Market Prices: The Great Chasm

At first, I was going to title this article "The Great Divide," which somehow sounds catchier… but just doesn’t have the right connotation. "Divide" suggests a gap that is difficult to bridge, whereas "Chasm"... well now, that's a place things fall into.

Back in June, my thinking went like this: If the “sub-prime” debacle is worse than realized, and if consumer discretionary spending (XLY) is at least correlated to home valuations, then wouldn’t there be more downside to the spending index, as well as the broader markets (IYY, SPY), as investors connect the dots?

Now fool me once, shame on me… fool me twice shame on… wait, no…

Anyway, in the search for a real estate bottom, many folks are missing the huge disconnect between low-end properties that are selling at rock bottom anyway you slice it, and high-end properties that haven't even corrected yet.

Since global market meltdowns are a tricky thing, we can let smarter pundits debate variables like illiquidity, de-leveraging, energy costs, unemployment, consumer spending, deficit spending, and market psychology… but regarding the big one - capitulation - dude, what’s everyone smoking, and where can I get some?

I cringe when folks talk about the inevitability of the subprime collapse. Not so much because it evokes a lame, Monday-morning, holier-than-thou, I-can’t-stand-you, do-you-even-annoy-yourself-when-you-speak-like-that sort of feeling, but rather because of how glaringly obvious it spotlights the rest of the iceberg.

Today, my thinking goes like this: If the “prime” debacle has not even happened yet, and if the market hasn’t baked this in, then wouldn’t there be more downside?

A huge percentage of homeowners, in the $750k to $2m market, have ARMs. None have re-set yet. They will.

Prime loan re-sets potentially pose a triple whammy threat of payment shocks:

• Conversion to principal-and-interest (from interest-only).

• Forced re-amortization over 25 years, not 30.

• Margins that immediately increase the fully indexed rate.

An $800k loan re-set that forces payments to re-amortize to principal- and- interest (from interest-only) over 25 years goes to $4,912 (from $3,667)… that’s $1,245/mo higher - and that’s with the same interest rate.

Some loans allow five more years of I/O payments after switching to adjustable, but keep in mind they will be re-amortized later over 20 years (not 25, not 30).

Some marginal folks will need to sell. And when they do, since there is exactly zero market for making loans in this segment, people will face increasing pressure to get out. And that’s with LIBOR staying low. Longer term rates could double.

We just saw the blueprint of how this plays out in “subprime”. It is not a socio-demographic thing, but rather a math thing. “Prime” homes will also decline in value. My call is 35%-40% off peak prices. Only this time, the real drivers of economic stimulus, the small business class, will cut back spending for real. And lay people off. And cash out investments. And sell assets below value.

And, speaking of assets, what about those shady Level III assets that banks are using to understate exposure? Echemm!! (SKF)… excuse me.

Major banks who have just received unprecedented amounts of cash infusions to plug up cartoon-like, bullet-ridden lending ratios will have to address the fact that depreciation of portfolios to date only reflects subprime default-related losses.

Maybe I should have entitled this article, “Market Prices: Which Chasm is Greatest?”

Disclosure: no positions currently held

Comments

[Carl Spackler:]

After living through one real estate depression (Texas in the 80's) and studying the other examples I found, there is one thing you can absolutely count on - the 3-10 rule. The 3-10 rule for real estate depressions is that it will take 3 years for prices to start appreciating and 10 years for them to recoup their previous high. Take this to the bank, because it stands the test of time and experience. If we take the real estate high water mark as 1st quarter of 2007 (my guess), that puts the botom as early 2010. You also will not see new highs in the market until 2017. After real estate bottoms, buyers are no longer willing let real estate have yearly gains above 5%, so all appreciation will be slow an laborious. Very few people nationally have lived through one, but I have and I will always remember the affect it had on everyone's psychology. I am sure that this same thing is also playing havoc with general consumer confidence.

2008 Dec 12 10:51 AM

[peterthepai...:]

you are right...c'mon ovva ta my blog an check out 'these banks are made for lending' - by nancy sinatra

2008 Dec 12 12:14 PM

[Seth Chalnick:]

Hi Carl, thanks for your comment. I agree it will take about 10 years to get back to previous highs, and eventually this too shall pass. After short-term deflation, I expect we’ll see massive inflation, followed by demographic explosion that will ultimately blow prices past previous highs.

I also see a wide gap between high and low-end market segments. As high-end falls from grace, some lower-end homes are trading below intrinsic value. I expect they will hold their own, or come up a bit to bridge the gap, as foreclosure displacement puts upward pressure on the rental market. Plus, while the historically low rates are only good for low-end purchases, it does present great buy and hold opportunities… especially now, while folks scramble to preserve their ass…ets.

2008 Dec 12 01:10 PM

[JKC1967:]

Thanks Carl - very interesting info on the 3- 10 Rule. I would think that in terms of making new highs, 2017 even seems a bit optimistic, I'd have guessed more along the lines of 2020 at the earliest, although I am no real estate expert. One other thing I wonder - with many ofthe baby boomers turning moving into old age during the 2010-2020 framework, wouldn't many of them be selling and trading down, thereby creating further headwinds for real estate price appreciation to struggle against?

2008 Dec 12 04:34 PM

[hoyt:]

Seth - loose the button down picture. get out your sweatshirt. take a new picture. you remind me of when I was trying to be a realtor....

other 'n that - i like your perspective.

2008 Dec 12 07:01 PM

[pslater:]

Seth, I think your analysis of the prime real estate market is spot on and I think you can add commercial real estate, credit card companies, etc. to the same list. This will roll through every sector of the credit markets before it's finished.

Like Carl I lived through a real estate depression in Anchorage, AK during the late 80's. In a three year period from roughly 1986 through 1989, the total assessed value of ALL property in the Municipality of Anchorage fell by 35%, seven out of ten banks failed, and the population fell by 15%. Hmm, wonder if it's just a coicidence that TX and AK are both oil dependent.....

When I moved back to CA in 2002, I would occasionally mention my AK real estate experience to friends. Poeple would look at me like I was nuts and sneer that this is CA and therefore that could never happen here. Never say never....

Anyway, what I believe Paulson and Bernanke are NOT telling us is that there is still a massive wave of bank failures to come. This is the impending disaster behind the 'critical need' for TARP.

2008 Dec 12 07:07 PM

[Clifton McGraw:]

Seth, glad to see you on SeekingAlpha. I actually met with you a couple years back, thinking about purchasing a house. You were the only person who actually was willing to talk to me without rose-tinted glasses on. I even remember you bringing up a few points from this article in our conversation, but mainly touching on Subprime. Didn't know you were a SeekingAlpha fan! Good job staying relevant in these trying times. Cheers!

2008 Dec 12 10:56 PM

[Seth Chalnick:]

Clifton, thanks very much for the acknowledgement. It is such a validation to hear about making difference… in fact, you made my very long week. I greatly appreciate your comment, and as agreed back then, I look forward to building upon our long-term relationship. sc

2008 Dec 12 11:27 PM