So, bye-bye, Miss American Pie
Drove my Chevy to the levee
But the levee was dry
And them good old boys were drinkin’ whiskey and rye
Singin’ this’ll be the day that I die
This’ll be the day that I die

Don McLean – American Pie

One of the hallmarks of a great song is its ability to be interpreted in different ways. American Pie is an allegory of our times, an ode to the death of our housing market. With leverage drying up, the party is over. The last drink is for the death of the market itself, and with it’s death, the death of the American Dream of home ownership for thousands of overextended homedebtors.

When a bubble in a financial market pops, it doesn’t explode in spectacular fashion like a soap bubble, it is more comparable to a breached levee which releases water slowly at first. Once the financial levee is ruptured, the equity reservoir loses money at increasing rates. It washes away the imagined wealth of homedebtors everywhere until the reservoir is nearly empty and the torrent turns to a trickle. Ultimately, the causes of failure are examined, the financial levee is repaired, and the reservoir again holds value, but not until the dreams and equity of homedebtors are washed away.

New Century Financial

Do you recall what was revealed
The day the music died?

The poster child for the great residential financial bubble of the 00’s will be New Century Financial. The date of their financial implosion will be regarded as the Day the Market Died. The death of New Century Financial will come to represent to death of loose lending standards and the beginning of the cycle of credit tightening as I described in my last post, The Anatomy of a Credit Bubble. Many people currently see the elimination of sub-prime lending as being the problem. It is much larger than that. It is the changes in behavior caused by loose lending standards epitomized by New Century Financial that will be the undoing of the housing market.

100% Financing

The most damaging change in buyer behavior was caused by 100% financing: potential buyers quit saving. Once 100% financing became widely available, it was enthusiastically embraced by all parties: the lenders suddenly had a huge source of new customers to generate high fees, the realtors and builders now had plenty of new customers to buy more homes, and many potential buyers who didn’t have savings were now able to enter the market. It seemed like a panacea; for two or three years, it was.

Now for ten years we’ve been on our own
And moss grows fat on a rollin’ stone
But that’s not how it used to be

There is a problem with 100% financing (which was masked by the rampant appreciation brought about by its introduction): high default rates. If you want a glimpse into the irresponsible mind of a typical 100% financing borrower, go read the post and comments in Update: an FB situation 14 months later. The FB stated in the comments,

“However, I take exception to the idea that I’m taking food out of someone’s mouth by sticking the bank with the loss. An appraiser made the valuation, and I got a loan. No one forced New Century to give me the loan to buy the house, but they did. They confirmed the value, and thus, assumed all risk, especially since I went no money down with an, at the time, 720 mid-FICO, and the wife as well.”

This borrower signed papers promising to repay money to New Century. He gave his word. How does it follow that New Century took all the risk? How does the presence or absence of a downpayment impact whether or not a borrower will live up to their commitments and responsibilities? We all know the answer: When people don’t put their own money into the transaction, they don’t feel responsible for what happens. At one point, the FB was celebrating, “I was planning on claiming insolvency to the IRS through my job loss, anyway, but they didn’t even give us a 1099!” Does it make you want to turn him in?

The courtroom was adjourned
No verdict was returned

The more money people have to put in to the transaction, the less likely they are to default. It is that simple. Taken to its extreme, 100% financing becomes the ideal tool for fraud. The FB from above probably intended to repay the loan when he got it, he just didn’t feel much of a sense of responsibility to the loan when the going got tough. People who commit fraud have no intention of repaying the loan from the start. Fraud is much easier to commit with 100% financing because the bank will loan you the full amount of an inflated appraisal. It is much harder to commit fraud when the bank will only loan you 80% of a property’s value.

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The point here is not about being irresponsible or committing fraud, it is about defaults. High loan-to-value loans have high default rates; this will cause 100% financing to disappear, and it will make other high LTV loans much more expensive, so much so as to render them useless. OC Fliptrack documented the elimination of the 100% LTV loans at HSBC. It is all part of the ongoing credit tightening cycle.

