When I started writing for this blog, I wrote a series of posts culminating in Predictions for the Irvine Housing Market published on March 11, 2007. It seems only fitting to take this opportunity to take a look ahead at 2008 and make some predictions for 2008 based on the events we have witnessed in 2007.
The first stages of a decline are are always slow to register on the median home price because the low end of the market collapses first leaving only the more desirable, high-end property transactions in the market. We have documented on this blog numerous individual properties sporting 15% to 20% declines, and housingtracker.net has documented a drop in asking prices in Orange County from $651,225 to $569,900 (12.5%). Foreclosures are up almost five-fold since April of 2007. With the ongoing tightening of credit, there are no signs that any of these trends are reversing or will reverse any time soon. In fact, foreclosures are likely to continue to pile up dramatically as adjustable rate mortgages continue to reset and more homeowners are underwater and unable to refinance.
In short, 2008 will likely see more declines. I will make the not-very-bold prediction that 2008 will see the worst single-year decline in the median house price ever recorded, and quite possibly the largest single-year decline we will witness in our lifetimes (although 2009 could be even worse.) My original prediction was for a 12% decline in 2008, I will stand by that number, although it could be even greater. Between 2008 and 2009, I believe we will see a 28% decline in the median home price. Am I crazy to think such a thing? Not if you ask Christopher Thornberg formerly of UCLA and now with Beacon Economics.
The cold, hard truth is that foreclosures are serving only to hasten the painful process of shifting housing prices back to a level the market can sustain. Prices must and will fall. Everywhere. Probably 25% to 30% from their peak.
Now I will give a caveat. The FED will likely continue to pursue its wreckless course of lowering interest rates causing rampant consumer price inflation in an attempt to provide enough liquidity to the financial markets to stop a string of catastrophic failures of several of our large financial institutions. If this liquidity somehow finds its way into residential mortgages (something I doubt,) then house prices may not drop in nominal terms as far as I have predicted. In inflation adjusted (real) terms, the drop will still be large and unprecedented. This caveat leads to another not-very-bold prediction for 2008: one or more of our major financial institutions and one or more of our major homebuilders will fail as a result of the collapse of housing prices.
BTW, if you want to see why the credit crunch is so serious, and why it is likely to push the economy into recession (and why the FED is so aggressively lowering rates,) examine the chart below I copied from Calculated Risk. Banks are not willing to loan money: period. They have lost all confidence in the ability of borrowers to repay loans. Is this throwing the baby out with the bathwater? Sure it is, but that is what happens when you have a credit crunch. The ratings agencies gave AAA ratings to a steaming pile of mortgage manure, and banks have lost all confidence in everyone's credit worthiness as a result. This is what the FED is trying to combat by providing as much credit as they possibly can. Of course, it isn't just lender psychology at work here. They are also hording cash to prepare themselves for the onslaught of bad loans and write-downs they are going to experience as house prices continue to fall. The combination of fear of the unknown and fear of the known is causing a dramatic decline in lending: a credit crunch.
Am I being an alarmist and a worry-wort? If so, I am not alone. Robert Shiller, Professor of Economics at Yale University, predicted that there was a very real possibility that the US would be plunged into a Japan-style slump, with house prices declining for years. If you need a refresher on what happened to Japan and what Ben Bernanke would have done about it, click on this PDF link to Bernanke's writing on the subject. You can see the current course of FED action outlined in this paper.
So what does all this add up to? My next not-so-bold prediction: a severe local recession. Huge amounts of money used to flow into our local economy through the subprime mortgage business. This business model is dead. It is not going to return. Yes, it may still survive, but it will shrink down to the 2% of the market is used to have rather than the 20% it enjoyed at the peak. This is a huge loss to our local economy. Also, the decline in house prices is going to shut off the housing ATM another huge source of unsustainable local spending. Then of course, there are the realtors who used to feast on all this borrowed money that is no longer flowing into residential housing transactions and the local homebuilders who are no longer building and selling many houses. Basically, our heavily real estated dependent economy is going to tank — badly.
