IR,

Nicely done. I am in particular agreement with your conclusion about the Bernanke Fed. A true free market is allowed to correct its excesses. This increase in the money supply and the acceptance of mortgages on boats (I kid you not) at the discount window is the stuff of banana republics. Sadly, the smoke and mirrors act may keep the asset class afloat temporarily, but our hard earned US dollars will keep devaluing as the price of this nonsense.
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This is good.  However, along with Robert Shiller, I would advocate adding expectations of appreciation to the list of causes.

If someone expects the price of houses to rise at 3-4% a year (near its long term historic average for the US, their carrying costs are about the same as rent (7% interest, 1.25% taxes and assessments, 2.5% annual maintenance costs and insurance, 33% State + Fed marginal tax rate = ~8% annual cost of ownership.  Subtract 4% appreciation and you get ~4% cost after appreciation, around $2,350 for a $700,000 house).

Now watch what happens with exactly the same numbers and a 12% rate of expected appreciation.  The expected carrying cost after appreciation is negative $2,317!  Yes, the house pays you to own it, even if it sits vacant.

That is an important point.  For expected appreciation rates where cost of ownership is moderately less than rent, it pays to be an owner.  It also pays to buy a house and rent it out.

When the expected rate of appreciation is high enough, you expect to make money on a house even if it sits vacant and you don’t get any rental income.  What do many people do under this circumstance?  Buy as much property as they can.

If the actual appreciation matches their expectation, they make money.  And many people made money for a while on vacant homes.  Many lending institutions were willing to make these loans, because they also thought prices would go up, and borrowers would be able to sell for more than the purchase price.

The problem comes when either people slow down lending to such borrowers (a credit contraction), or the expectation changes. 

Going back to the math, take a guess what the expected cost of buying a home today is, versus buying in a year?  If you think prices will decline 10%, the cost is about 18% of the value of the home (8% actual carrying cost + 10% loss).  That’s about $10,500 per month on a $700,000 home. 

Under those circumstances, renters with money don’t convert to buyers until the expected short and long term rates of appreciation go positive again. 

For an owner with a vacant depreciating house, renting it will slow the cashflow bleeding, but won’t do anything about the depreciation.

Great article IR! I will definitely be rereading and sending this out to some people!

Excellent post as usual.  As many have said the Fed can stimulate the demand for loans but they cannot make people want to give the loans.  I think this is why your last comment that the Fed cuts won’t save RE is accurate.  Unless of course the investors like our fearless leader can’t remember the famous saying: “Fool me once, shame on you, fool me twice, shame on me.”

“Ben Bernanke is taking us down this road yet again. If he continues to lower interest rates, investment capital will flow into a new asset class (no, it will not flow into housing and save the day.) How many more bubbles must we endure before the FED stops creating them?”

That is one possibility. However, I would like you to consider my argument:

Real estate probably has the distinction of being the highest ‘market cap’ asset class. Where else does the median ‘share’ cost 250k?

Without another costlier asset class, there isn’t anything to leverage against. Additionally, lower rates will not necessarily lead to a reflation of the credit bubble. Lenders are very cautious. Unwinding risky bets suddenly sound like more fun than making more of those bets. We don’t even need a majority of the lending community to be on board with this. Enough of them have probably looked over the cliff here that it will take a while until history gets forgotten again. Large providers of capital have received a bloody nose. They are likely to be wary of another huge bubble.

I believe that the only reason that the appetite for leverage and the bubble mentality took hold so quickly after the tech bust is that people thought “real estate is different - it only goes up”.

The only asset class that I can think of that maybe would drive speculative behavior higher is farmland.

Think of it - you have all the elements:
*Not making any more land - check
*People have to eat - check (a substitute for ‘people have to live somewhere’)
* Blah, blah, biofuels, blah, blah
* Doesn’t rely on subprime home borrowers.

I think that despite Bernanke’s best efforts to inflate, when the derivatives eventually crash, it will not be orderly, and the effect will be deflationary. After all, the fed funds rate was already trading below the target. Ben isn’t driving it down, he lowered the target to where it was already trading.

The flight to quality has just begun.

