Wednesday, February 27, 2008

Housing Crisis Will Get Worse, Much Worse

Home prices in certain cities like L.A. and Miami have dropped quite a bit recently, but I believe that the pain has only begun. When it is all said and done, home prices in these two cities may drop by as much as 41% and 44% respectively. This will financially destroy thousands upon thousands of people.

I don’t usually buy into hysteria, but I think that the data and the logic are there. Also, let me caution those that live outside of the West Coast, Arizona, Las Vegas, Florida, and the urban Northeast. I have found virtually no evidence that any bubble exists at all for you. To explain this bubble, let me start with a little background.

How did the housing bubble happen?

The housing bubble happened for three reasons:

1) The federal reserve has been lowering interest rates for 25 years now and those interest rates trickle down into the mortgage rates. The lower the interest rates, the more house we can all afford. The more house we all can afford, the higher home prices will go.
2) Subprime, no down payments, and adjustable rate mortgages allowed people in high cost cities to overextend themselves. Companies relied on default rates to price the interest rates on these loans. These default rates were masked by continually rising home prices. That is, fewer people walk away from a mortgage when they have rapidly rising equity in their home. They sell quickly instead of foreclosing.
3) Smart Growth urban planning restricted the supply of houses and drove up prices. A number of economists believe along with a gentleman named Wendall Cox who I was privy to hear speak on Feb. 26, believe that smart growth planning has been the largest contributing factor to the home price spike in many cities around the U.S. Smart Growth limits the supply of new houses and condos, and in a popular city that will lead prices to soar.

Why has the bubble burst?

The bubble busted in three different waves, and I think a third fourth is coming. The first wave came when the amount of capital (or money) needed to maintain this upward climb simply started to run out. There is a limit to the amount of resources we put into real estate. Eventually we have to start thinking about other priorities. The second and third waves came with the nature of mortgage lending. Adjustable Rate Mortgage rates suddenly jumped and many people, especially those who intended to flip a house with an ARM, could no longer afford their mortgage and had to default. Those with other exotic loans who could no longer afford them had to default as well because home prices were no longer rising fast enough to avoid foreclosure. The fourth wave is coming, and I will talk about it later.

How did you calculate this?

According to the S&P/ Case Shiller home price index which measures home prices in 20 large metropolitan areas throughtout the U.S., home prices in LA have already dropped almost 15%. In Miami, Phoenix, San Diego, and Tampa the price drops are even more shocking at 18.9%, 17.5%, 17.5% and 15.9% respectively. So, it may be surprising to hear that I believe that prices will continue to fall much further.

First, I looked at the stock market bubbles in the S&P and the NASDAQ in and around 1999. When I graphed the data, I was a little surprised to see that there seemed to be a modest growth trend for many years and then suddenly a sharp upward turn, hitting a peek, and then a sharp slide back to down to where that growth rate pointed before the bubble. It was true for the S&P and the NASDAQ.

I graphed the historical data available for the S&P/Case Shiller home price index as well. It appeared that, so far, home prices in many of these “bubble” markets looked almost exactly like the S&P and NASDAQ bubbles. I then calculated the home price growth rate between 1987 and 2002 (before the bubble). I then projected that growth rate out to Jan. 2008 to see what the home price “should be”. This is what the projection portends for certain markets:

Miami -32%
Los Angeles -31%
Tampa - FL -28%
Las Vegas -28%
Washington -24%

These drops are in addition to the drops that have already occurred.

It won’t be that bad will it?

I have seen several articles claim that home prices won’t fall dramatically, that there will be a “soft-landing”. They claim that as prices fall many people just won’t try to sell their houses. When fewer people try to sell their houses, the supply of homes for sale drops which causes buyers to compete for the remaining supply.

Hopefully, this is true, but I suspect that it will not be enough. Earlier I mentioned how many economists believe that smart growth urban planning have limited the supply of housing which has driven home prices sky high. This is only part of the economic story.

Not only has supply of homes been limited, but the supply curve has become more inelastic. In laymen’s terms, this means that even small changes in demand lead to big price swings. The very nature of the market that lead to rapid price spikes, like when homes in Pheonix and Las Vegas shot up by over 40% in a single year, can lead to rapid price drops.

The other thing working against this “soft-landing” theory are the number of foreclosures. Many people can pull their homes off of the market, but the hoards of foreclosures will limit the ability of the market to absorb all of the homes for sale.

What about this "fourth wave"?

There are two components to the fourth wave. Most of the focus on mortgage borrowing is on initial mortgages, but there are also millions of Americans who have borrowed from their home equity. These people are at risk of foreclosure if prices plummet and they get into a situation where they have to sell their home, like extended unemployment.

The unemployment picture in many states most affected by the housing bubble is growing dramatically worse.

California Unemployment 9 months ago 4.8% Today 6.1%
Nevada 9 months ago 4.3% Today 5.8%
Arizona 3 months ago 3.3% Today 4.7%
Florida 9 months ago 3.3% Today 4.7%

Compared to states where the bubble never hit:

Texas Unemployment 9 months ago 4.3% Today 4.5%
North Carolina 9 months ago 4.5% Today 5.0%

What can we do?

My concern for the next few years is that the housing bubble will be solely blamed on reckless mortgage companies, and not on smart growth urban planning. If smart growth does not get the blame, this cycle will repeat in just a few years. Excessive urban planning is the main reason why prices have soared and plunged.

And, of course, don’t buy houses in any of these bubble markets.


bearmaster said...

We did a vacation tour of the west last summer for the purpose of looking at housing and came to the exact opposite conclusion - the bubble exists EVERYWHERE. Sure, it isn't as extensive in some places as it was in, say, Los Angeles. But there is no way I'd pay the asking prices these other places want - it still looked and smelled like a bubble.

Reno was still in a heavy construction boom as we drove by - I don't know if that's changed. The Las Vegas strip must have had at least a dozen hotel construction projects going while we were there.

I looked at some houses in Ely NV in a pretty dumpy neighborhood. My guess at asking price - $130,000. Actual asking price - $260,000. The outskirts were not as bad though. There was even a development of tiny houses. I don't recall what they wanted for them.

St. George, UT as far as I'm concerned is steadily being ruined. Big builder housing developments set up in the pretty red rocks. People think St. George is cheap but I got the impression from talking to a few locals (who happened to be California escapees - imagine that!) that people are leaving one bubble and creating new bubbles in other areas.

The one difference could be if people plunk down cash entirely on these new areas so they don't pay a mortgage - that might help stabilize those areas containing California escapees. But if the escapees make the mistake of otherwise squandering their California windfalls...

I have a stack of real estate literature on the floor of my den from the trip. I hope to repeat the trip in a few years to see if anything's changed.

The cheapest housing we found was in the Las Vegas area - a mobile home - for about $35,000. And if we wanted to go ultra-cheap rent to ride out the storm there's always Battle Mountain - but that's for if we get desperate.

Brian Shelley said...

You may very well be correct. The S&P Schiller doesn't have data on every city. For some reason they don't collect data on Houston or Philadelphia even though both metros are around 6 million people.

I think it will be sad for many communities that are affected by this even though they weren't causing the problems.