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For my final not-so-bold prediction for 2008, I predict we will see many more angry homedebtor's troll the blog. As denial turns to fear and acceptance, it often detours through periods of anger. It will be extremely embarrassing for the many sheeple who got caught up in the financial mania to admit they made a huge mistake, particularly the most arrogant and willful of the the bunch. Since people generally do not want to take personal responsibility for their mistakes, many will come here and blame the "negative media" for the decline. We may report on the market, but we don't influence it, and we certainly don't control it. We will be a convenient place for many to vent their frustrations.
Financial manias have a way of deluding even the most intelligent of people. Sir Issac Newton was rumored to have lost £20,000 of public funds in the market — a substantial sum of money at the time. He is quoted as saying "I can calculate the motion of heavenly bodies, but not the madness of people." This financial mania infected many intelligent and successful people, and it will be the ruin of many of them.
Remember, housing markets do not move quickly. It is going to be a slow ride, so take it easy…
One of the cornerstones of my analysis of the housing market is the relationship between income, rent and house prices. When prices rise to where it is less expensive to rent, people who do not get caught up in the irrational exuberance of rising prices chose to rent rather than buy. From the graph above you can clearly see the last two bubbles: one in the late seventies caused by rampant inflation, and one in the late 80s caused by a booming economy and simple irrational exuberance. Our bubble is obvious.
We see “napkin” calculations on posts on this blog all the time. Someone will pick a somewhat arbitrary year when prices were “normal” and proceed to calculate how much it should be worth today based on inflation, etc. It is clear from the graph above that prices were too high back in 2000. By 2002, we were at the top of a minor bubble. By 2004 we were at the top of what would have been an unprecedented real estate bubble. Then, the Option ARM came along and sent prices even higher.
My premise is simple: prices will fall back to the historical relationship between prices and rents. It will because it must. Unless people suddenly start wanting to stretch to by depreciating assets, there won’t be very many buyers until we get back to rental equivalent value…
In many ways blogs are uniquely personal things. The personalities of the contributors and commenters shapes the conversation and gives the blog a personality all its own. The Irvine Housing Blog is a community — a community of like-minded individuals (and recovering kool-aid addicts) who have come together to make sense of the very unusual events we have witnessed in our housing market.
There are a number of great housing and real estate blogs. Calculated Risk is one of the finest, and the discussions over there are very cerebral. Quite honestly both Calculated Risk and Tanta are more intelligent and more experienced than yours truly. I go to their blog frequently to keep up on the evolving nature of the intellectual discussion of the issues surrounding housing. However, residential real estate is an emotional issue as well. A heady discussion of real estate matters is a useful part of the discourse, but the emotional aspect is equally important. This bubble we are living through was not created by logic or fundamentals: it was a perfect example of irrational exuberance.
Discussing and expressing the emotional side of the bubble is part of my mission as a blogger. I know I am not the only one with a Reservoir of Schadenfreude. I must confess that I enjoy going over to Housing Panic and reading the unbridled emotional release you find there. I couldn’t maintain the level of intensity Keith does and stay sane, but there are times when letting loose is appropriate, and Housing Panic is a place to do it.
Some people come to this blog for the analysis; some come for the schadenfreude. We welcome both groups. Some would like this blog to limit itself to analysis, and some would like nothing more than daily doses of schadenfreude. When I write for the blog, I want to express myself fully. I do not want to ignore my emotions nor do I want to discard my intellect. More of one side or the other may come out during any given day, but over the course of time, I hope I achieve a balance in my posts just as I hope to achieve a balance in my life.
Life is about balance; it is about being aware of your intellectual and emotional intelligences and being able to manage both. During a financial mania people allow their emotions to override their intellect, and the results are not pretty. It is only through the interplay of the intellect and the emotions that we can gain a deeper understanding of what really happened in the Great Housing Bubble.
I’m dreaming dreams, I’m scheming schemes, I’m building castles high. They’re born anew, their days are few, Just like a sweet butterfly. And as the daylight is dawning, They come again in the morning!
