5 Reasons Why The Housing Market Will Continue to Decline Until 2010: Extrapolating The Free Ride Bird and Dancing with the Housing Pied Piper.
Posted by: in Real-estate newsMany know the story of the Pied Piper of Hamelin. Legend has it, that in 1284 the town of Hamelin Germany was suffering from rat infestation. The townsmen where worried and desperate for any help. In comes a man in colorful garment promising the town that he would lure the rats away. The townsmen in return promise to pay the man. The man accepts the offer and plays a musical tune on his flute luring the rats away where they are led to water to drown. Even though he succeeded as promised, the people in the town refused to pay. The man left but later returned to the town to seek revenge. After returning, he played his pipe once again but this time lured children of the town away never to be seen again.
Now I’m sure many of you have used the term “pay the piper” but apparently many are now reneging on this promise and simply walking away from their mortgage obligations. What we suffer in this decade is a consumption infestation built on credit and when push came to shove, many people weren’t too attached to their homes. From a business stand point, if you are severely underwater on your mortgage walking away may be the best option. In fact, we are now seeing people employ this technique on auto loans and also credit cards. After all, if you are having a difficult time paying a resetting mortgage you may also opt to let the $80,000 luxury car go with it. In a USA Today piece there is a new trend emerging, some mystics and erudite economist are calling it Spend Less Than You Earn (SLTYE):
“There’s no turning back soon for mortgage loan originator Martin Richardson of Suffolk, Va. He used to buy four suits a year at J.C. Penney (JCP). In the past year, he didn’t buy any and will make do with his wardrobe again this year.
“I can’t afford it,” he says. “Nothing could lure me back. Not two-for-ones. Not 20% off. Nothing.”
It’s not just leaner times, Richardson says. “I won’t go back to my old ways when the economy improves,” he says. “It’s hard for friends to understand, but I’m working on becoming more of a minimalist. It’s a relief to have less.”
I think Henry David Thoreau just shed a tear from heaven. This is all well and good but the transformation is happening more out of necessity than the idea that it is now trendy to spend within your limits. What has occurred over the past two decades is an incredible consumption society that with stagnant wages, used credit to bridge the gap over the Nile river into believing they were somewhat wealthier than they truly were. So what are the five reasons housing will continue to decline over the next three years? There are many more but here is a brief list that we will go over; free ride bird no longer flying, new budget line item of servicing debt, down payments be gone, rewriting universal laws, and salt in the consumption engine.
1 - The Pied Piper Wants your Custom Home and Mercedes
*click to see free ride bird leave our economy for a few years.
The picture above sums up the past decade of our economy. At a certain point, the gig was going to end and we were going to have to face the music. The assumption made by many people, especially here in California, is that we had a large enough base of wealthy consumer that would contribute to ever increasing housing prices. As I wrote back in April of 2007 in America’s Codependence on Housing: 30% of Job Growth Contributed by Real Estate. 5 Point Plan on how the Bubble Will Burst, I looked at the Catch 22 that we found ourselves in. We became so reliant on housing that the only way the economy would continue to grow is if housing kept going up. Housing took a larger chunk out of our paychecks. You can read the article for greater details on this but the final point I made was we would be facing a housing led recession before any perma-bulls were willing to admit the fallacy of their own perpetual motion machine built on mortgages.
The free ride was built on easy access to credit fueled by the lax lending standards of the Federal Reserve and the lack of any enforcement of any laws. We had a monumental shift in psychology during this time. Through financial alchemy and risk management, it was no longer necessary for you to save to purchase homes or any other consumption items. Through the art of loans, you were able to have that $70,000 car on a 6 year note or that glorious $600,000 McMansion with a 2/28 Option ARM Mortgage. So what if your income was only $75,000 because you had to keep up with folks making $14,000 passing you up in the fast lane buying homes in the $700,000+ range. But all this spending was nothing more than a pyramid scheme. You had to keep getting new credit via refinancing or credit cards to simply keep the game going. In fact, many homes were the gift that kept on giving. With HELOC, you had a built in ATM machine with your house and many came to rely on their home as another source of credit.
Like any Ponzi Scheme, the game ends when there is no new money coming in. The housing market, even when it was stalling not even declinding, started showing cracks in early 2007. The gig was up.
