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The Fundamentals of Residential Real Estate Market Bottoms

This article was posted at The Big Picture this morning as I was guest-blogging for Barry.  That’s a first for me, and there is no better site to do it at.  I present the article here for those that did not see it at The Big Picture.

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This piece completes a series that I started RealMoney, and continued at my blog.  For those with access to RealMoney, I did an article called The Fundamentals of Market Tops, where I concluded in early 2004 that we weren’t at a top yet.  For those without access, Barry Ritholtz put a large portion of it at his blog.  I then wrote another piece at RM applying the framework to residential housing in mid-2005, and I came to a different conclusion: yes, residential real estate [RRE] was near its top.  Recently, I posted a piece a number of readers asked me to write: The Fundamentals of Market Bottoms, where I concluded we weren’t yet at a bottom for the equity markets.

This piece completes the series for now, and asks whether we are at the bottom for RRE prices. If not, when, and how much more pain?

Before I start this piece, I have to deal with the issue of why RRE market tops and bottoms are different.  The signals for a bottom are not automatically the inverse of those for a top. Tops and bottoms for RRE are different primarily because of debt investors.  At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.  There is a sense of invincibility for the RRE market, and the financing markets reflect that. Bottoms are more jagged, with debt financing expensive to non-existent.

As a friend of mine once said, “To make a stock go to zero, it has to have a significant slug of debt.”  The same is true of RRE and that is what differentiates tops from bottoms.  At tops, no one cares about the level of debt or financing terms.  The rare insolvencies that happen then are often due to fraud.  But at bottoms, the only thing that investors care about is the level of debt or financing terms.

Why Do RRE Defaults Happen?

It costs money to sell a home – around 5-10% of the sales price. In a RRE bear market, those costs fall entirely on the seller. That’s why economic incentives for the owners of RRE decline once their equity on a mark-to-market basis declines below that threshold. They no longer have equity so much as an option on the equity of the home, should they continue to pay on their mortgage and prices rise.

As RRE prices have fallen, a larger percentage of the housing stock has fallen below the 10% equity threshold. Near the peak in October 2005, maybe 5% of all houses were below the threshold. Recently, I estimated that that figure was closer to 12%. It may go as high as 20% by the time we reach bottom.

Defaults occur in RRE when there would be negative equity in a sale, and a negative life event occurs:

  • Unemployment
  • Death
  • Disability
  • Disaster
  • Divorce
  • Large mortgage payment rise from a reset or a recast

The negative life events, which, aside from changes in mortgage payments, can’t be expected, cause the borrower to give up and default. During a RRE bear market, most people in a negative equity on sale position don’t have a lot of extra assets to fall back on, so anything that interrupts the normal flow of income raises the odds of default. So long as there are a large number of homes in a negative equity on sale position, a certain percentage will keep sliding into foreclosure when negative life events hit. For any individual, it is random, but for the US as a whole, a predictable flow of foreclosures occur.

Examining Economic Actors as We near the Bottom

Starting at the bottom of the housing “food chain,” I’m going to consider how various parties act as we get near the RRE price bottom. At the bottom, typically Federal Reserve policy is loose, and the yield curve is very steep. Financial companies, if they are in good shape, can profit from lending against their inexpensive deposit bases.

This presumes that the remaining banks are in good shape, with adequate capacity to lend. That’s not true at present. Regulation has moved into triage mode, where the regulators divide the institutions into healthy, questionable, and dead. The bottom typically is not reached until the number of questionable institutions starts to shrink. Right now that figure is growing for banks, thrifts, and credit unions.

The Fed’s monetary policy can only stimulate the healthy institutions. Over time, many of the questionable will slow growth, and build up enough free assets to write off bad debts. Those free assets will come through capital raises and modest profitability. Others will fail, and their assets will be taken over by stronger institutions, and losses realized by the FDIC, etc. The FDIC, and other insurance funds, will have their own balancing act, as they will need to raise premiums, but not so much that it harms borderline institutions.

Another tricky issue is the Treasury-Eurodollar [TED] Spread. Near the bottom, there should be significant uncertainty about the banking system, and the willingness of banks to lend to each other. Spreads on corporate and trust preferreds should be relatively high as well. Past the bottom, all of these spreads should be rallying for surviving institutions.

Financing for purchasing a house in a RRE bear market is expensive to nonexistent, but the underwriting is strong. At the bottom, volumes increase as enough buyers have built up sufficient earning power and savings to put a decent amount down, and be able to comfortably finance the balance at the new reduced housing prices, even with relatively high mortgage rates relative to where the government borrows.

Many other players in RRE financing will find themselves stretched, and some will be broken. Consider these players:

1) Home equity lenders will be greatly reduced, and won’t return in size until well after the bottom is passed.

