The downward cycle of housing prices

Jul 30, 2010

Paris, France,

The markets gave no clear sign of their intentions yesterday. The Dow fell 30 points. Gold rose $8.

And this morning, stock markets in Asia dropped. Earnings are up, just as they are in America. But earnings have a "last waltz" sound to them. AP reports:

-------------- Become our Fan on Facebook and get a Thank-You gift --------------
On 10th August, at 10 am, we will launch our brand new investment guide, What the Charts Foretell, on how to understand the stock market better.
And we will launch this guide only on ...Yes, you guessed it right - Facebook! So become our fan and as a thank you gift, get this guide FREE. Quick! Just Go to Facebook. Click on the "Like" button and Become a Fan of Equitymaster now!

"New figures from Japan offered a sobering reminder that the world's No. 2 economy remains fragile: The jobless rate rose, deflation deepened, and factories made fewer cars and mobile phones."

There's news from the housing market. This update from Bloomberg:

"About 18.9 million homes in the U.S. stood empty during the second quarter as surging foreclosures helped push ownership to the lowest level in a decade."

The number of vacant properties, including foreclosures, residences for sale and vacation homes, rose from 18.6 million in the year-earlier quarter, the U.S. Census Bureau said in a report today. The ownership rate, meaning households that own their own residence, was 66.9 percent, the lowest since 1999.

Lenders are accelerating foreclosures as borrowers fall behind in mortgage payments after the worst housing crash since the Great Depression. A record 269,962 U.S. homes were seized in the second quarter, according to RealtyTrac Inc. Foreclosures probably will top 1 million this year, the Irvine, California- based data company said in a July 15 report.

"There are a lot of people losing their homes and either moving in with family or renting places to live," said Patrick Newport, an economist with IHS Global Insight in Lexington, Massachusetts. "Foreclosures are still going up."

"Foreclosure filings climbed in three-quarters of U.S. metropolitan areas in the first half as high unemployment left many homeowners unable to pay their mortgages, according to RealtyTrac Inc. "

"The number of properties receiving a filing more than doubled from a year earlier in Baltimore, Oklahoma City and Albuquerque, New Mexico, the mortgage-data company said today in a report. Notices of default, auction or bank seizure rose more than 50 percent in areas including Salt Lake City; Savannah, Georgia; and Atlantic City, New Jersey. "

"Foreclosures are spreading out from areas that had been hardest hit," Rick Sharga, senior vice president for marketing at Irvine, California-based RealtyTrac, said in a telephone interview. "We're dealing with underlying economic weakness as opposed to unsustainable home prices and bad loans." the housing situation isn't great. But housing is not a leading indicator. It's a lagging indicator. It's what happens after people have lost their jobs, for example.

But then, as more and more foreclosures happen, more and more houses are available for purchase - many in desperate circumstances. Prices tend to fall. And then, people who still have jobs and houses find that they their net worth isn't what it used to be.

Already, millions of people are underwater. As housing prices fall, millions more will slip beneath the waves. Some will go down with the ship. But many will take to the life boats - sending back the keys instead. This will add to the number of foreclosures and to the inventory of unsold and vacant houses.

When does it end? It ends when it comes to rest on the bottom.

Where's that? No one knows. But just as houses tend to be priced at more than they're really worth in a bubble, they tend to be priced at less than they are really worth in a bust.

*** You can get a rough idea where the bottom in housing might be by doing a little math. You should be able to buy a house at a price where, financially, the decision to buy or rent is relatively neutral. There's no particular reason why a person should invest in a house rather than in stock or in other investments. His goal is to maximize his quality of life...and his wealth. So, if he can rent a house for less than he can buy it...he should rent, because that gives him the same quality of life at a lower cost, leaving him more money to put to work increasing his wealth. On the other hand, if he can buy more cheaply, he should buy...for the same reasons.

If houses are going up, he'll pay more for a house - in anticipation of the capital gains. But if prices are flat or falling - he'll look only to the stream of income he can get from the house (or the enjoyment he'll get from it personally)...and put on an additional discount to protect himself from capital losses.

Three years ago, it cost much more to buy a place than it did to rent it. A house you might have rented for $1,500 a month might have sold for $300,000. There's no way that was a good investment. A 6% mortgage alone would be $1,500 a month in interest. Once you'd paid upkeep and property taxes, you'd be in the hole.

Now, that house is down a bit...say, to $200,000 or $250,000. But it's still a long way from the point where it makes sense to buy rather than rent. Figure you need about 10% per year to pay taxes and maintenance. Plus another 7% for the cost of money. So a house purchase makes sense when you can rent for 17% of the purchase price. Or, to look at it from the other direction, if a house will rent for $1,500 per month, you can pay $108,000 for it.

Now, assume that the price overshoots on the downside. You might expect to pick up the house at a price under $100,000...say $79,000 or $89,000. Most areas are far from yielding bargains like that. *** Yesterday, the alarm went off. The French government requires us to have a smoke alarm. And since the house is used for large groups who hold conferences here, we're also required to have fire doors that close automatically when the fire alarm is sounded.

So when the fire alarm sounded, the heavy doors swung shut, supposedly cutting off the flow of oxygen to the fire.

