What Housing Recovery?

*Please click on the title of this article to see a chart showing the decline in the Housing Market.

There has been a lot of talk in financial circles about whether or not we have seen the end of the fallout in the housing market. However, recent data suggests that house prices continue to decline and foreclosures are increasing. The Case-Schiller Housing Index, released on March 25, which tracks the twenty major US cities and suburbs, showed that house prices declined 10.7% compared to the same period last year. Interestingly, for the first time, the index revealed decreases in every metro area except Charlotte, NC. Therefore, it would seem to me that any talk about a full recovery and stabilization of house prices is premature at best and suggests a sort of irrational optimism. At this point there is more than enough evidence to suggest that we have only scratched the surface and things are liklely to get a lot worse before they get better. So, if you were a home owner in Charlotte NC would you be breathing a sigh of relief and thanking the heavens that you have been spared? or would you be bracing for the impact?

Foreclosure and You

I was recently asked by a reader to make the link between foreclosures and the nationwide fall in home prices. She did not quite understand why her property value would fall or why she could possibly end up losing her home because her neighbors lost their home through foreclosure; especially when she always paid her mortgage on time and in full. I find that the answer is more easily understood if it is framed outside the normal economic theory. So, consider the following scenario: Jane Doe lives on a quiet cul-de-sac in a middle class neighborhood. There are ten houses on her street, and of those ten houses she was the only one able to get a 30yr fixed rate mortgage because of her good credit and her job situation. Her nine neighbors, however, had a credit history of a lesser quality and as a result they had to accept mortgages at rates that were adjustable and tied to various terms that would see their mortgage rates go up significantly if they were late or missed a payment. Four of Jane’s nine neighbors started missing mortgage payments because they lost their jobs at a plant down the street when management outsourced most of the work to China. Then a fifth and sixth neighbor started missing payments for other reasons.
With unpaid mortgage debts piling up and no apparent hope of repayment the Bank has no choice but to repossess the houses and evict Jane’s neighbors. Now follow closely: The bank now has the homes of Jane’s neighbors and countless others on its balance sheets. These homes are earning nothing for the bank because there are no rents or mortgages forthcoming and besides that, the homes are deteriorating structurally due to lack of maintenance. The bank decides to get rid of these homes as fast as possible and cut its losses by selling the homes at “fire sale prices” usually close to half their original value. Bear in mind that Jane bought her house for $400,000 three years prior and after she bought the house she took out a $100,000 home equity loan from a second lender to purchase furnishings, do minor renovations and payoff student loans.
Now Jane realizes that she lives on a street where the average home sells for $275,000 and is faced with the reality that there is no way she could demand upwards of $400,000 for her home in a market where the average price is almost half of that. Her home value is cut in half through no fault of her own. It doesn’t stop there either: Remember that Jane had taken out a loan using the equity in her home as collateral. The decrease in the value of the property has all but wiped out the equity and now the terms of her loan are in question when her lender realizes that Jane has no equity left and, as such, has violated the contract terms of her loan. Her lender immediately demands payment of the remainder of the loan in full. She does not have the means to pay off the loan and tries to negotiate with her lender who notifies her that the only way for them to proceed is to increase the interest rate on the remainder of her loan in order to compensate for the risks associated with the declining value of the asset. Jane now has a higher monthly payment on her home equity loan and still has to pay a mortgage on a home which has declined significantly in value. It isn’t long before she starts to buckle under the increased expense, especially in light of the fact that her income has not increased. She misses a couple of payments and goes into default and her home is foreclosed by her first mortgagor.


Opportunity and Chaos

I admit that the scenario is somewhat of an over simplification because it is hardly likely that home values would decline that steeply or that our Jane Doe would be treated that harshly given her good credit standing. But I think the point was made. That being said, I would like to point out that the Chinese symbols for the words “chaos” and “opportunity” are one and the same. Of course the concept has become somewhat cliché over the last couple of months as the mainstream press and various pundits keep insisting that it is a buyers market as far as residential real estate is concerned. Well, I have a different view. While house prices are significantly lower than they were as recently as six months ago, it does not necessarily mean that it is a bargain, especially when you consider that prices could fall further. For instance, if we simply extrapolate the events that took place in Jane Doe’s neighborhood to her entire suburb, her county and her state we could get a picture of how, what is now known as the “housing crisis” ,has been spreading and could continue to spread.
The really interesting thing about this situation is that it feeds on itself because the increasing numbers of foreclosed properties that come on to the market increases the overall supply-and without ready buyers- the prices will just continue to trend down. It is basic supply and demand theory, it is a true constant and NEVER changes. Now, I do believe that there is plenty of opportunity in chaos but the extent to which one is able to exploit the opportunity is largely dependent upon ones ability to know where the chaos stops and where the opportunity begins. The bottom line is that one ought to be careful that one does not catch a falling knife in an attempt to catch a bargain. It is not at all inconceivable that you could purchase property today at perceived bargain basement prices and see a further 30-40% wiped off the value before it begins to turn upwards. There are players in the market who thought they found their “opportunity in chaos” in California and Florida in September 2006. House prices in these two markets (the worst hit so far) have declined significantly since then and still have further to go.

The Bottom of the Housing Market

I will end this conversation where I started: ignoring the pronouncements of recovery. I am not saying that I know where the bottom/turning point in the housing market will occur. If I did I wouldn’t tell you. Or maybe I would tell you after I have secured my positions so you could come in, with the rest of the herd, and push my asset values through the roof. However, if I were to guess I would say that the turning point will come when no one is interested in buying, when you literally have to give it away if you want to get rid of it. At least, historically that is when markets tend to turn. And as they say- history repeats itself. But quite frankly, I do not believe this will hold true because things are a lot different this time. In fact I would go as far as to say that it is unlike anything any scholar of Political Economic history has ever seen. For one thing it does not appear to be a mere correction in the real estate market. The instability is showing up in just about every asset class. Many long held views, principles and concepts which have made many millionaires are melting away and proving to be manifestly false. For instance, as I pointed out previously, many were under the impression that real estate was the only asset that always appreciated and now we are proving otherwise. There was also a long held belief that “all real estate is local” and that what happens in one area has absolutely nothing to do with what happens in another, this too is shaping up to be a falsehood as we see house prices fall and foreclosures increase from coast to coast for essentially the SAME reasons. The fact is that there are significant macroeconomic shifts taking shape that are driven by a number of different factors; sort of like the tentacles of an octopus. Bear in mind that this all started in the summer of 2007 when securitized mortgages started going bad. We can now look for similar things to start shaping up in securitized credit card, auto and student loans. These events will destroy a lot of wealth and create tremendous opportunities for profit at the same time. But that is the subject of a future article.