Housing Prices Near or at Bottom? ( Why the housing bears are wrong )

Smart Money ^ | May 2, 2008 | Donald Luskin

[SeekAndFind]

IF YOU WANT TO know how smart I am, read my columns. If you want to know how stupid I am, read the comments section of my columns, where readers get to rip what I say to shreds.

Used to be that when supposed "experts" like me talked, all people could do was listen. Now they can talk back, and their ideas can compete with mine head-to-head on the web.

The most frequent criticism I get in the comments section is that, in my generally bullish view on the economy and the stock market, I'm overlooking the lethal effect of the housing collapse. No matter what argument I make about why folks should be buying stocks or why the economy isn't really in a recession, there's always that one-word answer: housing. It's like a magical incantation. All one has to do is say it, and bulls fall over dead.

So let's talk about housing. I look forward to seeing what kind of response I get. Because, yes, I'm going to find something bullish to say about it.

First, let me say that I'm not denying that the housing sector of the economy is in a downright depression. Has been for a while now. But for me, that's just a starting point for analysis. It tells you nothing in and of itself.

How bad is it? It's bad, alright. According to the latest GDP data released on Wednesday, the housing sector of the economy contracted at a 27.1% annual rate in the first quarter, making it the 10th worst quarter since records have been kept.

This is the ninth quarter in a row of a decline in the housing sector, with eight of the quarters showing double-digit drops. As a nine-quarter run, it's the second worst in history — actually, it's almost a tie for the very worst.

How about home prices? According to the Case-Shiller Index — the housing index most often cited by the bears — home prices are 15% off their highs of about two years ago. It's hard to rank that historically, because the Case-Shiller Index doesn't go back very far. But I'm confident that this is among the largest declines ever.

So am I ever going to get to the bullish part? Yeah, here it comes.

I'm not going to get up on the table and dance here. But let's take a deep breath and remember one very important thing about all markets, including the housing market: They simply cannot go down forever.

They cannot go up forever, either. The bears who were predicting a housing collapse two years ago were right. But the bears are making the same arrogant mistake now that the bulls made then. At some point, enough is enough — and a smart investor knows when to call it quits.

Markets reach extremes, whether highs or lows, and then correct in the other direction, for one axiomatic reason: value. At the very highs, things just aren't worth any more. At the lows, they just aren't worth any less.

I'm not here to tell you that home prices are at absolute bottom this very moment. But I can argue pretty persuasively that they might be. Or that they are close.

What establishes value in a home price? Like anything else, it's a question of historical norms. So how do we determine the norms? Try this way on for size.

Let's think of value in terms of affordability — the ability of people to buy the home they want. That has three elements. First, home prices — the lower, the more affordable. Second, mortgage rates — again, the lower, the more affordable. Third, personal income — the more of it, the more affordable.

Put it all together by calculating the annual mortgage payment you'd have to make to buy a house at the average home price, and then take that as a percentage of income. The smaller a percentage, the more affordable the home.

Let's look at the history. For home prices, we'll use the National Association of Realtors' index. It's showing about the same price decline as Case-Shiller, but I like it for this exercise because the data goes all the way back to 1972 (Case-Shiller only goes back to 1987). For mortgage rates, we'll use the Freddie Mac's 30-year fixed rate index. And for income, we'll use the Commerce Department's estimate of per capita disposable personal income.

And guess what? Today home prices have fallen so much, mortgage rates are so low, and personal income is so high — that homes are more affordable today than at any other time, ever — with mortgage payments on the average home eating up about 40% of income. (Keep in mind, disposable personal income is after-tax income; also, this is calculated on an individual basis, not a household basis.)

With houses more affordable than ever before, why should we expect prices to fall much further from here? Yet the bears insist that they will. Kind of like insisting that the Nasdaq will go to 6000 just because it's at 5000, no?

We can use the same kind of logic — the idea that markets at extremes can't keep getting more extreme forever — to analyze the effect of housing on the economy.

