Why a 50% Drop in Housing is not the Bottom

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switters's picture
switters
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Why a 50% Drop in Housing is not the Bottom

The following are two excellent posts by Charles Hugh Smith about the prospects of the housing market.  A must-read for anyone pondering an investment in real estate.

Keep in mind, though, that regardless of this information it still might be a good time to buy a house if 1) you're not planning on selling it, 2) you are ready to hunker down and plant your garden, get your renewable energy systems going, build relationships with your neighbors, etc.

Also, it seems likely that interest rates will skyrocket in the coming years, so even though house values may be much lower still a mortgage with a 15% rate instead of a 5% rate might end up being more costly.  For example, the payment on a mortgage of $250,000 at 5% would be $1,340/month, excluding tax and insurance.  The payment on a mortgage of $150,000 at 15% would be $1,900/month.

So in spite of this information, it may not be a bad time to buy depending on your goals and needs. 

Why a 50% Drop in Housing Is Not the Bottom 

April 16, 2009 

The psychology behind the idea that a 50% reduction in bubble-era housing prices constitutes a "bargain" is flawed for a number of reasons. (NOTE: to view charts in full, please go to my main blog page at http://www.oftwominds.com/blog.html .)

I recently saw a few minutes of a Nightly Business Report program on PBS in which a Florida broker was observing that homes which once commanded $350,000 at the bubble top were selling briskly now at $169,000 to investors from every part of the globe.

In other words: "These homes are half off! They're screaming bargains! They can't get any cheaper than this!"

The psychology behind this euphoria is accessible to us all. It's easy to forget where housing prices were before the bubble and focus instead on how much they've dropped from the bubble peak. The same is true in any bubble, be it collectables, real estate, stocks, or tulip bulbs.

But valuation realities have no relation to bubble top pricing. Thus we should ground our analysis of housing valuations and what constitutes a "bottom" in metrics other than "it's 50% off it's top price."

Let's start by considering just how high the bubble took housing valuations:

Post #2:

Why Housing Is Not Coming Back 

April 21, 2009 

The financial MSM and government officials alike are looking for a recovery in the housing market to bubble valuations to "restart the economy." That is not going to happen--not this year, not in five years or even in ten years. Here's why.

The entire world is hoping that housing is about to "recover" and re-ascend its glorious bubble-era heights of valuation. But it's not going to happen.

Why not? For several fundamental reasons:

1. Bubbles do not re-inflate in the asset class which just popped. It is simply a truism that bubbles never reflate, ever. Tulip bulb valuations did not rise to stratospheric heights after the Tulip Craze popped, and the Nasdaq dot-com bubble did not reinflate, either, for the very good reason that bubbles are never based on rational valuations--they are based on the psychological state of mania which cannot be reinstated once lost.

Consider tech stock Cisco Systems (CSCO), a well-managed "real company" which continues to make profits providing real-world goods and services. It currently trades at around $17.50 a share, down from its dot-com bubble valuation of about $81/share.

To "recover" its bubble-era valuation, Cisco would have to rise five-fold. That's not going to happen. Now that the mania has dissipated, Cisco is valued on more rational metrics like earnings, profits, etc.

(more)

 

 

cmartenson's picture
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Re: Why a 50% Drop in Housing is not the Bottom
Chris Kresser wrote:

The following are two excellent posts by Charles Hugh Smith about the prospects of the housing market.  A must-read for anyone pondering an investment in real estate.

(...)

Chris, these are great posts indeed.  I think they run a bit over the "fair use" limit and I want to support traffic to Charles' site because he's a great thinker and writer and deserves it.

So I am going to now prune your post a little bit.  I hope you don't mind...

Best,
Chris

 

 

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Re: Why a 50% Drop in Housing is not the Bottom

 Yes, absolutely, Chris.  Thanks for doing that.  What exactly are the guidelines for the "fair use" limit, by the way?

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Re: Why a 50% Drop in Housing is not the Bottom

What?  Nothing here about how swine flu was intentionally unleashed by birth-certificate-lacking Obama in order to divert attention from the fact that WTC-7 was a controlled demolition?

Thanks anyway Chris K., but booooorrrrrrrriiiiiiiiinnnnnggggg.

