John Hussman: Home Price Erosion Will Continue

Excerpt from the Hussman Funds' Weekly Market Comment (5/12/08):

The following chart, presenting the ratio of median home prices to median household income, is courtesy of Ned Davis Research. Note that the decline in home prices even through the first quarter is a fraction of what we can expect to observe over time. While the “mean” in this chart is biased higher by the elevated ratios we saw in recent years, the lower ratios observed prior to 1987 are also unlikely because they were associated with very high interest rates. Given those considerations, it appears that median home values as of 3/31/08 were probably 15%-20% above sustainable norms, though we may not observe the full adjustment in just one cycle. The relatively low level of short-term interest rates (though only partially translating to low rates on adjustable mortgages) will probably help to buffer the full extent of the potential decline, but there's little doubt that we'll observe further serious defaults, foreclosures, and credit losses. (Click chart to enlarge.)

...Frankly, I don't think the prospects are good that government intervention will catch anything but the tail end of this problem, because policy takes time to develop, and the defaults are already largely baked in the cake.

What happened here is that the markets tolerated a huge “principal/agent” problem, where the people who were originating the mortgages (“agents”) didn't really have anything at stake, and could sell mortgage debt to willing buyers (“principals”) who would fund those loans in the belief that they were getting nice AAA paper. A lot of the money that was lent simply can't be paid back, because it was used to buy assets that were priced far in excess of sustainable market value.

In short, far from the credit crisis being over, it's likely that we will see a troublesome second round that eventually provokes government intervention. The financial markets shouldn't take too much comfort from the idea of intervention, since it will almost surely be of the sort that forces the lenders to take losses while providing some sort of reduced principal workout to homeowners. Some of these proposals are already being discussed, but with limited urgency. My guess is that all of that is likely to change in the months ahead.

Comments

[golds:]

I see a Stanford education was not wasted upon you. Dr. would you care to speculate as to what forms of intervention may produce positive results. I have read that in Q3 of 08 we will see the largest section of the sub-prime and Alt-A mortgage debt re-adjust. If this is true then we can expect even more foreclosures and home value declines. This leads to less consumer spending, less employment and lower corporate profits. What could the federal government due to prevent this?

2008 May 13 04:44 PM

[billddrummer:]

To GOLD,

Well put about the value of an education; I concur.

As far as intervention, perhaps the government could step in on those loans at the fringes of default--ones in danger of becoming fully indexed after the neg am balance has been reached, along with those with high reset payments in relation to existing payments. To me, those mortgages (and homeowners) represent the highest risk of default. If the government were to suspend recasts for, say five years, on that pool of mortgages, it would provide a safety net for the homeowners involved. That would give the markets time to stabilize and digest the modificatins, and the homeowners a 5-year window of relief while they consider their options.

2008 May 13 04:59 PM

[whidbey:]

Unmentioned is the effect of government being provoked into an invention in housing. Either the policy damages contract rights of lenders (the precedent is disturbing even if initially welcomed), or the policy damages the dollar further. In either case the value of real estate declines further, but buyer capacity to consume also declines. It turns into a chase to the bottom. There is a long ways to go and its dragging the economy along for the ride.

2008 May 13 06:28 PM

[mlambert890:]

Completely agree with this article. My thinking is that the US median home value needs to she about 35% of its high last year. Some markets will take a lot of pain, others will take less, to reach this number, but reach it we will.

I think it is a good thing and it would be disastrous to try to prevent it. Not to mention, it wont work. Home values were artificially inflated, institutional investors were ridiculously overleveredged with synthetic instruments, and the average schmuck was carrying a criminally irresponsible debt load and covering it with artificial "equity".

This deflation is needed. So is MUCH tighter regulation on the banks and investment banks (and any other institution that wants to start to act like a bank). Some forward thinking regulation might be nice also to catch the wave of CDO pirates who are now retreating into commodities and helping to create a bubble there rather than seeking to invest in the creation of real value.