I’m forever blowing bubbles, Pretty bubbles in the air, They fly so high, Nearly reach the sky, Then like my dreams They fade and die. Fortune’s always hiding, I’ve looked everywhere, I’m forever blowing bubbles, Pretty bubbles in the air. When shadows creep, When I’m asleep, To lands of hope I stray!
A financial bubble is a temporary situation where asset prices become elevated beyond any realistic fundamental valuations because the general public believes future price increases justifies current pricing. If this belief is widespread enough to cause significant numbers of people to purchase the asset at inflated prices, then prices will continue to rise. This will convince even more people prices will continue to rise facilitating even more buying. Once begun, this reaction is self-sustaining, and the phenomenon is entirely psychological. Once the pool of buyers is exhausted and the volume of buying declines, prices stop rising, and the belief in future price increases diminishes. When the remaining potential buyers no longer believe in future price increases, the primary motivating factor to purchase is eliminated; Prices fall. The temporary rise and fall of asset prices is the defining characteristic of a bubble.
The bubble mentality is summed up in three typical beliefs:
1.The expectation of future price increases.
2.The belief that prices cannot fall.
3.The worry that failure to buy now will result in permanent inability to obtain the asset.
The Great Housing Bubble was characterized by the acceptance of these beliefs by the general public, and the exploitation of these beliefs by the entire real estate industrial complex, particularly the sales mechanism of the National Association of Realtors.
Robert Shiller, in his book Irrational Exuberance, argues that speculative bubbles are caused by “precipitating factors.” Like a spark ignites a flame, a precipitating factor serves as a catalyst to begin the initial price increases that change the psychology of market participants and activate the beliefs listed above. There is usually no single factor but rather a combination of factors that stimulates prices to begin a speculative mania. The Great Housing Bubble was precipitated by innovation in structured finance and the expansion of the secondary mortgage market, the lowering of lending standards and the growth of subprime lending, and to a lesser degree the lowering of the FED funds rate.
Real Estate Only Goes Up
The mantra of the National Association of Realtors is “real estate only goes up.” This economic fallacy fosters the belief in future price increases and the limited risk of buying real estate. In general real estate prices do increase because salaries across the country do tend to increase with the general level of inflation, and it is through wages that people make payments for real estate assets. When the economy is strong and unemployment is low, prices for residential real estate tend to rise. Therefore, the fundamental valuation of real estate does go up most of the time. However, prices can, and often do, rise faster than the fundamental valuation of real estate, and it is in these instances when there is a price bubble.
Greed is a powerful motivating factor for the purchase of assets. It is a natural response for people to desire to make money by doing nothing more than owning an asset. The only counterbalance to greed is fear. However, if a potential buyer believes the asset cannot decline in value, or if it does, it will only be by a small amount for a very short period of time, there is little fear generated to temper their greed. The belief that real estate only goes up has the effect of activating greed and diminishing fear. It is the perfect mantra for creating a price bubble.
Buy Now or Be Priced Out Forever
When prices rise faster than their wages, people can obtain less real estate with their income. The natural fear under these circumstances is to buy whatever is available before there is nothing desirable available in a particular price range. This fear of being priced out causes even more buying which drives prices higher. It becomes a self-fulfilling prophecy. Of course, the National Association of Realtors, the agents of sellers, is keen to exploit this fear to increase transaction volume and increase their own incomes. If empirical evidence of the recent past is confirming the idea that real estate only goes up, the fear of being priced out forever provides added impetus and urgency to the motivation to buy.
The fallacy in this reasoning is easy to identify: who exactly is pricing out whom? When a housing unit becomes available for sale, it must be purchased by someone. The potential pool of buyers will put in competing bids to obtain the property. Unless very wealthy people start wanting to live in small condominiums, there will always be a housing unit available for someone willing to put in a competitive bid. At some point, the available housing stock gets bid up so high that people choose to rent rather than own. When the quality of units available for rent at a given monthly payment far exceeds the quality of those available for sale at the same monthly payment level, people chose not to bid on the property and chose to rent instead. One sign of a housing bubble is a wide disparity between the quality of rentals and the quality of for-sale houses at a given price point.
