many are about to find out). Volatility in housing prices is harmful to the community as the financial and emotional costs of the inevitable price crash are just too great. Everyone pays a price. Renters like myself who chose not to participate are forced to wait to obtain the security of home ownership at an affordable price, and buyers who endure the crash... well, their pain is obvious.

I don't know how to solve this problem, but I suspect government intervention will only make it worse. Part of the problem is embedded into the local culture (remember Southern California’s Cultural Pathology?) Perhaps after the pain we are about to witness is over, people will learn their lessons and break the cycle; however, human nature being what it is, I doubt it.

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Epilogue

People have commented on the confidence I have in my analysis of the market. To be very honest, most of the analysis came later. Early in this bubble I witnessed inflated prices begin to rise. My years of experience trading the markets told me it was a beginning of a financial bubble. I didn't know exactly what was causing it, I didn't know how high it would go or how long it would last; I just knew it would prove to be a bad time to buy. Even after watching prices go up significantly from there, I knew it wasn't going to last. I had seen the cycle too many times before. I was witness to the insanity as it unfolded, but it has only been in the last year that I became more interested and really researched the details of causes of this bubble. I have greatly increased my depth of understanding of this phenomenon, but I have never doubted my initial instinct; I still don't.