Jun292009

The Immunity Syndrome

One of the most important “big picture” lessons of The Great Housing Bubble is that when people believe they have no risk, they behave in very foolish ways. One of the most destabilizing impacts on our financial system was the development and widespread use of credit default swaps that convinced lenders and investors that they had no risk in large financial transactions. The people originating and pricing these instruments did not property analyse and price the risks they were taking on, and the resulting collapse destabilized our entire financial system and created the financial debacle we are enduring today.OCHN_periodical_ad

This foolish belief that there is such a thing as a no-risk financial transaction filtered down to individual buyers of residential real estate. With the easy money being supplied by the fools on Wall Street, the greater fools on Main Street were able to bid prices up on residential real estate to mind-boggling levels. There is an important concept to note with regard to this phenomenon:

The degree to which people believed neighborhoods were immune to price drops is the degree to which these neighborhood prices became inflated.

There is a direct correlation to the acceptance of the price immunity idea and the degree of price inflation; therefore, there is a direct correlation between the price immunity idea and the degree to which prices will collapse. I want to share three anecdotes with you today as indirect evidence of this phenomenon.

  1. In early 2008, I remember looking at properties in Newport Beach that were both for rent and for sale. I saw one property that was a small 3/2 ranch that needed updating. It was for rent at $2,700, and it was for sale at $1,400,000. WTF? A GRM of 518? One of our astute observers at the time was Surfing in Newport, and he said he had been researching properties like this for quite some time, and GRMs over 400 were the norm. That really opened my eyes. Best case scenario for these neighborhoods is that prices only cut in half.
  2. Back in 2007, we had a guy come into our forums and ask about properties in Newport Beach across the 73 from Turtle Ridge. When we suggested to him that these properties may decline significantly in value, he was incredulous. He said, “But this is practically in Corona Del Mar?” The implication of his statement was that there is some place on the planet where prices cannot go down, and this property is very close to it. Do you see the mentality? This is what drove prices so high.
  3. At the OC Register Blog, there is one of the long time bulls who lives near the water in Newport Beach. He has expounded his brilliant investment philosophy on a number of occasions; the gist of it is that you buy the most desirable properties in the most desirable neighborhoods because you will get the most appreciation, and your house values cannot go down. So far, this idea seems to be correct. That will change. Since this investing idea is not exactly unique or novel, many people acted on the same belief, and their actions drove prices up to unsustainable levels. I know a property owner in Corona Del Mar who purchased a home for $500,000 in 1995. That property appraised in 2007 (they were doing a renovation and needed to refinance) for $2,400,000. Does anyone think incomes have gone up nearly 500% since 1995? Realistically, the property is worth $800,000 at the bottom. Getting there from 2007 comps will require a 66% drop in prices; that is what’s coming.

Think how you would behave in a financial transaction if you really believed you had no risk of loss? Is there any price that is too high?

Imagine a room with 100 people representing the pool of subprime borrowers. These are new entrants to the market. They were previously unable to buy due to bad credit, lack of savings, and other reasons. All of them are told they are going to bid on an asset that never goes down in value, [this is where the belief that there is no risk takes over] and they will be given the ability to borrow unlimited funds (stated-income “liar loans”) The only caveat is the borrowed money must be paid back when the asset is sold (not that they care, they already have bad credit). Imagine what happens?

People start to buy the asset, and prices rise. Others in the room seeing the rising prices come to believe that the value of the asset never declines, and they join in the bidding. As the bidding drives prices even higher, a manic quality takes over the bidding and people compete with each other, often bidding higher than the asking prices. Nobody wants to be left out. There are fortunes to be made. Greed drives prices upward at a staggering rate. As the last of the 100 people buy, prices are very high, everyone has made money, and it looks as if prices will continue to rise forever . . .

Then something strange happens: there is nobody left to make a purchase. (A key indication of the end of a speculative mania is a huge decline in sales, as was witnessed over 2006 and 2007). Transaction volume drops off dramatically, and prices stop their dizzying ascent. Nobody is particularly alarmed at first, but a few of the more cautious sell their assets to pay off their loans. Since there are no more new buyers, the first selling actually causes prices to drop. This is unprecedented: prices have never declined! Most ignore the problem and comfort themselves with the history of rising prices; however, a few are spooked by this unprecedented drop and sell the asset. This selling drives prices even lower. Now those who still own the asset become worried, some continue to deny that there is a problem, and some get angry about the price declines. Some of the late buyers actually owe more than they paid for the asset. They sell the asset at a loss. The lenders now lose some money and refuse to loan any more money to be secured against the asset. Now there are even fewer buyers and a large group of owners who all want to sell before prices drop any lower. Panic selling ensues. Everyone wants to sell at the same time, and there are no buyers to purchase the asset. Prices fall dramatically. This asset which was sought after at any price is now for sale at any price, and there are few takers. People in the market rightfully believe the asset will continue to decline. Owners of the asset have accepted the new reality; they are depressed and despondent.

In any group of people, there are always a few who do not believe the “prices always rise” narrative. Some recognize that asset prices cannot rise indefinitely and cannot stay detached from their fundamental valuations. These people witness the rally and the resulting crash without participating. They wait patiently for prices to drop back to fundamental values, and then these people buy. As these new buyers enter the market, prices stop their steep descent and market participants start to hope again. It takes a while to work off the inventory for sale in the market, so prices tend to flatten at the bottom for an extended period of time; however, just as spring follows winter, appreciation returns to the market in time, and the cycle begins all over again.

What is written above is true of any asset whether it be stocks, bonds, houses or tulips. In this case, it is the local housing market, and the room of new buyers represents subprime borrowers, but the concepts are universal. One phenomenon somewhat unique to the housing market is the forced sale due to foreclosure (stocks have margin calls). Even if the psychological factors at work during the panic could somehow be quelled, the forced sales from foreclosures would drive down prices anyway. True panic is not required to crash a housing market, only dropping prices and an inability to make payments. Subprime lending was one of the leading causes of the Great Housing Bubble, and its implosion exacerbated the market decline.

When you track the psychology of the market, you can see the low end is reaching capitulation. There is no more denial and fear, there is only acceptance of their fate. The mid- to high-end of the market is starting to feel fear, but their is no capitulation — yet. The very-high-end in the “immune” areas may never capitulate. Like some of the crazy bulls that come and go, they may maintain their denial in the face of the obvious. The next couple of years will be an interesting market train wreck; we will all be watching.