Confirming fallacies
There are a number of fallacies also believed by the general public with respect to residential real estate that either affirm the belief in perpetually rising prices or minimize the fears of a price decline. These fallacies generally revolve around a perceived shortage of housing or a belief that the higher prices are justified by current or future economic conditions. These beliefs are not the core mechanism of an asset price bubble, but they serve to affirm the core beliefs and perpetuate the price rally.
They Aren’t Making Any More Land
All market pricing is a function of supply and demand. One of the reasons many house price bubbles get started is due to a temporary shortage of housing units. This is a particular problem in California because the entitlement process is slow and cumbersome. Supply shortages can become acute, and prices can rise very quickly. In most areas of the country, when prices rise, new supply is quickly brought to the market to meet this demand, and price increases are blunted by the rebalancing of supply and demand. Since supply is slow to the market in California, these temporary shortages can create the conditions necessary to facilitate a price bubble.
The fallacy of running-out-of-land plays on this temporary condition to convince market participants that the shortage is permanent. The idea that all land for residential development can be consumed ignores one obvious fact: people don’t live on land, they live in houses, and land can always be redeveloped to increase the number of housing units. If running-out-of-land were actually a cause of a permanent shortage of housing units, Japan and many European countries where there is very little raw land available for development would have housing prices beyond the reach of the entire population. Since this is not the case, it becomes obvious that the amount of land available for development does not create a permanent shortage of dwelling units.
Over the long term, rent, income and house prices must come into balance. If rents and house prices become very high relative to incomes, businesses find it difficult to expand because they cannot attract personnel to the area. In this circumstance one of two things will happen: businesses will be forced to raise wages to attract new hires, or business will stagnate and rents and house prices will decline to match the prevailing wage levels. During the Great Housing Bubble, many businesses in the most inflated markets experienced this phenomenon. The effect is a net outmigration of population to other areas.
Everyone Wants To Live Here
Everyone believes they live in a very desirable location, after all, they choose to live there. People who make this argument fail to understand that the place they live was just as desirable before the bubble when prices were much lower. What is it about their area that made it two or more times as desirable during the bubble? Of course, nothing did, but that doesn’t stop people from making the argument. There is a certain emotional appeal to believing the place you chose to call home is so desirable that people were willing to pay ridiculous prices to live there. The reality is prices went up because people desired to own an asset that was increasing in price. People motivated by increasing prices do not care where they live as long as prices there are going up.
Prices Are Supported By Fundamentals
In every asset bubble people will claim the prices are supported by fundamentals even at the peak of the mania. Stock analysts were issuing buy recommendations on tech stocks in March of 2000 when valuations were so extreme that the semiconductor index fell 85% over the next 3 years, and many tech companies saw their stock drop to zero as they went out of business. Analysts even invented new valuation techniques to justify market prices. One of the most absurd was the “burn rate” valuation method applied to internet stocks. Rather than value a company based on its income, analysts were valuing the company based on how fast it was spending their investor’s money. When losing is winning, something is profoundly wrong with the arguments of fundamental support. The same nonsense becomes apparent in the housing market when one sees rental rates covering less than half the cost of ownership as was common during the peak of the bubble in severely inflated markets. Of course, since housing markets are dominated by amateurs, a robust price analysis is unnecessary. Even a ridiculous analysis, like the ones produced by Gary Watts, if aggressively promoted by the self-serving real estate community provides enough emotional support to prompt the general public into buying. There is no real fundamental analysis done by the average homebuyer because so few understand the fundamental valuation of real property. Even simple concepts like comparative rental rates are ignored by bubble buyers, particularly when prices are rising dramatically and such valuation techniques look out-of-touch with the market.
