The next housing market deflation will be a long, slow grind

Prices in many housing markets around the country are rising at unsustainable rates. The last time this happened was 2004-2006, and the pundits at the time 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.

The bust from 2007-2009 was characterized by steeply falling prices. It was a relatively quick and severe crash by real estate standards. Residential real estate prices rarely fall, and when they do, they are generally “sticky” on the way down because discretionary sellers are loathe to sell at a loss. The only way residential real estate prices fall quickly is if must-sell inventory comes to market.

The bears pointed out 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. The delinquencies did, but the foreclosures did not. Many bulls erroneously claim the bears were wrong. The fact is that the foreclosure process became p0liticized, and 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 got to live payment-free. 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, If prices are inflated above levels of payment affordability, no amount of supply restriction helps. 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 have already 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 brings prices back in Riverside County, prices in Orange County will likely be in 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 Irvine) 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.

SCHIFF: The Housing Bubble Is Reflating, And It Will Crash Again

Peter Schiff, Euro Pacific Capital –Jun. 1, 2013, 4:41 AM

… The strong housing data is taken as proof that the economy has turned around and that a recovery is under way. Cooler heads may simply see how government policies have channeled money into real estate in order to reflate a bubble that has been collapsing for the last five years. Although the money is entering the market through slightly different paths than it did in 2005 and 2006, its effects on housing, and the broader economy, are the same as they were before the bubble burst. When the inevitable happens again, the ensuing damage will be eerily familiar.

Will it be different this time? In some ways, I think it will be. It won’t be different in that a price decline will be avoided or HELOC abuse will be permanent, but we may not see the sudden and rapid decline in prices we saw last time.

After five years of dismal real estate performance and a lackluster economy, it’s hard to fault people for believing that rising home prices are a good barometer of economic health. There can be little doubt that rising home prices feel good. Even single digit appreciation can make modest home buyers feel like mini-moguls. The effect is magnified in a falling interest rate environment where any appreciation can be instantly turned into an opportunity for cash out refinancing. The “wealth effect” created by such activities then translates into consumer spending and other seemingly positive economic developments. But some things can taste great but be very harmful (cinnamon buns come to mind). It felt good when real estate prices were rising during the pre-financial crisis bubble, but that rise only exacerbated the problems when the bubble burst. The questions we should now be asking ourselves is why are prices rising, are those higher prices sustainable, and what are the costs to the broader economy?

The truth is that most buyers cannot afford today’s prices without the combination of government guarantees and artificially low mortgage rates. The Federal Reserve has been conducting an unprecedented experiment in economic manipulation. By holding interest rates near zero and by actively buying more than $40 billion monthly of mortgage-backed securities and $45 billion of Treasury bonds, the Fed has engineered the lowest mortgage rates in generations. At the same time, Federal control of the mortgage industry has become nearly complete, with government agencies Fannie Mae, Freddie Mac, and the FHA buying or guaranteeing virtually all new mortgages. In addition, a variety of Federal programs, such as the Home Affordable Modification Program (HAMP) are in place to help keep underwater homeowners in homes that they could not otherwise afford. Taken together, these programs create far more favorable terms for home buyers than those that existed before the crash.

Imagine that we had no housing bubble. If prices were hovering near affordability limits in 2006 with interest rates at 6.5%, what would have happened if the federal reserve lowered mortgage rates to 3.5%? We probably would have had a huge rally in house prices, and everyone would be worried about rising rates bringing prices back down. If you want to see this dynamic in action, take a look at the concerns over Canada’s house prices.

… But their (investor) activities have a latent downside. The new ownership class is not motivated to buy and hold the way Mom and Dad would. They are not looking for a place to live, raise families, and retire. They are simply looking for a decent return on equity relative to other investments. Many would happily put money in higher yielding bonds where landlord headaches don’t exist. If better deals beckon, or if risks increase in the real estate market, the homes they bought will be dumped even faster. …

I don’t believe Mr. Schiff is right about investors dumping their properties, but I do believe future investor sales will limit appreciation.

The current combination of low rates and investor demand has succeeded in pushing up prices. But that doesn’t mean the market is healthy. For the first quarter of 2013, the Federal Reserve reports a 10% delinquency rate for residential mortgages (those with payments that are at least 90 days past due). This is more than 6 times the rate in the first quarter of 2006. In contrast, credit card delinquencies currently stand at 2.65%, the lowest rate in decades and 31% lower than the rate in the first quarter of 2006. Whether it is by choice, or simply by the ability to pay, Americans are clearly placing a low priority on paying their mortgages. …

As I recently noted, 1.7 million borrowers are seriously delinquent on government-backed loans.

