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Why a 50% Drop in Housing Is Not the Bottom

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Charles Hugh Smith
oftwominds.com
Monday, April 20, 2009

The psychology behind the idea that a 50% reduction in bubble-era housing prices constitutes a “bargain” is flawed for a number of reasons.

I recently saw a few minutes of a Nightly Business Report program on PBS in which a Florida broker was observing that homes which once commanded $350,000 at the bubble top were selling briskly now at $169,000 to investors from every part of the globe.

In other words: “These homes are half off! They’re screaming bargains! They can’t get any cheaper than this!”

The psychology behind this euphoria is accessible to us all. It’s easy to forget where housing prices were before the bubble and focus instead on how much they’ve dropped from the bubble peak. The same is true in any bubble, be it collectables, real estate, stocks, or tulip bulbs.

But valuation realities have no relation to bubble top pricing. Thus we should ground our analysis of housing valuations and what constitutes a “bottom” in metrics other than “it’s 50% off it’s top price.”

Let’s start by considering just how high the bubble took housing valuations:

Why a 50% Drop in Housing Is Not the Bottom CA homes

  • A d v e r t i s e m e n t

This chart reveals that housing in California more than tripled at the bubble top. A fall of 50% from that peak (i.e. $275,000) is still 60% above the starting point.

Let’s consider a model of all bubbles, regardless of the asset or the era:

Why a 50% Drop in Housing Is Not the Bottom anatomy bubble

No model can predict the timing, highs or lows of any bubble, but bubbles tend to follow a pattern traced in human psychology:

1. As euphoria grabs hold, prices rise in a steep ascent to a point at which “everyone” believes there is no end to the trend.

2. The initial descent from the bubble peak is a “shock” which leaves the bubble mentality intact, i.e. the Bull Market in tulip bulbs, real estate, tech stocks, etc. is only suffering a standard retracement/indigestion; the trend higher is still in place.

3. In housing, this psychology is embedded in such chestnuts as “they’re not making any more land,” “real estate always rises over time,” “population growth means demand for housing will always rise,” “the house is the foundation of middle class wealth appreciation,” and so on.

4. At some point speculators who were left out of the initial explosive rise jump in because “prices are a real bargain now.”

5still significantly cheaper than owning.

Why a 50% Drop in Housing Is Not the Bottom price to rent

While this graph is a few years old, the trend to historic highs in property taxes is clearly illustrated. Yes, you can petition your county to lower your appraisal, but unless your state is protected from fast-rising property taxes via a Prop 13-type law, then brace yourself for local governments to make up their declinign tax revenues on the backs of property owners–plummeting prices be darned.

(ARTICLE CONTINUES BELOW)

Why a 50% Drop in Housing Is Not the Bottom 335x205 graph128c aj

Why a 50% Drop in Housing Is Not the Bottom propertytaxes1960 2004

With reports of banks holding some 600,000 foreclosed or distressed properties on their books and off the market in the news, it is a foregone conclusion that any blip up in demand for homes will be met with a tide of new supply. After the current “bargain buying” dries up, inventory will exceed demand and prices will resume their fall.

Why a 50% Drop in Housing Is Not the Bottom inventory sales08

And last but not least, let’s note that we’re dealing not just with the aftermath of one historically extreme bubble, but three: one in stocks (shown here), one in housing (shown above) and another in bonds which have skyrocketed as yields drop to near-zero.

Why a 50% Drop in Housing Is Not the Bottom DJI history

The net result of declining asset values across all asset classes but gold is that there will be a global reduction in borrowing against assets. So add up the financial contexts which control real estagt; Array ( [0] =>gt; wpdb [1] =>gt; __construct [2] =>gt; __destruct [3] =>gt; set_prefix [4] =>gt; select [5] =>gt; escape [6] =>gt; escape_by_ref [7] =>gt; prepare [8] =>gt; print_error [9] =>gt; show_errors [10] =>gt; hide_errors [11] =>gt; suppress_errors [12] =>gt; flush [13] =>gt; query [14] =>gt; insert [15] =>gt; update [16] =>gt; get_var [17] =>gt; get_row [18] =>gt; get_col [19] =>gt; get_results [20] =>gt; get_col_info [21] =>gt; timer_start [22d is not limited to residential housing: How an economy foundering beneath stupendous debt can forcefeed housing prices higher via ever greater debt is unknown.

Why a 50% Drop in Housing Is Not the Bottom credit GDP2

Just as a refresher on the extremes the housing bubble reached even when adjusted for inflation:

Why a 50% Drop in Housing Is Not the Bottom housing prices2

A significant percentage of this debt comes due in the years just ahead:

Why a 50% Drop in Housing Is Not the Bottom debt due 2011

Another standard measure of valuation, the price-to-rent ratio, also reached historic highs. In some areas of the nation, this might have already returned to the mean, but with property taxes skyhigh and the cost of renting dropping, it may well be the cost of renting is still significantly cheaper than owning.

Why a 50% Drop in Housing Is Not the Bottom price to rent

While this graph is a few years old, the trend to historic highs in property taxes is clearly illustrated. Yes, you can petition your county to lower your appraisal, but unless your state is protected from fast-rising property taxes via a Prop 13-type law, then brace yourself for local governments to make up their declinign tax revenues on the backs of property owners–plummeting prices be darned.

Why a 50% Drop in Housing Is Not the Bottom propertytaxes1960 2004

With reports of banks holding some 600,000 foreclosed or distressed properties on their books and off the market in the news, it is a foregone conclusion that any blip up in demand for homes will be met with a tide of new supply. After the current “bargain buying” dries up, inventory will exceed demand and prices will resume their fall.

Why a 50% Drop in Housing Is Not the Bottom inventory sales08

And last but not least, let’s note that we’re dealing not just with the aftermath of one historically extreme bubble, but three: one in stocks (shown here), one in housing (shown above) and another in bonds which have skyrocketed as yields drop to near-zero.

Why a 50% Drop in Housing Is Not the Bottom DJI history

The net result of declining asset values across all asset classes but gold is that there will be a global reduction in borrowing against assets. So add up the financial contexts which control real estate valuations:

1. Extreme bubble valuations must eventually retrace to the starting point, and in many cases they drop below the starting point.

2. Housing and real estate are based on the availability of cheap, plentiful debt. As economy-wide debt loads are at historic extremes, it is prudent to ask what conditions will enable trillions more in debt to be issued to buy inflated housing.

3. As the Federal government borrows trillions of dollars on the open market to fund its mega-stimulus-bailout debts (in the trillions and counting), then the government is competing with private borrowers for a dwindling pool of capital/savings. That will drive up rates, making mortgages more expensive. And since prices drop as rates rise, this global push on interest rates is a profound headwind for housing prices globally.

4. Paying a mortgage requires steady income, which for most citizens means a steady job. Rapidly rising unemployment reduces the pool of potential buyers and adds to the inventory as those losing their incomes also lose their homes.

In short: with the national and household balance sheets at historic extremes of indebtedness it is difficult to see what fundamental financial foundation exists for higher housing prices.

The only conclusion to be drawn from the above charts is that those currently buying “at bargain prices” will very likely be disappointed as prices renew their downtrend in the near future.

This article was posted: Monday, April 20, 2009 at 3:42 am





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