How Bad Could Bad Get?

Many people when they first discover bubble blogs think housing bears are tinfoil-hat-wearing crackpots with extremely pessimistic outlooks on life. There are perma-bears (Roubini, Shiller, Fleckstein) as well as perma-bulls (Watts, NAR, Kudlow). The truth is generally somewhere in between. I learned long ago that extremists are never happy people because they seldom get their way. As the Buddha noted, it is the “middle path” that leads to happiness. I have spent my voting life as a independent/Libertarian voting for whoever I believed to be the best candidate, most generally a moderate. However, there are times when what is perceived as an extreme is actually the correct view. As Barry Goldwater noted, “…extremism in the defense of liberty is no vice! … moderation in the pursuit of justice is no virtue.” Many who read my post “Predictions for the Irvine Housing Market” thought the scenario I described as extreme. It only looks extreme because the psychology of the bubble as skewed the collective perspective of the market. That Predictions post was moderate; this one is extreme.

We have been witnessing a great deal of bad news lately, the impact of which cannot be good. If the perfect storm continues to form over our local housing market, things could become much worse, much faster than even the most bearish among us think possible. Have any of you noticed the carnage in Sacramento? For the doomsday scenario to take place, we would need the following: Foreclosures, unemployment, rising interest rates and tightening credit, and a decrease in home ownership. The combination of these forces could make the price collapse a catastrophe.


We all know the wave of foreclosures is coming.


And it should continue unabated for 5 more years.

March 2010 ARM Reset Schedule big

There isn’t much more to say. It is not bad yet, but it will be very bad, and it will go on for a long time.


We know layoffs are coming to Irvine/Orange County. New Century went bankrupt along with numerous other sub-prime lenders based in Orange county. People are already losing jobs. I think it is save to speculate this will have ripple effects through the local economy. Even if unemployment remains low, how much will incomes decline? Mortgage brokers, realtors and others in the REIC have been living on the transactions created by the borrowing of those about to go bankrupt. They may find other work, but the $250,000 a year days are over. The only mystery is how bad the unemployment problem will become. Right now, things don’t look good.

Rising Interest Rates and Tightening Credit

We know mortgage interest rates are near historic lows.


The large number of foreclosures will make lenders more cautious (either that or the losses will put them out of business). Increased lender caution will result in a tightening of credit and an increase in interest rates to compensate them for the increased risk. An increase to 8%, which is near the historic norm, would seem to be likely. If lenders become very cautious, an overshoot to 10% or more could easily take place. Interest rates have not begun to rise yet, and many are holding out hope that the FED will save them. It won’t. Due to the increasing risk premiums, the best one can hope for is a lowering of the FED funds rate to compensate for the increased risk premium. We will have to wait and see.

Credit is already tightening. This cannot be denied. The increased cost and decreased availability of credit will have a severe impact on demand.

lending standards

Credit Suisse estimates the most recent credit tightening just eliminated 21% of the borrowers in the market. This is assuming further problems in Alt-A or prime loans do not force credit to tighten even further (in other words, credit will tighten further.) This will crush demand and it will also put an end to serial refinancing. The inability to refinance is what will cause all the resets shown in the previous chart to go into foreclosure. Which leaves us with the most important question: Who is going to buy all of these houses in foreclosure?

Decrease in Home Ownership Rates

Ownership rates in Orange County have risen 2.8% between 1994 and 2005. This is actually behind the rest of the country where homeownership rates have increased nearly 5%. This is a direct result of lending money to those borrowers previously excluded from the housing market either because the borrower did not have the downpayment, or they lacked good credit.


Home ownership rates will decline as homeowners lose their homes in foreclosure. With foreclosure comes bad credit; those with bad credit just got eliminated from the buyer pool. Therefore, people who lose their house to foreclosure will move into a rental, and the previously owner-occupied home will likely enter the rental pool. (A popular misconception is that rents will go up. The number of rentals will increase along with the number of renters.)

There will be some new buyers (like many on this board) who have cash and good credit; however, this group is small in number, far smaller than the number of foreclosures about to hit the market (if you don’t believe me, ask yourself how many potential buyers you know with cash and good credit.) This means a significant number, perhaps a majority, of the houses due to hit the market due to foreclosure will be purchased as rentals.

If the bulk of the houses going through foreclosure are going to be purchased as rentals, prices will have to decline to the point where a rental generates a positive cashflow. Prices are double that today! Home prices will have to decline at least 50% for properties to make financial sense as rentals, so if this is the fate of the bulk of the upcoming foreclosure inventory, prices will decline at least 50% before buyers will enter the market and adsorb this inventory.


Foreclosures, unemployment, rising interest rates and tightening credit, and a decrease in home ownership are all required in some measure to create the doomsday scenario. Do I think this will happen? Probably not, but it could. Did anyone think the NASDAQ could drop from 5200 to 1200 from 2000-2003? Did anyone think housing prices in California would drop from $200K to $177K from 1991-1996 in our last “correction?” Did anyone think real estate prices in Japan would drop 64% between 1991 and 2005? When bubbles collapse, they often drop lower and last longer than anyone thinks.

Today we do not have any of these conditions to an impactful degree. Maybe these conditions will not develop further; however, all indications are that these problems will develop and get worse. So how bad could bad get? Ask them in Sacramento, their party is just getting started.