Housing: Is it Going to Get Worse Before it Gets Better?

by: Whitney Tilson

Herb Greenberg lives in San Diego, so he's seeing the bursting of the housing bubble up close:

San Diego Housing: From Bad to Worse


Here in San Diego, where housing prices were among the biggest winners, they are now among they continue their leading pace among the biggest losers.

Citing DataQuick, the San Diego Union-Trib this morning reported that San Diego County median housing prices fell to their lowest level if our years, with nearly half the existing homes selling at a loss. Most of the properties on the market, and feeding this downward frenzy, according to the story, are considered distressed. Also, remember that San Diego County, with 2.2 million people, is the third largest county in the state and the sixth largest in the country. Stretching deep into the desert, it's much bigger than a slice of homes along the coast.

You can read the full story here.

I read the article Herb linked to and it had some information that's enormously important, with very sobering (I debated hard whether to use the word "terrifying") implications for housing prices -- and therefore the credit crunch, the U.S. economy, etc. Here's the key line from the story:

LePage said a record 34 percent of resale homes last month were previously in foreclosure and 9 percent were in default. Nearly half of all resale houses and condominiums were sold at a loss from when they were last purchased. The median loss was about 25 percent.

By comparison, 5.3 percent of resales in January 2007 had been in foreclosure. The December figure was 31.2 percent.

Here's why this is so important: home prices have been holding up remarkably well in spite of the tidal wave of defaults, reduced access to capital, etc. -- in fact, according to the National Assoc. of Realtors, "For all of 2007, the median price of existing homes in the U.S. came in at $218,900 -- down 1.4 percent from $221,900 in 2006." How is this possible? The answer, in large part, is because homeowners are engaging in a sellers' strike: psychologically, they're in denial and don't want to admit that their home is worth less than the peak level it reached in 2006 or 2007 and/or less than they paid for it and/or less than the mortgage on it. As this article points out, "more than three out of four homeowners believe their own home has not lost value in the past year". This guy has it exactly right (from the same article):

Hugh Moore, a principal at Guerite Advisors, a research and financial advisory firm, said he wasn't surprised by the denial demonstrated in the survey results. He said research into previous housing busts shows homeowners are slow to accept that their home has lost value.

"It's a visceral reaction; you lock into the highest price you ever heard, and you're going to hang onto it," Moore said. "It's a grieving process. First you go through denial and disbelief. Acceptance is the last step you get to."

Moore said it's important to remember that only a small fraction of homeowners try to sell their home in any given year, and unless they are trying to get new financing or a home equity line of credit, there's no reason most will be confronted with the decline.

But he said the denial will make recovery from this current housing slump take longer and be more difficult because home sellers will be slow to adjust their asking price to the new market reality.

"Studies have shown stock markets have public markets that realign themselves rather quickly," Moore said. "But housing busts affect the economy twice as much, because home ownership is so much more widespread, and they take twice as long to correct themselves."

We can see homeowners' denial in the San Diego data: despite the percentage of sales that were homes in foreclosure skyrocketing from 5.3% to 34% in one year, the total sales of existing homes were down 33.5% (see chart below). Using simple math, excluding homes sold in foreclosure, that means regular home sales fell 50%!

More broadly, the result of homeowners still being in the denial phase (which precedes the panic and capitulation phase) is twofold: A) inventory has ballooned to nearly a year (typically it's only a few months) and B) it keeps reported home prices high because distressed home sales aren't happening to any material degree...

...until now. Most homeowners can (and do) choose to keep living in their homes if they can't sell it for the price they want -- but lenders are a different matter. When they foreclose on a home, they need to monetize it as quickly as possible, which in today's world means an auction, which tends to reflect a true market-clearing price. These market-clearing prices are much, much lower than the price declines that are being reported now.

So when should we expect to see a wave of foreclosures and auctions? The data shows that it will start building massively this year and peak in 2009 and 2010. Here's why (thanks to Sean Dobson of Amherst Securities for some of this data): the worst mortgages started to be written in early 2005, with the peak of the garbage written in 2006 and early 2007. For the Q1 05 mortgages, the worst schlock had two-year teaser rates, which triggered the surge in defaults in early 2007 that touched off the current crisis. Because lending standards got progressively worse in 2005, the default numbers got worse as 2007 progressed. This trend is certain to get much, much worse, given that Sean's data shows that lending standards completely went out the window in 2006 and early 2007, accompanied by a surge in volume.

But a foreclosure and auction (and a resulting collapse in home prices) doesn't happen immediately upon missing a payment. Sean's data shows that it takes an average of 15 months from the time a homeowner misses the first payment to foreclosure (I presume it then takes another month or two to auction the home). Thus, for the Q1 05 loans, for which there was a surge of defaults in Q1 07, the foreclosures and auctions are about to hit with full force -- and things will only escalate for another two and half years (reflecting 2005, 2006 and half of 2007)!

As evidence for the emergence of this trend (beyond the San Diego data -- 5.3% to 34% in 12 months!), I found a bunch of interesting graphs for some West Coast housing markets on this blog . Note the decline in sales, the surge of inventory and, critically, in the first four charts, the emergence of "Cumulative REOs". REO means real estate owned, which is the final phase before a bank/lender sells a home (the categories, in order, are usually 30 days delinquent, 60 days, 90 days, foreclosure and finally REO).
The result of all of this is going to be a train wreck in housing prices -- yet the Natl. Assoc. of Realtors is projecting a 1.2% decline in 2008 -- what a joke! Merrill is much more likely to be right :

The worst housing financial crisis in decades is only going to get worse, a Merrill Lynch report said Wednesday.

The investment bank forecasted a 15 percent drop in housing prices in 2008 and a further 10 percent drop in 2009, with even more depreciation likely in 2010.

This reminds me of that scene in the movie Titanic, in which the ship has struck the iceberg and come to a stop, but seems to be OK. But up on the bridge of the ship, the captain has called in an expert to assess the damage, and he tells the captain that the damage is too great and the ship is doomed. Yet nobody on the ship is aware of this, convinced that they're on the "Unsinkable Titanic" and the partying continues in the ballroom... My prediction is that things are going to get so grim that in about a year, as one of his first actions, President Obama and Congress will engineer an enormous bailout along the lines of the RTC . Yeah, I know about moral hazard and the reality that greedy and foolish homeowners will be protected from their actions, but the alternative -- millions of American families losing their homes and filing for bankruptcy -- will simply be politically impossible.

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