The next housing bust will see small price drops and large volume declines

Since lenders will can-kick during future times of economic weakness, houses may not be affordable, bringing sales volumes down, but prices probably won’t decline much.

In 2004-2006, the pundits said that appreciation would moderate and resume its “normal” 5%+ yearly rates in the future. Gary Watts even assured us that “Fifteen percent is pretty much in the bag for Orange County in 2006,” he says. “It’s impossible for prices to go down this year.”

It’s difficult to imagine a statement that was more wrong.

But Gary Watts wasn’t alone in his delusions. Most people who bought property in 2004-2006 assumed house prices were going to rise 10%+ per year forever. Recency bias pervades financial markets and taints investors’ decisions.

Prices fell steeply in the bust from 2007-2009. Real estate markets ordinarily don’t move down quickly, so the bust from 2007-2009 was relatively quick and severe. Residential real estate prices rarely fall, and when they do, prices are generally “sticky” on the way down because discretionary sellers loathe selling at a loss. The only way residential real estate prices fall quickly is if must-sell inventory comes to market — which probably will not happen again, at least through bank foreclosures.

Housing bears of the era noted that the toxic loans of the bubble rally were due to go bad on a roughly predefined schedule starting in 2007, with or without a weakened economy or recession. Once these loans reset their interest rates and recast to fully amortized payments, the payment shock would cause huge numbers of delinquencies. In turn, these delinquencies would be promptly processed by banks who needed the capital and liquidated as REO.

In fact, this is exactly what happened in 2007 through early 2009, and the first wave of foreclosures decimated prices in subprime lending areas because those loans recast first. A second wave was due to wipe out everything else from 2009 to 2011.

As we all know, the much-anticipated wave of foreclosures from the 2009 to 2011 delinquencies did not materialize, as you can see if you click here. The delinquencies occurred as expected, but the foreclosures did not. Many bulls erroneously claimed the bears were wrong.

With millions of delinquent and unhappy borrowers, the foreclosure process became politicized. Government regulators allowed the banks to change their accounting rules to avoid foreclosing on their legions of delinquent borrowers.

The delinquent borrowers who couldn’t afford the payment under the terms of their toxic mortgages became squatters. The banks wouldn’t or couldn’t foreclose, and the borrowers enjoyed a payment-free life. Over time, others recognized the predicament of the banks and strategically defaulted so they too could enjoy the benefits of free housing.

Lenders began cutting deals with delinquent borrowers to try to get them to pay something until prices rose enough to allow the bank to foreclose without a loss. Other than the housing bears, few in 2009 realized just how severe the troubles for the housing market were. Failed stimulus in 2009 and 2010 created a false rally which was followed by 18 consecutive months of falling prices.

What the banks learned throughout this ordeal was that they needed to limit the must-sell inventory on the market in order to stop house prices from crashing. Once the accounting rules were changed in 2009, the rate of price decline slowed, partly due to stimulus, but mostly due to a reduction in foreclosure inventories.

However, with prices inflated above levels of payment affordability, no amount of supply restriction could turn the tide. In early 2012 interest rates were at record lows which made houses relatively affordable in nearly every market. Further, can-kicking loan modifications were selected over foreclosures which greatly reduced must-sell REO inventories. High affordability and low inventory caused the market to bottom.

Unfortunately, interest rate stimulus is a blunt instrument. It applies stimulus everywhere rather than in selected markets that need it. As a result, markets like Coastal California reflated back to the limits of affordability, and with the ultra-low supply, there is growing concern of a new bubble. By the time interest rate stimulus brought prices back in Riverside County, prices in Orange County were approaching bubble territory.

The best analysis I’ve seen of the differential impact of interest rate stimulus — and its ultimate removal — comes from Fitch. The best markets (think San Francisco) will probably overshoot to the upside from the stimulus, then slowly deflate as the stimulus is removed. The weaker markets that are still well below their affordability limits (think Las Vegas) will likely continue to rise.

If we do overshoot fundamental values to the upside from excessive housing market stimulation, we will have to endure another market decline. With the lessons from the last crash, lenders will be hesitant to process their foreclosures quickly and flood the market with REO. Plus, most of the loans today are 30-year fixed-rate mortgages which historically have proven much more stable. In all likelihood, the next market deflation will be a long, slow grind as prices gently fall along with affordability limits.