Precisely because residential investment has been cratering for nine quarters, it's become a very small fraction of total GDP — only about 3.4%. At this point, further steep declines (if any) just can't have that much of an effect on the general economy.

Let's put it in concrete terms — jobs. Since the housing market started coming apart two years ago, jobs in the housing sector — broadly construed, to include everything from bricklayers to mortgage brokers — have already declined by over 1.5 million. That's about 1% of the whole national labor force, and it takes housing employment back to where it was in 2000 before the so-called "housing bubble" even got started. Which begs the question: How many more jobs are there to lose in this sector?

So let's head to the comments section. Go ahead, bears, take your best shot. Tell me how bad it is. And the more you do that, the more I'll say that you've had your day.

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Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at don@trendmacro.com.

[Southerngl]

It just sounds very ‘pajama blogger’ to me.

[Neidermeyer]

That leverage is GONE. Period. See ya. We can see new regulation coming down the tunnel every week now that is going to prevent the sort of lending stupidity of 2003 to 2006 from happening again.
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My aunt is moving to the Atlanta suburbs ,, she contracted on a nice small house at a price equal to what it sold for in 2000, the bank/mortgage lender refused to finance until the price came down an additional 10%, the seller agreed to the price reduction... my aunt has so-so credit but no debt and SS income and a gov’t pension , basically a no-risk customer for the bank... The banks ARE tightening substantially.

In my neighborhood I know of more than a few bank REO properties that are not on the market and probably won’t be for several years.. These properties will cap any price strength for quite a while, several owner occupies for-sales have been taken off the market also... I see at least 2-3 years before we get firming bids.

[loreldan]

If this chart is correct just about every single bank will go under. The average house value was around $220,000. So in the next year and definitely by 2012 most homeowners will be upside down in either their mortgage or home equity line. There will be no reason to keep the house so they will be abandoned or the banks will have to renegotiate mortgages and write off the losses.

Eventually when all these homes are abandoned there will be a shortage of property owners. Rent will skyrocket which will raise home prices again.

[Polybius]

If this chart is correct just about every single bank will go under. The average house value was around $220,000. So in the next year and definitely by 2012 most homeowners will be upside down in either their mortgage or home equity line.

I'm quite certain that "most" does not apply here unless, six years ago, America had already become a nation populated mostly by children with absolutely no impulse control.

I have two houses paid off and my debt load has been zero since 1997. That is not something that I consider extraordinary. That is something "most" Americans used to strive for.

For "most" Americans to be upside down, they would have had to borrow more money on home equity lines than all the equity they had ever accumulated before this Bubble stupidity began.

There will be no reason to keep the house so they will be abandoned or the banks will have to renegotiate mortgages and write off the losses. Eventually when all these homes are abandoned there will be a shortage of property owners. Rent will skyrocket which will raise home prices again.

In such a scenario, houses will not be "abandoned" like Thursday's leftovers.

The houses will belong to the mortgage holders, Property Management companies will step in to fix up the houses for cost plus a nice profit margin and then rent the houses out for 10% to 15% of the monthly rent as commissions.

The housing needs will be fully met by rental properties and nobody in their right mind will buy a house until the houses are priced where payments on down payment PLUS principal PLUS interest PLUS taxes do not devastate the household income.

Houses will then be like Delta Airlines jet aircraft. You rent a temporary seat for a certain period of time on a Delta Airlines jet but no average citizen ever considers actually buying such a jet at the prices they sell for.

[Right Wing Assault]

Location, location, location. Northern Ohio. Nice suburb. No packrats.

5 Bed, 3.5 Bath; 4,080 Sq. Ft.; 0.38 Acres; $264,900 (probably overpriced by about $30k)

[Jacquerie]

No, but there are plenty of examples where markets go down for 30 or 40 years.

Okay, name a few.