Comments would be appreciated.

IR,

I think you are mistaken that there was no subprime market prior to 1998.  There was a thriving one in the late 1980s.  One pioneer in this field was “The Money Store”.  Anyone who lived near Sacramento in the early 90s will remember their ludicrous “Egyptian Pyramid” looking headquarters they built on the banks of the Sacramento river.  Such hubris is usually followed by an ass whipping.  In this case, it came in the form of the last California housing meltdown which blew The Money Store out of the water.  They laid off legions of brokers and were acquired with a whimper. 

Obviously, when normalcy returned to the housing market, no one learned the lesson of the Money Store (since making money in fat times without thinking about lean times is the American way).  I would say the subprime market this time around was about an order-of-magnitude larger.  We are currently witnessing the obviously much larger meltdown.

Carl

Citigroup, UBS Say Subprime Losses Damage Results (Update1)

http://www.bloomberg.com/apps/news?pid=20601087&sid=adTwczrh9zlU&refer=home

Here is an old link on this topic worth a look.  Nice summary graphic from the New York Times summing the whole thing up.

Housing Busts and Hedge Fund meltdowns: A Speculator’s Guide
http://www.nytimes.com/imagepages/2007/08/05/weekinreview/20070805_LOAN_GRAPHIC.html

I think you touched on it here.
“Lenders are very cautious. Unwinding risky bets suddenly sound like more fun than making more of those bets.”
My guess, and admitedly this is only a guess because the actual information is hidden off balance, is that the big banks, hedge funds, and others are hoarding liquidity, (cash), and will continue to do so no matter what B-52 Ben does.  Why do I think this?  What possible logic is there to hoarding cash, (short term and longer term treasuries paying squat) ?  I am guessing they need to stay liquid because they are getting ready to pay out on massive amounts of credit default derivatives.  Anyways, it’s just a guess.

The Foreclosure Pickings Are Plentiful but Not Easy

http://www.nytimes.com/2007/09/29/business/yourmoney/29money.html?pagewanted=2&_r=3&adxnnl=1&ref=business&adxnnlx=1191254660-qvYIQbkkr6U7Pyu9RleMLg

In the second quarter of this year, an estimated 620,000 mortgages, or 1.4 percent of 44.3 million mortgages, were at some stage of the foreclosure process, according to the Mortgage Bankers Association, though only a fraction of that number will actually go into foreclosure. As a percentage of all mortgages, the record was 1.51 percent in the first quarter of 2002. While stark, the recent figures are not so surprising considering that homeownership is at a record high.

Getting Ready for the Roof to Fall

http://online.barrons.com/article/SB119102714463743349.html?mod=googlenews_barrons

Which asset class do you think this money will flow into?  I hate bubbles but if I see a bubble coming again, I want to enjoy the ride and forget about fundamentals for a while.

I’m gonna incorporate and IPO my corporate persona.

Then, I’ll take a lot of investment because I have so much potential.

At some point, I’ll create four subsidiaries, move the cash to my holding company, move the debt into the subsidiaries and I’ll move to my own Private Idaho.

Get ready for the next bubble:

“The personal potential IPO:  leverage your potential skill set to enhance the value to our partners in the financial ecosystem.”

Oh, btw, good post.

Oil, bio-fuels, solar.

The vaporized class .

Suppose I were an investor buying houses to flip for a profit.

It would make sense to minimize my payments, as my profit would come not from paying down my equity, but by holding the asset long enough for appreciation to occur.

This would apply as well to flippers who rehabbed for profit.

Hence, these investors should have used Option ARMs for their purchases.

I hate to see it mentioned how subprime borrowers used them, when even those with far better means were using them to increase the size of their ‘empires’.

If Angelo Mozilo (the Tan Man), over at Countrywide has his way, we’re gonna see a lot more foreclosures in the coming year.

From Paul Krugman @ the NY Times:

“Countrywide made more questionable loans than anyone else - and its postbubble behavior does stand out. As Ms. Morgenson reported in yesterday’s Times, Countrywide seems peculiarly unwilling to work out deals that might let borrowers hold on to their homes - even when such a deal, by avoiding the costs of foreclosure, would actually work to the benefit of both sides”.

