Do very low short sale prices still have shock value? If too many sellers go this route, the shock wears off, and expectation of lower future prices becomes the norm.

Asking Price: $568,000

Address: 26 E Midsummer Irvine, CA 92620

{book1}

When I was a child
I caught a fleeting glimpse
Out of the corner of my eye.
I turned to look but it was gone
I cannot put my finger on it now
The child is grown,
The dream is gone.
I have become comfortably numb.

Comfortably Numb — Pink Floyd

Recently, an astute observer noted that my being less angry about the Great Housing Bubble may be a sign of Stockholm Syndrome. Have I become comfortably numb to my subjugation to the will of my Wall Street masters that I no longer feel the rage over the injustice? Have I become numb through exposure to this issue every day?

Psychologists know that repeated exposure to any anxiety-producing stimulus will lead to a reduced response over time through gradual desensitization. Perhaps me and many readers have become desensitized to the outrageous behavior of our Government and their Wall Street Overlords.

Kool aid intoxication will wear off through gradual desensitization, and the short sale gambit is at the heart of this phenomenon.

Short Sale Gambit

The short sale gambit is the ploy used by sellers and realtors where a property is listed for sale significantly below recent comps to generate buyer interest and hopefully ignite a bidding war. In our market this year with its limited inventory, this gambit has worked quite well. This ploy relies on kool aid intoxication for its effectiveness. People think the good deal is real, and there will not be other deals like it in the future — they still fear being priced out forever.

To give you an idea of how widespread this phenomenon is, consider the following listings:

• 26 E Midsummer Irvine, CA 92620
• 8 New Market Irvine, CA 92602
• 93 Highland Vw #56 Irvine, CA 92603
• 1 Fallcrest #98 Irvine, CA 92614
• 15 Sagamore #59 Irvine, CA 92602

What do all these listings have in common? They are all priced well below comps to solicit bids in the short sale process. So what do you think happens when sellers do this too much?

Over time, buyers come to realize that sellers are playing a game. The property is listed to attract offers, then the bank takes months to process the offer price, and by the time the bank approves a short sale price, the bidders have long since moved on to other properties. When this practice becomes common — which it is now — buyers become cynical and they stop putting in offers.

What would be the natural reaction of sellers when buyers stop putting in offers? They make the discounts even more extreme. If 5% below comps fails to generate interest, perhaps 20% below comps will (see 22_Rockwren_Woodbridge_Irvine.pdf for an example). Do you see where this is going?

As short sellers increase their discounts to attract offers, it actually serves to make buyers more skittish. Why would you bid on a property with a 5% discount when waiting will prompt a 20% discount? Ultimately, the short sale gambit is self defeating, and it becomes the primary mechanism for lowing prices in the market. Low inventory is the only thing keeping prices high right now. What happens when more inventory hits the market and the properties start competing with each other to attract buyer attention? Lower prices happen.

The Private Mortgage Insurance Problem

The short sale gambit does create a unique opportunity for property flippers. There are many properties where the listing agent has obtained a dozen or more bids on a short sale, but the bank refuses to take one of these offers and instead opts to foreclose, even when the short sale bid brings in more money. Many property flippers are buying properties at auction for 20% less than existing short sale offers on the property — it is practically a no-risk transaction for the flipper. Why are lenders doing this?

If the mortgage is covered by private mortgage insurance (PMI), the lender actually makes more money by foreclosing than by accepting the short sale. If they foreclose, the shortfall at the auction is covered by the PMI company. If they accept a short sale, PMI does not pay out. Basically, the flippers at the auction are making a profit at the expense of the PMI company.

I wonder how many PMI policies AIG has issued? and how many of these losses we are going to pay through our taxpayer bailout?

Asking Price: $568,000

Income Requirement: $142,000

Downpayment Needed: $113,600

Purchase Price: $960,000

Purchase Date: 5/19/2006

Address: 26 E Midsummer Irvine, CA 92620

The short sale gambit does make for interesting loss calculations — despite the realistic inaccuracy of the results. If this property sells for its current asking price, and if a 6% commission is paid, the total loss on the property will be $426,080. It is being offered for 41% off its peak purchase price.

Asking Price: $368,000

Income Requirement: $92,000

Downpayment Needed: $73,600

Purchase Price: $500,000

Purchase Date: 4/8/2005

Address: 8 New Market Irvine, CA 92602

THIS IS A SMOKING DEAL!!! The LOWEST PRICED home in the very desirable
community of West Irvine. ***BEAT THE BANK*** This is an investors
dream. Dual Master Suites, Dual Vanities, & HUGE walk-in closets
plus additional powder room for guests. Loads of storage throughout.
Durable laminate flooring & newer carpet, high ceilings and many
windows that bring in a lot of natural light. Recessed lighting in
every room. Custom Built DUAL Computer Niche, with more storage and
shelving, offers the perfect work space. Separate laundry room. 2 car
garage with direct access and more storage. Custom stamped concrete
throughout the private and enclosed courtyard. Situated in a quiet and
desirable location within the community, which offers a tot lot, pool,
spa, kiddie pool, and tennis courts. Easy access to both 5 & 55
fwys. Near the Tustin Market Place, Farmers Market, Tustin Sports Park,
Award Winning schools, hiking & biking trails and many more
ammenities + LOW Mello Roos roughly $44/mo.

ammenities? At least the words “throughout” and “Separate” were spelled correctly.