[RipSawyer]

“Today home prices have fallen so much, mortgage rates are so low, and personal income is so high — that homes are more affordable today than at any other time, ever — with mortgage payments on the average home eating up about 40% of income.”
>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>

Yep, the man is an idiot all right! Back in the sixties any banker worth his salt would have refused to lend fifty cents to someone who proposed to spend forty percent of income on a mortgage payment. Best I remember they used to tell people not to spend more than twenty five percent of TAKEHOME pay max.

[KTM rider]

if you dropped that house into my town, redondo beach california it would be going for OVER 2 million easy and would probably sell in 6 months or less to a rich foriegner or movie star

[KTM rider]

"No, but there are plenty of examples where markets go down for 30 or 40 years.

Okay, name a few. " Japan.....lol ! !

japan recovered from the bubble burst of 1945 but never did recover from the bubble burst in 1972

[fightinJAG]

Let's think of value in terms of affordability — the ability of people to buy the home they want. That has three elements. First, home prices — the lower, the more affordable. Second, mortgage rates — again, the lower, the more affordable. Third, personal income — the more of it, the more affordable.

Mr. Luskin is right so far as he goes. But there's one very important element he completely leaves out.

Movement in the housing market is determined by affordability---as Luskin points out, a dynamic of home prices, the cost of money and personal income. But it's equally determined by emotion (for lack of a better word). IOW, it's not enough for housing to be affordable. Buying or selling a home, or investing in real estate, also has to be desirable---i.e., something the individual wants to do for reasons above and beyond the fact that he can now "afford" a different house.

What I see in this market that is new is a complete change in the mentality that underlies the housing market. I've explained it before with reference to years ago when the mentality (emotion) about cars was that it was desirable--almost necessary---to trade in one's car every few years, if not every year, and that one of one's goals in life was to get an ever nicer ride.

Somewhere along the way this mentality changed. More and more people began hanging on to their cars longer and longer, even until they were junkers and driving them into the ground. It no longer was the socially required/expected thing to do to always be getting a new car and always be trying to upgrade one's auto. People on a large scale decided that a certain level of car worked for them and that was that. We never went back to the scene where cars were traded like marbles and they were the ultimate status symbol (except for a much smaller social segment who continues to care about such things).

This downturn has been so shocking to middle America and hit so deep into the populace that it seems many have re-evaluated why they wanted to keep moving from home to home every few years anyway. The new mentality is "eh, this place is good enough; let's just get on with our life."

Since the market has always had only a relatively few buyers and sellers who HAD to move (for a job, a family reason, etc.), and was mostly made up of people who WANTED to move ("I really need a mudroom;" "I'd like to be closer to work or have a bigger yard"), a wholesale change in how people formulate their housing desires will be a big determinant of how low prices have to go before even people who are satisfied with staying put go, "That deal is too good to pass by."

I do agree that the potential impact of the housing sector's collapse on the general economy may be overblown. However, within the sector it's the Great Depression and most of us knew people whose financial mindsets were set by the Great Depression for the rest of their lives. That, too, may be true in the housing sector's "Great Depression."

There is a mass awareness of a fact that people previously failed to appreciate: that real estate can, in fact, lose value for a very long time. Once that is internalized by many, many people, there will be many who won't be looking to dabble in the market unless they absolutely have to.

The deeper this new mindset is ingrained, the deeper prices have to be cut to overcome it. IOW, if indeed the whole mentality about whether one even "needs" (i.e., WANTS) a new house has changed, the amount of resistance to returning to the market has changed---it has increased and exponentially. Therefore, the "cure"--lowering of prices---has to be even stronger to overcome that greater resistance.

[fightinJAG]

I agree.

[fightinJAG]

No, many Americans who made conservative financial choices, but who happened to buy within the last 4-5 years, are still upside down in their houses. I know some neighborhoods where the homes lost over $200K in value in two years, for no reason except that a couple of miles down the road a zillion developments opened at once, right as demand was already slackening. With literally hundreds of vacant never-lived in homes sitting on the market, the “newer” resale market was the first to tank.

[rdb3]

Where exactly is this house in Northern Ohio or which suburb?