The “wealth effect’ from rising home prices combined with the similar influence of rising stock prices creates an aura of recovery. In fact, this week’s revisions to first quarter GDP revealed that consumer confidence and spending are up despite real discretionary per capita incomes plunging at a 9.03% annualized rate. That is worse than the largest plunge during the 2008-2009 crisis (7.52%). Additionally, the household savings rate fell to an abysmal 2.3%, the lowest since the 3rd quarter 2007. Debt-financed consumption supported by inflated asset prices is what led to the financial crisis of 2008. It’s amazing how willing we are to travel down that road again.

The problem with federal reserve intervention is that it merely perpetuates unsustainable financial behavior. Ponzi schemes all ultimately fail. Whether those Ponzi schemes are run by businesses or individuals, they all fail, and it’s very painful when they do. However, the pain is necessary because sustaining and reflating Ponzi schemes only leads to more pain later. Recessions are supposed to be cleansing, but the federal reserve circumvents this natural cleansing process and promotes financial illness.

Of course rising asset prices are completely dependent on continued Fed support. As we have seen time and again, whenever the Fed even hints at tapering its massive QE programs the stock market sells off.

And the recent spike in interest rates from 3.5% to 4.0% over the last few weeks bears this out in the bond market as well.

The housing market is even more dependent on that support. Given the risks, it is arguable that no private market for home loans would even exist without government intervention. The bubble that popped in 2008 consisted mainly of government-guaranteed mortgages. This time, the mortgages are not merely government-guaranteed, but government owned.

You will be paying nearly all the costs of the next bailout should one occur.

In the meantime, by blowing more air into a deflating housing bubble, the Fed is misdirecting money into a sector that investment capital should be avoiding. A successful economy can’t be built on housing. Rather, a robust real estate market must result from a healthy economy. You can’t put the cart before the horse. As a nation, we do not need more houses. We built enough over the last decade to keep us well sheltered for years. Private equity funds should be using their investment capital to fund the next technology innovator, not wasting it on townhouses in Orlando and Phoenix.

Houses don’t produce anything. They are an item of consumption. Money invested in housing provides no long-term benefit, unlike a factory that will produce goods and services for many years. Capital improvements are a far better investment of our national wealth.

Of course the real risks in housing center on the next leg down, in what I believe will be a continuation of the real estate crash. We can’t afford to artificially support the market indefinitely. When significantly higher interest rates eventually arrive, the fragile market will again be impacted. We saw that movie about five years ago. Do we really want to see it again?

The mainstream media is eager to deny his conclusion as the conspiracy to downplay the risks in housing plays out:

Higher Mortgage Rates Won’t Kill Housing Recovery

Will higher mortgage rates kill the housing market? Maybe not!

Perhaps higher interest rates won’t cause a housing crash as Mr. Schiff suggests, but it certainly could cause a long, slowly grinding deflation as affordability limits drop due to rising interest rates.

Over-improve then walk away

Today’s featured property was extensively renovated during the housing bubble. It was over-improved, and the owners couldn’t sustain ownership. Rather than funding their improvements with cash or commercial lender financing, these owners took out very large private party loans to do their work. One of these second mortgage lenders foreclosed on the property, and they are hoping to sell it for enough to pay off the first mortgage, get their money back, and turn a profit. Perhaps in our restricted inventory environment, they might pull it off, but with the steep discounts typical REOs in this price range sport, they may struggle to pull it off.

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34752 DOHENY Pl Dana Point, CA 92624

$1,499,000    ……..    Asking Price
$254,000    ……….    Purchase Price
10/12/1995    ……….    Purchase Date

$1,245,000    ……….    Gross Gain (Loss)
($119,920)    …………    Commissions and Costs at 8%
$1,125,080    ……….    Net Gain (Loss)
490.2%    ……….    Gross Percent Change
442.9%    ……….    Net Percent Change
10.4%    …………    Annual Appreciation

Cost of Home Ownership
$1,499,000    ……..    Asking Price
$299,800    …………    20% Down Conventional
4.48%    ………….    Mortgage Interest Rate
30    ………………    Number of Years
$1,199,200    ……..    Mortgage
$297,033    ……….    Income Requirement

$6,062    …………    Monthly Mortgage Payment
$1,299    …………    Property Tax at 1.04%
$0    …………    Mello Roos & Special Taxes
$312    …………    Homeowners Insurance at 0.25%
$0    …………    Private Mortgage Insurance
$0    …………    Homeowners Association Fees
$7,673    ……….    Monthly Cash Outlays

($1,734)    ……….    Tax Savings
($1,585)    ……….    Principal Amortization
$496    …………..    Opportunity Cost of Down Payment
$395    …………..    Maintenance and Replacement Reserves
$5,246    ……….    Monthly Cost of Ownership

Cash Acquisition Demands
$16,490    …………    Furnishing and Move-In Costs at 1% + $1,500
$16,490    …………    Closing Costs at 1% + $1,500
$11,992    …………    Interest Points at 1%
$299,800    …………    Down Payment
$344,772    ……….    Total Cash Costs
$80,400    ……….    Emergency Cash Reserves
$425,172    ……….    Total Savings Needed
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