HERE’S WHY:

“Countrywide can make money from the fees it charges on foreclosures, while the losses from mortgages that could have been saved, but weren’t, are borne by others.”

http://www.nytimes.com/2007/10/01/opinion/01krugman.html?_r=1&n=Top/Opinion/Editorials and Op-Ed/Op-Ed/Columnists/Paul Krugman&oref=slogin

Great article… I’ve never seen all of this so clearly laid out… Keep up the amazing work!

Carl,

You make a good point. Do you remember Guardian Savings? They used to be the joke in the 90s if you could fog a mirror you had a loan. They collapsed and IIRC they were bought by Long Beach Mortgage which was bought by WAMU and now shut down by WAMU.

Wash, rinse and repeat.

CNBC’s Maria Bartiromo/Bill Maher Housing Bubble Video

Here is a clip from Real Time with Bill Maher which aired Friday September 28th. I have never heard the housing slump sound or look this good.

http://thegreatloanblog.blogspot.com

looks like it’s flowing into the DOW as we speak

Liquidity is number one for banks right now, not earnings.

The sub prime CDO scare back in feb/mar was just the tip of the iceberg.  All that did was get the wheels turning in loss mitigation departments across the country.

Wall St realized that they were utterly foolish and their going to end up looking like idiots for not accurately assessing risk.

Graphrix,

I do remember Guardian Savings.  I also remember that in the late 80s, when subprime was first available in a big way, there was a big stigma associated with it that obviously went away.  It was akin to getting a payday loan, which also seems to have lost its stigma.

Perhaps there will be a return to stigma that will hopefully reduce the pressure to push these loans on people.

Carl

PS People here seem to think we are headed for 160X price-to-rent ratio… I dunno… if prices in Turtle Rock get back to 2003 pricing (about 700k for a 2000 sq-ft SRF), I’ll bite the bullet and jump back in.  People always underestimate California.

Excellent post IR!

Amazing that such a concise analysis of the Bubble can not be found in the Business section of any newspaper.

Or perhaps I shouldn’t be surprised.

Here’s a new one: Being too broke to sell

http://www.chicagotribune.com/business/columnists/chi-mary_re_09-30sep30,0,40543.column

Another reason for the runup:

Subprime buyers are generally of low intelligence.
This is why they are subprime in the first place.

They will pay the maximum price for a home if they are allowed to borrow the money.
This drove up the price as much as anything.

I seem to remember a bunch of subprime lenders that were located in Irvine in the early to mid 90s that suddenly went out of business.  I vaguely remember reading somewhere that the founders of New Century were involved in one of these earlier companies.

In 1998 Consumer’s Report published a study about lending fraud in California.  Nothing seems to have changed in the last ten years.

http://www.consumersunion.org/finance/hsreportwc898.htm

What We’re Hearing
http://data.nationalmortgagenews.com/columns/hearing/

Last week, we reported how loan brokers were getting blamed for the nation’s current mortgage mess. I received a ton of e-mails, several with epithets aimed at consumer advocate Bruce Marks of Neighborhood Assistance Corp. of America who before Congress likened brokers to a pest commonly found in several Jersey City apartments that I rented in my youth. Let’s just say many brokers were offended by Mr. Marks’ comments.

(Note: this comment is about the speculators - both prime and subprime)

It’s not stupid to take zero risk (ie. already have bad credit, no down payment, bad job, no hope of ever making a lot of money otherwises) for a shot of hitting the jackpot with someone else’s money.  Worst case scenario - free rent until foreclosure.

It is unethical though.

WaMu: Leading The Way Or Stating The Obvious??

http://www.cnbc.com/id/21082604

“As part of its new broker standard, WaMu will require evidence that the broker has made certain disclosures to the borrower early in the application process, including:

Irvinerenter, so based on where we are today and no news insight on credit crunch, where is the economy heading?  People are getting into stocks like crazy and you mentioned possibly another asset class, but wait, US consumer spending is the one that drives earnings of these large companies.  When they start to lose homes and jobs, consumer spending will curtail and will negatively impact the earnings.