The problem for the future housing market created by 100% financing is that people quit saving money for downpayments. People respond to incentives. This is basic economic theory. The availability of 100% financing removed the incentive to save for a downpayment. People responded; our national savings rate went negative as people stopped saving and borrowed instead. This is going to create a huge problem going forward: nobody has the newly required downpayments.

Elimination of Entry Level Buyers

Oh, and there we were, all in one place
A generation lost in space
With no time left to start again

People who currently own entry level housing (2 bedrooms or less and small 3/2s) are bagholders. With the elimination of 100% financing, they have missed their chance to sell to a greater fool. Even if these fools were still out there (they have been decreasing in number), they no longer have the ability to borrow all the money required to buy, and they have no way to make up the difference. The entry level market was destroyed the moment 100% financing was eliminated because nobody has a downpayment.

Collapsing from the Bottom Up

The players tried for a forward pass
With the Jester on the sidelines in a cast
Now the half-time air was sweet perfume
While the Sergeants played a marching tune
We all got up to dance
Oh but we never got the chance

Housing markets collapse from the bottom up. The first sign of a troubled real estate market is a dramatic reduction in volume. This is particularly pronounced at the lower end of the market for reasons outlined above. Since the lower end of the market has a more dramatic drop in volume than the top of the market, the median stays at artificially high levels which is not reflective of pricing of individual properties in the market. In other words, things look better than they are.

The graphic on the right (borrowed from Calculated Risk) shows the problem when the entry level is eliminated. For a more detailed analysis, please read Why the Sub-Prime Meltdown is a Problem. As the problem at the entry level becomes more serious, more and more transactions higher up the house chain fall out of escrow. Volume plummets, and the whole market seizes up. That is where we are today. There will be no summer bounce this year.

Helter Skelter in a summer swelter
The birds flew off with a fallout shelter
Eight miles high and falling fast

Eight Miles High and Falling Fast

The market will not stay seized-up forever. Many bitter renters have complained about greedy sellers, but it isn’t the sellers who determine market prices, it is the buyers. Think about this: what if every seller in the market decided they would not sell for less than $10,000,000? Would houses suddenly become worth $10,000,000? Of course not because no buyers could afford to pay that much. Buyers determine the market price by putting in competing bids. Sellers can decided to accept or reject the highest bid. If all bids are rejected, there is no market because there is no transaction.

Buyers are never forced to buy, it is always a choice; however, sellers may face circumstances when they are forced to sell. Over the past several years, greedy buyers motivated by rising prices and fueled by loose lending standards were able to bid prices up to ridiculous levels. None of them were forced to buy. The exotic financing was not a result of high prices, it was the cause of high prices. Those of us who are financially conservative and do not wish to take on debt under terms which will put us into bankruptcy have been competing with those afflicted with Southern California’s Cultural Pathology. It is a competition we were all better off losing.

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Now the tables are turned. The once greedy buyers are becoming desperate sellers, their dreams of riches from perpetual appreciation in tatters. Many will be forced to sell due to their inability to make their mortgage payments. Those that hang on will be homedebtors with 50% or more of their income going toward paying off an asset which will be declining in value. It is not a set of circumstances I envy.

Prices will fall. We will see weakness at the bottom first, but it will work its way through all market strata. It is only a matter of time. Will you remember The Day the Market Died?

A long, long time ago…
I can still remember
How that music used to make me smile…

I can’t remember if I cried
When I read about his widowed bride,
But something touched me deep inside
The day the music died…

I met a girl who sang the blues
And I asked her for some happy news
But she just smiled and turned away
I went down to the sacred store
Where I’d heard the music years before
But the man there said the music wouldn’t play

And in the streets the children screamed
The lovers cried, and the poets dreamed
But not a word was spoken
The church bells all were broken
And the three men I admire most
The Father, Son and the Holy Ghost
They caught the last train for the coast
The day the music died

Link to YouTube Video – American Pie – Don McLean