2 - When Servicing Debt Eats into Your Nonexistent Savings
Take a long hard look at the above charts. How can it be that a booming housing market with so many artifacts of wealth floating around have underneath its hood, a society that was heading toward a negative savings rate and had a larger percentage of each paycheck being eaten up by servicing debt? There is a sense of irony that in 2005 when we hit the absolute peak of the housing bubble, that is the same year that we solidly entered a negative savings rate as a nation. That is, we were spending more than we were taking in. We’ve learned well from our government who has a continual monthly trade deficit.
This didn’t seem like a problem when credit was easy and the only requirement to get a loan was the ability to fog a granite countertop. Now, with the August 2007 credit crunch, easy credit is becoming more and more of a historical footnote. You may be thinking, but didn’t people need to have some cash to purchase homes during this boom? If you say that housing was accelerating while savings was dwindling, how were so many millions of Americans able to purchase homes with negative savings rates? Well my friends, creative financing had a solution to that one and it was called no money down.
3 - Down Payments are Coming Back!
You may be surprised that in 2006, 21% of all California buyers went no money down. This is a stark contrast from 2000 when only 3.9% of buyers went no money down. Keep in mind that well into the middle of 2007, many of these absurd mortgage products were still floating out in the market. However, with the advent of tighter credit standards the market has completely dried up. Bringing the down payment back and simply looking at income (refer to point #2) was enough to pop the entire housing market. Nationally, we already know that we are facing a correction. But just take a look at the data for California:
|
Data for January 2008 |
|||||
|
State of California |
Current |
Last |
Year |
M-to-M |
Y-to-Y |
|
Period |
Period |
Ago |
Change from Last Period |
Change from Year Ago |
|
| Existing Home Sales (SAAR) |
313,580 |
297,970 |
446,820 |
5.20% |
-29.80% |
| Median Home Price |
$430,370 |
$476,380 |
$551,220 |
-9.70% |
-21.90% |
| Unsold Inventory Index (months) |
16.8 |
14.2 |
7.6 |
18.30% |
121.10% |
| Median Time on Market (days) |
71.6 |
66.6 |
68.7 |
7.50% |
4.20% |
| 30-year fixed-rate mortgage (FRM) |
5.76% |
6.10% |
6.22% |
-0.34% |
-0.46% |
*Source: California Association of Realtors
How bad is it here in California? Well having a median price drop of $120,850 statewide isn’t a sign that the market is recovering. In one year, we have already seen a statewide drop of 21% - interesting that we had 21% of people going no money down in 2006. Coincidence? Of course. Interesting facts? Absolutely! Aside from price, I draw your attention to unsold inventory and median time on the market. Unsold inventory has increased a whopping 121% in one year. What this means is we will keep on seeing major price drops as the market continues to adjust. The fact that lenders now require even token down payments of 5% is 5% too much for many saving starved buyers. The 80/20 piggyback loans or the 90/10 loans are no longer available. Even with Fannie Mae and Freddie Mac gearing up for the jumbo market, you will still have to show you have the income to support the payment. Unless Freddie and Fannie are willing to do Pay Option ARMs this, they can raise caps to $1 billion because underwriting on these loans actually examine income and your ability to pay, something that wasn’t done for past years. This may all be a small sign of what is to come but people are now realizing that the housing bunny rabbit may be a figment of their imagination.
4 - E=mc2 and Housing Never Goes Down
What happens when something you believed in for your entire life is now shattered? Last year we’ve witnessed the first national median price decline in housing since the Great Depression. Given that the majority of our population never lived through this time, we are now witnessing something that is new to our generation. Many of the 20 to 30 something finance and real estate hot shots never learned in real estate class that prices do decline if you look at a longer history. I’ve seen many finance books that conveniently leave out the Great Depression when calculating returns on the S&P or the DOW. How nice, why don’t we leave out the Dark Ages and the Inquisition out of history books? For those of you interested in the past and what we can learn from it, I suggest you take a look at our Lessons from the Great Depression series.