2008 May 13 07:27 PM

[ArnoldCountry:]

I think too many are focused on the effects and not enough on resolution and then let it run. The market needs to hit a bottom and none of the proposals are going to take it to a bottom but make the bottom fall more.

Recommendations:

Government:

* $10,000.00 tax credit for homeowners that purchase a home in the next year. Extend as needed.
* $15,000.00 tax credit for homeowners that purchase a home in the next year in which the area has been defined as a declining market. Extend as needed.

Finance Industry:

Lower rates on all OPTION ARMS and Sub-prime loans to 2% for the next 5 years. While they will sustain a loss, that will almost instantly vaporize the numbers of people from walking from the homes which will stabilize the market by stopping new inventory competing with the old.

Between these two things, you would see a different market in the next year.

Reality... never going to happen... how will the lending industry tell all those bond holders that hold the traunches on the option arms and sub prime loans for the rates above 2% that just lost 100 cents on the dollar? The litigation will soar!

So, any other ideas?

2008 May 13 07:35 PM

[icandoitdon:]

i do not chuckle at the misfortune of others but i do chuckle at those fair weather capitalists..invariabl... the "small government" advocates...who believe in reaping the rewards of capitalism but sharing it's penalties. all in the name of helping "the economy" of course. but ythey're in good company...ben bernake is with them.

the issue here is simply how broadly or how narrowly to spread the pain. bernake, understandably, wants to spread it narrowly...force lenders/mortgage holders to take big haircuts to spare consumers who are 70% of the economy. he also believes that is the best course for lenders...given the choice between getting something or getting nothing, which is what they stand to get if people walk away or if lenders foreclose in the midst of a declining market for real estate. they might have to cut dividends and/or raise capital, diluting their investorsin the process, but most will survive.

i would rather see a crash because i believe it is how excesses are best cured in a capitalist economy, like it or not. for those investors/homeowners who are wiped out there will be others (most of whom have the sense to be liquid in times of crisis) who profit handsomely in the aftermath. adversity always breeds opportunity. and importantly.....it is the american way...or it used to be.

but i don't think that's how it will play. i believe there will be a bailout, mostly financed by the lenders/mortgage holders and their investors. loan balances will probably be reduced and/or low-cost financing will be arranged, subsidized by you and me. anyone who has a money market fund in treasury securities is already subsidizing it by getting 1 3/4% interest in a 5-10% inflationary environment. (no i don't believe in their phony CPI statistics).

regulation could have prevented much of the pain but we do not have effective regulation because our leaders believe in spiking the punch and never taking away the punch bowl.

2008 May 13 09:33 PM

[Polabair:]

To the folks who really needed a shelter to raise their families, the lack of loan regulation was shameful.
To investors with risk capital in play...
Have a nice day!

2008 May 14 11:46 AM

[Bigbuilder:]

Housing is a symptom of a larger problem. We are totally insolvent as a nation. Read "Running on Empty" by Pete Peterson. The national promises for entitlements (and routine spending), when added to expected future revenues and discounted to present value results in a negative "net present value" of the federal balance sheet of over $44 trillion. That negative gets bigger by the day.

This does not include state and local negatives.

Couple this with an unending demand for consumption and a gross misapplication of capital (e.g. media rooms, crown molding and granite counters) into non productive assets and the future for the average Joe is dim in terms of material standard of living.

Prediction: We will become protectionist on trade, raise taxes, further regulate business into inefficient oblivion and the masses will clamor for more state action. Each political demagogue will further destroy our national unity by search for scapegoats.

I think the housing mess is the canary in the mineshaft. Profoundly greater problems await us.

We so lack moral fiber and resolve that we will panic in ways that will destroy the nation. Top that off with a cultural battle with fundamental Islam and see where we end up.

2008 May 15 08:39 AM

[Munki's Unkel:]

To sum up Bigbuilder's prognostigation, I would like to quote Bill Murray's character Dr. Peter Venkman in Ghostbusters, "Human sacrifice, dogs and cats living together... mass hysteria!"

2008 May 15 01:44 PM