[Straight Vermonter]

That is what the writer said:

Today home prices have fallen so much, mortgage rates are so low, and personal income is so high — that homes are more affordable today than at any other time, ever — with mortgage payments on the average home eating up about 40% of income.

[Vince Ferrer]

For some markets I can agree with the author, but those markets are the ones who were not participating in the bubble to begin with. They may have gotten a panic dip, but will stabilize this year as people realize the sky isn't falling on them.

For the bubble states, however, this is still just beginning. Although the bubble burst well over a year ago in central California, it is only now starting to get to the premier markets like San Fransisco and Silicon Valley. Prices will eventually have to get cut by about 50% more, but there are still a lot of factors delaying that, from the psychology of the defaulted home renters to the banks struggling to avoid taking possession of an enormous number of properties and taking the loss.

In order to call the bottom in northern California, The foreclosed properties will be bought from the banks at the same rate they are being added, and they will no longer be driving the prices down. None of this is close to happening yet. I don't see it happening this year.

[Right Wing Assault]

Hey, rdb3, long time. It's in Westlake. 24862 Framingham. It's not a foreclosure, either.

I checked on the square footage, though, and the county auditor says it's only 2684.

http://auditor.cuyahogacounty.us/REPI/res_bldg.asp?txtParcel=21530109

So I guess it would only be a million in CA.

Here's the listing. http://auditor.cuyahogacounty.us/REPI/res_bldg.asp?txtParcel=21530109

[Right Wing Assault]

Interested in a riverfront house with 60’ dock? (The Rocky River’s mouth is about a half mile north. Then it’s 60 miles across Lake Erie to Canada.) Only a million. Check it out. Of course out boating season is only about 6 months long.

It used to have a marina for sale with dockage for 43 boats. It was there this morning, now it’s gone. I think that went for 2.5 million.

http://realtyone.realliving.com/Property/Details.aspx?PropID=3978156

[Polybius]

No, many Americans who made conservative financial choices, but who happened to buy within the last 4-5 years, are still upside down in their houses. I know some neighborhoods where the homes lost over $200K in value in two years, for no reason except that a couple of miles down the road a zillion developments opened at once, right as demand was already slackening. With literally hundreds of vacant never-lived in homes sitting on the market, the “newer” resale market was the first to tank.

Americans who bought in the last 4-5 years did NOT make a "conservative financial choice".

They made a foolish choice by buying at a price that was wildly inflated because every burger flipper at MacDonalds had a $200,000 mortgage offered to him and everybody on a teacher's salary had an $800,000 mortgage offered to them.

They were even more foolish than the burger flippers because they were matching, with real money they intended to repay, the bids offered by the burger flippers with smoke & mirrors money they could not possibly repay.

My two houses were paid off more than 10 years ago. The stock market after the High Tech Bubble crash was doing so so and I had a lot of cash available to invest in anything I wanted to.

Be that as it may, I was not going to touch that Bubble Real Estate market with a ten foot pole because it was built on smoke and mirrors. Buyers were taking on debt that they could only barely afford "Interest Only" monthly payments on and was guaranteed to bankrupt them once the grace period on the gimmick loans expired. Yet, those buyers bought anyway because everybody knew that real estate trees grow to the sky and the worst that could happen was that, three years down the road, they could sell the house at a profit.

The houses prices were totally out of synch with what people could actually pay without gimmicks and the current disaster was totally predictable.

What should the buyers of the past 4-5 years have done?

Wear one of these T-Shirts during the years of the Real Estate Bubble market:

That is what "making conservative financial choices" was all about during those years.

[Polybius]

That is what the writer said: ..... Today home prices have fallen so much, mortgage rates are so low, and personal income is so high — that homes are more affordable today than at any other time, ever — with mortgage payments on the average home eating up about 40% of income.

Spending 40% of income feeding a mortgage is way out line with historical percentages.

Traditionally, before the current insanity, 28% of your pre-tax income had been the maximum amount that mortgage lenders would even allow.

[WashingtonSource]

Don is frequently on CNBC. Always interesting to hear or read.