Yet we live in a time that is based on hyper-consumption so it logically followed that larger homes and bigger mortgages would not keep many from taking the dive. Why not? Never in recent memory have prices declined and not here in California where everyone earns $200,000 per year and sweats gold. The lines that were being told to people simply blew me away. Home prices never go down! Let us use the 20 percent returns we were having during this boom plus the peak $550,000 price to follow it out seven years:
Assuming 20 percent yearly gains:
|
1/1/07 |
$551,220 |
|
|
1/1/08 |
$661,464.0 |
year 1 |
|
1/1/09 |
$793,756.8 |
year 2 |
|
1/1/10 |
$952,508.2 |
year 3 |
|
1/1/11 |
$1,143,009.8 |
year 4 |
|
1/1/12 |
$1,371,611.8 |
year 5 |
|
1/1/13 |
$1,645,934.1 |
year 6 |
|
1/1/14 |
$1,975,120.9 |
year 7 |
*base year price of January 2007 is based on actual California median price
Following this logic, a home would double in price almost every 4 years. Even a simple back of the napkin calculation showed that this was not possible. Of course the above model is now shattered and not only are we seeing prices drop but prices fiercely correcting since much of the wealth that was created was fictional. Also, many lenders and Wall Street did not predict that many people would simply moonwalk away from their purchases.
There is a double-edge sword to 24/7 information flow. Good ideas get spread quicker than ever before but so do bad. When housing was ramping up the idea “housing always goes up” was enabled by easy lending policies by lenders and the Fed accommodated this bubble plus all the housing porn on cable networks. Wall Street created the pen for it to play in. In similar fashion, people in trouble now realize “why pay when you can walk away” is a good idea and the flow of information is educating people on the reasons to do this. One of the reasons this is so appealing is the idea of simple living.
5 - Resurrecting Henry David Thoreau and Simple Living
Keeping up with the Joneses can be exhausting. In fact, we are seeing a shift in our culture that having less may be similar to having more. A couple of weeks ago, there was a fascinating piece on 60 Minutes highlighting the statistically happiest nation, Denmark. The U.S., as you may already know was nowhere even in the top 20. One of the main reasons for this I’m sure came to a shock to many Americans. Was it because they had more money? No. Was it because they had bigger McMansions and faster cars? No. In fact, there reason had nothing to do with money. It was that they kept their expectations low. If you lower the bar, even a slight success makes you happy. They interviewed four students and they were asked about their perception of Americans. One student to paraphrase said, “Americans seem to want it all. They want the bigger home, the better job title, the more expensive car. It never seems like enough. I’d be happy with having a healthy family and doing something I love.” This wasn’t said in a condescending perspective, but more as a naturalist looking at a habitat from the outside.
Many Americans are now realizing that being tied to material items comes at a heavy costs. If you have beaucoup debt you are unable to do other things. When you ask Americans to imagine a wealthy individual, they will tell you that they drive in a foreign luxury car, wear a $5,000 watch, and live in an uber McMansion. Yet the reality is very different. As highlighted in the Millionaire Next Door, many of the day to day millionaires drive nice but not super expensive cars, live in modest homes, and don’t spend ridiculous amounts on artifacts of wealth. The book was written before the housing bubble but the fact remains, wealth is not possession of expensive items. Wealth is having the freedom to do what you want. Having massive amounts of debt hanging over your head is not wealth, it is a financial albatross that will take your freedom away. Many Americans realizing this new concept, are deciding to walk away. So what if their credit is ruined, they can rent so the logic goes. This is a new sociological trend and is only in its infancy. These are not new however. The idea of being happy on very little was exemplified by families coming out of the Great Depression. When everything is taken away, many will realize a sense of liberty they have not experienced ever in their life.
Of course not everyone will welcome this change. We are a long way from having any sort of bottom or cleansing from this bubble and there are still entrenched interests that will fight to prop up the market. Deeply ingrained ideas take time to change but the seeds of change are sprouting up all across this nation. Why do you think the change message is catching on with many? There is something going on that is changing a large portion of society. Those that don’t take heed are simply ignoring the psychological facts of human nature. At a certain point cleaning out the garage is a good idea. Even if you doubt what is going on, simply look at the number of people walking away from their homes. We really need to prioritize our goals as a nation. You want to know where our money is going? Take a look at the breakdown for the Federal Budget top four expenditures:
Social Security: 21%
National Defense: 19%
Medicare: 14%
Interest on Debt: 9%
With only these four areas, we are spending a whopping 64% of our entire budget. And get this, the first baby boomers are now going into full retirement only to put more stress on Social Security and Medicare. Things do need to change and many Americans are finally waking up to the reality that the pied piper is back and seeking revenge.
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