This is an investors
dream. Really, why?

{Adsense-ir}

This second property is borderline on being priced to market. It is a bit below, but perhaps not far enough to generate bidding-war interest. If it sells for its current asking price, and if a 6% commission is paid, the total loss will be $154,080. It is being offered for 26% below its 2005 purchase price.

The housing bubble is unwinding like many asset bubbles before it. Understanding and recognizing these stages will help you better time your home purchase; Timing Does Matter.

Asking Price: $439,000

Address: 83 Vermillion Irvine, CA 92603

{book6}

Change changing places
Root yourself to the ground
Capitalize on this good fortune
One word can bring you round
Changes

Changes — Yes

Market conditions are constantly changing. These conditions can best be understood as part of a series of psychological stages the market must pass through in order to work of the excesses of the housing bubble. I first wrote about the stages of a bubble in Houses Should Not Be a Commodity. I rewrote and expanded that work in The Great Housing Bubble which is reprinted in this post. For more conceptual background on the basics of market function, please read Efficient Markets vs Behavioral Finance.

Psychological Stages of a Bubble

Once a bubble starts to form, it will go through several identifiable stages: enthusiasm, greed, denial, fear, capitulation, and despair. Each of these stages is characterized by different speculator emotional states and different resulting behaviors. There are outside forces that also act on the market in predictable ways in each one of these stages. Most often, these outside factors serve to reinforce the market’s herd behavior and exacerbate changes in price.

Precipitating Factor

There is often a precipitating factor causing the initial price rally that pushes prices above their supported fundamental values. A bubble rally is usually kicked off by some exogenous event, but it may occur simply because prices have been rising and investors take notice, or it can be merely the result of a lack of investor fear and the widespread belief prices cannot go down. In a typical market, there is a significant selloff when prices exceed fundamental valuations. This selloff is a natural reaction to inflated prices as a decline to fundamental valuations is normal and expected. Many seasoned market observers will “sell short” here to profit from the initially inflated values caused during the take-off stage. However, in a financial mania, this sell off is short-lived, and it traps many who are bearish on asset pricing on the wrong side of the trade. This “short squeeze” may prompt a feverish activity of buying as short sellers cover their positions before their losses get too great. A short squeeze may act as a precipitating factor. In a securities market, a precipitating factor may be a very large order hitting the trading floor, and in a real estate market it may be a dramatic lowering of interest rates as it was in the Great Housing Bubble. Regardless of its cause, the initial price rise has the potential to spark sufficient interest to prompt further buying and set a series of events in motion which repeat with a remarkable consistency. Market bubbles can be found in all financial markets and on multiple timeframes.

Figure 35: Psychological Stages of a Bubble Market

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. If prices fail to drop to fundamental valuations and instead push higher, media attention is often drawn to the speculative market. The general public starts to take notice of the money being made by people who have bought the featured asset and they begin to participate in larger numbers. Of course, this stimulates more buying and prices continue to climb. The market sentiment turns very bullish. Buyers are everywhere and sellers are scarce. At this point, prices are completely detached from fundamental valuations, but people are not buying because of the underlying value, they are buying because prices are going up.

In residential real estate markets, the enthusiasm stage is often greeted by lenders with open arms. With prices rising, there is little risk of loss from default. If a borrower gets in trouble, they can simply sell into rising prices, and neither party takes a loss. With neither party fearing loss, and since lenders make most of their money on the transaction itself through origination fees, there is an inevitable lowering of standards to meet market demand. This in turn creates more market demand leading to further lowering of standards. The credit cycle reinforces the bullish psychology in the market and helps push prices even higher.

Greed Stage

In the greed stage, the bullish sentiment reaches a feverish pitch and prices rise very rapidly. Every owner in the market is making money and most believe it will go on forever. As prices continue to climb, buyers become very enthusiastic about owning the asset, and they tell all their friends about their great investment. The word-of-mouth awareness and increased media coverage bring even more buyers to the market. Egomania sets in as everyone thinks she is a financial genius. Any intellectual analysis at this stage is merely a cover for emotional buying and greed. During the Great Housing Bubble, there were many instances of properties receiving a dozen or more offers the day they were listed, with many in excess of the asking price. Encouraged by realtors, some buyers wrote emotional letters to sellers to convince them why they should be bestowed with the honor of home ownership.