When rental cashflow models fail, which they do during the rally of a housing bubble, the arguments justifying prices turn to an owner’s ability to make payments. The argument is that everyone is rich, and everyone is making enough money to support current prices. It seems people began believing the contents of their “liar loan” applications during the bubble, or perhaps they counted on the home-equity-line-of-credit spending to come from the inevitable appreciation. Even when confronted with hard data showing the everyone-is-rich argument to be fallacious, people still claim it is true. One of the unique phenomenons of the Great Housing Bubble was the exotic financing which allowed owners the temporary luxury of financing very large sums of money with small payments. There was some truth to the argument that people could afford the payments. Unfortunately, this was completely dependent upon unstable financing terms, and when these terms were eliminated, so were any reasonable arguments about affordability and sustainable fundamental valuations.
It Is Different This Time
Each time the general public creates an asset bubble, they believe the rally in prices is justifiable by fundamentals. When proven methods of valuation demonstrate otherwise, people invent new ones with the caveat, “it is different this time.” It never is. The stock market bubble had its own unique valuation methods as described above. The Great Housing Bubble had proponents of the financial innovation model. Rather than viewing the unstable loan programs of the bubbles with suspicion, most bubble participants eagerly embraced the new financing methods as a long-overdue advance in the lending industry. Of course, it is easy to ignore potential problems when everyone involved is making large amounts of money and the government regulators are encouraging the activity. Alan Greenspan, FED chairman during the bubble, endorsed the use of adjustable rate mortgages in certain circumstances, and official public policy under the last several presidential administrations was the expansion of home ownership. When everyone involved is saying things are different and when the activity is profitable to everyone involved, it is not surprising events got out of control.
Who Cares?
Why should anyone care about financial bubbles? The first and most obvious reason is the financial fallout is stressful. People buying into a financial mania too late, particularly in a residential housing market, will end up in foreclosure and most likely in a bankruptcy court. Stock market bubbles will only cause people to lose their investment. It may bruise their ego or delay their retirement, but these losses generally do not cause one to lose their home or declare bankruptcy like a housing market bubble does. In a stock market collapse, a broker will close out positions and close an account before the account goes negative. There is a safety net in the system. In a residential housing market, there is no safety net. If house prices decline, a homeowner can easily have negative equity and no ability to exit the transaction. In a housing market decline, properties become very illiquid as there simply are not enough buyers to absorb the available inventory. A property owner can quickly fall so far into negative territory that it would take a lifetime to pay back the debt. In these circumstances bankruptcy is not just preferable; it is the only realistic course of action. It is better to have credit issues for a few years than to have insurmountable debt.
The real problems for individuals and families come after the bankruptcy and foreclosure. The debt addicted will suddenly find the tools they used to maintain their artificially inflated lifestyles are no longer available. The stress of adjusting to a sustainable, cash-basis lifestyle can lead to divorces, depression and a host of related personal and family problems. One can argue this is in their best interest long-term, but that will be little comfort to these people during the transition. The problems for the market linger as well. Those who lost homes during the decline are no longer potential buyers due to their credit problems. It will take time for this group to repair their credit and become buyers again. The reduction in the size of the buyer pool keeps demand in check and limits the rate of price recovery.
Conclusion
The Great Housing Bubble, like all asset bubbles, was driven by the belief in permanent house price appreciation, an unrealistic perception of the risk involved, and the fear that waiting to buy would cause market participants to miss their opportunity to own a house. These erroneous beliefs were supported by a host of fallacious beliefs embraced by everyone involved. As with any mass delusion, it is difficult to see beyond the fallacies to the deeper truth; however, it is essential to do so because the cost in emotional and financial terms of getting caught up in the mania is very high. Foreclosure and bankruptcy are never positive outcomes.
I found this blog entry on Calculated Risk. If you did not see it, it brilliantly and concisely demonstrates the problems facing the market in the foreseeable future.
In the ’90s, as prices fell in California, foreclosure activity (using Notice of Defaults NODs) increased. Prices bottomed in 1996, as foreclosure activity peaked.
Now imagine what will happen over the next few years as house prices fall. Foreclosure activity is already at record levels (2007 estimated on graph). Yet, as prices fall, foreclosure activity will probably continue to increase – the activity will be literally off the chart!
It is pretty difficult to but a bullish spin on that one.