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Re: Why a 50% Drop in Housing is not the Bottom
Lemonyellowschwin wrote:

What?  Nothing here about how swine flu was intentionally unleashed by birth-certificate-lacking Obama in order to divert attention from the fact that WTC-7 was a controlled demolition?

Thanks anyway Chris K., but booooorrrrrrrriiiiiiiiinnnnnggggg.

hehe.

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Re: Why a 50% Drop in Housing is not the Bottom

"Fair use" means a few paragraphs and a link.  Always the link.

Never the entire article, which can be tricky with some shorter artciles that consist of little more than a few sentences arranged as paragraphs.

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Re: Why a 50% Drop in Housing is not the Bottom

Chris (Kresser)

Why on earth do you think interest rates will go up ? 

My humble take on it is that if the economy has gone to custard, rates will be LOW to keep stimulating money circulation and spending.   Although in fact that probably won't make any difference and we will get stagflation.

You are right, interest rates will affect house prices.

But why is is likely they will sky rocket ?????

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Re: Why a 50% Drop in Housing is not the Bottom

Amanda,

I know your question was directed to Chris K., but let me jump in here because it's a worthy question and it highlights an important point.

I think that what Chris K is probably anticipating is a bursting of the treasury bond bubble which would cause a dramatic rise in yields which would cause a dramatic rise in interest rates.

The first thing you have to know is how mortgage rates are determined.  Mortgage rates are not "set" by any central authority.  Hundreds of lenders constantly adjust their rates based on market forces.  By far the most important determinant is the yield on treasury notes.  Think about that for a minute so you can understand why it is.  Let's suppose a lender has $200,000 to lend to Joe the Plumber.  It is trying to decide how much to charge in interest to Joe the Plumber.  The lender looks over at what the government is paying to borrow money.  The lender looks at the 10 year treasury note yield and sees that it is 2.5%.  That gives the lender information about inflation expectations and it tells it that the most credit worthy borrower in the world (humor me) pays 2.5% for a loan.  Of course, individual borrowers are way more risky investments, so the lender has some sort of formula and adjusts its interest rate calculation accordingly.  Long story short, if treasury note yields rise, then mortgage rates rise.  And if treasury note yields fall, then mortgage rates fall.

You are correct that the Fed WANTS mortgage rates to be low in order to stimulate borrowing and spending and support housing prices and basically in order to keep the economy from totally imploding.  But can the Fed directly control mortgage rates?  The answer is "no."  It exerts influence by trying to keep yields down on treasury notes.

But the Fed's power to keep yields down is not at all absolute.  The Fed does not dictate yields.  Yields are dictated by the market.  Yields are a function of how much investors are willing to pay for government debt that returns a certain rate of interest.  If there are lots of investors that want the investment, they will pay more for the bonds and the yields will be low.  But if there is a lack of demand for treasury notes, then they pay less for the notes and the yields go up.

This brings us to the conflict.  When investors become less interested in owning treasury bonds -- something that is arguably happening right now -- they pay less for the bonds and the yields rise, causing a corresponding rise in interest rates.  But this conflicts with the Fed's need to keep yields low.  So what can the Fed do?  What it probably does is print money and buy the bonds itself thereby creating artificial demand for the bonds.  But this increases inflation expectations and if investors get wise to it then they sell their treasury bonds.  This means the Fed needs to buy more bonds with printed money, and then you have a slippery slope where you get a bursting of the treasury bond bubble and a slew of printed money entering the system and, well, you get the picture..

 

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Re: Why a 50% Drop in Housing is not the Bottom

Lemonyellowschwin

Thank you so much.  That was so readable that even I could understand it.  I didn't know any of that.  I am really grateful that you took the trouble to explain that so well. 

Unfortunately that blows my theory that interest rates will stay low and lower forever.  Although I am in NZ, the banks borrow from the US.  Buggar.

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Re: Why a 50% Drop in Housing is not the Bottom

Also bear in mind that longer term there are significant barriers to housing price recovery. In particular, the aging of populations that has begun in japan and some european nations will have spread to the US, canada and Oz over the next 20 years. An increasing overhang of relatively wealthy (relative to younger generations) elderly will keep house prices depressed, especially if future generations are continually robbed to bail out pension holders and current owner-occupiers.