2) Many unregulated and liberally regulated lenders are out of business. The virtue of a strong balance sheet and a deposit franchise speaks for itself.

3) Buyers of subordinated RMBS have been destroyed; same for many leveraged players in “high quality” paper. Don’t even mention subprime; that game is over, and may even be turning up now as vultures pick through the rubble. This has implications for MBIA, Ambac, and other financial guarantors, since they guaranteed similar business. How big will their losses be?

4) Mortgage insurers are impaired. In earlier RRE bear markets, that meant earnings went negative for a while. In this case, one has failed, and some more might fail as well.

5) Do the GSEs continue to exist in their present form? That question never came up in prior bear markets, but it will have to be answered before the bottom comes. Will the FHLB take losses from their mortgage holdings? Will it be severe enough that it affects their creditworthiness? I doubt it, but anything is possible in this down cycle, and the FHLBs have absorbed a lot of RRE mortgage financing.

6) Securitization gets done limitedly, if at all. This is already true for non-GSE-insured loans; the question is how much Fannie and Freddie will do. My suspicion is near the bottom, as loan volumes increase, banks will be looking for ways to move mortgages off of their balance sheets, and securitization should increase.

7) The losses have to go somewhere, which brings up one more player, the US Government. Through the institutions the US sponsors, and through whatever mélange of programs the US uses to directly bail out financially broken individuals and institutions, a lot of the pain will get directed back to taxpayers, and, those who lend to the US government in its own currency. It is possible that foreign lenders to the US may rebel at some point, but if the OPEC nations in the Middle East or China haven’t blinked by now, I’m not sure what level of current account deficit would make them change their policy.

That said, the recent housing bill wasn’t that amazing. Look for the US Government to try again after the election.

A Few More Economic Actors to Consider

Now let’s consider the likely actions of parties that are closer to the building and buying of houses.

1) Toward the bottom, or shortly after that, we should see an increase in speculative buying from investors. These will be smarter speculators than the ones buying in 2005; they will not only not rely on capital gains in order to survive, but they require a risk premium. Renting the property will have to generate a very attractive return in order to get to buy the properties.

2) Renters will be doing the same math and will begin buying in volume when they can finance it prudently, and save money over renting.

3) At the bottom, only the best realtors are left. It’s no longer a seemingly “easy money” profession.

4) At the bottom, only the best builders survive, and typically they trade for 50-125% of their written-down book value. Leverage declines significantly. Land gets written down. JVs get rationalized. Fewer homes get built, so that inventories of unsold homes finally decline.

As for current homeowners, the mortgage resets and recasts have to be past the peak at the bottom, with the end in sight. (In my piece on real estate market tops, I suggested that after the bubble popped “Short rates would have to rally significantly to bail these borrowers out. We would need the fed funds target at around 2%.” Well, we are there, but I didn’t expect the TED spread to be so high.)

5) Defaults begin burning out, because the number of the number of properties in a negative equity on sale position begins to decline.

6) Places that had the biggest booms have the biggest busts, even if open property is scarce. Remember, a piece of land is not priceless, but is only worth the subjective present value of future services that can be derived from the land to the marginal buyer. When the marginal buyers are nonexistent, and lenders are skittish, prices can fall a long way, even in supply-constrained markets.

For a parallel, consider pricing in the art market. Many pieces of art are priceless, but the market as a whole tends to follow the liquidity of the rich marginal art buyer. When liquidity is scarce, prices tend to fall, though it is often masked by a lack of trading in an illiquid market.

When financing expands dramatically in any sector, there is a tendency for the assets being financed to appreciate in value in the short run. This was true of the Nasdaq in the late ’90s, commercial real estate in the mid-to-late 1980s, lesser-developed-country lending in the late ’70s, etc. Financing injects liquidity, and liquidity creates confidence in the short run, which can become self-reinforcing, until the cash flows can’t support the assets in question, and then the markets become self-reinforcing on the downside, as buying power collapses.

The Bottom Is Coming, But I Wouldn’t Get Too Happy Yet

There are reasons to think that we are at or near the bottom now:

But I don’t think we are there yet, and here is why:

My best guess is that we are two years away from a bottom in RRE prices, and that prices will have to fall around 10-20% from here in order to restore more normal price levels versus rents, incomes, long term price trends, etc. Hey, it could be worse, Fitch is projecting a 25% decline.

Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.

Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and keep me in the game today. Avoiding the banks, homebuilders, and many related companies has helped my performance over the last three years. I hope that I — and you — can do well once the bottom nears. There will be bargains to be had in housing-related and financial stocks.