How long before reality sets in?  Fed will keep cutting as we saw these guys are more worried about the recession (rightfully so) in lieu of imflation, but true inflation since 2000 is running at around 10% if we take out the non-discretionary (discretaionary - food, energy, consumables), will falling $, we will only see rise in consumer costs. 

Anyone here can predict the next 12 months??

When you said Golman Sachs I believe you meant Bear Stearns.  It was the Bear Stearns sub-prime hedge funds that blew up early last summer.

Of all the financial brokers, only Goldman Sachs made a stunning quarter........ no surprise here, they were shorting their own business (mortgage and securities).

There is a D is Goldman

O.C. office rents, vacancies spike
Orange County’s vacancy rate hits 10.53% in 3rd quarter, Voit Commercial reports.

http://www.ocregister.com/money/percent-square-office-1868577-construction-million

Bankruptcy ‘tweak’ could save 600,000 homes
Consumer group pushes for change to bankruptcy law; others worry about negative impact on mortgage-debt markets.

http://money.cnn.com/2007/10/01/real_estate/subprime_bankruptcy_change/

Great post.

I would add mortgage fraud - both the outright illegal and the shoulda been illegal type - seller financed downpayment assistance programs. DAPs were a significant enabling factor in certain markets like Sacramento, starting in the late 1990s.

Elizabeth,

I was waiting for someone to bring this up. Just like everything else in this mess, after the curtain is pulled back, there will be massive fraud exposed. There was last time (S&L scandals) and there will be this time. There was just too much money out there for the taking. Although IR believes we are in either the fear or panic stage of this bubble and supports his thesis with some pretty good proof, I still think we’re in the mass denial stage.

This stock market rally today is a good example. The Citigroup pre-announcement that they lost 60 billion in MBSs and still closed up over 2% on the day was treated by traders as a signal that Citi had come clean and the worst is over. Maybe for on balance sheet liabilities, but not off balance sheet. Same with the rest of the biggies. The corporate bodies are going to be washing ashore piecemeal, one at a time.

There will come a time when this toxic debt HAS to be priced to sell--or “marked to market” and that’s when we’ll all know. Bernanke just gave them a little more time to concoct some cockamamie spin. It’s coming. Tick tock.

You are correct. I had to go back and read the post again to make sure I said Goldman Sachs instead of Bear Stearns. I meant Bear Stearns.

I guess they are all the same. My mind thinks one and types the other…

Is everyone listening?

Yep.  Makes sense.  Likely why the Fed keeps trying to inject liquidity - they just don’t want to lend it out.

How is it that no one has mentioned the role of the ratings agencies?

Could be an investment bubble in green energy biofuels/solar/wind technology, but is that so bad?

Greenspan: World Economic Health Hinges on Housing
http://www.cnbc.com/id/21078887

Like the saying goes: There’s no inflation-as long as you don’t eat or go anywhere!
Fuel and food majorly up. Housing prices insane. No real inflation to speak of, for sure....

Plot of asking prices in Orange County

http://www.housingtracker.net/askingprices/California/LosAngeles-LongBeach-SantaAna/SantaAna-Anaheim-Irvine

Pending U.S. Home Sales Probably Fell in August to Record Low

http://www.bloomberg.com/apps/news?pid=20601087&sid=aCEwTPVdwBEw&refer=home

I have had no small confusion about the role of rating agencies myself. How do AAA ratings become BBB overnight?

Then again, if the ratings reflect market value and the market suddenly changes, seems to me the ratings must suddenly change as well (if the raters are doing their jobs).

So it should not be a surprise that in the face of low delinquencies or foreclosures (before the bubble burst) that risky pools might have had a good rating and that the sub-prime implosion may have adversely affected that rating and triggered the subsequent down-grading of those investments.

So if somebody is in the know, please tell us, were Moody’s and other ratings agencies accomplices in this mess, or were they doing their job and are simply “guilty by association”?

How affected is the highrise market in Irvine?

The highrise market will likely see the most serious declines in value. The fees are very high, which makes the cashflow value very low. I would not be surprised to see 75% declines on these units.