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. Once everyone is made aware of the market rally and is convinced to buy, you simply run out of new buyers. Once there is a shortage of potential buyers, prices can only go down.

Denial Stage

When the limit of affordability is reached and the pool of available buyers is exhausted, prices start to decline. At first market participants are still overwhelmed by greed, and they choose to ignore the signs that the party might be over. In 2007 most real estate markets were in the denial stage as prices had not dropped enough to cause real fear. Denial is apparent in polls in mid-2007 where 85 percent believed their home would rise in value during the next five years, and 63 percent believe a house is a good investment. That is 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 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 a couple of years prior. 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 the emotion of denial as a signal to exit their positions to lock in profits or prevent further damage.

In the denial stage of a residential real estate market, many speculators are unable to obtain the sale price they desire. The accumulation of unrealistically priced houses starts to build a large inventory of homes “hanging” over the market. Overhead supply is a condition in a financial market when many units are held for sale at prices above current market prices. Generally there will be a minor rally after the first price decline as those who missed the big rally but still believe prices will only go up enter the market and cause a short-term increase in prices. This is a bear rally. It is aptly named as those bullish on the market buy right before the bear market reverses and quickly declines. For prices to resume a sustained rally, the overhead supply must be absorbed by the market. Once prices stopped going up and actually began to fall, demand is lessened by diminished buyer enthusiasm and the contraction of credit caused by mounting lender losses. With increasing supply and diminished demand prices cannot rally to absorb the overhead supply. The overall bullish bias to market psychology has not changed much at this point, because owners are in denial about the new reality of the bear market; however, the insufficient quantity of buyers and the beginnings of a credit crunch signal the rally is over and the bubble has popped.

Fear Stage

In the grieving process there is a shift from denial to fear when the reality being denied becomes too obvious to be ignored or pushed out of awareness. There is no acceptance of reality, just the idea that reality might be fact. The fact that an investment might turn out to be a very poor financial decision with long-term repercussions to the speculator’s financial life is generally very difficult to accept. The imaginings of a horrifying future creates fear, and this fear causes people to make decisions regarding their investments.

The most important change in the market in the fear stage is caused by the belief that the rally is over. Price rallies are a self-sustaining price-to-price feedback loop: 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 suddenly 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 becomes a means to take a position in the housing commodity market. Nobody cares how much they are borrowing because they never intend to pay off the loan through payments from their wage income. Most believe they will pay off whatever they borrow in the future when they sell 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 8 to 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 amounts of money.

In August of 2007, a more serious credit crunch gripped financial markets, and during the times that followed there was increased liquidation of bank held inventory. Banks tried to get their wishing prices through the prime selling season, but by the end of the year, there was pressure to get these non-performing assets off their books. The sales of bank foreclosures and the ongoing tightening of credit drove prices down an additional 5% to 10%. This caused some major problems for owners of residential real estate. Fear began to grip the market.

By the time a financial market enters the fear stage, greed stage buyers are seriously underwater. Comparable properties may be selling for 10% less than their breakeven price, and there is little hope that prices will rally. Some sell at this point and take a loss, but most do not. People who bought in the enthusiasm stage come up to their breakeven price and face the same decision the greed stage buyers faced earlier: sell now or hold out for a rally. Even though there is good reason to fear, most do not sell here. They regret it later, but they hold on. Speculators generally only sell an asset when the pain of loss becomes acute. The pain threshold is different for each individual, but there is no real pain until the investment is worth less than the purchase price, so few sell for a profit or at breakeven. Inventories grow in the fear stage because many would like to sell, but sales volumes are light because few are willing to sell at prices buyers are willing to pay.

Prices do not rally here because 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 either choosing to sell or being forced to sell, and 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 mortgages and endure the associated pain and stress. In the past, since the bubbles of the 80s and 90s were largely built on conventional mortgages, people just held on. During the Great Housing Bubble, people used exotic loan financing terms, and they simply could not afford to make their payments. They borrowed from other sources until their credit lines were exhausted and they imploded in foreclosure and bankruptcy. During this stage many renters who would otherwise have purchased a home put off their purchase and save more money because they correctly see the decline in prices has momentum and prices should continue to drop further.

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. In residential real estate, people are compelled to sell by anxiety, and the mechanism for force is foreclosure. Once a critical mass of selling is reached, the selling causes prices to decline further which in turn causes more selling. This convinces even more people the rally is over yielding even more selling: a downward spiral. The same price-to-price feedback mechanism that served to drive prices up during the rally works to drive prices down during the crash. 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 very few buyers. 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 who cannot afford their home sells out and capitulates to the forces of the market. Each seller accepts the market rally was a bubble, and the frenzy of selling activity clears out the overhead supply. The capitulation stage is the counterpart of the greed stage. Sellers are everywhere and buyers are scarce. This puts prices into free-fall until a critical mass of buyers is ready to buy again.