What the planners apparently hadn't considered is what would happen to the old and the weak, trapped behind the fire doors. Our mother, 88, reports:

"When the alarm went off I didn't know what to think. But the cat was disturbed by the high-pitched noise so I thought we should both leave the room. But when I got out into the hall I discovered that the hall doors were closed. I tried to push them open, but I couldn't. The cat and I were stuck. It's a good thing it wasn't a real fire, or we would have been cooked."


Three out of four economists are wrong

What does an economist think... when he adjourns to the local bar...or is hauled away to the asylum? In the dead of night or the quiet of a confessional, does he laugh sourly at having fooled most of the people most of the time? Or does he curse his trade and feel like hanging himself?

The thing economists said was nearly impossible actually happened last week. Yields on 2-year US debt hit a record low just as the Treasury prepares for another record-setting deficit. The supply of Treasury debt and the demand for it hit new highs - together. Stranger things have happened. But the strangeness of this event has caused a furor loquendi amongst economists. Usually, there are only two major ways of misunderstanding current events. Now there are at least 4 of them.

Party economists take the party line; whenever the party flags, get out more gin. Now, they say the recovery is proceeding, thanks to adroit demand management. Unsurprisingly, since they are the authorities, they claim that record low Treasury yields mean investors have confidence in the authorities. Deficits don't matter, they add.

Another group - the Paul Krugman, Martin Wolf, Joseph Stiglitz wing of the neo-Keynesian faction - fear the recovery may stall, as it did in America in the '30s and Japan in the '90s. They say deficits do matter; they wish there were more of them. Low bond yields are cheap gin to them.

In opposition is a large group of "inflationistas." (Marc Faber, Jim Rogers...). They believe the authorities have already added too much monetary juice. And now they're afraid the feds will run bigger deficits and add even more monetary inflation. Along with tightened supplies and demand pressure from the emerging markets, this will cause consumer prices to rise more than expected. The dollar and bonds will be crushed.

A small group of 'hardcore deflationists,' meanwhile, believes falling yields prove the economy is sinking into deep hole of debt destruction and depression. (Robert Prechter, Gary Shilling) These Jeremiahs expect the main US stock index - the Dow - to lose 95% of its value and the bond market to continue to rise.

Yet another school of thought confines itself to this Daily Reckoning. It acknowledges that nobody knows anything, but it doesn't mind taking a guess. Herewith is its view, beginning with a critique of its opponents. Fair-minded reader, you be the judge.

Mainstream opinion is contradicted by the facts. Fewer people are employed today in the US than when the stimulus program began. Sales are down. Growth is falling. Credit is contracting. Even hair stylists and cab drivers know something is wrong.

As for the 'inflationistas' view, it makes sense. The feds add money. Prices should rise. But in Europe and America, the rate of consumer price inflation is generally ebbing. That's what low bond yields are really telling us; they signal deflation, not inflation. Maybe the inflationistas will be proven right, eventually. But for the moment, prices in the developed world are going down; they should remain weak until this phase of debt reduction is largely complete.

Meanwhile, 'hard-core' deflationists could be right too. A big credit expansion typically gives way to a big credit contraction. The past is not prologue, it is an account payable. Now it's due. But there's room for negotiation. If the 'hard-core deflationists' are right, credit will contract back to '70s levels and asset prices will correct as much. But a lot has happened since the Carter era. There's much more demand, for example, coming from all over the world. China is now a bigger energy consumer than the US, and a bigger auto buyer too. Demand for just about everything is growing. This new demand is bound to boost prices.

The supply side, too, puts a brake on deflation. The easy, cheap oil has already been pumped. Other resources - including food and water - require huge new capital investments before supplies will increase. Domestic inflation rates in China and India are already increasing. It's just a matter of time before the exporters put inflation in a shipping container and send it west.

But we don't need to rely purely on guesswork. We have an example right in front of us -- Japan. The island has been de-leveraging its private sector since 1990 - complete with ultra-low bond yields. Consumer prices fell. Between real estate and stocks, investors lost an amount equal to three years' total output.

Economists misunderstood it completely and gave consistently bad advice. And the authorities took the advice and squandered a whole generation's savings. But the world did not come to an end. Japan de-leveraged while the rest of the world went on a buying spree. Now, the entire developed world de-leverages, while the emerging world continues to shop.

Nobody knows anything. But readers should expect a long, soft correction just the same.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

Recent Articles

A New Infrastructure Boom March 26, 2019
Selva Freigedo talks about the potential in 5G network and how it could transform the way we communicate.
A 40 Somethings Guide to YouTube Hits March 20, 2019
Vivek dwells into a new YouTube phenomenon.
As the Economy Slows Down, Maruti and Two-Wheeler Companies Cut Production March 19, 2019
The country's largest car maker has cut production by more than a fourth.
In Supporting Demonetisation, RBI Behaved Like an Old Uncle Not Willing to Take a Stand March 13, 2019
The minutes of the meeting of the RBI Board which happened before demonetisation have been released.

Equitymaster requests your view! Post a comment on "The downward cycle of housing prices". Click here!