Populations in Japan are now falling, with populations in europe following suit soon. Populations in US and other western offshoots may well begin to fall much sooner than expected (perhaps as early as 2015) as a result of the depression reducing the amount of young couples starting familiers, the lack of government funds to provide the welfare payments that have previously attracted immigrants, and the resistence of existing jobless populations to the new immigration required to prop up lower-than-replacement fertility rates amongst native populations.

 

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Re: Why a 50% Drop in Housing is not the Bottom

Why on earth do you think interest rates will go up ? 

My humble take on it is that if the economy has gone to custard, rates will be LOW to keep stimulating money circulation and spending.   Although in fact that probably won't make any difference and we will get stagflation.

Amanda,

LYS explained it very well:

Lemonyellowschwin wrote:

I think that what Chris K is probably anticipating is a bursting of the treasury bond bubble which would cause a dramatic rise in yields which would cause a dramatic rise in interest rates.

Bonds are the next bubble.  Like all bubbles, it will also burst.  At that point treasury rates will rise.  Another reason they might rise is inflation.  Once the increase in money supply hits the real economy, and inflation kicks in, the Fed will have to raise interest rates (like Volcker did in 1981) in an attempt to prevent inflation from getting out of control.

I highly recommend reading the two full articles that I linked to.  It will explain in detail how this all works and what (in my opinion and the opinion of the author) is likely to happen in the housing market.

As I said previously, there is likely to be a "sweet spot" when prices are still falling and interest rates have not yet risen.  That would be the time to buy.  Unfortunately, it's notoriously difficult to time the market like that.  My intuitive (read: completely uncertain) guess would be 2011-2012 for this sweet spot, but there are so many unpredictable variables involved that I hesitate to even throw a number out.  I'll be watching carefully, that's for sure.

Chris

 

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Re: Why a 50% Drop in Housing is not the Bottom

Keep in mind, though, that regardless of this information it still might be a good time to buy a house if 1) you're not planning on selling it, 2) you are ready to hunker down and plant your garden, get your renewable energy systems going, build relationships with your neighbors, etc.

If you plan on buying and hunkering down, be sure to keep water security in mind and buy something with a well rather than counting on the local water utility to maintain a reliable supply.

 

switters's picture
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Re: Why a 50% Drop in Housing is not the Bottom
JohnV wrote:

If you plan on buying and hunkering down, be sure to keep water security in mind and buy something with a well rather than counting on the local water utility to maintain a reliable supply.

Absolutely!  A rooftop water catchment system with tank in an area receiving more than 30 inches of rain a year is another option.

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Re: Why a 50% Drop in Housing is not the Bottom

FWIW - I recently listed and sold my condo, in just 8 days amazingly enough, because I strongly feel that prices will continue to drop. Prices in my area have "only" dropped about 20% from the highs. Seeing that other markets in the country are down as much as 50%, I'd say we still have a ways to go. I'm going to rent for a year, but keep my eye on land or home w/land prices in the meantime. You may be right Chris K, the sweet spot may be about a year or so away.

Anecdotally, I am on my condo board and a few weeks ago, we met with an executive from a mid-size local bank to discuss a loan for our complex. He indicated they are making loans now, as opposed to January and February when nothing was doing. I quizzed him on TARP, and some other market issues. He admitted, to my surprise, that the economy won't bottom out until real estate bottoms out. And real estate will bottom out only when prices return to the historical home price to income ration of 3 to 1. I was shocked to hear this from a bank exec. of all people!

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Re: Why a 50% Drop in Housing is not the Bottom

I agree on the bond bubble and that when it pops the economic levers the government can pull will be useless.  But I can not wrap my mind around why they continue to talk like they do not understand this danger.  There are very smart people involved.  Why on earth do they keep spinning "the economy is getting worse less quickly" as a good thing?  Is it conflict of interest?  Political expediency?  I just don't buy it that they are dumb to the facts.  Perhaps just blind to them by choice. 

Even if I may disagree on certain policies, I don't blame Obama for delivering on his campaign promises, otherwise he'd be called a hypocrite.  The real test is if he gets re-elected in 2012 whether or not he sets the level for the country... we delivered what people want, now we have to balance the ledger.  I guess the more near term question is whether one or more of the three E's makes the administration do that before the next election.

Stu

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