Full disclosure: no positions in companies mentioned






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7 Responses to The Fundamentals of Residential Real Estate Market Bottoms

  1. flow5 says:

    Bottoms or tops occur when monetary flows (MVt) turn:

    (1) Ben S. Bernanke
    Chairman and a member of the Board of Governors of the Federal Reserve System. Chairman of the Federal Open Market Committee, the System’s principal monetary policymaking body.

    At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections.

    2) European Central Bank (ECB) Central Bank for the EURO

    The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level…

    3) Janet L. Yellen, President and CEO of the Federal Reserve Bank of San Francisco

    You will note that I am casting my statements about the stance of policy and the outlook in very conditional terms. I do this because of the great uncertainty that surrounds these issues. Frankly, all approaches to assessing the stance of policy are inherently imprecise. Just as imprecise is our understanding of how long the lags will be between our policy actions and their impacts on the economy and inflation. This uncertainty argues, then, for policy to be responsive to the data as it emerges, especially as we get within range of the especially as we get within range of the desired policy setting.

    (4) Thomas M. Hoenig
    President of Federal Reserve Bank of Kansas City

    Monetary policy must be forward-looking because policy influences inflation with long lags. Generally speaking a change in the Federal funds rate may take an estimated 12-18 months to affect inflation measures….But the course of monetary policy is not entirely certain. & will depend on how the economy evolves in the coming months.

    (5) William Poole*
    President, Federal Reserve Bank of St. Louis

    However inflation is measured, economists agree that monetary policy has at most a minimal influence on the rate of change in the price level over relatively short time periods—months, quarters or perhaps even a year. Central banks are responsible for medium- and long-term inflation—such inflation, as Milton Friedman wrote, is a monetary phenomenon that depends on past, current and expected future monetary policy. As a practical matter, the medium- to long-term likely is a period of two to five years.

    (6) Robert W. Fischer – President Dallas Federal Reserve Bank

    November 2, 2006:
    “In retrospect [because of faulty data] the real funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer than it should have been. In this case, poor data led to policy action that amplified speculative activity in housing and other markets. The point is that we need to continue to develop and work with better data.”

    (7) Governor Donald L. Kohn

    I think a third lesson is humility–we should always keep in mind how little we know about the economy. Monetary policy operates in an environment of pervasive uncertainty–about the nature of the shocks hitting the economy, about the economy’s structure, and about agents’ reactions. The 1970s provide a sobering lesson in the difficulty of estimating the level and rate of change of potential output; these are quantities we can never observe directly but can only infer from the behavior of other variables.

    ————————————————–First, there is no ambiguity in forecasts. In contradistinction to Bernanke (and using his terminology), forecasts are mmathematically “precise” (1) nominal GDP is measured by monetary flows (MVt); (2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, demand deposit turnover) that matters; (3) “money” is the measure of liquidity; & (4) the rates-of-change (roc’s) used by the Fed are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;

    Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus.

    The lags for monetary flows (MVt), i.e. proxies for real GDP and the deflator are exact, unvarying, respectively. Roc’s in (MVt) are always measured with the same length of time as the economic lag (as its influence approaches its maximum impact; as demonstrated by a scatter plot diagram).

    Not surprisingly, adjusted member commercial bank “free/gratis” legal reserves (their roc’s) corroborate/mirror, both lags for monetary flows (MVt) –– their lengths are identical — (like Max Planck’s constant in physics (a scale of energy X time)

    The lags for both monetary flows (MVt) & “free/gratis” legal reserves are indistinguishable. Consequently it has been mathematically impossible to miss an economic forecast (bubble). There are no inaccuracies, just some non-conforming & unavailable data (e.g., revisions have been overlaid & lost, flawed deposit classification). This is the “Holy Grail” & it is inviolate & sacrosanct.

    The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, not quarterly.

    Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP. Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.

    Because of monopoly elements and other structural defects which raise costs and prices unnecessarily and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 percentage points. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.

    Some people prefer the devil theory of inflation: “It’s all Peak Oil’s fault.” This approach ignores the fact that the evidence of inflation is represented by “actual” prices in the marketplace. The “administered” prices of the world’s oil producing countries would not be the “asked” prices were they not “validated” by (MVt), i.e., validated by the world’s Central Banks.