Since buyers in the aftermath of a bubble tend to be the risk averse who did not participate in it, they will make cautiously low offers on properties. Buyer caution is reinforced by lender caution. In stark contrast to the days of bubble lending, large downpayments are suddenly required, appraisals are carefully reviewed, eligibility is tighter, and most exotic loan programs are gone. 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.

Despair Stage

From a perspective of market psychology, it is difficult to tell when the ca-pitulation stage ends and the despair stage begins. Both stages have an extremely negative bearish sentiment. It is called the despair stage because most who own the asset are in despair and wish they did not own it, and the general public is still selling. Most who still own their homes are able to afford the monthly payments, but realize they will face a large loss if they sell their house anytime soon. They feel like prisoners in their own homes because they are unable to relocate for a better job or any other reason. One distinguishing feature of the despair stage is the increased buying activity of investors-true investors, not the speculators who were wiped out during the price decline. Investors are not in despair during this stage. This is the time they were anticipating to make their purchases.

There is an extreme emotional toll paid by those who participated in the mania. Losing a home to foreclosure is devastating. The emotional ties to a home go beyond seeing it as an investment. A home is supposed to be a safe haven where people raise a family. It is a unique reflection of the family, adorned with mementos and family photographs. Being forced to leave the family home is difficult for reasons that have nothing to do with money. Unfortunately, this is often followed by personal bankruptcy, and the difficulties in bankruptcy have everything to do with money.

In some ways, those who endure foreclosure may be the lucky ones as they get to leave their debtor’s prison and go find an affordable rental. The income that used to go toward housing is now freed up to go toward living a life. Those homeowners who hang on, who are desperately underwater, and who are putting 50% or more of their income toward a house worth less than they owe on it, their circumstances are arguably even more dire. There is no light at the end of their tunnel; they must live with their pain every day.

The despair stage is not desperate for everyone. What makes the despair stage different from the capitulation stage is that buyers who focus on funda-mentals like rental savings or positive cashflow return to the market and begin buying. Affordability has returned to the housing market, and those who did not participate in the mania finally get their chance to become homeowners-at reasonable prices. These buyers are not concerned with appreciation; they simply want an asset which provides a savings or 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 that creates a bottom.

Where are we now?

The psychological stage of the market here in Irvine is different for the various market segments. The high end of the market is still firmly in denial. The Immunity Syndrome is in full effect. In some of the beach communities, this denial is moving toward fear because the inventory is so large, but here in Irvine, denial rules the high end. The middle of the market is showing fear. The price reductions are more numerous, and the occasional property like today’s show the transition from fear to capitulation. As we have documented on many occasions, the low end has already capitulated.

Old Listing

Old Asking Price: $660,000

Income Requirement: $165,000

Downpayment Needed: $132,000

Purchase Price: $660,000

Purchase Date: 11/23/2005

Address: 83 Vermillion Irvine, CA 92603

* * * Property is being sold as a Short Sale * * * Subject to lender
approval * * * Beautiful 3 bedroom, 2 bath home located minutes away
from Irvine Spectrum * * * Property features tri-level floorplan, like
new paint, carpet, granite countertops. Stunning Turnkey Townhouse in
Best Location Viewing Greenbelt. Fully Upgraded & Customized with
Cherry Hardwood Floors, Ceramic Tile, Premiu m Carpets & Neutral
Two-Tone Paints. Awesome Kitchen with Cherry Cabinets, Stainless Steel
Appliances and Granite Counters, Island & Backsplash. Large Great
Room w/ Fireplace & Ceiling Surround Speakers. Formal Dining Rm,
Computer Room w/ Built-ins, Inside Laundry Rm, Main floor BR & BA.
‘PERFECT’! HOA Pool, Spa, Gym, Fireplace & More,

Title Case

* * * asterisks * * *

New Listing

New Asking Price: $439,000

Income Requirement: $109,750

Downpayment Needed: $87,800

Purchase Price: $660,000

Purchase Date: 11/23/2005

Address: 83 Vermillion Irvine, CA 92603

It is pretty rare to see a 33% price reduction, but today’s featured property manages it. Of course, they are playing the short sale bidding war game, but when you look behind the gambits and into the mind of the seller, you see capitulation. This seller is no longer going to obtain the fantasy price that would have avoided all pain from their mistake. Now it is only a matter of how bad the consequences are. That is capitulation.

Will other owners give up and capitulate? Will mass capitulation lead to the collapse of pricing like in Las Vegas? With our current buying frenzy, this doesn’t seem likely, but market conditions can change quickly, particularly if new supply is added to the market.

Lemming Migration Along the Norwegian Coast (Britannica.com)