Why Sub-Prime Doesn't Worry Me

Back in May, I ran a series of articles in The Kelly Letter in which I examined the state of real estate in Colorado and California. I spent more than a month driving around, talking to realtors, comparing the word on the street to bold headlines, and sending along my findings to subscribers.

From my May 19 report:

I wrote a couple of weeks ago that housing prices in Colorado were no bargain. Now I see that they're no bargain in southern California, either. The popping of the bubble, the bottom of the market, the slump, or whatever else the media wants to call their phantom news story about housing's demise, is nowhere. True bargain hunters are holding cash, because bargains are hard to find.

I had dinner with another friend of mine, a fairly wealthy investor who's always on the lookout for something new. His circle of friends, he told me, are watching real estate and waiting...and waiting...and waiting. They've been waiting for three years. The media keeps reporting a fire sale, but nobody's seen any smoke.

What I've concluded is that the general real estate market is not a buyer's paradise.

Since then, the sub-prime issue has ballooned to an even bigger news event, but my subscribers and I remain undaunted for a couple of reasons. First, we've thought since the end of April that the stock market would see a weak medium term after rising higher in the short term. That's exactly what's played out.

Second, and more important to this article, is that the stakes are not as high as shrill headlines would have you believe. True, the housing market has slowed. Ask yourself, however, what it has slowed from. Did it slow from a moderately good pace to a bad pace? Did it slow from a bad pace to a dismal pace?

No. It slowed from a breakneck amazing pace to a decent pace. Nobody thought the runaway housing market of the past few years could last forever, did they? To put this in perspective, home sales and housing starts are about where they were in 2002. Those levels were considered fine back then. They're still fine today.

Next, ask yourself how much of the U.S. economy housing represents. By the tenor of the news these days, you'd think half of the U.S. gross domestic product comes from the housing market. It doesn't. Housing accounts for a mere 5% of the economy.

Even if housing slipped by 50%, the overall economy would suffer only a 2.5% loss. That's not nothing, but it's not the stuff of The Big One. Besides, housing is nowhere near falling 50%, so we're actually looking at a hit to the overall economy of maybe 1%. Folks, this is no disaster. The stock market is not finished. We're not seeing the front edge of a storm that will demolish all we've built over the years.

We probably have further downside ahead, but it will be followed by up, and we'll still be standing. Smart investors are watching for good entry prices on stocks they've wanted to own for years and hoping for a lower market in the near term. You read that right: hoping for a lower market.

The Kelly Letter has already bought one stock in the downturn so far, and we're looking to buy more, including a home builder. If you can't recognize the word O-P-P-O-R-T-U-N-I-T-Y between the headlines these days, you're in the wrong business.

Comments

[robert99:]

Good luck...

2007 Aug 16 09:53 AM

[Malkiel:]

Analysts have been pointing out for a decade that the economy was being held up by consumer spending enabled by high credit card balances, and mortgage refi's have been allowing consumers to reset those balances, so if that all comes to an end there may actually come a true recession like 1991 and, if so, there may not be any profitable transactions in either stocks or real estate for a few years unless you're willing to buy and hold. That's not necessarily bad, but don't go into debt to buy that bargain real estate or equities until we see how long the shakeout looks to be...

2007 Aug 16 11:18 AM

[steve12:]

Jason,

You are probably right about the lack of bargains right now in some markets. Brooklyn -- which should present bargains vs. Manhattan -- has only gotten tighter. That lag is often under-appreciated. Real estate tends to turn like an aircraft carrier, not like a PT Boat. But when it does, watch out.

Consider the 87 stock market crash and NY real estate. Many onetime NYers now in their late 40s and early 50s bought their first apartments with great confidence after the stock market crash of 87, in 88 and through 89. They believed that increasing sales prices clearly showed the stock market could not stop the unending upward movement of NY apartment prices (sound familiar?)

These first time buyers soon found a different kind of reality. Three years+ after the crash came tighter credit, decreasing apartment prices, and increased interest rates. Financial services layoffs created a major decline in young investment bankers paying cash. (aka fixed income hedge funders, mortgage and real estate brokers this time). Owners could not sell their expensive studios and one bedrooms, even though many were getting married, having children, and needed the room. Even worse, few could rent because building regulations prohibited it. This became a perfect slow moving black cloud (Taleb would say a black swan).

By 1991 I saw numerous large buildings in Manhattan with over 50 empty studios for sale. But even with drastically reduced prices, few apartments sold. Tough credit and high interest rates combined to keep the next round of first time buyers out of the market, including me.

Want to find some "bargains" today? Check out West Palm Beach. Owners I know there are already in this 1991 NY situation. Many apartments are for sale and there are no buyers. Although as condo owners they can still rent -- that will be for well below cash flow, all BEFORE the massive credit tightening that is happening as you read this. Now throw in the possibility of regulators prohibiting nominal and variable rate mortgages and even an interest rate HIKE. Funny how when the economy goes bad, interest rates seem to go up, creating lots of bargains but nobody able to buy and no banks willing to finance. Cash truly becomes king. If you are able to buy in this scenario, once it becomes apparent, long term you should make money.

But when it goes wrong, it tends to all go wrong at once. We are not be there yet, but it would be naive to think this cannot happen. There were lots worse scenarios in Southern California after the early 80s burst. Take a look at Washington Mutual's year ending balance sheet. Over 30% of its nominal (pay as you like) mortgages were sold in Southern California: New York and Florida were next. Consider the devastating wealth shrinking power of negative amortization loans -- aka interest charged upon interest that will make credit card debt look small. Now add that lovely home equity loan balance that is completely variable.

You may want to keep that powder dry. Those bargains are coming. Or buy my friend's place in West Palm Beach -- it'll be you or the bank. Good luck to you.

2007 Aug 16 01:22 PM