  2. flow5 says:

    Yea for these, our sterling pieces, all of pure Athenian mold — ARISTOPHANES, THE FROGS

    Monetary flows (MVt) peaked Oct. 1974 (the stock market bottom)
    Monetary flows (MVt) peaked Oct. 1982 (1 month after the stock market bottom).
    (MVt)’s lag for long-term rates peaked Sept. 1981 (this century’s peak in long-term interest rates).
    Monetary flows (MVt) peaked in Jun 1984 (the stock market bottom). 1 option trade beat Prechter’s trading championship record with his 200+ trades
    The stock market bottom of 1982 was identifiable a year and ½, earlier

    Go, presently inquire, and so will I, where money is. — THE MERCHANT OF Venice

    1938-1940 roc’s in “free” legal reserves pulled us out of the depression.
    1951 (Korean War) had the highest roc’s in inflation & in “free” legal reserves since WWII.
    1973 had the highest roc’s in inflation & the highest roc’s of “free” legal reserves ever.
    1979-1980 had the highest rates of inflation & the highest roc’s of “free” legal reserves ever.
    “Black Monday” Oct. 19, 1987, coincided with the sharpest and fastest peak-to-trough decline in the roc for real GDP since 1915.
    The stock market’s 1QTR top in 2000 coincided with a +3.24 (roc) in Dec. 1999, which reversed to -.32 in Feb 2000. An historic reversal.
    Feb 27 coincided with the sharpest decline in 1) the absolute level of “free” legal reserves, & 2) & an historically large peak-to-trough reversal of roc’s for proxies on real GDP & the deflator.

    The policy rule is ex-post. (e.g, Taylor Rule).

    Bank debits & “free/gratis” legal reserves are ex-ante.
    Some people think Feb 27, 2007 started across the ocean In fact, it was home grown.

    http://fraser.stlouisfed.org/docs/MeltzerPDFs/bogsub020538.pdf Member Bank Reserve Requirements; Feb, 5, 1938. “In 1931 this committee recommended a radical change in the method of computing reserve requirements, the most important features of which were…”(2) uniform percentage requirements against the volume of deposits of both types and in all classes of cities; and (3) requirements against debits to deposits.”

  3. Flow5, perhaps you should have your own blog, because you write a number of interesting things.

    I’m not objecting to your comments here, except that they don’t fit with my subject, seemingly.

  4. Annette says:

    Hello David,

    I found your summary of a bottom in real estate, as well as savings and boomers, posted/reposted in recent days very thoughtful. One issue not often focused on (at least it has not been picked up to any large degree by commentators yet) is the demographic impact cited below:

    (This quote is copied from an reader’s comment on the Fullermoney.com site, posted 9-4-08):.

    ……Plus, boomer children have 72% more debt than their parents did at the same age so they can’t afford to buy homes in any case especially now proper underwriting will be done. Boomers start retiring over the next few years. In their 50′s there is one buyer for every seller and by age 70, there are 3 sellers for every buyer and it is 9 to 1 by 80, a perfect storm indeed for continuing housing problems. There are demographic issues that are equally problematic for housing and looming Medicare and Social Security shortfalls. Between 1980 and 2000, there was a 20% increase in the native-born, English speaking, college-educated 25-54 year old group that was part of the fuel in the housing bubble. Between 2000 and 2020, there is no increase in this 25-54 age group with the same demographics so who will pay for the $99 Trillion unfunded liabilities. That is Pete Peterson’s number. That gets us back to why M-3 was done away with, but that is another story……. (end of quote)

    I’d appreciate any thoughts/further details you have on this that you might be able to weave into your blog when you speak of real estate in the future. Thank you very much and best regards,
    A.S.

  5. Annette, the cohorts behind the baby boomers are larger than the boomers. Few realize that. The Baby boomers were so notable because they were so much larger than their predecessors.

    Thus, the Baby boomers *had* a big impact on real estate in the 80s & 90s, but their sale of it won’t be as big. As for there being more debt on the younger generation, that may be true, but they save more. The Baby boomers are notorious for their profligacy.

    One other set of changes — people are staying in their homes longer, and household sizes are getting smaller. I don’t see demographics as a big effect here.

    The $99 trillion is not correct — it is more like $40 trillion. It is still bad, and no one really considers it, but it will begin to weigh on us 10 years from now.

  6. flow5 says:

    Most of the time housing has lead the economy out of recessions, i.e., real money flows increase at a faster rate than inflation, rates-of-change in inflation are minimized, which allows depository institutions to “reliquefy”.

    Your analysis focuses on the effects of money flows & not the cause of the FED’s mismanagement, whose policies are primarily responsible for this inflationary bubble – housing, et al. & their policies will largely be responsible for the turnaround in our economy.

    Bernanke is very smart, but he and his colleagues don’t understand money and central banking (& in that, he is universally vacuous).

    Conspiracy has accompanied the evolution of commercial banking (I am not likening it to the Jekel Island crew, hard money advocates, etc.) but literally to the Webster dictionary interpretation.

    I don’t discriminate, but I will stop my posts on your blog, and will no longer rail on your defenseless positions.

  7. That’s fine, flow5. Come back when you want, and comment as you like. Take care.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


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