Is Housing Bottoming? Don't Bet On It   (August 18, 2008)

Frequent contributor Harun I. provided a cogent summary of the fundamental forces weighing against those anticipating a near-term bottom in housing prices.

More Home Loans on Edge Interest-only and Alt-A borrowers may be in the next wave of foreclosures. (Merced CA Sun-Star)

"Prices likely won't increase if supply vastly surpasses demand, but they will only fall so far before hitting a natural bottom, he said. California's growth rate, rental rates, construction costs and income levels help determine that level, and O'Toole said he thinks some communities, such as Stockton, which leads the nation in foreclosures, might already be near the bottom."

This is like saying that your injury will stop hurting when the pain goes away.

The mantra many others and I have been repeating is that home prices will fall until they are in line with income. But I realized that is, perhaps, a gross miscalculation which I must address. I have new hypothesis: Prices will fall below the level of median income support; they will overshoot to the downside and bottom at "market clearing" prices. (emphasis added: CHS) The reasons are high inventory, high unemployment, scarcity of credit, scarcity of qualified buyers and poor sentiment.

Alt-A and Interest Only mortgages are going to be the next big wave of RRE defaults, which will dump more inventory on the market. The number of homes on the market in the US will take several years to clear in a normal environment but bubbles are obviously not normal. High inventories will demand lower prices.

In other words, if builders flooded a normal market with inventory, prices would have to lower in order to sell those homes regardless of incomes. This factor alone is the most important. Regardless of wages, prices will overshoot downward because there is too much supply. One may argue that population growth will create a greater demand and I would reply that that population must have employment and wages and be creditworthy in order to qualify. Which brings us to the employment factor.

Don't look to BLS numbers for any realistic view of employment. By the time the numbers are high enough that even the BLS numbers look bad, that means the problem is already very deep. Unemployment is at a historical low, and we like to think we can exist as a service economy but as this illusion unravels, as it is presently, unemployment will increase. The trend will be like any other, it will persist longer than and further than anyone thinks. High unemployment will create a shortage of qualified buyers. This will be another factor pressuring prices. I do concede that this implies an income factor, that factor being zero.

It is no secret that banks are in need of cash and RRE losses are nowhere near over let alone the coming CRE debacle. Currently they have been raising money just for losses, their ability to lend is greatly reduced. Securitized products may not be dead forever but they are dead for now. Banks that have to keep loans on their books are going to be discerning along more traditional lines than they were during the bubble. It will be difficult to get a loan under normal lending standards. This will play a role in decreasing the pool qualified buyers, which in turn, will keep inventories high, which will pressure prices lower.

Market forces will propel long-term lending rates (risk premiums) higher regardless of the Fed. Home prices must fall to offset the difference, as this once again will impact the number of qualified buyers at any particular price point. The low saving rate in the US says that most don't have a 10-20% down payment. Saving up an adequate down payment will be harder with high unemployment and low wages. The current wave of foreclosures will create a pool of ineligible buyers for at least 4-7 years after the event. Even if they are considered, interests rates will be such that prices must be lower in order for them to qualify.

Finally, poor sentiment will take hold. At some point, people will not want to have anything to do with real estate. The losses will have been so great and gone on for so long that the widespread idea of RE as easy road to riches will fade. This is good, as it will mark the beginning of the bottom. When magazine covers highlight the permanent death of the housing market it will be one of many signs that the sector trend is about to reverse. But don't expect this anytime soon. Japan was in much better shape to weather their bubble and though the bubble has deflated, in reality, they still haven't recovered.

In summary, prices will fall to market clearing levels and that level is not singularly tied to incomes. Even in normal markets prices oscillate around the mean. After such a great distortion (bubble) it is somewhat unrealistic to think that prices will fall right back to the mean. The deflation of home prices is nothing more than a trend, and it will persist. Affordability is a factor in the clearing of inventory but it is not the only factor. It is the other factors that I have mentioned here which form a positive feedback loop which increases inventory, a combination of factors that I believe will cause RE prices to slip below median income support.

Thank you, Harun. Housing Bulls believe certain "backstops" are already in place which will arrest housing's free-fall. One is low interest rates, which as Harun observes, will be rising regardless of the Fed's attempt to change the tides with its Fed Funds Rate sand-castle.

The second one is income, which as Harun notes, will be pressured by rising unemployment and stagnant wage growth.

The third "backstop" is no-down/low-down payments, enabling a large pool of households with no real savings to qualify for a mortgage. But with credit drying up and standards rapidly being raised to limit risk, a paucity of savings will greatly reduce the number of households who truly qualify for a conforming loan.

Recall that many households are so burdened with debt (auto loans, student loans, credit cards, etc.) the notion that they are low-risk candidates for immense new mortgages does not align with the new "recognition of risk" lending realities.

A fourth backstop is "replacement value," a notion which I have seen used recently to justify the purchase of still-overpriced properties. For instance, "you couldn't build this for the asking price." Perhaps, but in a nation with some 15 million vacant homes, who will be risking capital building more luxury homes in markets glutted with vacant luxury homes and condos?

Bottom line: replacement value shows up in appraisals, but not in the market price, which is set by the demand of willing buyers, the ready availability of mortgages/ money to borrow and the inventory of available houses.

Supply and demand do not respect replacement values. Homes in highly desirable urban areas with walkable neighborhoods and nearby public transit and retail are still commanding bubble-era prices here in the San Francisco Bay Area, as these qualities are still attracting buyers who are qualified by virtue of huge cash down payments--vast cash positions which in many cases were created by selling their previous homes at the bubble top 2005-2006.

These few homes are still fetching prices far above replacement, while their exurban counterparts are slumping toward "market clearing" prices--the price at which cash buyers appear.

Meanwhile, the stock market is "discounting" further declines in housing and forecasting a "bottom." Take a look at these charts of the Housing Sector Index (HGX) and the S&P Homebuilders ETF (XHB).

Both charts are showing signs of "bottoming", suggesting the market has "discounted" current declines and is anticipating a recovery in early 2009.

Housing Bulls can certainly point to this technical evidence in making their case that homebuilders have bottomed. But with all the traditional "backstops" of valuations crumbling, we have to ask: as the recession finally tightens its grip in 2009, who will be left who A) wants to take on a huge mortgage as their income/employment gets iffier B) is qualified for a huge mortgage by conventional lending standards and C) doesn't already own a house (or three)?

I have been writing for two years about "false bottoms" created by speculators overly-anxious to "bottom feed" and a media primed by its advertisers and handlers to seek a "bottom" at the earliest possible point. This certainly looks like just such a "false bottom." The real bottom in these indices will be closer to zero.

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